How to Figure Capitalization on Real Estate

You can value an office building with the income capitalization approach.

The income capitalization approach is a method of valuing rental property in which you divide the property's net operating income, or NOI, by a capitalization rate to calculate its estimated value. A property's NOI is the amount of income it generates after operating expenses. A capitalization rate, or cap rate, is a percentage based on market data that represents the relationship between a property's NOI and its value. The income capitalization approach requires fewer calculations than other, more complex methods, but uses NOI for only one year, which may overlook changes in income in later years.

Instructions

1. Determine a property's net operating income that you expect it will generate over the next year. NOI equals a property's gross income minus its total operating expenses. Adjust its current NOI for any increase or decrease you expect to occur over the next year. For example, if you expect a property's NOI to increase from $180,000 in the current year to $200,000 in the next year.

2. Determine the average cap rate for similar properties recently sold within the same area as the subject property. You can contact a local broker and ask for average caps rates in your area or find the average cap rate in local real estate market reports published by brokerages and research firms. For example, some properties use a cap rate of six percent.

3. Divide the property's expected NOI for the next year by the cap rate to figure the property's capitalized value. For example, divide $200,000 by six percent. This equals a $3.3 million capitalized value for the property and represents a price for which a buyer may purchase the property on the open market.

References

• Property-Investing.org: Income Capitalization Approach
• Institute of Real Estate Management: Capitalization