The Capitalization Approach to Appraisal

The income capitalization appraisal method works on income-producing real estate only.

Appraisers and real-estate investors use the income capitalization approach to estimate the value of apartment buildings, office buildings and other income-producing real estate. Using this approach, the value of a property is the present value of its future income stream discounted using a capitalization rate, which is a benchmark interest rate for calculating property values.

Facts

Income capitalization converts property income to value. Property value is equal to net operating income divided by capitalization rate. Net operating income is effective gross income minus operating expenses. Effective gross income is potential maximum income or scheduled gross income minus vacancy loss, which includes vacancies and lost collections.

The capitalization rate is the minimum rate of return expected from real estate investment properties. It is equal to net operating income divided by property value and expressed as a percentage. According to the PropEx website, capitalization rates are usually determined from recent sales of similar properties. For example, if a comparable property with an annual operating income of $50,000 sold recently for $1 million, the capitalization rate is 5 percent [100 x ($50,000 / $1 million)].

Direct Capitalization

Direct capitalization is the most widely used income capitalization approach, according to PropEx. It is used for properties with consistent and reliable annual operating incomes and readily available capitalization rates. PropEx cites the example of a multiunit apartment building that generates consistent operating income as an example of a property that can be valued using the direct capitalization approach. Detailed projections of future income are not required because an average net operating income over several years or a single year's income is used to calculate the property value. For example, if a property has a steady annual net operating income of $100,000 and the market capitalization rate is 8 percent, the property value is $1.25 million ($100,000 / 0.08).

Yield Capitalization

Yield capitalization is more complex than direct capitalization. It is based on a property's detailed net operating income projections over several years and potential price appreciation at resale. The net operating income streams are discounted back to the present using an appropriate discount or yield rate. According to Thomas A. Steitler of PropEx, the yield rate can be determined from published real estate yield-rate surveys of national lenders, investor interviews or rates on alternative investments, such as U.S. Treasury securities and high-quality corporate bonds.

Considerations

Capitalization rates and discount rates depend on several factors, including short-term Treasury rates, property location, liquidity and investors' specific rate of return expectations. A property's operating income depends on the overall economy; for example, a recession leads to job losses and lost business revenues, which usually means higher rental-property vacancy rates and lower net operating income.

References

• PropEx: The Income Capitalization Approach
• PropEx; Cap Rates vs. Yield Rates in the Income Approach; Thomas A. Steitler
• The Financial Analyst: Income Capitalization Approach to Property Value; Wayne H. Miller