- r = required return on investment
- g = growth of Net Operating Income or appreciation/depreciation rate
- It is not unheard of for “g” to be negative when valuing real estate; this reflects a recapture premium required of the investment.
- NOTE: a discount rate represents the overall required rate of return on an investment, while the capitalization rate (also called the “going-in” rate) is the required return, net of the underlying asset’s growth.
Direct Income Capitalization Approach
The direct income capitalization approach can be used to estimate the market value of income producing real estate, by dividing the net operating income by the capitalization rate.
Market Value: MV0 = NOI / R0
With accurate data, the direct income capitalization approach allows investors to estimate market value in a single step. The challenge is how to determine an accurate capitalization rate.
Determining the Capitalization Rate
Market Extraction Method: As the title indicates, this method allows the analyst to use market data to derive the capitalization rate.
- If the analyst can obtain reliable market data on income and market values, then he/she can back into the cap rate.
- R0 = Net Operating Inc. / Market Value of Comparable Property0
- NOTE: the analyst might not just use data from one comparable property, but calculate several cap rates based on data from several properties and apply an average cap rate to the real estate investment in question.
Built-up Method: In this approach, an analyst will decompose the cap rate into its components and build-up a cap rate for the property under consideration.
- Interest rate: The risk free rate, net of any real estate tax shield.
- Illiquidity premium: Adjustment to account for the inability to quickly sell real estate.
- Recapture premium: Adjustment for appreciation/depreciation.
- Risk premium: Property specific risk.
- Under the built-up method, the cap rate equals the sum of these items.
Band of Investment Method: Allows the capitalization rate to reflect a weighted average cost of capital for instances where both debt and equity financing are used.
- Mortgage Constant: This is an adjusted interest rate to capture the sinking fund factor in a mortgage; the mortgage constant will be used as the cost of debt rate in the WACC calculation.
- Mortgage Constant = Interest Rate + Sinking Fund Factor
- The analyst will apply the weights employed to a mortgage constant and a required return on equity capital to determine a WACC that will be used as the capitalization rate in valuation.
Capitalization Rate Challenges
It can be challenging to determine the “correct” capitalization rate. The rate should reflect expected behavior of investors.
It can be difficult to obtain accurate data around net operating income.
The capitalization rate seeks to capture many fluid considerations, such as: income appreciation, capital appreciation, the financing environment, property liquidity, the need to employ managerial oversight, and the characteristics of cash flows.
