Income Property Valuation Using Capitalization Rate

The income-based perspective is appropriate for valuing investment properties, rather than residential real estate.

Real Estate Capitalization Rate is the required rate of return minus the growth rate; it can be used in conjunction with NOI to value income generating real estate.

Capitalization Rate = R0 = r – g

• 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.