The income capitalization approach is one of the three major property valuation methodologies. In applying this approach two different techniques can be used: 1) the direct income capitalization technique, which is quite simpler, and 2) the more sophisticated technique that involves the use of the discounted cash flow model.
The income capitalization approach is primarily used for the valuation of income-producing properties, that is, properties that are leased to tenants in exchange for rental payments. The other two main valuation approaches include the sales comparison approach and the cost approach.
Direct Income Capitalization Approach
The direct income capitalization formula is widely used in the real estate investment industry, especially for very quick and rough calculations of the value of a property investment by dividing the property’s Net Operating Income (NOI) at the time of analysis, or the one expected in the first year of its holding period, by the market capitalization rate. The market capitalization rate actually is an initial income return that investors active in the particular marketplace are willing to accept for acquiring a property of similar risk. As such, it also reflects the market relationship between a single year’s net operating income and price for the particular property profile. See our post How to Calculate a Market Cap Rate for a more detailed discussion of the various techniques that can be used for identifying/estimating the market capitalization rate.
The analyst needs to very carefully select the capitalization rate applied to the NOI of a particular property, as no property is exactly similar with another one in its physical characteristics, amenities, design, quality, and location. The capitalization rate used ideally needs to be based on current market arm’s length market transactions and needs to reflect the idiosyncratic characteristics of the property evaluated. Thus, the formula used for the direct capitalization approach is:
Property Value = NOI/Market Cap Rate
Property investors and analysts should use the above formula with extreme caution because the property value estimate is very sensitive to cap rate figure used in the denominator (read our post on the exit cap rate for a more detailed discussion of the sensitivity of value estimates using the above formula). That is why it is extremely important to ensure, as much as possible, that the cap rate used for the particular property is the right one. Notice that market cap rates differ by property type, quality, metropolitan market, strength of location within the metropolitan market, risk characteristics of the property examined, etc.
According to the direct income capitalization approach, the value of the property can also be calculated as the product of the property’s NOI times the capitalization factor:
Property Value = NOI x Capitalization Factor
The capitalization factor is actually equal to one over the capitalization rate and can be calculated from current sales transactions involving properties comparable to the property under consideration in the local property market as:
Capitalization Factor = Property Value/NOI
The capitalization factor is actually equal to the Net Income Multiplier. See our post Property Investment Basics: Gross Income Multiplier for a more detailed discussion of the Net Income Multiplier
Discounted Cash Flow Model
The discounted cash flow model is a more sophisticated application of the income capitalization approach and a more accurate methodology for estimating the value of an income-producing property. It is more accurate than the simple approach discussed above because it takes into account the projected detailed cash flow profile of the property and its timing over the planned holding period. See our post Property Investment Analysis: The Discounted Cash Flow Model for a more detailed discussion of the use of this model in evaluating a property for investment purposes.
Brueggeman, W. B. and Fisher J. D. (1993). Real Estate Finance and Investments. Irwin: Homewood, IL.
Kolbe, P. T., & Greer, G. E. (Author), Gaylon E. Greer. (2012). Investment Analysis for Real Estate Decisions, 8th Edition. Dearborn Real Estate Education.
Clauretie, T. M., & Sirmans, G.S. (2009). Real Estate Finance: Theory and Practice 6th Edition. Oncourse Learning.
Geltner, M., Miller, N. G., Clayton, J., & Eichholtz, P. (2013). Commercial Real Estate Analysis and Investments (with CD-ROM). Oncourse Learning
Sivitanides, P. 2008. Real Estate Investing for Double-Digit Returns. BookSurge Publishing.
Property Investment Basics: Equity Capitalization Rate
Property Investment Analysis: The Discounted Cash Flow Model
Internal Rate of Return (IRR) and Property Investment
Going-in Cap Rate
Exit Cap Rate: A Key Figure in Estimating or … Misestimating the Resale Price