Capitalization is the process of
converting the income of a property into a
capital value and, more specifically, the
estimating of the present worth of a series
of anticipated future periodic cash flows
through the application of an appropriate
rate or factor, referred to as a
capitalization rate. More than one rate may
be embodied in the factor:
A rate providing for interest on the
investment, (referred to as the discount
rate).
A rate providing for the recapture
of capital (the recapture rate).
Two methods are used to arrive at value
through capitalization: the direct method
and the yield method. Capitalization, using
either method, is most commonly associated
with the income approach to value, one of
three approaches used in the appraisal field
(the others being the direct comparison
approach and the cost approach).
Capitalization, and more specifically the
yield method, is increasingly associated
with the field of real estate investment
analysis.
The ratios expressing a relationship
between annual net operating income and
present worth (value) or sales price. Simply
put, the capitalization rate expresses the
mathematical relationship between the net
operating income that a property produces
and its capital value. Because income
generated by income-producing property can
take different forms and may be measured at
differing levels of net-ness, different
capitalization rates are applicable to
various components of net income.
Capitalization rates are broadly grouped
under income rates and yield rates. Income
rates generally involve ratios derived from
marketplace activity and are not necessarily
tied to expected returns. Yield rates are
derived from investor expectations
concerning anticipated returns on property
with regard to current market conditions.
Income rates are associated with direct
capitalization and yield rates are applied
in the case of yield capitalization.
Two methods are used to arrive
at a capitalization rate:
The direct capitalization
method; and
The yield capitalization
method
The
direct
method is
most
frequently
associated
with small
income
investment
properties.
The yield
capitalization
method
applies more
commonly to
larger
investment-grade
commercial
projects and
properties.
A rate
that
includes
return on
and return
of capital
invested in
improvements,
separate and
apart from
capital
invested in
the
under-lying
land. The
building
capitalization
rate is used
in residual
techniques
which
separate
property
income into
components
attributable
to land and
improvements.
Land exists
in
perpetuity
and is not a
wasting
asset. The
valuation of
land does
not require
a factor for
recapture of
the
investment.
Buildings
have a
terminal
life and
must be
addressed
differently.
The
equity
capitalization
rate
expresses
the
relationship
between cash
flow before
taxes and
the equity
invested in
a comparable
property
Cash Flow
Before Taxes
= Net
Operating
Income –
Annual Debt
Service
Equity =
Value of
Property –
Mortgage
Value
If the
amount of
mortgage
financing on
the subject
property is
known, the
value of the
property can
be
calculated
using the
equity
capitalization
rate.
Expresses
the
relationship
between the
annual debt
service and
the mortgage
value
(remaining
principal
amount). If
the equity
for the
subject
property is
known, the
value of the
property can
be
calculated
by using the
mortgage
capitalization
rate
(frequently
referred to
as the
mortgage
constant),
which
requires
various
assumptions
in order to
arrive at
value.
The
overall
capitalization
rate is made
up of two
rates:
The
rate of
return
on the
investment
(discount
rate).
The
rate of
return
of the
investment
(recapture
rate).
Every
investor is
entitled to
a return on
and of
invested
capital.
When a
capitalization
rate for an
improved
property is
10% or 12%,
the rate is
said to be
blended:
The
rate of
return
on the
money
invested
in both
the land
and the
building
(discount
rate);
and
A
rate of
return
of the
money
invested
in the
building
which is
a
wasting
asset
(recapture
rate).
The blended
rate is
known as an
overall rate
which:
Expresses
the
relationship
between
the
current
year’s
income
and
value;
and
Represents
a blend
of rate
of
return
on the
investment
and rate
of
return
of the
investment.
Value of
Property =
Net
Operating
Income ÷
Overall
Capitalization
Rate
V =
I ÷ R
Two methods
are used to
determine
the overall
capitalization
rate.
Sale
of
Comparable
Properties:
Net
operating
incomes of
comparable
properties
are compared
with their
respective
sale prices.
Properties
must be
highly
comparable,
e.g.,
income/expense
profile,
financing,
age, and
type.
Band
of
Investment
Method:
Equity and
mortgage cap
rates can be
used to
arrive at an
overall
capitalization
rate based
on the
relative
contribution
of equity
and mortgage
components
in the
marketplace.
R =
(Mortgage
Ratio x
Mortgage
Capitalization
Rate) +
(Equity
Ratio x
Equity
Capitalization
Rate)
R =
(Mortgage
Ratio x
Mortgage
Capitalization
Rate) +
Equity
Capitalization
Rate x (1 –
Mortgage
Ratio)
Income
properties
can be
divided into
analytic
components
for
valuation
purposes.
Traditionally,
residual
techniques
applied to
land and
building
(improvement)
components,
but can be
used with
other
components,
e.g., equity
and
mortgage.
Residual
techniques
consist of
four steps.
The
value of
the
known
component
is
capitalized
by the
appropriate
capitalization
rate.
Annual
income
needed
to
support
the
known
component
is
deducted
from
total
net
operating
income
to
derive
the
residual
income
applicable
to the
unknown
component.
The
residual
income
is
capitalized
at an
appropriate
rate to
derive
the
present
value of
the
component.
Add
the
value of
the
residual
component
and the
known
component
to
arrive
at an
estimate
of
value.
The general
term
appropriate
capitalization
rate
requires
emphasis as
the discount
rate applies
in
calculating
residual
values.
Land
Residual
Technique:
This
technique is
used when
the building
value is
known and
the value of
the land is
unknown.
This method
separates an
improved
property
(existing or
projected),
into its
physical
components.
The income
necessary to
provide for
a
competitive
return on
and an
appropriate
recovery of
the building
is deducted
from net
operating
income to
arrive at a
residual.
This
residual
income,
available to
provide a
return on
the capital
invested in
land, is
then
capitalized
at the
appropriate
rate
(discount
rate) to
arrive at an
estimate of
value for
the land.
Building
Residual
Technique:
This
technique is
used when
the land
value is
known and
the value of
the building
is unknown.
This method
separates an
improved
property
(existing or
projected)
into its
physical
components.
When the
value of the
land can be
reliably
estimated
independently,
the residual
income
(after
allowing an
appropriate
return on
the capital
invested in
the land),
is
capitalized
at the
appropriate
capitalization
rate
(building
cap rate),
and added to
the land
value to
arrive at a
total
estimate of
value.
The gross
income
multiplier
expresses
the
relationship
between the
effective
gross income
(alternatively
referred to
as gross
operating
income in
commercial
reference
materials)
and the
value. The
GIM, while
occasionally
discussed
under the
general
topic of
capitalization
rates, is
technically
a multiplier
(the
reciprocal
of a
capitalization
rate), and
is detailed
separately.
However,
from an
overall
perspective,
value is
derived from
similar
facts
concerning
the subject
and
comparable
properties.
Example of
Capitalization
Gross Income
Multiplier
(GIM)
Assume that
the subject
property has
an effective
gross income
of $52,850
and a highly
comparable
property
sold for
$392,000
with an
effective
gross income
of $56,000.
The GIM is
$392,000 ÷
56,000 = 7.
This
multiplier
is then
applied to
the subject
property:
Estimate of
Value = 7 x
$52,850 =
$369,950
(rounded to
$370,000)
Converts
future
benefits
into present
value by
discounting
all future
benefits by
an
appropriate
yield rate
where the
process of
converting
such
benefits is
referred to
as
discounting
and the
yield rate
is commonly
referred to
as the
discount
rate.
Looking to Buy or Sell Luxury
Real Estate In Toronto, North York, Thornhill,
Woodbridge, Vaughan, Richmond Hill, Aurora, King
City and beyond...visit LuxuryBroker.ca
Mortgages247.ca 2011 Apply Online without Blackouts Mortgages247.ca is designed to provide competent and
reliable information regarding the subject matter covered. However it is
provided, free of charge, with the understanding that the authors are not
engaged in rendering legal, financial or other professional advice. Law and
practice often vary from province and province and if legal or other expert
assistance is required, the services of a professional should be sought. The
authors specifically disclaim any liability that is incurred from the use or
application of the contents of this website.
