| 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. |
| |
|
Building Capitalization Rate |
| 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. |
| |
|
Equity Capitalization Rate |
| 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. |
| |
| Value of Property =
Mortgage Value + Equity |
| |
|
Mortgage 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. |
| |
|
Overall Capitalization Rate |
| 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) |
| |
|
Residual Techniques |
| 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. |
| |
|
Gross Income Multiplier
(GIM) |
| 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) |
| |
|
Yield
Capitalization |
| 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. |
| |
| See Also |
|
Capitalization |
