Income
Capitalization is a
valuation method appraisers and real estate
investors use to estimate the value of
income producing real estate. It is based
upon the premise of anticipation
i.e., the expectation of future benefits.
This method of valuation relates value to
two things: [1] the "market rent" that a
property can be expected to earn and, [2]
the "reversion" (resale) when a property is
sold.
To an
investor, the future cash flows dictate what
the present value should be and what he/she
is willing to pay for the property.
Income
capitalization converts anticipated cash
flows into present value by "capitalizing"
net operating income by a market derived
"capitalization rate".
Essentially, a capitalization rate is a
rate of return on investment much like a
dividend earned on a stock. It is used by
real estate investors as a benchmark for
determining how much they should pay for a
property. In appraisal practice,
capitalization rates are extracted from
"sales" of similar investment properties and
applied to the net income of a subject
property to determine it's value.
There are several ways to estimate value
using "capitalization". These include direct
capitalization and yield capitalization.
The method used depends upon several factors
such as the timing and regularity of the
cash flows, period of time the investment is
held, whether or not long term leases are
involved, and so forth.
Direct capitalization is the most widely
used in residential properties and simplest
approach to apply. It is used when income is
not expected to vary significantly over
time.
Yield capitalization, on the
other hand, requires explicit projects of
income, holding period, and property
reversion and generally considers the income
streams for several years.
Yield capitalization does not
necessarily rely on comparable sales but
does require selection of an appropriate
discount rate and considers the timing of
recapture. Conceptually, yield
capitalization involves the conversion of
future benefits into present value by
applying an appropriate yield rate to the
various cash flows. These future benefits
include any series of periodic incomes with
or without a reversion (resale) of the
property. In the determination of market
value, typical investor’s yields are
applied.
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