Capitalization

Income capitalization is the market valuation of a property based upon a one-year projection of income. In other words, it relies on a single year’s stabilized NOI to estimate the value of a property. The income capitalization approach estimates the value of a property by applying a proper investment rate of return to the annual net operating income (NOI) expected to be produced by the property, using the IRV formula:

Income (I) ÷ Rate (R) = Value (V)

It may help to think of the IRV formula in the form of a house. The income capitalization method real estate managers use is the same one appraisers use. Two key elements in this formula are the stabilized NOI (I) and the capitalization rate (R).

Stabilized NOI
Stabilized NOI (I) is the true earning potential of the property in the absence of undue or extraordinary circumstances. According to the pro forma statement, it is income adjusted for operating expenses, before considering debt service. An accurately projected NOI is a critical component in determining value.

It is often easiest to estimate the value of a property at present by capitalizing a property’s NOI for the next year. Generally, using next year’s NOI to capitalize is recommended, which reinforces the importance of accurate forecasts. The year chosen makes a difference in setting a property’s market value. The rules about choice of year are informal and flexible, and they differ from locale to locale. Choice of year may also change as the market changes.  

Capitalization Rate

The capitalization rate (R) is the rate of return used to estimate the property’s value based on that property’s net operating income. Often called a cap rate, it is the method for determining the attractiveness of the investment for the owner.

• The lower the capitalization rate, the higher the value of the property

Sources of Capitalization Rates
As you would expect, the capitalization rate varies between properties. Demand for a particular type of property, quality of the property, and future potential benefits are key variables that influence the capitalization rate. In addition, average capitalization rates for each property type are listed in newspapers and on websites such as http://www.realtyrates.com.

Many valuable sources are available for finding accurate cap rates. Appraisers can calculate cap rates, adjust NOI, and estimate the market value of a property with greater skill than someone who has limited training. They are good sources of cap rates.

Other sources of cap rates can be derived from comparable properties that have recently been sold. Enough comparable properties must be considered to have a representative sample.

Major buyers of real estate, such as pension funds, real estate investment companies, and life insurance companies, can be contacted for information on cap rates. These companies are good sources for cap rates for large properties. Other good sources are publications such as the National Real Estate Index, brokers, and banks and other lenders.

IRV Formula
The IRV formula (Income ÷ Rate = Value) can be rearranged to calculate any of its elements: Income (NOI), Rate, or Value.