The Income capitalization approach is one of the three major property valuation methodologies.
Two techniques can be used in applying this approach: 1) the direct capitalization technique, which is simpler, and 2) the more sophisticated one that involves the use of the discounted cash flow model. The other two valuation approaches include the sales comparison approach and the cost approach.
The income capitalization methodology is primarily used for the valuation of income-producing properties, that is, properties that are leased to tenants in exchange for rental payments.
Direct Income Capitalization Formula
The direct income capitalization formula is widely used in the property investment formula, especially for very quick and rough calculations of the value of an income producing property by dividing the property’s NOI at the time of analysis or the first year of its holding period by the market capitalization rate. The market capitalization rate is an income rate that reflects the market relationship between a single year’s operating income and market prices.
The analyst needs to very carefully select the capitalization rate used for the particular property, as no property is exactly similar with another one in its physical characteristics, amenities provided, 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
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.
Property value according to this approach 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 and can be calculate from such transactions as the ratio of the NOI over property value:
Capitalization Factor = NOI / Property Value
The capitalization factor is actually equal to the Net Income Multiplier.
Discounted Cash Flow Methodology
The discounted cash flow methodology is a more sophisticated and accurate methodology for estimating the value of an income producing property taking into account the projected detailed cash flow profile of the property over the planned holding period.