Capitalization Rate - Use For Valuation

Use For Valuation

In real estate investment, real property is often valued according to projected capitalization rates used as investment criteria. This is done by algebraic manipulation of the formula below:

• Capital Cost (asset price) = Net Operating Income/ Capitalization Rate

For example, in valuing the projected sale price of an apartment building that produces a net operating income of $10,000, if we set a projected capitalization rate at 7%, then the asset value (or price we would pay to own it) is $142,857 (142,857 = 10,000 / .07).

This is often referred to as direct capitalization, and is commonly used for valuing income generating property in a real estate appraisal.

One advantage of capitalization rate valuation is that it is separate from a "market-comparables" approach to an appraisal (which compares 3 valuations: what other similar properties have sold for based on a comparison of physical, location and economic characteristics, actual replacement cost to re-build the structure in addition to the cost of the land and capitalization rates). Given the inefficiency of real estate markets, multiple approaches are generally preferred when valuing a real estate asset. Capitalization rates for similar properties, and particularly for "pure" income properties, are usually compared to ensure that estimated revenue is being properly valued.