Direct Capitalization
This is simply the quotient of dividing the annual net operating income (NOI) by the appropriate capitalization rate (CAP rate). For income-producing real estate, the NOI is the net income of the real estate (but not the business interest) plus any interest expense and non-cash items (e.g. -- depreciation) minus a reserve for replacement. The CAP rate may be determined in one of several ways, including market extraction, band-of-investments, or a built-up method. When appraising complex property, or property which has a risk-adjustment due to unusual factors (e.g. -- contamination), a risk-adjusted cap rate is appropriate. An implicit assumption in direct capitalization is that the cash flow is a perpetuity and the cap rate is a constant. If either cash flows or risk levels are expected to change, then direct capitalization fails and a discounted cash flow method must be used.
In UK practice, Net Income is capitalised by use of market-derived yields. If the property is rack-rented then the All Risks Yield will be used. However, if the passing rent differs from the Estimated Rental Value (ERV), then either the Term & Reversion, Layer or Equivalent Yield methods will be employed. In essence, these entail discounting the different income streams - that of the current or passing rent and that of the reversion to the full rental value - at different adjusted yields.
However, capitalization rate inherently includes the investment-specific risk premium. Each investor may have a different view of risk and, therefore, arrive at a different capitalization rate for a given investment. The relationship becomes clear when the capitalization rate is derived from the discount rate using the build-up cost of capital model. The two are identical whenever the earnings growth rate equals 0.
Read more about this topic: Income Approach
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