Capitalization is the mathematical process of estimating the present value of income property based on the amount of anticipated annual net income it will produce. Capitalization converts the future income stream into an indication of present worth of property. There are several methods of capitalizing net income. Our discussion will deal with the direct method.

There are four types of capitalization (cap) rates used in the appraisal process:

  • The interest rate is the rate of return on invested capital. It is the same as the yield rate or risk rate. It does not include any provision for the return of investment capital.
  • The recapture rate is the rate at which invested funds are being returned to the owner.
  • The capitalization rate is derived from the interest rate and the recapture rate.
  • The overall rate is derived from the relationship between net income and value for the total property and theoretically provides in one rate for both return on, and recapture of, the capital investment. The overall cap rate is an income rate. Any interest in income producing property can be valued using this rate but appraisers apply it most commonly to fee simple estates.

Capitalization rates may be estimated by several methods:

  • market or sales data;
  • band of investment (uses a weighted average rate by combining a rate for mortgage loan money and a rate for investor's equity); or
  • summation (has very limited use - involves building up a "safe" interest rate based on various risk/investment factors).

Of course, the market or sales data method involves an appraiser's systematic comparison of recent sales of similar properties. The appraiser analyzes each comparison property's sales price, rents, expenses, net income and cap rate, makes needed adjustments and selects an appropriate indicated overall cap rate for the property being appraised. This rate represents both the return on and the return of the investment. To ensure reliability of the selected rate, the appraiser uses judgment and experience to make certain the comparables and the subject property have similar age, physical, location, income, expense and risk characteristics.

Capitalization rate formula. The capitalization rate is a combination of the interest rate (return on the investment) and the recapture rate (return on the investment in improvements). If only the land produces income, the cap rate and interest rate are the same. However, when improvements contribute to the income production, a provision must be made for recapture of the value of the improvements before the end of their economic life. Land has no limited economic life; it will never wear out and thus will always be able to produce income. The building is a wasting asset and cannot be used indefinitely.

The most common method of providing for recapture of the investment in the improvements is the "straight line" method, with the building value recaptured in equal annual installments. The recapture rate is computed by dividing the remaining economic life of the improvements into 100%. Thus, the annual recapture rate for a building with an estimated remaining economic life of 40 years is 2.5% (100% / 40). If the remaining economic life is 25 years, the recapture rate is 4%.

To find the indicated value of income property, divide the net annual income by the capitalization rate:

Net Annual Income divided by Capitalization Rate = Property Value
I / R = V

If any two factors in this formula are known, the third can be obtained.

I = R x V
R = I / V