Income capitalization is the process of converting a periodic cash flow into a capital sum.
The mathematics is relatively simple. The annual cash flow sum (usually a net rental) is divided by the
capitalisation rate (otherwise known as ‘cap rate’, ‘yield’ or ‘return’)
For example say the net rental of a building is $50,000 and the investor required yield is 7%. The capitalised
amount is:
$50,000 ÷ 7% = $714,285
What is the Capitalisation Rate?
The Capitalisation Rate is also referred to as either the Cap Rate, Yield or Return (the terms
are used interchangeably).
It is the amount of return that an investor requires to assume the level of risk associated with owning a
particular property. It is always expressed from the investor/purchaser’s point of view.
For example, if we take the previous calculation of $50,000 ÷ 7% = $714,285. This is the amount which the
investor can afford to pay for the property while achieving his/her desired rate of return.
However, if the same investor deemed that there was a higher level of risk associated with owning the
subject property. Say he or she required a return of 8.5% instead of 7%.
The calculation is:
$50,000 ÷ 8.5%= $588,235.
As you can see, the higher the required return the lower the amount an investor can afford to pay for the
property.
How is the Capitalisation Rate Calculated?
There are two main methods:
$75,000 ÷ $950,000 = 7.89%.
The mathematics is relatively simple. The annual cash flow sum (usually a net rental) is divided by the
capitalisation rate (otherwise known as ‘cap rate’, ‘yield’ or ‘return’)
For example say the net rental of a building is $50,000 and the investor required yield is 7%. The capitalised
amount is:
$50,000 ÷ 7% = $714,285
What is the Capitalisation Rate?
The Capitalisation Rate is also referred to as either the Cap Rate, Yield or Return (the terms
are used interchangeably).
It is the amount of return that an investor requires to assume the level of risk associated with owning a
particular property. It is always expressed from the investor/purchaser’s point of view.
For example, if we take the previous calculation of $50,000 ÷ 7% = $714,285. This is the amount which the
investor can afford to pay for the property while achieving his/her desired rate of return.
However, if the same investor deemed that there was a higher level of risk associated with owning the
subject property. Say he or she required a return of 8.5% instead of 7%.
The calculation is:
$50,000 ÷ 8.5%= $588,235.
As you can see, the higher the required return the lower the amount an investor can afford to pay for the
property.
How is the Capitalisation Rate Calculated?
There are two main methods:
- Market Based method - The most generally accepted method is by analysis of market
transactions. We investigate completed sales of similar properties and ascertain what rate of return
other investors have required for this class of asset. Again, say a property sold for $950,000 and the
net rental was $75,000. The capitalization rate is calculated thus:
$75,000 ÷ $950,000 = 7.89%.
- Build-Up method - In the absence of direct market evidence, the build-up method can be used. The
risk free rate is established (often the return from longer term government bonds) and a percentage is
added to reflect the added risk of owning the asset. This method is very subjective and should only be
used in the complete absence of other market evidence.
 |
| |
 |
| |
 |
| |
 |
| |
 |
| |
 |
| |
 |
| Mathematics of Income Capitalisation |
 |  |  |  |  |
| Free Calculators |
| PO BOX 9018, Wellington 6141 | phone: (04) 240-0124 | fax: (04) 232-4414 | email: valuer@ vcnz.co.nz Innovation + Experience |
Risk v Return
The higher the level of risk, the greater the rate of return required to compensate the investor. Commercial
risks include the character of the tenants, quality and age of the building, desirability of the neighbourhood,
amongst others. It is not limited to the building itself but should also include external factors.
The higher the level of risk, the greater the rate of return required to compensate the investor. Commercial
risks include the character of the tenants, quality and age of the building, desirability of the neighbourhood,
amongst others. It is not limited to the building itself but should also include external factors.
|
Innovation + Experience |