Valuation, income approach (direct capitalization) is a real estate appraisal method that values a property by taking net operating income and dividing it by a predetermined capitalization rate. The income valuation method is not suitable for valuing owner-occupied residential properties, as it relies on income produced as a function of the property’s overall value. The direct capitalization method estimates a single year’s income.
The income capitalization formula is as follows:
Market Value = Net Operating Income (NOI) / Capitalization Rate
After calculating a property’s net operating income, a capitalization rate is determined by using market sales of comparable properties in the area. For example, say an investor finds that Class A apartments in the submarket are trading at a 5.8% cap rate. After determining the appropriate rate, one can divide NOI by the cap rate to determine a value. If the NOI of the Class A apartment was $2.8 million, the property would be valued at approximately $48.275 million ($2.8 million divided by 5.8%). Note that there is an indirect relation between the terminal cap rate and sale value.
There are two instances in which direct capitalization is used. 1.) The property is operating on a stabilized basis. Meaning, it is leased at market rents and occupancies are not outside of the local market norms. If the property had a high vacancy rate, direct capitalization would not be the best valuation method. 2.) There are enough similar properties to extract a reliable capitalization rate.
The major advantages of the direct capitalization method are that it's easy to use and explain. For it to work, though, there must be good comparable sales data.