Direct Capitalization

How Does the Direct Capitalization Method Work?

The direct capitalization method is a standard real estate appraisal method frequently used among industry practitioners to estimate the value of a property.

Under the direct capitalization method – one of the two property appraisal approaches categorized under the “Income Approach” designation – the implied property value is determined by dividing the net operating income (NOI) of a given property by an appropriate cap rate based on market data on comparable properties.

• Net Operating Income (NOI) → The NOI of a property equals the sum of its projected rental income and ancillary income, minus direct operating expenses. The greater the NOI of a property, the higher the property value (and vice versa).
• Cap Rate (%) → The cap rate, shorthand for “capitalization rate,” is the expected return on an income-generating property investment. As the cap rate decreases, the value of the property increases (and vice versa).

By dividing the net operating income (NOI) of a property – most often projected on a twelve-month basis (or until the property has reached stabilization) – by an appropriate cap rate, the projected income stream in one year is converted into an estimate of the property’s value.

Therefore, the direct capitalization method determines the valuation of income-generating, rental properties based on their potential to generate NOI and the market cap rate.

The stabilized NOI and cap rate are each pro-forma measures determined by analyzing the relevant market data on comparable properties around factors such as the current rental rates (i.e. pricing), vacancy rates (or the inverse, occupancy rates), credit loss rates around the collection of rental payments from tenants, and the incurred operating expenses (Opex).

How to Calculate Direct Capitalization Method

The step-by-step process to calculate property value using the direct capitalization method is as follows:

1. Calculate Net Operating Income (NOI) → The initial step is to project the stabilized NOI of the property, where the key operating drivers are the vacancy and credit loss rates, as well as the operating expense assumptions.
2. Determine Cap Rate → The cap rate assumption is determined by compiling market research and analyzing the data on comparable properties currently on sale or was part of a recent transaction to establish parameters to guide pricing.
3. Estimate Property Value (NOI / Cap Rate) → In the final step, the property value can be estimated under the income approach by dividing the stabilized NOI of the property by an appropriate cap rate.

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Direct Capitalization Formula

The formula to perform a real estate appraisal under the direct capitalization method divides a property’s NOI by the market cap rate (%).

Where:

• Net Operating Income (NOI) = (Rental Income + Ancillary Income) – Direct Operating Expenses
• Cap Rate (%) = Net Operating Income (NOI) + Property Value

Conversely, the net operating income (NOI) can be expressed using the following formula.

• Net Operating Income (NOI) = Effective Gross Income (EGI) – Direct Operating Expenses

Where:

• Effective Gross Income (EGI) = Potential Gross Income (PGI) – Vacancy and Credit Losses

Generally speaking, the direct capitalization method is most reliable for stabilized, income-generating properties, where there is more than sufficient market data to support the validity of the cap rate assumption.

The drawback to the direct capitalization method is the implicit assumption that NOI (and operating costs) will remain constant, i.e. the stabilized NOI reflects the income of the property going forward.

With that said, the direct capitalization method is thus most suitable for properties that generate consistent income, where the projected NOI at stabilization is not too far-fetched (and is backed by historical data).