Direct Capitalization: An Introduction to Cap Rates

858.259.4900-San-Diego-Commercial-Appraiser-direct-capitalizationIn the income capitalization approach to value, direct capitalization is a method used to convert a single year’s expected income into value. This method is done in one step, by dividing the net operating income estimate by an appropriate income rate.

Direct capitalization is generally used when the property is operating on a stabilized basis. For example, the property is leased at market rents and has a market occupancy rate. This method is also used when there is a sufficient supply of comparable sales to extract capitalization rates, and/or there are enough other methods for determining capitalization rates.

Direct capitalization is less useful when the property is not stabilized. Examples of a property not being stabilized include high vacancy and irregular income/expenses expected in the near future. Additionally, direct capitalization is also less useful when there is not a sufficient supply of comparable sale data.

The advantages of direct capitalization are that it is simple to use and easy to explain, it often expresses the way the market thinks, and it provides strong market value support when there is enough sale data. Disadvantages include the fact that it does not consider individual cash flows beyond one year and that there must be enough sufficient comparable data.

The most basic method of direct capitalization is applying an overall capitalization rate to relate value to the entire property income (i.e., net operating income). The formula for this is as follows: San-Diego-Commercial-Appraisal-Cap-Rate Overall capitalization rates can be estimated with various techniques, which depend on the quantity and quality of data available.  Examples of these techniques include:

  • Comparable sale data (cap rates from comparable sales)
  • Band of investment—mortgage and equity components
  • Band of investment—land and building components
  • Debt coverage analysis
  • Analysis of yield capitalization rates
  • Surveys (Broker, Investors, Owners, etc.)

If you have a stabilized income producing property in San Diego, then direct capitalization may be one of the methods to value your commercial real estate. If you have any questions about direct capitalization, or if you have any San Diego commercial real estate appraisal needs, please contact us today. You can also check out our YouTube Channel, which includes various topics on the commercial appraisal process.

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