When appraising commercial real estate based on a property’s income potential, an appraiser uses capitalization to convert income into value. In fact, the definition of capitalization is simply the conversion of income into value.
We have previously discussed direct capitalization, which is the process of converting a single year’s expected income into value in one step, either by dividing net operating income by a capitalization rate (cap rate), or multiplying income by an appropriate factor. Direct capitalization is most commonly used for small commercial properties or properties which have stabilized, predictable income (such as apartment complexes).
Yield Capitalization – What is it?
The other capitalization method used to appraise commercial real estate is yield capitalization, which is defined as the process of converting future benefits into present value. In other words, future cash flows that a property generates are converted into a present value conclusion using an appropriate yield rate. The most commonly used method of using yield capitalization is discounted cash flow analysis, where each future year of income is discounted to present value using a discount rate. While capitalization rates are typically derived from market data (sales that reported a cap rate), discount rates are typically supported by published yield rate data or by interviews with market participants such as investors.
When Does an Appraiser Use Yield Capitalization?
Yield capitalization is often used to value complex commercial properties (such as office towers and shopping centers) or properties which will take several years to become stabilized (such as high vacancy properties, proposed projects, etc.). It is also used to by valuation professionals to estimate value over a given holding period. For example, if an investor plans to purchase a property, hold it for five years, and then sell it, then yield capitalization can be used to determine value based on the projected performance (future cash flows) during the five-year holding period.
What’s the Difference Between Direct and Yield Capitalization?
The main difference between direct and yield capitalization is time. Direct capitalization is based on only a single year’s income, while yield capitalization takes into account several years of cash flows. Depending on the property type, income characteristics, and the overall assignment, one or both methods of capitalization may be appropriate.
If you have any additional questions about yield capitalization, or if you are in need of a discounted cash flow analysis of commercial real estate, please contact us today.