In the beginning of Lesson 5, we discussed the definition of the income approach to value and the definition of an income stream, in Lesson 6 we discussed components and shapes of the income stream, and Lesson 7 discussed income and expenses and processing gross income down to some net income level. This lesson provides an overview of the process of converting an income stream into value:
Assessors' Handbook Section 501, Basic Appraisal discusses the income approach in Chapter 6. Page 100 through page 102 discusses conversion of income into value and the basic capitalization formula; please read this portion to enhance your learning.
Capitalization is any method used to convert an income stream into value. There are two primary income capitalization methods: direct capitalization and yield capitalization. (A capitalization rate is any rate used to convert an estimate of future income into an estimate of market value.
Direct Capitalization is a method used to convert an estimate of a single year's income expectancy into an indication of value in one direct step. Dividing the income estimate by an appropriate rate or by multiplying the income estimate by an appropriate factor converts the income stream into an estimate of value. In essence, direct capitalization expresses value as a relationship between income and a rate or multiplier. The direct capitalization technique employs capitalization rates and multipliers extracted from comparable sales. Yield and value changes are implied, but not directly identified.
How to derive value by direct capitalization will be discussed in detail in Lesson 9 (Multipliers – Derivation and Valuation) and Lesson 12 (Valuation of Property using Overall Rates).
Yield Capitalization is a capitalization method used to convert future benefits into present value by discounting each future benefit at an appropriate yield rate. The future benefits may also be discounted by developing an overall capitalization rate that explicitly reflects the investment's income pattern, value change, and yield rate. As such, this method is also known as the discounted cash flow (DCF) model. The yield rate represents the multi period rate of return that an investor would expect when investing in the property given the risk of the income stream. Yield capitalization explicitly considers the size, shape, and duration of the income stream and any change in the value of the property. Future income is discounted using the present value factors (PW1 and PW1/P).
How to derive yield capitalization rates will be discussed in Lesson 13 (Derivation of Yield Rates).
Generally, income streams are converted into indicators of value by using rates and factors. The two basic formulas are:
The key variables of income capitalization include: (1) the income to be capitalized; (2) the capitalization rate or factor used to convert the income into a value indicator; and (3) the time period over which the income is to be realized. The capitalization rate or factor must provide for both the return OF the portion of the investment and the return ON the investment.
In its simplest form, the capitalization process may be represented by the equation:
V = I ÷ R