Valuing a property by capitalization is generally used in the context of rental investments. In other words, the investor is not buying a property, but rather a return: “given this rent, and wanting a 6% yield, what is the maximum price I want to pay?”.
Capitalization rate = rental yield? No. While the two are similar, the rental yield includes registration fees (transfer duties). The method is called “yield-based valuation” when the yield rate is used.
This article explains how to calculate the value of a property using this methodology.
Theoretical approach
In the capitalization approach, the value is tied to the property’s rental income:
Present value = Net operating income / Capitalization rate
Net operating income is the sum of rent collected, minus expenses (taxes, withholding tax, etc.). The capitalization rate is determined based on observation of the local market and the segment in question. Indeed, the capitalization rate depends on:
- Location: the capitalization rate is lower in prime locations. The underlying logic is that an investor accepts a slightly lower yield if the location is very good. Conversely, to attract an investor to a smaller town, the capitalization rate needs to be higher (proportional to the yield).
- The segment: the capitalization rate in commercial and retail real estate is higher than in residential, notably to cover the risk of rental vacancy (e.g. an unrented office).
To take an example, a rental property with an annual net operating income of €700,000 and a capitalization rate of 6% would be worth €11.7M.
The advantage of this method is that it takes into account the actual yield of the property. On the other hand, it tends to overvalue properties with a good yield (e.g. a student housing building) and undervalue properties with a poor yield (e.g. a single-family house).
In practice, to calculate the value of a property by capitalization, we need two elements:
- The property’s rental income
- The capitalization rate
Determining a rent and a capitalization rate
Using the information available
To determine a property’s rental income, there are three scenarios:
- The building is 100% rented
- The building is partially rented (80% rented: 5 apartments, 1 of which is currently vacant)
- The building is not rented: this is the case if the lease has just ended or if the owner occupied the property
If lease agreements are available, the rental value shown on them can serve as a basis to justify the property’s actual rental income. If the property is not rented or only partially rented, an estimated rental value will need to be determined.
For the capitalization rate, you can rely on market knowledge and an investor’s expectations (minimum yield). But it is always useful to know the yield observed in a specific geographic area and for a particular segment.
Using a market analysis tool
Without market knowledge or a current lease, it is more complicated to establish a reference rent for the expected investment. You can use the comparison-point tool Market Explorer, which lets you extract the following financial information:
- price per square meter;
- rent per square meter;
- gross rental yield (calculated from the two previous values).
Let’s take an example with an apartment of ±90m² in Brussels, Mutsaard neighborhood. Let’s start by entering an address and selecting a market (secondary residential market, for example):
Choosing an address and a reference market in Market Explorer
Once the dropdown menu is collapsed, we click on “More criteria” to reveal the filters panel. This lets us refine the search for our segment (2-3 bedroom apartment) and keep only comparables that are fairly similar in terms of condition and size. Note that the more you filter, the fewer points will appear on the map!
Filtering via the filters panel in Market Explorer
Once the filters are applied, we can freely select a group of points with the Lasso tool (here the Mutsaard neighborhood in Brussels) corresponding precisely to your area of interest.
Selecting a neighborhood and statistical analysis in Market Explorer
We can see that for an apartment of around 90 m² in the neighborhood, the rent will be €927/month (€10.3/m² x 90m²). The capitalization rate for this segment and neighborhood is 4.61%. We can then estimate the value of this property at around €241,000.
Why does the app display “rental yield” instead of capitalization rate? For the sake of simplicity, this terminology was used to be understandable to as many people as possible. The displayed value does not account for registration fees and is therefore comparable to the capitalization rate.
This data forms an excellent basis for the calculation since it accounts for the precise location (thanks to the lasso) as well as the exact typology studied (thanks to the filters).
Conclusion
We have seen what the capitalization valuation method is, and how to determine a market rent and reference capitalization rate for a given segment.
Of course, this article is only intended to illustrate the capitalization calculation and does not replace a viewing, or the involvement of an expert or agent who can assess specific elements that will increase or decrease the value of a property.