Property valuation by capitalization is generally used for rental investments. In other words, the investor is not buying a property, but rather a yield: "given this rent, and I want 6% yield, what is the maximum price at which I want to buy?".
Capitalization rate = rental yield?
No. If the two are similar, the rental yield includes fees (registration fees). The method is called "valuation by yield" when the rate of return is used.
This article explains how to calculate the value of your property using this methodology.
Theoretical approach
In the capitalization approach, the value is linked to the property's rental income:
Present Value = Net Operating Income / Capitalization Rate
Net operating income is the sum of rents received, less expenses (taxes, withholding tax, etc.). The capitalization rate is determined based on observation of the local market and the segment in question. The capitalization rate depends on :
- Location: capitalization rates are lower in good locations. The underlying logic is that an investor will accept a slightly lower yield if the location is very good. Conversely, to attract an investor to a smaller city, the capitalization rate needs to be high (proportional to the yield).
- The segment: the capitalization rate for commercial and retail property is higher than for residential property, in particular to cover the risk of tenant vacancy (e.g. an unlet 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 €11.7 million.
The advantage of this method is that it takes into account the actual yield of the property. On the other hand, it tends to overestimate properties with good yields (e.g. student housing) and underestimate properties with poor yields (e.g. single-family homes).
In practice, to calculate the value of an asset by capitalization, we need two elements:
- Rental income from the property
- Capitalization rate
Determining rent and capitalization rate
Using the information available
There are three ways to determine the rental income from a property:
- Either the property is 100% leased
- Either the building is partially let (80% let: 5 apartments, 1 of which is currently empty)
- Either the property is not rented: this is the case if the lease has just expired or if the owner was occupying the property.
If rental leases are available, the rental value indicated above can be used as the basis for justifying the property's actual rental income. If the property is not rented or is only partially rented, an estimated rental value must be determined.
The capitalization rate can be based on knowledge of the market and an investor's expectations (minimum return). But it is always interesting to know the yield observed in a specific geographical area and in a particular segment.
Using a market analysis tool
Without market knowledge or a current lease, it's more complicated to establish a reference rent for the expected investment. You can use the benchmark tool Market Explorerto extract the following financial information:
- price per square metre ;
- rent per square metre ;
- gross rental yield (calculated on the basis of the two previous values).
Let's take an example of a ±90m2 apartment in the Mutsaard district of Brussels. Let's start by entering an address and selecting a market (Secondary residential market, for example):
Once we've collapsed the drop-down menu, we click on "More criteria" to reveal the filter pane. This will enable us to refine the search on our segment (2-3bedroom apartment) and to have only comparables that are fairly similar in terms of condition and surface area. Please note: the more you filter, the fewer points will appear on the map!
When filters are applied, we can freely select a group of points with the Lasso tool (here, the Mutsaard district in Brussels) corresponding precisely to your area of interest.
We can see that for a 90m2 apartment in this neighborhood, the rent would be €927/month (€10.3/m2 x 90m2). The capitalization rate on this segment and in this neighborhood is 4.61%. We can therefore estimate the value of this property at €241,000.
Why does the application display "rental yield" instead of "capitalization rate"?
For the sake of simplicity, this terminology has been used to make it understandable to as many people as possible. The value displayed does not take registration fees into account, and is therefore comparable to the capitalization rate.
These data provide an excellent basis for the calculation, since they take into account 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 reference market rent and capitalization rate for a given segment.
Of course, this article is only intended to illustrate the capitalization calculation and does not replace a visit, the intervention of an expert or an agent who will be able to evaluate specific elements that will increase or decrease the value of a property.