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What is Income Capitalization?

K.C. Bruning
K.C. Bruning

Investors and appraisers in real estate use income capitalization to project the future income-producing value of a property. This valuation method can help a potential buyer to determine the best price for a property based on its anticipated profitability. Income capitalization takes into consideration several factors, including the condition of the property, how it compares to similar properties, the amount of time it was held by the previous owner, and the status of current leases.

Direct capitalization and yield capitalization are two methods by which income capitalization can be determined. The yield capitalization method helps to gauge the current value of a property by determining the expected return on investment. This is calculated primarily by considering patterns of past performance and making projections based on that information. Direct capitalization considers borrowed capital and debt by contrasting market trends with the property under consideration.

Man climbing a rope
Man climbing a rope

One of the most important overall elements of income capitalization is the examination of current market trends in general, and of like properties in particular. This data is compared with the income and losses sustained by the property being considered for purchase. By understanding the value of like properties and the market as a whole, it is possible to gauge whether the property in question is, and has been, living up to market expectations.

Another important facet of income capitalization is the evaluation of risk. This includes an inventory of past and current issues balanced against any potential risk factors. Problematic trends, incidents, and risks associated with like properties may also be included in this assessment.

Once all of the basic elements of a property are expressed in data form, the appraiser can use a series of ratios to calculate a value. A ratio may include information such as operating expenses, debt coverage, and loan-to-value. Ratios are chosen and adjusted according to the characteristics of the property and market. For example, the value of a property with a troubled history or high risk factors will usually be calculated with a different ratio than that of a relatively trouble-free entity.

The income capitalization method is one of three approaches to property valuation. The other two commonly used means of appraisal are cost approach and sales income approach. The cost approach determines value by balancing the current value of the property against any improvements made over time and the depreciation of those improvements. Sales comparison approach primarily takes into consideration the value of comparable properties when determining what would be an acceptable market price for the property.

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