Investing in income-generating real estate involves market data and a degree of subjectivity. One of the most important assumptions that a real estate investor must make when valuing properties is choosing an appropriate capitalization rate. which is the required rate of return on real estate, net of value appreciation or depreciation. Put simply, it is the rate that is applied to net operating income, to determine the present value of a property.

Calculating with Capitalization Rate

For example, if a property that is expected to generate net operating income (NOI) of $1 million over the next 10 years is discounted at a capitalization rate of 14%, the market value of the property would be determined to be $7,142,857 (market value = net operating income / capitalization rate = $1,000,000 / .14). The $7,142,857 market value represents a good deal if the property is selling at $6.5 million and it would be a bad deal if the sale price is $8 million.

Determining the capitalization rate is one of the key metrics in valuing an income-generating property. There are several methods that investors can use to find an appropriate capitalization rate.

Market-Extraction Method

This method assumes that there is current, readily available net operating income and sale price information on comparable income-generating properties. The advantage with the market-extraction method is that the capitalization rate makes the direct income capitalization more meaningful.

Determining the capitalization rate is relatively simple here. Assume an investor is considering buying into a parking lot that is expected to generate $500,000 in net operating income. In the area, there are three existing comparable income generating parking lot properties.

1. Parking lot 1 has a net operating income of $250,000 and a sale price of $3 million. In this case, the capitalization rate is 8.33% ($250,000/$3,000,000).

2. Parking lot 2 has a net operating income of $400,000 and a sale price of $3.95 million. The capitalization rate is 10.13% ($400,000/$3,950,000).

3. Parking lot 3 has a net operating income of $185,000 and a sale price of $2 million. The capitalization rate is 9.25% ($185,000/$2,000,000).

Based on the calculated rates for these three comparable properties (8.33, 10.13 and 9.25%), an overall capitalization rate of 9.4% would be a reasonable representation of the market. Using this capitalization rate, an investor could determine the market value of the property. The parking lot investment opportunity would be valued at $5,319,149 (Market value = Net operating income/overall capitalization rate = $500,000/.094).

Build-up Method

The build-up method is slightly more complex, compared with the market-extraction method. The capitalization rate is achieved by combining interest rate, non-liquidity rate (by which it is illiquid due to the nature of real estate), recapture premium and rate of risk.

Given an interest rate of 4%, a non-liquidity rate of 1.5%, a recapture premium of 1.5% and a rate of risk of 2.5%, the capitalization rate of an equity property would be summed as 11.5% (6+1.5+1.5+2.5). If net operating income was $200,000, the market value of the property would be $1,739,130 ($200,000/.115).

Obviously, performing this calculation is very straightforward. The complexity lies in assessing accurate estimates for the individual components of the capitalization rate, which can be challenging. The advantage of the build-up method is that it attempts to define and accurately measure individual components of a discount rate.

Band-of-Investment Method

The band-of-investment method requires the most advanced calculations of the three methods. The capitalization rate is computed using individual rates of interest for properties that use both debt and equity financing. The advantage of the band-of-investment method is that it is the most appropriate capitalization rate for financed real estate investments.

The first step is to calculate a sinking fund factor. This is the percentage that must be set aside each period to have a certain amount at a future point in time. Assume that a property with net operating income of $950,000 is 50% financed, using debt at 7% interest to be amortized over 15 years. The rest is paid for with equity at a required rate of return of 10%. The sinking fund factor would be calculated as:

Interest rate / 12 months

Plugging in the numbers, we get:

.07/12

This computes to .003154 per month. Per annum, this percentage equals 0.0378 (.003154 x 12 months). The rate at which a lender must be paid equals this sinking fund factor plus the interest rate. In this example, this rate is 10.78%, or .1078 (.07 + .0378).

Thus, the weighted average rate, or the overall capitalization rate, using the 50% weight for debt and 50% weight for equity is 10.39% ([.5 x .1078] + [.5 x .10]). As a result, the market value of the property would be $9,143,407 ($950,000/.1039).

The Bottom Line

These methods are specifically designed for income-generating properties like apartment houses, commercial and industrial properties. It should be noted that these methods are not appropriate for properties that are occupied by owners. Guessing at the value of an income-generating property can lead to inaccurate assessments and failed investments. Selecting an appropriate capitalization rate increases the precision of an appraisal, and thus, the ability to choose good income-generating property investments. (For more related readings, check out How To Analyze Real Estate Investment Trusts . Simple Ways To Invest In Real Estate . and Key Reasons To Invest In Real Estate .)