CAPITALIZED VALUE METHOD- ALL YOU NEED TO KNOW

CAPITALIZED VALUE METHOD- ALL YOU NEED TO KNOW

Capitalized value is the current worth of an asset, usually real estate, based on a calculation of expected income from the asset over the course of its economic lifespan. Capitalized value is a useful tool for investors to decide whether an asset is a good investment. Normally, capitalized value is estimated by dividing the expected yearly income by the capitalization rate and reducing the sum by a discount rate in order to accurately reflect the present value. The discount rate is needed because the calculation shows future income, and under the time value of money concept, future money is worth less in current money because of inflation and missed interest opportunity. The discount rate is calculated using different methods but usually is determined based on the foregone interest the money could have accrued in other investments.

Both high foreclosure rates and a scarcity of renters can force a rental property owner to sell his property at a loss or allow it to go into a foreclosure process. In some cases, an unexpected down-slide in the real estate market is to blame for the owner’s rental property mishap. In other cases, the failure of the property owner to achieve a desired return on his investment is due to his failure to analyze the income-producing property’s historic and probable performance over time using the capitalized value method.

Purpose

A real estate investor requires the ability to quantitatively measure the performance of an income-producing property at a particular point in time and for a particular time period. Static performance measurements evaluate a property’s performance for a time period, such as a month or a year, or for a specific point in time. In turn, the capitalized value method determines a property’s performance over a series of time periods by identifying the net value, in terms of money, income stream or other benefit that is generated by the property. The conversion of the income stream to a present value of the property is referred to as capitalization.

Theory

The principle of the capitalized value method is that the value of an income-producing property is reflected in the present value of the future net income derived from the property as of a particular valuation date. Capitalization is the process of converting a property’s income stream to a single value, which is the capital that a prudent investor would pay for the property. This value is equal to the forecasted net income for the specified time period. The investor converts this net income to a property’s rate of return, which is compared to that of other income-producing properties to identify the optimal investment.

Method

The investor must estimate the property’s net operating income on the basis of existing market data related to the property in question and that of similar properties. The investor then relies on the property’s rent roll to estimate the property’s gross income. The projected income loss is then calculated, which reflects probable property vacancies and collection actions based on property supply and demand in the particular market and the property’s occupancy history. The probable income loss is subtracted from potential income to obtain the projected gross income. The property’s projected operating expenses, derived from its operating history, are then subtracted from the estimated gross income to determine the net operating income.

 

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