Capitalization (Income) Approach

Income capitalization is a valuation method that appraisers and real estate investors use to estimate the value of income-producing real estate. It is based on the expectation of future benefits. This method of valuation relates value to the market rent that a property can be expected to earn and to the resale value.

Capitalization (income) approach converts income into value.

We all know that a property that brings in more income is worth more. The capitalization approach helps determine exactly how much.

Determining the cap rate is a very difficult part of this approach. 
Methods used to determine the capitalization rate are the market comparison method, the band of investment method, or the summation method.

The cap rate is directly related to risk. A hardware store would have a high cap rate because it is a higher risk. A post office building would have a lower capitalization rate because it is a lower risk. A shopping center would be another place to use this approach.

Capitalization rate or "cap rate" is a measure of the ratio between the net operating income produced by an asset (usually real estate) and its capital cost (the original price paid to buy the asset), or alternatively its current market value. The rate is calculated in a simple fashion as follows:
If a building is purchased for $1,000,000 sale price and it produces $100,000 in positive net operating income (the amount left over after fixed costs and variable costs are subtracted from gross lease income) during one year, then $100,000 / $1,000,000 = 0.10 = 10%
. The asset's capitalization rate is ten percent.

Capitalization rates are an indirect measure of how fast an investment will pay for itself. In the example above, the purchased building will be fully capitalized (pay for itself) after ten years (100% divided by 10%). If the capitalization rate were 5%, the payback period would be twenty years.

Note that a real estate appraisal in the U.S. uses net operating income. Cash flow equals net operating income minus debt service. Where sufficiently detailed information is not available, the capitalization rate will be derived or estimated from net operating income to determine cost, value, or required annual income.