Direct Capitalization vs. Yield Capitalization

by Landon M. Scott

Direct Capitalization

Most  newcomers to the vocabulary of commercial real estate will have heard about or have some basic understanding of what a “CAP” rate is. “CAP” generally refers to “Capitalization” (i.e. the process of converting income to value), and more specifically Direct Capitalization. They will likely also know that the equation for a CAP rate is: CAP Rate = Net Operating Income/Value (Net Operating Income divided by the value or sales price of the property).

For example, if you hear someone say that a property sold at a 7.00% CAP rate, they are saying the Net Operating Income of the property in the first year of ownership when capitalized at 7.00% yields the value/sales price of the property TODAY (by the way, the NOI used here is ANTICIPATED – it is an estimate of an NOI that will be realized one year from the date of purchase, so called “Year 1” of ownership).  In other words, the one year monetary yield of the property (the NOI in the twelve months of ownership subsequent to purchase) in relation to the sales price/value is 7.00%. You can think of this CAP as like a dividend, it measures the money the property “spits off” and does not take into account any appreciation or depreciation of the underlying asset.  Under Direct Capitalization only a single number is “directly” capitalized – the Year 1 NOI.

To reiterate, consider that the method of Direct Capitalization gives you the relation between a single year’s income (Year 1) and the value/sales price of the property. Direct Capitalization has nothing to do with anticipated resale value, income in the future, inflation, or anything else that takes place outside the scope of the first year of ownership and the price paid at the beginning of that period. Direct Capitalization reflects a one year return, it has nothing to say about the future. Therefore, to the extent that you believe CAP rates tell you something about how desirable an investment in property is, it is nevertheless a measure of its current desirability only.

Finally, also keep in mind that the CAP rate is a function of the marketplace. That’s why appraisers and brokers talk about “prevailing” CAP rates; real estate markets are typically deep and broad and buyers of real estate are usually price takers and pay something close to the prevailing CAP rate.  And so as to cut down on all the comments to the contrary, I concede that real estate markets are particularly inefficient and that this gives rise to many arbitrage opportunities. But still, buyers are still largely price takers when it comes to commercial real estate, no one buyer can really move the market.


Yield Capitalization

Yield Capitalization is heavily relied on in real estate finance and valuation because properties are long lasting typically; just as equities and bonds take into account the future of the underlying, long-lived corporation or borrower (bonds are debt instruments), so should a piece of real property be valued and priced with a thought towards the future.  Is it not conceivable that inflation could increase, rents could rise due to future capital expenditures like renovations, maintenance and repair costs could climb soon after you assume ownership due to insufficient investments by the prior owner, etc?

There are many factors like those above that are going to make your return on the property change from year to year.  But what about a total return for the entire holding period expressed in an annual rate?  In other words, wouldn’t it be superior to be able to calculate an anticipated, annualized average return for the property for the entire holding period of the property? Of course it would, which is why everybody from commercial real estate appraisers, to investors, to brokers, to regulatory agencies rely on Yield Capitalization, or the conversion of income over a period into a current value.  And instead of the CAP rate, the metric at the heart of Yield Capitalization is the Internal Rate of Return (IRR) (for a systematic explanation of how to calculate the Yield Capitalization rate, see Internal Rate of Return).

Before I go on, and to re-reiterate, I want the reader to consider for a moment how bizarre it is to value a multi-year investment based on a single year’s performance as is done with a CAP rate. Take equities for example: a common way to value stocks is to base the market value upon the anticipation of future years’ income back to the present. All aspects of the business get evaluated to help determine what those future cash flows will look like and both elements external and internal to the firm in question are assessed.  But the takeaway is that all this research is meant to paint a picture of the future, not just the present year. What if this one year period of evaluation was an outlier?

Or how about athletes? What ball club signs a multi-year contract with an expensive new recruit without consideration of his anticipated performance in the future? Who buys gold based only the present desirability of its price, without reflecting on the future prospects of gold? Even the late night TV crowd who buys gold does so because they hear everybody and their brother talk about the rising price of gold. Who looks at the spot price of gold (analysts aside) in exclusion and determines whether it’s too dear or a great buy? Why, then, would anybody buy a multi-million dollar piece of commercial property – which they anticipate holding for more than a single year – based on the performance of a single year? And for those investors who want to base the desirability of a property on last year’s performance (see In-Place CAP rate), the question is even more absurd: why spend millions of dollars on a property based on what happened in the past?

This brings us to the chief objection to the Yield Capitalization approach among those that swear by the CAP rate approach exclusively: “I won’t rely on the Internal Rate of Return because I know what happened in the past but nobody can tell the future!” That is, decisions based upon the past are supportable because there is a record of fact to consult; decisions about the future are purely speculative. Both statements are true, yet the desired inference from those statements is fallacious or at least incomplete; we have no guarantees the future will resemble the past (see Nassim Taleb) and while nobody can be 100% accurate about future events we can assign probabilities to events.  This is where bigger than a bread box and smaller than a jet airliner is actually of some use because at least we know it is bigger than a bread box and smaller than a jet airliner; to ignore that knowledge in your valuation is omitting precious information.

Also consider how silly it is to rely on past performance to the exclusion of what you anticipate to occur in the future. Anybody who bought real estate between 2002 and 2007 perfectly understands that past performance is no guarantee of future performance. Past data might be factual but its reliability lulls one into the trap that there is nothing new under the sun. In finance, at least, the past is certainly NOT prologue.

While nobody can be 100% accurate about future events we can assign probabilities to events. Let’s take a rather crude example to illustrate this point. A family is faced with the choice of buying season passes to Disneyland as they attempt to purchase a day pass only. The season ticket costs 25% more than only the day pass. Last year they went to Disneyland zero times. This year the family moved to a neighboring city (closer than their old home) and Disneyland has put in a handful of new rides and attractions. Also, the children tell their parents all their new friends at school frequently go to Disneyland as they are season pass-holders as well. Should the family purchase the season tickets? I don’t know, but you can see that the decision requires much more than simply considering their past behavior. Assuming they can afford both options and wish to save money, the answer will inevitably center around whether more frequent family visits in the future, as compared to the past, is MORE or LESS PROBABLE. The family can’t tell the future and neither can we, but we all make a million purchase and investment decisions based upon the probability of future outcomes.

“But I’m not an expert, and neither are you!” Let us consider this oft heard retort when you suggest to your investor client that they value a proposed acquisition based upon a period of time out into the future, aka through the Yield Capitalization approach. First of all, I’ll let Taleb try and convince you of the utter worthlessness of “expert” forecasters. But even if you believe “experts” are better able to predict the future than yourself (or your broker), you are still left with a sense of probability that constitutes information. If you decline to incorporate this knowledge into your investment decision process, you are doing yourself a real disservice. We don’t need an expert to tell us that an inflation rate of something more than zero is highly likely  (even in these near deflationary times); that multifamily rents are more likely to rise than fall due to limited construction and an increase in the renter population; that interest rates are likely to raise given that they are near zero now.

Direct Capitalization is convenient, but then so is the microwave. Take some advice and use it as a way to measure how expensive a property is in relation to similar properties currently, not whether it’s a good long term investment. For this, we look to Yield Capitalization. See Required Returns for more information on how an investor should value a proposed acquisition.

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