Under this approach, there are two different techniques for converting net operating income into a value indication: 1) direct capitalization, which employs an overall capitalization rate on the net operating income from a stabilized 12-month period and 2) yield capitalization
, which employs an internal rate of return on a stream of annual cash flows and a residual capitalization rate on the reversionary property value at the end of the projected investor holding period.
The yield capitalization
method is a traditional discounted cash flow method, in which net cash flow is projected for several years into the future and discounted to present value by a rate appropriate for the type of investment and the degree of risk.
Two methods are commonly used: the direct capitalization method and the yield capitalization
Of the two basic income capitalization models, direct capitalization and yield capitalization
, direct capitalization is usually the preferred method, as it is perceived to be simple.
It illustrates how value equivalency can be achieved between direct capitalization and yield capitalization
is the most comprehensive method because it includes separate consideration of the return on investment, the growth of income and asset value over time, and reversion.
While the development of market-extracted overall capitalization rates are obviously critical components of direct capitalization, they are also an important element to the correct application of yield capitalization
using discounted cash flows.
This suggests that yield capitalization
, which specifically considers future changes in income and value, would be an appropriate valuation framework.
An excellent reference on how to calculate equivalent level income can be found in Course 510, Session 6: "Stabilizing Income and Yield Capitalization
(DCF) Using an Equity Yield Rate.
This yield capitalization
procedure specifically considers both the equity and mortgage requirements in estimating risk-related effects on overall income capitalization rates.
Correctly and fully incorporates the time value of money and treats all relevant cash flows correctly, making it at least equal to any simplified form of yield capitalization
The problem with any yield capitalization
process is how to select, derive, and use an appropriate yield rate.