What Is Capitalization?
Capitalization is the process of estimating a value of an asset by using an appropriate percentage rate to convert income generated by that asset into a monetary amount.
What Is The Purpose Of The Capitalization Process?
The capitalization approach is useful in estimating the value of real estate as an investment. Because we have an established net operating income from operating the property, we have a reliable number to begin with, but we do not have an established value.
How Does The Capitalization Process Work?
If we define capital as money or property invested in an asset to create wealth or generate income, then the capitalization approach works backward in order to value the asset. Starting from an income, the capitalization approach applies a rate to the income generated by that asset to determine the monetary value of that asset.
The cap rate allows us to convert the investment property's income into a market value. The cap rate is a percentage rate that is established by the market for similar investment properties.
We can determine the cap rate by looking at recent sales of comparable properties. With a known sales price and net operating income (NOI), we can establish a cap rate to value similar properties.
Capitalization provides a useful approach to determining an amount to be invested in an asset to produce a benchmarked income and generate wealth.