Question

In the Direct Capitalization method, if the market capitalization rate increases while the Net Operating Income remains constant, what happens to the estimated value of the property?

Accepted Answer

In the Direct Capitalization method, the estimated value of a property is calculated by dividing the Net Operating Income by the capitalization rate. Net Operating Income is the total annual income a property generates after subtracting all operating expenses. The capitalization rate is a percentage that represents the expected rate of return on an investment based on the income the property is expected to generate. Because the capitalization rate is in the denominator of the equation, it has an inverse relationship with the property value. When the Net Operating Income remains constant and the capitalization rate increases, the result of the division must decrease. For example, if a property produces 100,000 dollars in income and the capitalization rate is 10 percent, the value is 1,000,000 dollars. If the rate increases to 12.5 percent while the income stays at 100,000 dollars, the value drops to 800,000 dollars. Therefore, an increase in the capitalization rate always leads to a decrease in the estimated value of the property.

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In the Direct Capitalization method, if the market capitalization rate increases while the Net Operating Income remains constant, what happens to the estimated value of the property?