Direct Capitalization and Discounted Cash Flow Valuation Methods

Direct capitalization method, the stabilized net operating income (NOI) is divided by the market capitalization rate. In contrast, for the DCF method, the NOI for each year during the holding period plus the salvage value at the end of the period is discounted at the required rate of return to obtain the present value market rates.

In the direct capitalization method, the stabilized NOI is projected based on the market data, i.e., rental rates, vacancies, collection loss rates, and operating expenses for comparable properties in the market. This makes it difficult to justify the projected NOI since it’s based on observed market data and creates a scenario where the property value is understated or overstated when determining the vacancy rate and demand for rental space. DCF method allows for annual adjustments in rental rates, vacancy, collection loss rates, and operating expenses; it reflects an investor’s expectation of growing NOI over time. However, when a property is fully leased and or no anticipated occupancy changes, then DCF doesn’t provide any useful information.

Both methods are appropriate in the valuation of properties in certain circumstances. However, direct capitalization is appropriate for stable NOI properties while DCF is appropriate for properties expected to change NOI; thus, settling for the appropriate capitalization rate and discount rate may prove difficult for both methods.

Question

A real estate property has been rented out at an NOI of $599,000 for the first year, and the capitalization rate on comparable properties is 7%. The value of the property is most likely to be:

1. $ 599,000
2. $ 41,930
3. $ 8,557,143

Solution

The correct answer is C. 

$$ \begin{align*} \text{Value} &=\frac {NOI}{\text{Cap rate}}=\frac {$599,000}{0.07} \\ \text{Value} & = $ 8,557,143 \end{align*} $$

Reading 36: Investment in Real Estate Through Private Vehicles

LOS 36 (b) compare the direct capitalization and discounted cash flow valuation methods.