Inputs of Direct Capitalization and Discounted Cash Flow Valuation Methods

Inputs of Direct Capitalization and Discounted Cash Flow Valuation Methods

Net Operating Income

The net operating income (NOI) is calculated when using the income approach to evaluate properties. The number of revenues collected from a commercial property net of operating expenses before interest and taxes.

However, NOI is guided by the relevant terms on the lease agreements. Specific clauses may require the occupant to carter their utility bills, which is excluded when calculating NOI.

NOI is calculated as follows:

  1. Determine the potential gross income derived from the property, i.e., rent income + income generated from parking, etc., assuming full occupancy.
  2. Determine the effective gross income by deducting costs related to vacant units and loss on rent collection from the potential gross income.
  3. Determine the operating expenses, excluding interest expense and income taxes.
  4. Deduct the operating expenses from the effective gross income to get the net operating income.

Capitalization Rate

The direct capitalization valuation method embraces both the NOI and cap rate.

The capitalization rate, commonly referred to as the cap rate, is a resulting proportion of NOI compared to the commercial property asset value and is derived as follows:

$$ \text{Capitalization rate (CR)} = \frac {\text{Net operating income (annual NOI)}}{\text{Property cost (value)}} $$

The cap rate is important in commercial real estate valuation since various properties differ in size and scale and thus provide a platform to benchmark similar properties. It also permits for property valuation based on a year’s NOI.

The downside of the cap rate is that it ignores any subsequent increase or decrease in expected cash flows generated over the investment property’s lifetime, making it misrepresentative in determining property market performance.

Discount Rate

The discounted cash flow valuation method utilizes the discounting rate to determine the net present values of future cash flows generated from commercial real estate property.

Typically, the required rate of return or the weighted average cost of capital (WACC) acts as the discounting rate whereby future cash flows are compounded and ensures that the investors’ capital injection into the property investment guarantees the anticipated returns light of the projected property cash flows.

The discount rate utilizes all future cash flows in the holding period to generate the present values instead of the cap rate, which only focuses on a single years’ NOI.


The below information relates to an office building.

  • Size of the property 250,000 sq. ft
  • Gross rental income $30 per sq. ft
  • Other income $85,000
  • Vacancy and rent collection loss 5% of gross rental income.
  • Property taxes and insurance $350,000
  • Utilities and maintenance $900,000
  • Interest expense $395,000
  • Income tax rate 30%

Calculate NOI.

  1. $5,565,000
  2. $5,960,000
  3. $3,895,500


The correct answer is B.

Step 1: Calculate the potential gross income:

$$ \begin{array}{rr} \text{Gross rental income} =(250,000\text{sq. ft} \times $30) = & $7,500,000 \\ \text{Add: Other income } = & $85,000 \\ & \overline{$7,585,000} \end{array} $$

Step 2: Calculate the effective gross income:

$$ \begin{array}{rr} \text{Potential gross income } = & $7,585,000 \\ {\text{Less: vacancy and collection loss } 5\% } & \\ {\times \text{Gross rental income } (5\% \times $7,500,000) }= &\frac{($375,000)}{$7,210,000} \end{array} $$

Step 3: Determine the operating expenses:

$$ \begin{array}{rr} \text{Utilities and maintenance }= & $900,000 \\ \text{Property taxes and insurance }= & $350,000 \\ & \overline {$1,250,000} \end{array} $$

Step 4: Determine the net operating income (NOI):

$$ \begin{array}{rr} \text{Total gross income }= & $7,585,000 \\ \text{Less: Vacancy and collection loss }= & ($375,000) \\ \text{Operating expenses }= & ($1,250,000) \\ & \overline{$5,960,000} \end{array} $$

A is incorrect. The amount considers the deduction of interest expense as part of operating expenses when calculating NOI.

C is incorrect. The amount has factored in the interest and income tax deduction when calculating NOI.

Reading 36: Investment in Real Estate Through Private Vehicles

LOS 36 (c) Estimate and interpret the inputs (for example, net operating income, capitalization rate, and discount rate) to the direct capitalization and discounted cash flow valuation methods.

Shop CFA® Exam Prep

Offered by AnalystPrep

Featured Shop FRM® Exam Prep Learn with Us

    Subscribe to our newsletter and keep up with the latest and greatest tips for success
    Shop Actuarial Exams Prep Shop MBA Admission Exam Prep

    Daniel Glyn
    Daniel Glyn
    I have finished my FRM1 thanks to AnalystPrep. And now using AnalystPrep for my FRM2 preparation. Professor Forjan is brilliant. He gives such good explanations and analogies. And more than anything makes learning fun. A big thank you to Analystprep and Professor Forjan. 5 stars all the way!
    michael walshe
    michael walshe
    Professor James' videos are excellent for understanding the underlying theories behind financial engineering / financial analysis. The AnalystPrep videos were better than any of the others that I searched through on YouTube for providing a clear explanation of some concepts, such as Portfolio theory, CAPM, and Arbitrage Pricing theory. Watching these cleared up many of the unclarities I had in my head. Highly recommended.
    Nyka Smith
    Nyka Smith
    Every concept is very well explained by Nilay Arun. kudos to you man!
    Badr Moubile
    Badr Moubile
    Very helpfull!
    Agustin Olcese
    Agustin Olcese
    Excellent explantions, very clear!
    Jaak Jay
    Jaak Jay
    Awesome content, kudos to Prof.James Frojan
    sindhushree reddy
    sindhushree reddy
    Crisp and short ppt of Frm chapters and great explanation with examples.