YIELD CAPITALIZATION ANALYSIS

YIELD CAPITALIZATION ANALYSIS

Yield capitalization analysis is a method of converting economic benefits of ownership into present value by
discounting each anticipated benefit at an appropriate yield rate, or by developing an overall capitalization rate
that explicitly reflects the required yield rate and anticipated changes in income and/or value, if any. This
method simulates typical investor assumptions by using formulas that calculate the present value of future
economic benefits based on specified rate of return requirements.

The future economic benefits that are typically considered in this analysis are periodic cash flows and reversion.
The procedure used to convert these future economic benefits into present value is called discounting, and the
required rate of return (or yield rate) is referred to as the discount rate. The discounting procedure is based on
the assumption that the investor will receive an adequate rate of return on the investment, plus return of the
capital invested. Unlike Direct capitalization using market-extracted rates, the method and timing of the returns
on and of capital are explicit in yield capitalization analysis. This valuation method can be used to value the fee
simple interest in a property, or any property interest for which all future economic benefits can be estimated.

The most common form of Yield capitalization analysis is called discounted cash flow analysis. In this
valuation technique, each anticipated future economic benefit of ownership of the property or property interest
being valued must be estimated. Next, each benefit is discounted to present value using a discount rate that
reflects the risk associated with the characteristics of the investment. This rate must be based on market
attitudes and expectations for rates of return for similar assets. Yield rates inherently include a safe, risk-free
rate, along with premiums to compensate the investor for the added risk, illiquidity, and burden of management
associated with the specific investment. The safe rate included in the yield rate includes an inflationary
expectation for the anticipated term of the investment. Finally, the present value of each future income benefit is
summed for the total present value of the property.

The following discounted cash flow analysis example summarizes the application of Yield capitalization
analysis to a simple real estate problem. The property to be appraised is expected to produce a first-year net
operating income of $100,000, which is expected to increase at 3 percent per year over a seven-year holding
period. At the end of the holding period, it is anticipated that the property can be sold for $1,000,000 net of
sales expenses. The appropriate yield rate for this investment is concluded to be 13 percent. The following table
shows the anticipated cash flows, along with the present value factors and the calculated present value of each
year’s cash flow.

Discounted Cash Flow Analysis
Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7
Net oper $100,000 $103,000 $106.090 $109,273 $112,551 $115,927 $119,405
income
Reversion $1,000,000
Total inc $100,000 $103,000 $106,090 $109,273 $112,551 $115,927 $1,119,405
Present val factor x 0.8850 x 0.7831 x 0.6931 x 0.6133 x 0.5428 x 0.4803 x 0.4521
Present value $88,500 $80,659 $73,531 $67,017 $61,093 $55,680 $475,859

TOTAL PRESENT VALUE: $902,339; rounded to $900,000.

(The present value factors in this analysis were calculated using a financial calculator, but could have been
obtained from a set of financial tables.)