Direct Capitalization
~13 min read · Apply IRV, extract cap rates from sales, and build one by band of investment.
Direct capitalization is one division: value = NOI ÷ cap rate. The craft is in the rate — extracted from comparable sales, or built from mortgage and equity components by band of investment. IRV in all its rearrangements is guaranteed exam material.
IRV
Income = Rate × Value, so Value = Income ÷ Rate and Rate = Income ÷ Value — the T-bar of income property. Direct capitalization converts ONE stabilized year's NOI into value with an overall capitalization rate (Ro) that embeds the market's total expectations (return ON and OF capital). Rate and value move inversely; a point of cap rate is a large move in value.
- V = I ÷ R; R = I ÷ V; I = R × V
- One stabilized NOI, one overall rate
- Rate up → value down, sharply
Extracting the rate from sales
Market extraction: for each comparable income-property sale, Ro = its NOI ÷ its price. Consistency is everything — the comp NOIs must be computed the SAME way as the subject's (reserves in or out, management imputed, stabilized). Extract several, reconcile toward comps most like the subject in class, risk, and location. Published surveys corroborate; extraction leads.
- Ro = comp NOI ÷ comp price, several times
- Identical NOI methodology across comps and subject
- Reconcile toward the most similar properties
Band of investment
When sales are thin, build the rate from financing reality: Ro = (LTV × mortgage constant) + (equity share × equity cap rate). The mortgage constant (Rm) is annual debt service ÷ loan amount (a function of rate and amortization); the equity capitalization rate (Re, equity dividend rate) is the pre-tax cash-on-cash return equity investors demand. Weighted by the typical financing structure, the components recombine into an overall rate.
Worked example
Subject NOI: $157,347. Three comp sales extract Ro of 7.2%, 7.0%, and 7.4% (the 7.0% comp is most similar). Alternatively: typical financing is 70% LTV at a mortgage constant of 0.0782, and equity investors want an 8.5% cash return. Value the subject both ways.
Extraction: reconcile toward the most-similar comp — conclude Ro ≈ 7.1%. Value = 157,347 ÷ 0.071 = $2,216,155, call it $2,215,000. Band of investment: Ro = (0.70 × 0.0782) + (0.30 × 0.085) = 0.05474 + 0.0255 = 0.0802 → value = 157,347 ÷ 0.0802 = $1,961,933. The two rates disagree (7.1 vs 8.0) — which is information: current financing costs are dragging on what buyers can pay versus what recent sales embedded; the appraiser reconciles, favoring extraction when the sales are good and recent, and explains the spread. Sensitivity check the exam loves: at 8% the same NOI is worth $250,000 less than at 7.1%.
Common exam pitfalls
Extracting rates from inconsistent NOIs.
Reserves, management, and stabilization must be computed identically for comps and subject — else the rate is garbage.
Capitalizing EGI or PGI.
Ro applies to NOI — the rate was extracted from NOIs; feed it anything else and the division lies.
Confusing the mortgage constant with the interest rate.
Rm = annual debt service ÷ loan — it includes principal amortization, so Rm > interest rate on amortizing loans.
IRV runs the division; the market sets the rate — extract it from sales, or weld it from mortgage and equity.
Recap
- V = NOI ÷ Ro; all IRV rearrangements
- Extraction: Ro = NOI ÷ price from consistent comps
- Band of investment: LTV × Rm + equity × Re
- Mortgage constant includes amortization
- Reconcile rates toward the most-similar evidence
- Small rate moves = large value moves
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