Introduction:
A real estate appraisal is an essential step before buying, selling or investing in any property.
In this article. We will explain two important concepts in real estate valuation: Capitalization rate and discount rate. We explain the difference between the two and how they are used to determine the value of a property.
What is the capitalization rate?
The capitalization rate is a tool used to convert real estate income into value. This rate is used to estimate the recoverable value of the property. That is, the price at which it can be sold in the market.
Methods for calculating the capitalization rate:
- Market Extraction Method: Based on analyzing similar properties that have recently sold.
- Lender Yield Method: This method is used by lenders to determine the interest rate on real estate loans.
- Market survey method: Based on published studies from statistical centers or large real estate companies.
An example of a capitalization rate calculation:
Suppose an apartment building generates a net operating income of SAR 550,000 per year. It was recently sold for 7 million riyals.
Capitalization rate = SAR 550,000 ÷ SAR 7,000,000 = 0.078 or 7.8%
What is the discount rate?
The discount rate is the required rate of return on an investment. This rate is used to discount a property’s future cash flows (such as rents) to determine its current value.
Methods for calculating the discount rate:
- Estimate the opportunity cost of capital:
- Internal Rate of Return (IRR)
- Cumulative model
- Correct the market capitalization rate:
- Weighted Average Cost of Capital (WACC)
The difference between the capitalization rate and the discount rate:
- Capitalization rate: Used to determine the value of an existing property.
- Discount rate: Used to determine the value of the property.
The correlation between the capitalization rate and the discount rate:
- The higher the discount rate. The current value of the property has decreased.
- The lower the discount rate. The current value of the property has increased.
In conclusion:
Understanding the concept of capitalization rate and discount rate is essential to accurately value real estate.
