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In today's real estate markets, a tremendous emphasis is placed on the income capitalization approach to value, primarily the direct capitalization and discounted cash flow techniques. As a result, there seems to be continuing discussions regarding the relationship between the capitalization rate (R^ sub o^) and yield rate (Y^ sub o^) employed in the respective analyses. This relationship is generally stated in the equation R^ sub o^ = Y^ sub o^- CR, where CR represents the constant ratio change in income and value.
This formula is perhaps the most misunderstood, overused and oversimplified property model. While some professionals swear by it, others disregard it as being completely invalid and not applicable in the real world. This article presents a practical analysis of the relationship between Ro and YO by addressing the inherent problems in the Ro =Yo-CR formula when applied to day-to-day analyses.
In general, there are two assumptions inherent in the R^ sub o^ =Y^ sub o^ -CR formula that many overlook. First, this property model assumes that the capitalization rate and the yield rate are being applied to essentially the same income stream. In other words, the derivation of the income estimates in the two techniques must be the same. In practice, however, investors typically capitalized stabilized net operating income prior to capital cost deductions, while discounting the cash flow estimate after accounting for such costs as tenant improvement allowances and leasing commissions. Consequently, an adjustment to the property model is required.
The second assumption inherent in the model is that income and value grow at the same rate over the assumed holding period, and that the growth occurs on a constant ratio basis. Yet in the discounted cash flow models used by appraisers and investors, the growth in income and the growth in value often differ due to differences in the going-in and terminal capitalization rates as well as deductions for cost of sale in calculating the reversion estimate.
Given these discrepancies between the inherent assumptions in the Ro =Yo -CR model and the practical application of the discounted cash flow models, modifications to the property model are required in order to accurately reflect the relationship between Ro and YO.
Simple Model
The following scenario illustrates the Ro = YO -...