The Income Capitalization Approach and the Cap Rate (Session #5)
Q: If using the Yield model of capitalization to arrive at net present value of the NOI stream of payments, you are using more variables which are all still assumptions than in using the Direct model. Is the Yield model really more reliable?
A: Yes, even though we are using multiple NOI and Capitalization Rate assumptions about future performance. The improved reliability of the Yield model lies in the fact that we are acknowledging that Net Operating Income and Capitalization Rates will change in the future and are making a best effort to estimate those values. In exercising this diligence in establishing expected NOI and Cap Rates over time, we are building the credibility of our ultimate calculation of the property’s estimated value. Better input yields better results.
The Direct model relies on only one definition of NOI and only one definition of the Cap Rate over the designated timeframe. The Direct model completely disregards the fact both metrics will change over time, while the Yield method acknowledges the changes even if they are only estimated. That flexibility is the essence of the better reliability of the Yield method.
As we saw in moving through this session, a fundamental task for us is to remove as much uncertainty as possible from all the Net Operating Income (NOI) components: rents, vacancies, and operating expenses. We also have the responsibility to refine the cap rate by reducing uncertainty when possible as we did in the Yield model example provided.
By estimating these components of the Income Capitalization Method calculation in drawing on historic performance, we further build the credibility of the result.