What is the purpose of capitalization in value estimation?

• A. Converts net operating income into a value estimate via a cap rate or a rate.
• B. Calculates gross income before vacancy.
• C. Determines land value independent of income.
• D. Adjusts sale price to replace depreciation.

Answer: (B)

Capitalization is the process of turning the income a property can produce into an estimate of value. It does this by taking net operating income and applying a capitalization rate (or cap rate). The fundamental relation is value equals NOI divided by the cap rate. This shows how market return requirements and risk are reflected in price.

This approach uses net operating income because it accounts for operating expenses and vacancies, focusing on the income after those costs, not just the potential gross income. It differs from simply calculating gross income before vacancy, which would be about potential earnings rather than the property’s value. It also isn’t about determining land value independent of income or about adjusting sale price for depreciation, which are separate concepts in appraisal. For example, if NOI is $100,000 and the cap rate is 8%, the estimated value would be $1,250,000.