Yield Capitalization

A capitalization method used to convert future benefits to present value by discounting each future benefit at an appropriate yield rate or by developing an overall rate that reflects the investment's income pattern, value change, and yield rate. 5

The Income Capitalization Process is not a new concept.  Thousands of pages have been devoted to explaining it and its various components since the beginning of 20^th century.  We strongly recommend that the reader do some reading about the history of the capitalization process. 6 An understanding of how the method has been applied over the years as capitalization techniques have evolved will place the techniques used by Analyst in perspective.

Investment Analyst and the Capitalization Process
The capitalization process is the basis for the techniques that are used in Analyst.  All of these techniques convert an income stream into value.  More specifically, each of the mathematical techniques used by Analyst conforms to the definition of Yield Capitalization, as defined above.  Analyst applies three mathematical techniques.

• Advanced Mortgage Equity Technique
• Present Value Discounting
• Calculation of the Internal Rate of Return

These techniques fall into one of two general categories;
1. Development of an Overall Capitalization Rate
2. Discounted Cash Flow Analysis

Development of an Overall Capitalization Rate
Numerous techniques have been employed over the years to develop an OAR. These include:

• Capitalization in Perpetuity
• The Band of Investment
• The Mortgage Equity Technique - Ellwood Method

The goal of each technique is to develop a capitalization rate that reflects the pattern and timing of the future benefits produced by an investment.  This rate is then applied to (divided into) the current income estimate to produce a present value indication for the investment.  As such, each of these techniques is a form of Yield Capitalization.

The above techniques were each progressively more successful in meeting their goal of converting future benefits into present value.  However each fell short of considering all benefits and costs.

Capitalization in Perpetuity makes no assumptions about the future at all, except that the future will be a continuation of the present - FOREVER. No financing, no changes in income, no future sale of the asset is recognized.

The formula is simple: Net Income / Required Rate of Return = Value

The Band of Investment was an early attempt to mathematically quantify the factors that comprised a capitalization rate. Before computers became widely available and Capitalization Theory was fully developed, the tools to perform this calculation were limited. The best that one could do was to account for Mortgage Financing (by reference to payment tables and later using the HP12C) and the investor's required yield (simple math).

The Mortgage Equity Technique, sometimes referred to as the Ellwood Method, implicitly relies upon the Time Value of Money concept. It builds (develops) a multiplier, referred to as the Capitalization Rate that mathematically represents the series of cash flows produced by an investment over the holding period of the investment. The first year (stabilized) income of the investment is then capitalized to determine the value of the investment's cash flows. The Mortgage Equity Technique is superior to the Band of Investment because it better reflect the circumstances of a real property transaction by recognizing three important factors that are excluded from the Band of Investment.

The investment is typically not held forever - there is a "holding period". There is an "equity buildup" as the mortgage loan is paid down. The investor receives the proceeds of the sale at the end of the holding period.

Advanced Mortgage Equity Technique
Analyst uses a technique that we call the Advanced Mortgage Equity Technique to develop an Overall Capitalization Rate.  In addition to the factors used in the Mortgage Equity Technique, several other factors that influence the investor's yield are incorporated and considered in the development of the OAR. These factors include Closing Costs, Selling Expenses, the Growth Rate for Net Income and the Growth Rate for Value. Including these factors allows one to determine the precise IRR that will be received by the investor.

The value produced by this technique will always equal the value produced by a Discounted Cash Flow Analysis as long as the investment has a level income stream or an income stream that changes at a constant annual rate.

Discounted Cash Flow Analysis
Discounted Cash Flow Analysis (DCF) explicitly discounts each individual cash flow that is produced by an investment.  The sum of these discounted values is equal to the present value of the investment.  The methodology of the Present Value Theory is discussed in detail in the Analyst Manual. Analyst employs two variations of the Present Value Theory. 

Present value discounting

This technique discounts to present value the future benefits that are produced by an investment at an appropriate yield rate

Calculation of the IRR

This technique calculates the Internal Rate of Return of the series of cash flows.  The IRR is calculated in order to provide a separate, independent check that insures that the Present Value Discounting was performed correctly.

OAR and DCF Compared
When the income stream produced by an investment is level or when it changes at a constant rate, the value produced by using an OAR that was developed by the Advanced Mortgage Technique (AMET) is identical to that produced by a DCF.  The techniques are mathematically equivalent under these conditions.  The advantage of using both techniques in a single analysis is the additional proof provided when the same result is achieved using two separate techniques.