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Capitalisation methods estimate the value of an asset (V) by dividing the rent (R) by a rate, or yield (Y), which amounts to capitalising to infinity the flow of income that an asset brings to its owner:

V = R/Y

This apparently very simple method nevertheless raises a few questions:

  • What value does this calculation represent: the selling price or the purchase price? Does it include or exclude registration fees and costs?
  • What rent should be used: gross rent or rent net of charges? Current rent, economic rent, face rent or market rent?
  • What rate should be used: the capitalisation rate or the rate of return?

Let’s explore these questions in detail.

Value

The capitalisation rate establishes the link between the rent and the sale price of a property (its value excluding transfer duties), whereas the rate of return links the rent with the purchase price (its value including transfer duties).

So if you apply the capitalisation rate to the rent, the result of your valuation corresponds to the sale price. If you use the rate of return, you obtain the purchase price.

Similarly, the name of the method varies according to the rate used: the yield method or the capitalisation method. In actual property valuation practice, experts and asset managers today tend to use the rate of return.

Rent

What rent should be capitalised to determine the value of a property?

Gross rent or net rent

Annual rent is always capitalised. This rent may be gross or net of charges.

Gross rent is the rent paid by the tenant, whereas net rent is the income actually received by the owner.

The general rule is to capitalise net rent at the capitalisation/net return rate and to use gross rent when the rate applied is gross.

So, when you capitalise the gross rent, you must offset the charges considered by using a higher rate (the gross capitalisation/return rate).

Actual rent or theoretical rent

Experts also distinguish between two types of rent: actual rent and theoretical rent.

Actual rent is the indexed face rent at the valuation date. The face rent is the annual rent shown on the lease in question. To obtain the actual rent, valuers generally take the rent for the last quarter and multiply it by four. The theoretical rent corresponds to the estimated rental value (ERV), the price that property market players are prepared to pay on average for the annual rental of a similar asset. This price is often expressed in euros per square metre per year on the reference date.

The choice of rent to be capitalised depends on the occupancy of the asset at the valuation date.

Choice of rent for vacant lots

If the asset being valued is vacant, the theoretical rent (ERV) at the valuation date will be used. This is generally defined in €/m².

It sounds easy: just multiply it by the surface area. However, once again we are faced with the problem of choosing the surface area. What type of surface area should be considered? Useful, habitable, gross?

As you already know, this depends on the use of the property.

Choice of rent for rented lots

If the lot is currently leased, a distinction must be made between two periods for valuation purposes:

  • The period up to the expiry of the current lease
  • The period from the day following the expiry of the current lease, to infinity.

Consequently, the income for the first period is the current rent and that for the second period is the market rental value.

Rate

You have already learned that the expert can capitalize the rent at the yield rate or the capitalization rate: the choice of the rate will determine the result of the valuation. The difference between the purchase price and the selling price corresponds to the amount of registration fees paid by the buyer (currently 6.2% – 6.9% of the selling price), as well as other costs related to the purchase of this asset. This partly explains the gap between the yield rate and the capitalization rate.

How is the applicable rate determined?

The rate chosen by the expert is based on recent transactions of comparable properties.

It is then adjusted according to the risk the rent presents: the higher the risk of the income received, the higher the rate.

The French capitalization method suggests using a single rate for the capitalization of both the Estimated Rental Value (ERV) and the current rent, even though it is obvious that the income from the current rent is more secure than that of the ERV, which is only an estimate of future rent.

Conversely, English methods (“term & reversion” and “hard core & top slice”) allow for the distinction between capitalization rates for different rents.

In general, the “term” and “hard core” rates used to calculate the current rent are lower than the “reversion” and “top slice” rates with which the ERV is capitalized. Thus, experts can manipulate the different rates to better reflect their expectations of the real estate market in the value of an asset.

To summarize, here are the relationships between value, rent, and the rate applied by the expert.

  • Purchase Price (Value Including Fees) = Net Annual Rent / Net Yield Rate
  • Purchase Price (Value Including Fees) = Gross Annual Rent / Gross Yield Rate
  • Selling Price (Value Excluding Fees) = Net Annual Rent / Net Capitalization Rate
  • Selling Price (Value Excluding Fees) = Gross Annual Rent / Gross Capitalization Rate

Calculation Methodology

Regarding the calculation technique, this method offers us several options (3):

“The French method”

  • Capitalize the Estimated Rental Value (ERV) in perpetuity (A).
  • Define the gain/loss relative to the current rent or vacancy and calculate its net present value until the expiration of the current lease (B).
  • Add the two together (A + B).

“Term & Reversion”

  • Calculate the net present value of the current rent until its expiration (A).
  • Discount the ERV to the end date of the current lease and capitalize it in perpetuity (B).
  • Add the two together (A + B).

“Hard core & top slice”

  • Capitalize the current rent in perpetuity (A).
  • Define the gain/loss relative to the ERV, discount it to the end date of the current lease and capitalize it in perpetuity (B).
  • Add the two together (A + B).

You can download the Excel file here with the proposed calculations for each of these three techniques.