Valuing investment property using the capitalized earnings method

Purpose of the capitalized earnings method

This method is used to determine the value of investment properties. This is done by calculating the market value, which, in contrast to methods for owner-occupied real estate, is determined by rental income. This valuation method is mainly used for rented properties or commercial real estate. The method is also used to calculate the value of mixed properties, such as residential buildings with offices and practices as well, that are used as residential and commercial properties on the basis of the surpluses from income and costs. This provides prospective investors and those interested in buying an insight into the benefits of the investment and the potential income they can generate from the property.

Definition and calculation of the capitalized earnings

The term refers to the value of a property based on the expected rent or lease, i.e., the potential income that the property can generate. This important key figure is calculated using various factors. An important element here is the land value, which is added to the building income value of the structure. The costs for the property are then deducted from this, and the result is the capitalized earnings value. This procedure is referred to as the simplified capitalized earnings method. Points to be included are the property interest rate, rental or lease income, and maintenance and hospitality expenses. The structural conditions, i.e. possible damage to be repaired, as well as the so-called multiplier are also important for the calculation of the capitalized earnings value. This is a value determined on the basis of the remaining useful life and the property interest rate.

An example of a simplified capitalized earnings value method may look as follows: If a 500 m² plot of land has a standard land value of 120 euros, this results in a land value of 60,000 euros. A gross profit of 28,000 euros (annual rental income), from which hospitality costs of 4,000 euros are deducted, results in a net profit of 24,000 euros. If the land value interest is 3,000 euros, this is also deducted, so that the building value is 21,000 euros. With a remaining useful life of 25 years, the multiplier is 14. The building income value is now 294,000 euros, adding the land value results in a value of 354,000 euros. If value-influencing circumstances exist, they must be added or subtracted when calculating the capitalized earnings value.

Pros and cons of the capitalized earnings method

The capitalized earnings value method is considered advantageous because it is practical and takes into account real rental income generated by a property. Due to the various factors, it is also an accurate method of calculating the capitalized earnings value. However, there are downsides as well. Thus, the procedure depends on the property interest rate, which, in many cases, cannot be adequately quantified. In addition, this does not take into account possible increases in rental income. This is where the modified capitalized earnings method offers a solution, because it includes not only past income but also simulations of opportunities and risks in the future. Thus, it is more accurate than the simplified capitalized earnings method for real estate.

Capitalized earnings method in practice

It is considerably more complex to calculate the capitalized earnings value than to determine the real estate value using other methods, since the yield is a decisive factor here. For this reason, the method is usually only used for investment properties. Typical areas of application are rented properties, but also commercial properties such as office buildings, retail locations, practice or law firm premises and other commercially used properties. Due to the dynamic development of the real estate market, the modified capitalized earnings value method is also of growing importance in order to determine the value as accurately as possible.