What Is Capitalization of Income?

Capitalization of income is a business term that refers to investors and their investments. This is a method of appraising the estimated value of an investment or a potential investment by calculating the expected future earnings from the investment. For instance, if someone wants to buy a piece of commercial real estate, such a person can use the capitalization of income model to estimate how much profit such a property will yield over a set period of time.

A potential real estate investor would take into consideration factors like the going rate for the property, the neighborhood where it is situated, how many units are in the property, and how much he or she can reasonably charge for the rent or lease of the property. If the investor is buying the property for resale at a future date, he or she will consider factors like current trends in the real estate market. Some of the variables might be the possibility of a rise or dip in the price of real estate and if the location of the real estate is experiencing a surge in demand.

The sum total of how much the investor will earn over time, all things being equal, is known as the future cash flow. It is based on these calculations that the investor will decide if the property is a valid investment, and if it is worth the asking price. If the expected future cash flows do not compare favorably to the present going rate, the investor might decide to opt out of investing in that particular deal.

The capitalization of income method for determining the value or expected returns of an investment is mostly used by those in the real estate sector. Such a method is invaluable in determining if a piece of real estate is worth the investment. The investor could also calculate the value of real estate by checking the value of similar properties in order to determine the expected future cash flows.

To this end, if an investor wants to buy a 50-unit apartment complex, an analysis of similar apartment complexes, with the same amenities and in the same district will provide an approximate value of future cash flows. The main purpose of capitalization of income is to reassure investors that their investment is a viable one that will yield proper returns in the future. Investors do not want to invest in property with depreciating value that will not allow them to not only recoup their capital, but to also make profits.