Rental Value and Capitalisation Rate
The two inputs every income valuation rests on, and how to take both from the market.
Every income valuation needs two numbers: the net rent the property can earn, and the rate at which to capitalise it. Get either wrong by a small margin and the value moves a lot. At 8%, every ₹1 lakh of net rent is worth ₹12.5 lakh of capital; at 7%, it is worth about ₹14.3 lakh.
Both numbers should come from the market. Rent comes from comparable lettings, and the capitalisation rate from comparable sales of let property. When the market is thin, rent can be built up from cost instead, which is how rent is fixed for many government and institutional leases.
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Kinds of Rent
- Market rent
- The rent a property would let for on the valuation date, between willing parties on normal terms.
- Contractual (passing) rent
- The rent actually payable under the current lease. It may be above or below market rent.
- Standard rent
- The rent fixed under a state rent control law, often far below market rent. A tenancy protected by rent control reduces the landlord's interest sharply.
- Profit rent
- Market rent less rent paid. It is the lessee's gain and the basis for valuing the lessee's interest.
- Ground rent
- Rent for the land alone, typically under a long lease where the lessee builds.
Worked Example: Deriving a Capitalisation Rate
Illustration only. Three let shops on the same Hyderabad high street sold recently. Net rent is rent less the owner's outgoings.
Shop A
Sale price
₹2.00 crore
Net rent a year
₹15.0 lakh
Capitalisation rate
7.50%
Shop B
Sale price
₹1.50 crore
Net rent a year
₹12.0 lakh
Capitalisation rate
8.00%
Shop C
Sale price
₹2.40 crore
Net rent a year
₹18.6 lakh
Capitalisation rate
7.75%
Adopted rate
Sale price
Net rent a year
Capitalisation rate
7.75%
| Comparable | Sale price | Net rent a year | Capitalisation rate |
|---|---|---|---|
| Shop A | ₹2.00 crore | ₹15.0 lakh | 7.50% |
| Shop B | ₹1.50 crore | ₹12.0 lakh | 8.00% |
| Shop C | ₹2.40 crore | ₹18.6 lakh | 7.75% |
| Adopted rate | 7.75% |
Applying the Rate
The subject shop earns ₹10 lakh net a year at market rent. Value = 10 ÷ 0.0775 = ₹129.0 lakh, about ₹1.29 crore. Each comparable's rate is net rent divided by price, so the rate already carries the market's view of risk, location and growth for that kind of property.
The rate and the income must be on the same basis. A net yield applied to gross rent overstates value; a gross yield applied to net rent understates it. Likewise, a rate derived from shops let at market rent should not be applied, unadjusted, to an over-rented or rent-controlled property.
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Fixing Rent From Cost
Illustration only. Used where there is no rental market, for example a building leased to a government department. Land worth ₹50 lakh; building DRC ₹40 lakh; owner bears outgoings of ₹1 lakh a year.
- 1
Return on land
6% of ₹50 lakh = ₹3.0 lakh. Land does not wear out, so a plain return is enough.
- 2
Return on building
8% of ₹40 lakh = ₹3.2 lakh. The higher rate covers the return plus the sinking fund needed to replace the building.
- 3
Add outgoings
₹3.0 + ₹3.2 + ₹1.0 = ₹7.2 lakh a year, or ₹60,000 a month.
Capitalisation Rate vs Discount Rate
A capitalisation rate converts one year's income into value and already allows for expected growth. A discount rate is the full return required and is used in a DCF where growth is shown in the cash flows. For income growing steadily, capitalisation rate is roughly discount rate less growth: 12% less 4% gives 8%.
How the Valuation Examination Tests This
Expect questions that derive a rate from two or three sales, or ask the effect of a rate change on value. The traps: averaging prices instead of rates, mixing gross and net figures, and treating standard rent under a rent control law as if it could be raised to market rent at will.
FAQs
How is the capitalisation rate for property calculated?expand_more
From comparable sales of let property: divide each sale's net annual rent by its price, then adopt a rate from the range, weighting the closest comparables.
What is the difference between market rent and standard rent?expand_more
Market rent is what the property would let for today on open terms. Standard rent is the rent fixed under a rent control law, which can be far lower and limits what the landlord can collect.
What happens to value when the capitalisation rate falls?expand_more
Value rises. ₹10 lakh of net rent is worth ₹125 lakh at 8% and about ₹133 lakh at 7.5%.
Is a capitalisation rate the same as a yield?expand_more
In practice the terms are used together: an all-risks yield is a capitalisation rate derived from market sales. What matters is using a net rate with net income and a gross rate with gross income.
Next steps
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