Capitalization

Definition

Capitalization in Finance

Capitalization in finance refers to the method of converting anticipated future income into a present lump sum value, using a Capitalization Rate. It is the sum of the Interest Rate and the Recapture Rate. This method is frequently employed in real estate to value properties based on their income-generating potential.

Example:

A property expected to yield an annual income of $10,000 and valued at $80,000 represents the capitalization of the $10,000 income stream. Consequently, if annual property taxes increase by $500, the property’s value would reduce by $6,000 as part of the capitalization process.

Capitalization in Accounting

In accounting, capitalization involves recording an expenditure as an asset on the financial statements rather than expensing it immediately. The asset cost is then depreciated over its useful life.

Example:

A machinery asset with a 15-year depreciable life is capitalized, meaning its cost is spread out and deducted over this period rather than being expensed in a single accounting period.

Examples

1. Real Estate:

   • A commercial building generating an annual rental income of $50,000 is capitalized at a rate of 8%, suggesting a value of $625,000 ($50,000 / 0.08).

2. Accounting:

   • A company purchases office equipment for $20,000, which it expects to use for eight years. The cost is capitalized and amortized over these eight years rather than expensed immediately.

Frequently Asked Questions

What is a Capitalization Rate?

• The capitalization rate, or cap rate, is the rate of return on a real estate investment property based on the expected income that the property will generate. It is calculated by dividing the property’s annual net operating income by its current market value.

Why is capitalization important in real estate?

• Capitalization helps investors determine the current value of a property based on its ability to generate future income. This assists in making informed investment decisions.

How does capitalization affect property value?

• Changes in anticipated periodic income, such as rental payments or property taxes, affect the capitalization rate and thus directly impact the calculated present value of a property.

What distinguishes capitalization in finance from accounting?

• In finance, capitalization focuses on income valuation and property investment returns, while in accounting, it pertains to how expenditures for assets are handled on financial statements.

Related Terms

• Capitalization Rate: A measure used to determine the value of an income-generating property.
• Interest Rate: The proportion of a loan charged as interest to the borrower.
• Recapture Rate: The rate at which investment capital is returned to the investor from the income generated by the investment.
• Depreciable Life: The period over which an asset is expected to be used and therefore the time over which the asset’s cost is spread.
• Net Operating Income (NOI): The income generated from a property after deducting operating expenses, but before deducting taxes and financing costs.

Online Resources

1. Investopedia: Capitalization Definition
2. IRS: Depreciation Overview
3. Real Estate Investment Trusts (REITs) Capitalization Rates

References

1. Brueggeman, William B., and Jeffrey D. Fisher. Real Estate Finance and Investments. McGraw-Hill, 2015.
2. Lynford Graham, Fraud in Financial Statements.pdf (2020).
3. United States. Internal Revenue Service, IRS Publication 946 - How To Depreciate Property.

Suggested Books for Further Studies

1. Principles of Real Estate Practice by Stephen Mettling and David C. Ling: Explains inputs for evaluating real estate and their capitalization.
2. Financial Accounting: An Introduction to Concepts, Methods, and Uses by Roman L. Weil: Delves into concepts of capitalization in accounting.
3. Real Estate Finance & Investments by William B. Brueggeman and Jeffrey D. Fisher: A comprehensive resource on real estate principles.

Real Estate Basics: Capitalization Fundamentals Quiz