Capitalized income is a business term used in the income capitalization valuation method. In this method, accountants calculate the value of an asset based on both its present worth and expected future income. The term "capitalized income" refers to an asset's future income that is calculated and then added to the purchase price of that asset. This method of value assessment is used only with income-producing assets, such as businesses and real estate.
Rationale
When people buy income-producing assets, they are buying the revenue that these assets will generate in the future. Similarly, when people sell these assets, they lose the regular income the assets produce. So, a fair purchase price should include an estimate of future income. For example, imagine you are selling a restaurant. The restaurant's assets -- chairs, refrigerators and cooking equipment -- add up to $100,000. Asking a $100,000 purchase price would undervalue the restaurant's worth. A fair price would include capitalized income, an estimation of the business's future profits.
Methods of Calculation: Direct Capitalization
Two primary methods of calculating worth using the income capitalization method include direct capitalization and yield capitalization. Direct capitalization is the simplest and fastest method. It requires that you know either the amount of income produced by the asset for one year or the asset's average yearly income. However, the direct capitalization method can be used only when you expect an asset to make the same amount of income year after year.
Methods of Calculation: Yield Capitalization
Use the yield capitalization method to calculate the worth of an asset that will likely produce an income that changes greatly over time. However, calculating yield capitalization is difficult because it requires several years of income information as well as specific future income projections.
Capitalization Rate
The capitalization rate is the ratio of an asset's yearly net income to its purchase price or market value. The capitalization rate shows the degree to which capitalized income is influencing the prices of income-producing assets on the market. The capitalization rate, or cap rate, can help sellers set accurate prices and buyers know when they are getting a fair deal. For example, if the cap rate on the house you want to buy is 10 percent, and most other properties in the neighborhood have an 8 percent cap rate, you may need to negotiate down to get a fair deal.
