According to the summation method, how is the capitalization rate calculated?

The summation method of calculating the capitalization rate involves the aggregation of various component rates that reflect the different risks and costs associated with an investment property. Specifically, it sums the percentages related to interest (the return on investment), risk (the potential for fluctuations in property value), nonliquidity (the difficulty in quickly selling an asset), and depreciation (the decrease in value over time due to wear and tear or obsolescence).

This comprehensive approach provides a nuanced view of the expected return on the property, accounting for several factors that can influence profitability. By looking at these components, an appraiser or investor can arrive at a capitalization rate that represents the expected yield required by investors given the perceived levels of risk associated with the property.

In contrast, adding depreciation and interest only focuses on just two aspects and neglects other crucial components that impact the overall return on investment. Assessing market value solely bypasses the income-producing aspects of the property. Averaging income over several years does not yield an accurate capitalization rate, as it does not consider the diverse factors impacting risk and return in real estate investment. Thus, the summation method stands out as a comprehensive and effective way to calculate the capitalization rate.