Supporting Capitalization Rates – Part I
The Income Approach is the main approach to value when appraising a property that is purchased for its income producing ability. This series will take a look at one of the key components of the direct capitalization analysis, a common technique used within the Income Approach to value. Direct capitalization is based on the simple formula of Value = Income / Overall Capitalization Rate. The estimation of an appropriate capitalization rate is probably the most critical step in the direct capitalization analysis, since in most cases the historic income data for a property is readily available and fairly reliable, and the future income can be easily estimated. Therefore, the capitalization rate plays a large role in determining the value of a property. Small differences in an estimated capitalization rate can lead to large differences in market value.
For example, let’s consider a 4,000-square-foot office building that is producing an annual net operating income of $50,000 per year. If an overall capitalization rate of 8% is considered it produces a value of the property of $625,000, or $156 per square foot. If an overall capitalization rate of 9% is considered it produces a value of the property of $555,556, or $139 per square, which is almost a $70,000 dollar difference (-11%) in value. This example clearly shows the importance of estimating an accurate and reliable capitalization rate. If a capitalization rate is not property developed it can lead to misleading results. Luckily, there are several methods an appraiser can use to estimate a reliable capitalization rate.
The overall capitalization rate is typically estimated using the market extraction method, the mortgage/equity band of investment method, the debt coverage ratio method, and the investor survey method, all though there are several other ways capitalization rates can be estimated. The most desirable and most reliable method is the market extraction method because the method is based on actual capitalization rates from actual comparable properties. If a market derived rate can be produced it should be still tested against other methods such as the band of investment of debt coverage ratio method. The market extraction method should be used as the primary method, while the other methods should only be considered if no meaningful capitalization rates can be extracted from the market. In part II of this series we will define each of these methods in further detail.