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Supporting Capitalization Rates – Part II
In the first part of this series we talked about the importance of accurately estimating the capitalization rate within a direct capitalization analysis and briefly introduced four common methods used to estimate a capitalization rate (OAR). In this part of the series we will more thoroughly describe and define these four methods which include market derivation, band of investment, debt coverage ratio, and investor’s survey. As we discussed in the first post, deriving capitalization rates from comparable sales is the favored method.
A market-derived capitalization rate can be characterized by several factors. It is the rate of return on the entire purchase without taking into consideration who contributes the funds (i.e. bank or REIT). The market derived rate is not influenced by the structure of debt and equity. The market derived rate indicates the connection between one year’s net operating income and the total purchase price. The market derived rate does not clearly consider projected future income or changes in property value. The market derived rate represents a going-in rate of return. The reciprocal of the market derived rate is a net income multiplier. If a market-derived capitalization rate is not able to be estimated, the next most credible methods include the construction of an OAR through component parts. The band of investment and debt coverage ratio methods represent two ways to construct an estimated OAR.
Band of investment analysis, by definition, “is a technique in which cash flow rates attributable to components of a capital investment are weighted and combined to derive a weighted average rate attributable to the total investment.” Because most investments are purchased with debt and equity capital, the overall capitalization rate must satisfy the return of both investors. The debt coverage ratio method, or DCR method, is based upon standard underwriting guidelines determined by commercial lenders. It is based on lender’s debt coverage ratio which represents the amount of net operation income needed to cover the debt associated with a property.
Finally, the Investor’s Survey can be used to estimate the OAR and is considered a good check on market-derived and constructed rates. Investors surveys are published by several different outlets and can provide good support in estimating a capitalization rate. In the next part of this series, we will look at the strengths and weaknesses of each of these approaches.
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.