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Estimating Capitalization Rates – Part III

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In the first two parts of this series, we have introduced and defined four different methods of estimating capitalization rates. In this part of the series, we will take a detailed look at market-derivation methods and the factors that should be considered when extracting market-derived capitalization rates. As has already been discussed in the previous two installments of the series, market derivation is the most reliable and applicable approach in most cases. The band of investment and debt coverage ratio methods are the next best options, and the investor survey method can be a reliable check for the other methods.
The market derivation method is important because it is closely tied to market activity and it can easily be understood my market participants. It provides the best insight into how investors in the subject’s unique market are actually making decisions. Most of the drawbacks of a market derived capitalization rate occur when the appraiser does not consider that these rates are being extracted from comparable properties. The comparable sale that the capitalization rate is being extracted from should share similar characteristics with the subject property. The appraiser must consider if the comparable is similar to the subject in terms of quality, location, investment grade, and occupancy.
The date of sale of a comparable must be considered, in case conditions related to income rates and supply and demand may have changed. Since market derivation is partially a sales analysis, financing terms and conditions of sale should also be considered. Additionally, it is important that the income sources for the comparables be considered. The appraiser should analyze if the leases are at market rates, as well as the credit quality of the current tenants. Another important consideration is the type of buyer. Different types of buyers may have different expectations in regards to return requirements. For example, a real estate investment trust may have different requirements than and institutional buyer. When these factors have been fully considered and similar comparables can be produced, the market derivation rate is very reliable and the other methods can be used as a check. When market extracted capitalization rates are not available, the appraiser can turn to the other methods to produce a capitalization rate. In the final part of this series we will take a look at the factors that must be considered in the reconciliation of a capitalization rate.

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Supporting Capitalization Rates – Part I

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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.