Home | Business News | Browse by Publication | A | Appraisal Journal

An argument for establishing a standard method of capitalization derivation.

Article Excerpt
ABSTRACT

A capitalization rate may be extracted from any sale of income-producing real estate for which the selling price and the net income are known. The accuracy of the capitalization rate calculation depends on the accuracy of the information used to derive the net income. Incomplete information produces inaccurate capitalization rates. The quality of the pool of information used by appraisers, lenders, brokers, and investors suffers from inaccurate data, The purpose of this article is to advocate for a standard method of capitalization rate derivation, as well as for the Appraisal Institute to serve as the agent to promote a standard method.

**********

The capitalization rate is essential to any analysis through the income capitalization approach. It is part of the simple, three-part formula involving net income, capitalization rate, and value that allows calculation of the third when any two are known. The analyst who applies a capitalization rate that has been derived through well-founded methods is well on the way to an accurate valuation. The analyst who applies a capitalization rate that has been derived from incomplete data is on the way to an inaccurate, misleading valuation.

The purpose of this article is to point out inconsistencies that produce inaccuracy in the present methods of extracting a capitalization rate from the sale of a commercial property. This article argues for a standard method of capitalization rate derivation, and proposes that the Appraisal Institute serve as the agent to promote such a standard method, to benefit not only appraisers but brokers, lenders, investors, and all who require accuracy in valuation.

The Capitalization Rate

The capitalization rate ([R.sub.o] is the rate that converts net operating income (NOI) into value (V) through the formula V= NOI/[R.sub.o]. The simplest and most direct method of capitalization rate derivation is to divide net income by selling price where both of these can be known, at the date of a property's sale. The selling price is a number that is typically not in dispute. In disclosure states, the selling price is stated in the deed. On occasion, adjustments for seller incentives are required, as in the case of a low-interest loan made by the seller. The net income, on the other hand, is subject to variation, depending on the methods employed by whoever makes the calculation. Inconsistency in the calculation of net income is the primary source of the variation and the resulting bad data that contaminates the data pool used by appraisers in the analysis of commercial real estate.

An Apartment with a Faulty Capitalization Rate

A source of bad data can be seen in a common example from the market.

Suppose that a six-unit apartment building has been sold. The broker who listed the property for sale compiled an income and expense pro forma to be given to prospective buyers. It listed the annual gross income from rents ($60,000) and listed expenses, including the real estate taxes, insurance, utilities, trash removal, grounds maintenance, and painting (in all, $25,000). The property sold for $500,000. When an appraiser calls the broker to verify the sale, the broker provides the appraiser with the additional information that the capitalization rate was 7% (net income of $35,000 divided by...

View this article FREE - Now for a Limited Time, try Goliath Business News
Free for 3 Days!