Real Estate Appraisal: Income Approach to Value Part 2 Selecting an Overall Cap Rate

*Methods of Deriving Market Cap Rates Investor Surveys

An appraiser selecting an appropriate overall rate may be guided by rates reported on similar property types that have sold nationwide. Several real estate organizations collect historical data and investor expectations by surveying investors and other parties to transactions. They periodically publish these surveys for use in real estate analysis. The data applies in varying degrees to a property, but is generally useful to help establish parameters in a market where no similar properties of that type have sold.

Cap Rate Selection

Capitalization rates reflect the expectation of what an investor will earn from property in the future. •If property pays fixed amount of income, what investor is will to pay for property depends on his/her expected rate of return considered market rates of return ("OPPORTUNITY COSTS") and the degree of perceived risk of the property or market.

Yield Capitalization Method

This method and its variants are based on a rate of return on capital and adjusted for anticipated changes in income and value over a projected holding period. Although projected changes are based on market data, projection results do involve some risk and imprecision.

Debt Coverage Ratio Method

This method is based on lender criteria and assumptions of risk. This overall rate is derived from the formula of debt coverage ratio multiplied by loan-to-value ratio multiplied by the mortgage constant. This method relies on a lender's control over a property with regard to the amount of risk reflected in the loan's size, interest rate and term requirements, and the amount of net operating income required to cover the debt. As with the "band-of-investment method," these assumptions are based on both surveys and market data.

Band of Investment Method

This method presumes that a capitalization rate equates to a composite of debt and equity funds. This overall rates is extracted by deriving the weighted average of the mortgage capitalization rate and the equity capitalization rate. Market data components in this equation are the proportions of debt and equity in a typical deal and surveys of mortgage interest and equity return rates as well as actual market data for these components where available. The reliability of this method depends on the accuracy of the analyst's research and the disparity of rates between surveys and actual transactions.

Cap Rate Selection

• An appraiser would use a HIGHER overall cap rate to estimate the value for a property with: 1. Higher than typical risk 2. Excess rent •An appraiser would use a lower overall cap rate to estimate the value for a property with higher than normal expectations for future increases in property value based on the Principle of Anticipation.

Using Overall Cap Rates

•A small change in the overall rate results in a significant change in estimated value. Example: •The estimated value of a property having an NOI of $100,000 and capitalized at 10% is $1 million. ($100,000 ÷ 0.1 = $1,000,000) Assuming the same net operating income but changing the capitalization rate to 12% results in an estimated value of $833,333, a value almost 17% lower. ($100,000 ÷ 0.12 = $833,333.33) •Derivation of the overall rate is an important component of the appraisal analysis.

*Income & Value

•Appraisers estimate the market value of income-producing commercial property using the direct-capitalization approach. •The appraisal technique converts a single year's income into a value estimate by dividing net operating income by an overall capitalization rate. •The calculation simulates the analysis used by many buyers and sellers of this property type.

Market Data Determines Cap Rates

•Capitalization rates are selected by appraisers based on market data. •To select a methodology for estimating an appropriate overall rate for a specific property, the appraisal analyst considers: 1. The characteristics of that property 2. The availability & reliability of market data 3. The level of perceived risk associated with the property 4. How a typical investor would evaluate the property

*Methods of Deriving Market Cap Rates

•Frequently, appraisers use more than one method to substantiate the rate selected. •Ideally, if market assumptions are consistent, the rates derived by various techniques are within a narrow range. •Appraisers use the following methods to support their cap rate selection: 1. Market-Extracted Rates 2. Constructed Rates 3. Investor Surveys

Market-Extracted Cap Rates

•The most RELIABLE and persuasive overall rate is derived from ACTUAL SALES OF SIMILAR PROPERTIES. 1. The rate is extracted from a market transaction by dividing the property's net operating income by its sale price. 2. The rate derived by this formula implicitly includes all of the assumptions about specific investor expectations incorporated in that sale transaction. •Rates derived by this technique are most accurately applied to properties with similar characteristics, such as occupancy, quality, age, and location. •This technique's reliability also depends on the reliability of the transaction's reported income. •The appraiser must make certain that the NOI of each comp is calculated and estimated in the same way that the NOI of the subject property is estimated. Example: Derivation of Overall Cap Rates from Comp Sales Comp.......Sales Price.......NOI....Cap Rate Comp 1...$1,368,500 | $130,418 | 0.0953 Comp 2..$1,425,000 | $134,093 | 0.0941 Comp 3..$1,310,000 | $128,904 | 0.0984 Comp 4.$1,500,000 | $139,200 | 0.0928 Subject Sales Price: $129,900 ÷ 0.0950 =$1,367,368 =$1,370,000 (Rounded) Subject NOI: $129,900 (Calculated using Reconstructed Operating Statement) Subject Cap Rate: 0.0950 (Extracted from Comparable Sale Cap Rates above)

*Deriving Overall Cap Rates Know Your Critical Components

•The overall capitalization rate is a critical component in evaluating income-producing property. •To derive a reasonable and supportable overall rate, an appraiser must consider several ways to develop it. •By using all available market data and considering its proper application, the selected rate will result in a reasonable estimated value.

Market-Extracted Cap Rates & Risk

•The overall level of risk associated with each comparable should be similar to that of the subject property. •Risk can be analyzed by investigating the following: 1. Credit rating of the property's tenants 2. Market conditions for the particular property 3. Stability and durability of the property's income stream 4. Property's upside or downside potential

Using Overall Cap Rates

•The overall rate is one of many assumptions regarding the appraised property and its market that are incorporated into the appraisal. •But this assumption has the largest impact on the concluded value estimate, exceeding the impact of other assumptions, such as vacancy and credit loss, replacement reserve, allowance for tenant improvement and operating-expense projections.

*Constructed Cap Rates

•Various methods allow an analyst to construct an overall rate by analyzing its conceptual components. 3 most commonly used methods: 1. Band of investment method 2. Debt coverage ratio method 3. Yield capitalization method NOTE: The Debt coverage ratio and Yield capitalization method can be used to estimate an overall rat of support rates derived from market sales. However, they are not primary methods of direct capitalization.