The capitalization rate is the foundation of
analysis through the Income Capitalization Approach. A major
problem for anyone attempting to estimate the value of real estate by
this method – especially, for appraisers – is
inconsistency in the way the capitalization rate is derived.
An article by this writer (Eric Reenstierna) in the Fall 2008 issue of
The Appraisal Journal, titled “An Argument for Establishing a
Standard Method of Capitalization Rate Derivation,” discusses
the problem and proposes a solution.
Appraisers are always in search of reliable, high-quality
data. When an investor who has bought a building tells us,
“I bought it at a cap rate of 8.2%,” we write that
down in big print, post it on the wall, and maybe send the investor a
box of chocolates. Because the investor has given us
something that to us is as good as gold. It is something that
will inform our decisions of what capitalization rate to apply to any
similar income-producing property. It comes to us
unadulterated. It is from the horse’s
But what have we really got?
Presumably the investor derived the 8.2% rate by simple math, dividing
the property’s net income by the price that was
paid. The next question is, how was the net income calculated?
If this is an apartment building, was the rent that was used to
calculate the gross income the actual rent or the market
rent? These can differ. Did anyone take out a
vacancy allowance? Did the list of expenses include anything
to pay a building manager? Did it use last year’s
heat cost or an estimate for the coming year? With fuel costs
rising and falling all over the chart, those can be worlds
apart. How about a replacement reserve? Did the
list of expenses include one of those? Should it?
Maybe yes. Maybe no.
Depending on whether one group of expenses or another is used, the
capitalization rate that is reported from a given transaction can vary
widely. That 8.2% rate might really be a 7.3% rate, or
9.5%. How were the expenses that produced the 8.2%
capitalization rate derived? Too often, the answer is
“who knows?” The information that we have
enshrined on the office wall may be the key to our next
assignment. Or it may be useless misinformation.
Whichever it is depends on what we know about how it was derived.
Appraisers and everyone else in the industry need transparency in how
rates are reported. We also need standardization.
The same way that the organizations of building management have
established a standard method of calculating the square foot area of a
building – so that, when a broker says, “the
building has 21,000 net rentable square feet,” everyone knows
what that means - appraisers need to establish a standard method of
calculating capitalization rates.
The lack of transparency and standardization affects appraisers more
than anyone. Accuracy is an appraiser’s
business. Our professional organization, The Appraisal
Institute, is a good choice as the agent to develop and promote a
standard method of deriving the capitalization rate that we extract
from any income-producing property that has been sold.
If we can do that – if we can standardize the method of
calculation – we can make our analyses far more
accurate. That is something that we and our clients alike
should seek. It is what appraisers are paid for.