Right Rates, Wrong Rates

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 mouth.  

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.