Valuation Management Group Capitalization Rates Discussion

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Valuation Management Group Capitalization Rates Discussion

Valuation Management Group stresses the importance of staying educated on the real estate appraisal industry and market trends. Capitalization rates are one of the areas that receive much study and scrutiny within the commercial appraisal world.  Various firms and data services report monthly, quarterly, and annual trend data as it relates to capitalization rates.  Countless articles and discussion have been posted in various forums on this topic.  The VMG Commercial Quality Assurance Review team makes every effort to stay up to date on all of the various industry publications.

Capitalization is the conversion of income to value. A capitalization rate is the rate used to convert income into value.  The rate represents the rate of return on a real estate investment based upon the income that the property is expected to generate.  In general, a lower cap rate indicates there is less risk associated with the investment and a higher cap rate indicates a higher risk alternative.  The risk can be attributable to a variety of factors.  Some of these risk factors include location, construction quality and age, tenant creditworthiness, length remaining on the lease, and various market factors.

Cap rate support in an appraisal report can come from a variety of sources, including extraction from comparable sales, broker/investor interviews, investor surveys, and/or database publications.  Generally, comparable sales are perceived as the most accurate and influential data in this regard.  It is important to understand how the cap rate was derived in the comparables so that the cap rate is applied in the same way to the subject property.  For example, were reserves included above or below the net operation income line.  The Band of Investment or Mortgage Equity Technique can be used as a secondary tool or test of reasonableness for the primary cap rate support.  The Band of Investment formula should be supported with the most current interest rate information and data.  The appraiser can then adjust or load the cap rate based upon dissimilarities in the data group versus the subject property.  An example of when a loaded cap rate may be appropriate is in the case of a property that it under-assessed for taxation.  The appraiser can load the cap rate to account for the anticipated increase in taxes during the next year’s income analysis.  Any cap rate adjustment or load factor should be reasonably and adequately supported and explained in order for the user of the report to follow the analysis and conclusion.

Valuation Management Group strives to ensure that both our clients and vendors are informed of industry methodologies and trends. The VMG Commercial Quality Assurance Review team is composed of Certified General real property appraisers who are knowledgeable in market trends and as such are well-equipped to consider the reasonableness and credibleness of the cap rate support.  Our clients have confidence that appraisals that rely upon a cap rate have been thoroughly reviewed by the commercial team for adequate and relevant support, and that the cap rate within the final report has been found to be reasonable and adequately supported.

Valuation Management Group is a national, full service appraisal management service company that manages the appraisal process for financial institutions, banks, mortgage bankers, and credit unions. We offer the full array of commercial and residential appraisal products and services. We take the appraisal process from ordinary to extraordinary.

Source: Appraisal Institute, The Dictionary of Real Estate Appraisal, 5th ed. (Chicago: Appraisal Institute, 2010).

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