— By Jim Popp, as published by Real Estate Forum, December, 2005
differing definitions of market value that are
used to value property for various purposes.”
The basic valuation formula of net operating income divided by capitalization rate equals value strickes a familiar note for almost all property owners. However, the determination of the appropriate capitalization rate is often the most misunderstood part of the property tax valuation process.
At a recent American Property Tax Counsel symposium on cap rates, Jeffrey Fisher, director of the center for real estate studies at Indiana University’s Kelley School of Business, identified the key questions about cap rates: What is a cap rate? What are the sources of cap rates? Are all cap rates calculated the same way? The answers provide guidance on how to avoid cap rate misuse.
A capitalization rate is defined as any rate used to convert income into value. Direct capitalization provides the basis for converting a single year’s expected income into a value measurement. Thus, it would appear that if the income and the value of a property are known, a cap rate might easily be calculated. However, the income and value components of the ratio warrant exploration in the understanding of a cap rate. Income and value mean different things to different people and are calculated differently, depending on their purpose. This ultimately leads to the derivation of cap rates with different meanings.
Cap rates come from a variety of sources. The most common are sales analyses, which come up with a rate by dividing the income of the property by its sales price; interviews with buyers and sellers, which inquire as to the cap rates at the time of sale; and a band of investment analysies, which reviews lender and equity investor requirements.
All cap rates are not calculated on the same basis. The misuse of cap rates begins with the differing definitions of market value that are used to value property for various purposes. Generally, taxing units must meet the requirement to value property for property tax purposes, based on a fee-simple market value definition. To develop a fee-simple market value, market rent, market occupancy and a fee-simple cap rate must be considered. In contrast, most property sales and financing deals use a leased-fee market value definition, thus providing the largest source of cap rate information. The leased-fee market value is derived from contract rent, actual occupancy and a leased-fee cap rate.
The misuse of cap rates occurs because the information is based on leased-fee sales rather than fee-simple market sales. For example, if the property’s NOI comes in above market because of above-market leases, the leased-fee cap rate will be lower than the fee-simple rate, resulting in excess property taxes. The same result occurs if the sold property has an occupancy level that is greater than overall market.
This problem is exacerbated by the fact that cap rates, even for leased-fee properties, are not calculated in the same way. The NOI may be based on different initial calculations. For instance, some include a reserve allowance in the NOI for tenant improvements and leasing commissions. The NOI used in the calculation may be last year’s, this year’s or next year’s. Some use a stabilized NOI as a substitute for an actual figure. For sold properties, the motivations and investment criteria of the sellers and purchasers affect the cap rate. In addition, different expectations for the property’s income growth influence the cap rate. Purchasers also have different criteria for the evaluation of risk. Then, too, different motivations exist for institutional versus non-institutional investors. All of these factors must be considered to understand whether an inappropriate cap rate has been employed.
Finally, another misuse comes to pass when a cap rate derived from the sale of a property, such as a hotel, includes real property as well as personal and intangible property. Each of these three components of a business’ total assets may have a different cap rate. The use of a cap rate for real estate, which has been derived from a sale involving business value, is not appropriate for the valuation of just the real estate component.
Determining whether the tax authorities developed an appropriate cap rate for the valuation of any given property becomes a daunting task. Owners will benefit greatly from having their tax representative probe deeply into the methodologies used by the assessor to derive the cap rate employed in their property’s valuation.
Jim Popp is a partner with the Austin-based law firm of Popp Gray & Hutcheson, a member of American Property Tax Counsel, the national affiliation of property tax attorneys. He can be reached at email@example.com.