Cap Rates are the Key to Valuing Income Producing Real Estate
One key tool used by real estate investors and appraisers to value real estate is the cap rate. A cap rate (short for capitalization rate) is essentially the rate of return on an investment that an investor should receive from an income producing property. With this tool investors can compare different income producing properties based on the income each property generates and the amount of the investment needed to purchase each property. The cap rate is calculated by dividing the Net Operating Income of a property by the Purchase Price.
Here is a simple example:
Assume that you are considering purchasing Property X, an income producing with an NOI of $100,000 and an asking price of $1,000,000.
NOI = $100,000
Purchase Price = $1,000,000
100,000 (NOI)/1,000,000(Purchase Price) = 10% Cap Rate
Now consider that another property is for sale, Property Y, an income producing property with an NOI of $75,000 and an asking price of $1,000,000.
NOI = $75,000
Purchase Price = $1,000,000
100,000 (NOI)/1,000,000(Purchase Price) = 7.5% Cap Rate
What do the differences in the cap rates of these two properties convey to an investor? Properties with a lower cap rate tend to be lower risk investments. It may be because of the greater certainty of the income because of long-term leases with reliable tenants. Or it may be because of the demand in the market for a particular property that is expected to increase in value over time. Whatever the reason, properties with lower cap rates are less risky investments than properties with higher cap rates. For that reason, they command a higher purchase price in relation to the NOI that they produce.
In the context of property tax abatements involving income-producing properties, often times a key difference between the municipal appraiser’s value and the taxpayer’s appraiser’s value of a property amounts to a dispute over what is the appropriate cap rate for the property. Each appraiser will collect and interpret data regarding what the market suggests about the cap rate for a property and similar properties. Almost invariably, the municipal appraiser will determine a lower cap rate for an income producing property than the taxpayer’s appraiser.
Using the example of Property X above, except that in the context of the property tax appeal the value of Property X is unknown. What is known is the NOI of Property X is $100,000.
Assume that the municipal appraiser determined that the appropriate cap rate for this property is 7.5%.
$100,000(NOI)/7.5% (Cap Rate) = $1,333,333.
The municipal appraiser’s opinion of value of the property would be $1,333,333 because he or she capitalized the NOI using a 7.5% cap rate.
Now consider the taxpayer’s appraiser determined that the appropriate cap rate for Property X is 10%.
$100,000(NOI)/10% (Cap Rate) = $1,000,000.
The taxpayer’s appraiser’s opinion of value of the property would be $1,000,000 because he or she capitalized the NOI using a 10% cap rate. The difference between the municipal appraiser’s opinion of the cap rate and the taxpayer’s appraiser’s opinion of the cap rate results in a 33% difference in value for Property X.
In order to obtain a favorable outcome, it is important that the information presented during a property tax appeal supports the cap rate that produces a lower value than the assessment. It may be in the form of cap rates from sales in the market for which the property being appealed would be sold in. Alternatively, an appraiser may rely on surveys to extrapolate the cap rate for the market the property would be sold in. In the end the cap rate that is appropriate for the property is one that is most likely to represent the rate of return that an investor would require based on the risk involved in the asset.
Allobar Strategies, a property tax consulting firm has ability to assist taxpayers with issues with their tax assessment and how to file a tax abatement. Explaining capitalization rates in an effective manner in connection with a property tax appeal is a way that Allobar Strategies can assist clients in order to obtain the best results.
By: John F. Hayes, Esq., General Counsel/Senior Tax Representative to Allobar Strategies and former general counsel to the New Hampshire Department of Revenue Administration