Cap Rates vs Yield Rates in the Income Approach

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Synopsis  In the income approach analysis of real property value, there is often confusion as to which rates to use and what these rates represent. In the direct capitalization approach, the cap rate is merely the ratio of stabilized net operating income to sales price – i.e. the property dividend rate.

In discounted cash flow analyses or other yield capitalization techniques, future cash flows are discounted by use of a discount rate which is a true yield rate – which can be directly compared to other before tax, unleveraged return rates such as stock and bond yields, etc.

discussion, crea, competerea, compete real estate, answers, nana smithDiscussion The premise of the Income Approach is that the value of a property is the present value of future benefits of property ownership. All of the Income Approach techniques discount or translate, in some fashion, future net cash flows to a current property value. This is usually done on a before tax, before financing basis and usually deals with the net income stream from the real estate – before financing charges, depreciation or taxes – what appraisers call Net Operating Income (NOI).

dirrect capitalizationDirect capitalization is simply applying an appropriate overall capitalization rate to next year’s stabilized NOI. This cap rate is the property dividend rate or, more popularly, simply the ratio of next year’s NOI to sales price – usually supported by direct market evidence gleaned from other market sales.

cap rate, completerea, CREA, compete real estate asnwers, nana smith, appraiser, stamford, ctProperties that have high demand and / or low risk have cap rates in the low end of the range. Properties that have high risk and / or low demand have cap rates in the high end of the range. Put another way, savvy investors try to pay high cap rates (i.e. relatively low price relative to NOI) while retail type buyers for popular properties have to pay low cap rates (i.e. demand bids the price up for a given income stream).

The strength of Direct Capitalization is its simplicity and familiarity with market players – particularly for smaller commercial properties. A variation of this approach is also used in small rented residential properties – where a gross rent multiplier is applied to stabilized rents. The gross rent multiplier is simply the sales price divided by next years’ stabilized gross rents. Obviously, to be used effectively, the appraiser must know the terms of the lease – i.e. who pays what and also what the likely occupancy will be next year.

Loan Real Estate Stocks
Cap/Dividend Mortgage Constant NOI/Sales Price 1/PE Ratio
Yield/Discount Rate Interest Rate Discount Rate Dividend rate + Price Growth Rate

In other words, the discount rate is the property yield rate and includes a component related to annual income (read an annual dividend with stocks or, alternatively, NOI with real estate) and appreciation at resale (future stock price with stocks or, alternatively, future sales / reversion price of the property at the end of the investment term with real estate). The above discussion reflects property yields that are appropriate for the overall property cash flows. Obviously, a similar analysis could be done for only the equity component of future cash flows (i.e. NOI less debt service) – the resulting present value of the equity would then be added to the mortgage amount to arrive at an indicated property value.

inally, support for cap rates is usually direct market evidence from other sales and these market cap rates are not adjusted but simply used to bracket or select an appropriate cap rate for the subject property. Remember, next year’s NOI is usually used for the subject and therefore should be used on the comparables.

Support for yield rates is usually from market indices such as published yield rates on real estate from surveys of national lenders or from investor interviews or from yield rates required from other alternative investment options.

This article presented By Thomas A. Steitler, MAI

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The Appraisal Institute

The Appraisal Institute has published guidance to help appraisers learn what evaluations are, when they are used and who can prepare them. The Appraisal Institute’s “Guide Note 13: Performing Evaluations of Real Property Collateral for Lenders” addresses how appraisers should prepare an evaluation for a lender and comply with the Uniform Standards of Professional Appraisal Practice (USPAP).crea, complete rea, completerea, stamford ct

The Guide Note states, “Federally insured lending institutions in the United States are subject to regulations regarding real estate appraisals. For lending transactions involving real estate, a lender must obtain an appraisal from a state licensed or certified appraiser. There are 12 exemptions from this requirement. For three of these exemptions, in lieu of an appraisal by a licensed or certified appraiser the lender may obtain an evaluation.”

Evaluations, per the Interagency Appraisal and Evaluation Guidelines, are market value opinions that may be provided by individuals who are not state licensed or certified appraisers. However, state licensed and certified appraisers may provide them, according to the Appraisal Institute’s Guide Note. The interagency guidelines also state that an evaluation must be based on a valuation method that is appropriate for a transaction rather than the method that renders the highest value, lowest cost or fastest turnaround time.

The Appraisal Institute’s Guide Note states that USPAP allows an appraiser to adjust the scope of work for a valuation assignment as long as the resultant value opinion is credible, given the intended use. When preparing an evaluation, the appraiser may consider narrowing the scope of work as appropriate.

According to the interagency guidelines, a lender may obtain an evaluation in lieu of an appraisal when the loan transaction: Has a transaction value equal to or less than $250,000; is a business loan with a transaction value equal to or less than the business loan threshold of $1 million, and is not dependent on the sale of, or rental income derived from, real estate and the primary source of repayment; or involves an existing extension of credit at the lending institution, provided that there has been no obvious and material change in market conditions or physical aspects of the property that threaten the adequacy of the institution’s real estate collateral protection after the transaction, even with the advancement of new monies; or there is no advancement of new monies other than funds necessary to cover reasonable closing costs.

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I have 15-years’ experience as a residential appraiser for Fairfield County, Connecticut. I have extensive, and historically, excellent experience in Real Estate Owned (REO) appraisals for both lenders and various other.

My areas of expertise are mostly comprised in the Lower portion of Fairfield County, particularly; Stamford, Norwalk, Greenwich, New Canaan, Darien, Fairfield and Bridgeport.

Having based my company locally in Stamford, CT has afforded me the ability to stay on top of the current market in Lower Fairfield County as well as gaining comprehensive knowledge of the local REO market.

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Along with being a certified appraiser, I am also a licensed real estate agent, which keeps me up to date on current market conditions.

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