Direct Capitalization: An Introduction to Cap Rates

858.259.4900-San-Diego-Commercial-Appraiser-direct-capitalizationIn the income capitalization approach to value, direct capitalization is a method used to convert a single year’s expected income into value. This method is done in one step, by dividing the net operating income estimate by an appropriate income rate.

Direct capitalization is generally used when the property is operating on a stabilized basis. For example, the property is leased at market rents and has a market occupancy rate. This method is also used when there is a sufficient supply of comparable sales to extract capitalization rates, and/or there are enough other methods for determining capitalization rates.

Direct capitalization is less useful when the property is not stabilized. Examples of a property not being stabilized include high vacancy and irregular income/expenses expected in the near future. Additionally, direct capitalization is also less useful when there is not a sufficient supply of comparable sale data.

The advantages of direct capitalization are that it is simple to use and easy to explain, it often expresses the way the market thinks, and it provides strong market value support when there is enough sale data. Disadvantages include the fact that it does not consider individual cash flows beyond one year and that there must be enough sufficient comparable data.

The most basic method of direct capitalization is applying an overall capitalization rate to relate value to the entire property income (i.e., net operating income). The formula for this is as follows: San-Diego-Commercial-Appraisal-Cap-Rate Overall capitalization rates can be estimated with various techniques, which depend on the quantity and quality of data available.  Examples of these techniques include:

  • Comparable sale data (cap rates from comparable sales)
  • Band of investment—mortgage and equity components
  • Band of investment—land and building components
  • Debt coverage analysis
  • Analysis of yield capitalization rates
  • Surveys (Broker, Investors, Owners, etc.)

If you have a stabilized income producing property in San Diego, then direct capitalization may be one of the methods to value your commercial real estate. If you have any questions about direct capitalization, or if you have any San Diego commercial real estate appraisal needs, please contact us today. You can also check out our YouTube Channel, which includes various topics on the commercial appraisal process.

Preparing for a Commercial Appraisal: Two Ways to Help Appraisers Produce an Accurate Report

Encinitas-Commercial-AppraiserThere are many components involved in a commercial appraisal. From researching zoning and market conditions to confirming sale and lease data, much of the report preparation is done by appraisers in their office away from the subject property. While this is true, the parties involved with the subject property – whether it is an owner, attorney, accountant, or broker – all play a very important part in helping the appraiser provide an accurate valuation. Here are two ways to help appraisers produce an accurate report.

Property Information

One of the ways to help is to provide as much information about the property as possible, especially if it is an income producing property such as a shopping center or a multi-tenant office. Here are some important items that appraisers will need:

  • Rent Roll: A report showing the current rent information of each tenant is important as it may differ from the lease. For example, the landlord may not enforce rental increases even though they are stated in the lease.
  • Leases: Ideally, it is best to provide the entire lease (as opposed to just the first page with the pertinent information) because it gives the appraiser a chance to review how expenses are handled, information regarding options (if any), and other addenda items such as tenant improvement allowances, free rent, etc.
  • Operating History/Profit and Loss Statement: This includes historical information regarding the subject’s income and expenses (e.g. taxes, insurance, repairs and maintenance, etc.). Generally, an appraiser would like three years of history, year-to-date information, and a projected budget (if available) to look for trends or anomalies. This operating history is typically found in financial reporting software, but can also be found on the Schedule E form of a Tax Return.

Property Inspection

The second way to help an appraiser produce an accurate report involves the property inspection. The objective of the inspection is to take pictures and measurements of the building as well as see the property’s physical and location characteristics (such as deferred maintenance, traffic, surrounding neighborhood influences, etc.).

Typically, it is best for an appraiser to inspect the interior and exterior of the entire property. Therefore, the owner should contact every tenant to let them know of the appraiser’s arrival and that they will be taking pictures and measurements. This may not be possible with all commercial real estate appraisals such as hotel appraisals and apartment appraisals (due to units being occupied or unavailable), so the next best scenario would be to see a representative sampling of each type of unit. For example, if a 20-unit complex includes 10, two-bedroom units and 10, one-bedroom units, then the appraiser should inspect two to three of each type.

Summary

The parties involved with a property being appraised play an important role in helping an appraiser produce an accurate and credible report. Providing as much information as possible as well as assisting the appraiser with inspecting the entire property are important pieces to the appraisal process.

If you have any questions about the appraisal process or real estate valuation, or if you are in need of San Diego appraisal services or valuation consulting, please contact us today.

How to Save Thousands in Appraisal Fees: The Difference Between Appraisals for Lenders and for the IRS

IRS Estate Tax Appraisal San Diego

In the appraisal of real estate, you are probably most familiar with ones for a bank; you want to refinance or sell a property, and an appraiser contracted by the lender comes out to your property and creates an appraisal report that will be used for lending purposes.

However, an appraisal performed for estate tax, planning, or gifting purposes is slightly different. Here’s how:

Different Definition of Market Value

Appraisals for lending purposes are considered to be a federally related transaction, which means that the Federal Deposit Insurance Corporation (or FDIC) or any regulated institution is involved and that the transaction requires the services of an appraiser. These types of appraisals are done based on a definition of market value found on the FDIC website.

On the other hand, appraisals for estate tax purposes are prepared for the Internal Revenue Service (or IRS), which has a different definition of market value.

While the two are somewhat similar, it is important to know the difference because if an appraisal submitted to the IRS has the wrong definition of value, it may be rejected.

Different Intended Users

The other difference between these two appraisals are the intended users of the report. For appraisals used for federally related transactions, the intended user is primarily the lender. However, appraisals for estate tax purposes need to list the IRS as an intended user. Additionally, there are typically other intended users for these types of appraisals, such as accountants who will be preparing your tax documents.

How to Save Thousands on Appraisal Fees

An appraisal firm that specializes in performing appraisals for estate tax purposes is typically familiar with these differences. When considering an appraiser for your estate needs, it is important to interview them and ask if they have experience with preparing appraisals that go to the IRS. As additional screening, you could also ask what definition of market value they would use and who are typically the intended users for such a report (if they give different answers other than above, it might be beneficial to find another appraiser more experienced with this type of valuation).

In short, make sure you conduct your due diligence before hiring an appraiser. Appraisals (especially commercial real estate appraisals) can cost several thousand dollars, and if an appraisal prepared by someone inexperienced is rejected by the IRS, then you may have to order an entirely new appraisal.

Summary

There are a couple differences between appraisals prepared for lenders and appraisals prepared for the IRS. It is best to use an appraisal firm that knows the difference between the two; otherwise, you could end up paying more than you should. If you have any questions about appraisals for the IRS or the appraisal process, please contact us today.

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