Direct capitalization is used to convert a single year's income into a value estimate. The income is converted by a capitalization rate. Capitalization rates can be determined in a variety of ways, but the best way is to derive them from market transactions of similar properties. The overall capitalization rate is determined by dividing a single year's net operating income (NOI) by the sale price of the comparable property. From an adequate sample of market transactions an appropriate capitalization rate can be reconciled and used to estimate the value of similar properties.
If you have a 10 year old community retail center in "Eastside Neighorhood" then ideally you will use sales of retail centers in this neighborhood, that are similar in age, quality, size, etc. You must be certain that the sale comparables used have net operating income calculated in the same way as the subject NOI. Any financing that affected the sale prices of the comparables requires adjustment, as do nonmarket rents. The objective is to compare apples to apples, because a small change in capitalization rate can result in a big difference in the value estimate.
Once the appropriate capitalization rate has been derived you can generate a value estimate. Divide the NOI of the subject property by the capitalization rate to get the value estimate. The lower the capitalization rate, the higher the value, and the higher the capitalization rate the lower the value. In good times cap rates are low because investors are willing to pay a higher multiple of NOI for the right properties. When times are tougher, as they were in the Great Recession, capitalization rates rise because risk tolerance falls and investors will only pay a lower multiple of NOI for properties.
When you are developing a value estimate for a property tax appeal you want to use the highest capitalization rate that you can. You will probably have to pay for capitalization rate information. Appraisers and other commercial property professionals put a lot of time and effort into discerning the NOI on many transactions. They do not perform this research free of charge. There are several sources of capitalization rate information available for a fee. RealtyRates.com, Real Estate Research Corporation or RERC.com, PwC Real Estate Investor Survey at pwc.com, and CoStar.com are some of the companies that I use that provide capitalization rate information.
CoStar has cap rate information on individual properties. The others are all surveys of market participants and the capitalization rates do not apply to any specific property. Realty Rates has capitalization rate information by property type applied to the entire country. In other words, Realty Rates will give you a hotel capitalization rate but not for a specific geographic area. PWC and RERC have surveys of market participants from individual metropolitan areas so you can get cap rate information on office buildings in Atlanta and on hotels in Dallas, for example.
Realty Rates generally has the highest capitalization rates of the sources I have listed, so if you are preparing for a property tax appeal and are looking for cap rate information, I would start there. The tax assessors are supposed to estimate the market value of your property. You need market rents that are low and market expenses that are high to get the lowest net operating income possible, and a capitalization rate that is high to obtain the lowest taxable value possible.
