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.

Net operating income (NOI) is defined by the Appraisal Institute as "the actual or anticipated net income remaining after all operating expenses are deducted from from effective gross income, but before mortgage debt service and book depreciation are deducted."

Effective gross income (EGI) is "the anticipated income from all operations of the real property adjusted for vacancy and collection losses. This adjustment covers losses incurred due to unoccupied space, turnover, and nonpayment of rent by tenants." This definition refers to market estimates of gross income adjusted for market vacancy and market collection losses. Your actual income may be very different from the "market."

When appealing your property tax assessment for an income producing property there are some expense items that you should not include in your income approach to value. The Appraisal Institute defines operating expenses as the periodic expenditures necessary to maintain the real property and continue the production of the effective gross income. Operating expenses can be fixed expenses that do not vary with occupancy, or variable, which generally vary with the level of occupancy or the extent of services provided. They include management charges, leasing commissions, utilities, heat and air conditioning, general payroll, cleaning, maintenance and repair of structure, decorating, grounds and parking area maintenance, security, supplies, rubbish removal and exterminating.  

There are non-operating expenses that you might be tempted to use in your income approach but the tax assessor will throw them out, or tell the board of equalization that you are including non-operating expenses. Some of these non-operating expenses are expenses that the IRS allows on your tax return, which causes some confusion.

While preparing your property tax appeal you need to be aware of how the tax assessors generated your value. For residential property they have probably used a cost approach to value in combination with a sales comparison approach. For commercial properties they may use the cost approach, the sales comparison approach, and an income approach to valuation.

For residential properties, the tax assessors often use a cost approach on all properties. Then they compare their values generated with the cost approach to actual sales prices to determine whether their cost approach is low or high. Based on sales in your neighborhood the assessors will adjust their cost values up or down to get as close to market value (sales) as possible.

Unless you are real estate professional you probably don't have the expertise to do a cost approach on your property. The best approach is to look at sales within your neighborhood and compare them to the assessed value of your property. If the sale prices per square foot of building area are lower than your assessment per  foot of building area then you have a basis for a property tax appeal.

The same is true of commercial properties, but often an income approach to value is thrown in. Income approach is used on properties that are often rented, and that is true of most commercial property types. To do an income approach to value you need market rental rates, typical expense ratios, and a capitalization rate.

As a commercial property owner/operator you may have a firm grasp of what the market rent is for your property, in your market. You probably know what your expense ratio is as well, but you may not know if this is typical. Your Net Operating Income (NOI) needs to be capitalized into an estimate of value. Capitalization rates can be developed in a couple of ways, but deriving them from sales of similar properties is the best way to get them.

So those are basically the three things that you can argue that the assessor is wrong on. You can argue that the market rental rate is lower than what the assessor is using. You can argue that your property is unique in some way and will never have an expense ratio as low as what the assessor is using. You can also argue that the capitalization rate that the assessor is using is too low.

You can look online for rental rates and sales at a site like LoopNet and you can get expense ratio and capitalization rates at RealtyRates. If would like to put your property tax appeal on autopilot, contact the professionals at Fair Assessments LLC.