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Instructor Blog - Credit College - Commercial Real Estate

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Session #5: The Income Capitalization Approach and the Cap Rate


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  • 11/20/2019 9:52:31 PM

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  • Credit College - Commercial Real Estate
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Q: Why don't we account for the net operating income (NOI) growth rate in the cap rate, or NOI / (cap – growth)?

A: We do account for NOI growth (or decline) when we employ the Yield Capitalization approach to calculate the net present value of the property’s anticipated NOI cash flow over time. Recall that the Yield Capitalization approach is structured such that we can change any of the four Valuation Drivers (potential gross income, vacancy and collection losses, operating expenses, and the capitalization rate) to reflect our expectations for any particular year or years.

In setting the Drivers, note that potential gross income, vacancy and collection losses, and operating expenses are key to defining NOI. By changing any or all of the Drivers up or down for as many periods we might choose, we are creating a more refined estimate of NOI and, in turn, a more refined estimate of the property’s value.  

Please refer to Slide 26 for the demonstration of how the Yield Capitalization approach works we employed during the webinar. Recognize that the lender can adjust both NOI and the Cap Rate by year to infinity, but we must be guided by the reasonableness of our projected expectations. Note also that we could again adjust our estimate of NOI or the cap rate to reflect growth or a decline in either.

We’re not familiar with the formula you cited in your question. Please note that it appears that the denominator could move to a negative value and distort the calculation of the estimated property value.              

Q: Sometimes owners of a property essentially pay themselves a management fee. How would you adjust this amount paid? Is there a rule of thumb for property management fees?

A: Management fees can vary greatly from property to property depending on the property's condition, the commitment and intensity needed to satisfy tenants, and the owner’s management philosophy. The Institute for Real Estate Management (IREM) usually provides various common size expenses in numerous real estate markets and might be a useful reference. Check also with local real estate agents, property management trade associations, or other properties in your book of business or that of your institution to become more aware of customary management fees.

Consider pursuing an adjustment only if it's clear that the management fee in question appears to be abnormal. Remedies come in direct and frank conversation with the property owner and may take the form of a direct reduction in the management fee, or by establishing financial performance covenants that cause the owner to act proactively in managing the business to include a reduction in management fees to achieve the covenant’s objective.  

Q: In our experience, most appraisers have been reluctant to change their appraisal reports. How would you suggest approaching appraisers to acknowledge and correct a large variance as was presented in your webinar illustration?

A: Few appraisers will change their evaluations of the property value. The estimate of market value expressed in the appraisal represents a good faith effort and is their best estimate at the time they submit the appraisal.

A lender, however, does not have to live with appraisal results. The appraisal is an independent element of due diligence that has simply been outsourced to an appraiser with no skin in the game. This webinar is designed to enable lenders to analyze the appraiser’s work in a more confident way. As a result there will be times that our analysis and exercise of judgment brings us to a different conclusion than the appraiser regarding NOI and the estimate of the property’s market value.

When a significant difference surfaces between the lender’s estimate of value and the appraiser’s estimate, the lender is compelled to explore and understand the reasons for the differences. On understanding the cause for the differences, the lender must decide which set of conclusions are more reasonable and then proceed with loan structuring employing that information. It is important that the lender be prepared for meaningful dialogue with both the appraiser and the borrower to build a shared understanding of the facts.

Course overview: The Income Capitalization Approach and the Cap Rate

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