Ashworth Real Estate Appraisal Instructor Explains The Most Important, Controversial, And Least Known Phase Of Property Valuation

Thanks to J. Parks for permission to use this Photo.

The most important phase of property valuation is also the most controversial and least known. This procedure is called the rate of capitalization. It is used to determine a market rate of capitalization. Through this rate, estimated future net income can be converted into a sum of present value. The rate of capitalization acts as a lever which pushes income into a height of value. Here is how the lever works. The lower the rate of capitalization is, the higher the value per dollar of income is. Thus, the value of a particular property will also be higher. The opposite is true if the rate is higher. The higher the rate of capitalization is, the lower the value per dollar of income is. Thus, the value of a particular property will also be lower.

If speculation or motives other than investment buying are prime reasons for purchase, the sale price of the property in relation to its income is of little aid to an appraiser in search of applicable market rates of capitalization. In fact, such sales may prove highly misleading as indicators of prevailing yields on real estate investments. You can see why I stated earlier that the rate of capitalization procedure is very controversial. This procedure has the potential to yield misleading results.

Most appraisers would find themselves at a loss if the application of the income approach and the selection of a rate of capitalization had to be sustained solely by analysis of investment sales in their community. You may wonder why this is true. Well, real estate transactions are traditionally private in nature and factual income data is often difficult to obtain. Thus, it is very difficult to select sales which could be usefully employed for statistical income analysis.

Although real estate as a commodity is local in character, the financing and purchase of real estate, both for investment and speculative purposes, have the distinct characteristics of a national market. The mobility of credit and the flexibility of investment buying with income reserves and surpluses have channeled funds into community areas where the investment returns in relation to capital markets are the highest. The existence of a national real estate investment market makes national income and rates of return statistics, compiled by investment firms and real estate analysts, available for real properties. These national indices of investment yields, when adjusted for community and regional risks for given classes of real properties, can be used as effective guides in judging the reasonability of rates of capitalization secured from market analyses of comparable sales.

Bob Chaapel
Real Estate Appraisal Instructor
Ashworth University

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