Keep Your Powder Dry, Your Cap Rates Unloaded, and Your Values Correct by C

Spring 2003 • 61

Keep Your Powder Dry, Your Cap Rates Unloaded, and Your Values Correct BY C. KEVIN BOKOSKE, MAI

pplication of the capitalization rate, service or profit to the owner. To calcu- Awhether loaded or unloaded, is one late the NOI, the vacancy and credit loss of the concluding steps in the appraisal is first subtracted from the potential gross analysis of income properties. Most asses- income, resulting in the effective gross sors and appraisers learn early that there income. Any operating expenses are then are three traditional approaches to deducted from the effective gross income, value—the cost approach, the sales yielding the NOI. comparison approach, and the income ap- The rate variable in the formula is the proach. Using the income approach often capitalization, or cap, rate. The capitali- involves using the IRV formula (Income = zation rate is defined in Property Assessment [Capitalization] Rate × Value). Also known Valuation as “a composite rate used for as the direct cap approach, this formula converting income into a property value” is basic to the direct capitalization of a (IAAO 1996). There are various ways to single stabilized year’s income. estimate the appropriate capitalization If any two variables of the IRV formula rate. These include extracting the infor- are known, the appraiser can determine mation from analysis of recent sales of the missing element. In appraisal, value similar local properties, subscribing to is the variable most sought, so the income published sources that periodically re- and rate variables need to be determined. lease the capitalization rates for various Income is usually the net operating in- property types, calculating the rate from come (NOI), which is the money remain- a band-of-investment formula, or under- ing after the payment of all property ex- writing a capitalization rate study. For the penses, but before the payment of debt purpose of this article, the method used

C. Kevin Bokoske is manager of commercial reappraisal, Shelby County, Tennessee. He is currently a CAE candidate and holds the MAI designation from the Appraisal Institute. The statements made or views expressed by authors in Assessment Journal do not necessarily represent a policy position of the International Association of Assessing Officers. 62 • Assessment Journal

to obtain the cap rate is not essential. Note taxes are not known—a method pre- that this rate may also be referred to in scribed by IAAO—is to load the capitali- appraisal texts as the overall rate (OAR) zation rate with the effective tax rate

or by the symbol Ro. (ETR). The ETR is defined by IAAO as “the rate expressing the ratio between the ETR SOLVES THE PROBLEM property value and the current tax bill; In nearly all appraisal assignments not the official tax rate of the taxing jurisdic- involving ad valorem taxation, real es- tion multiplied by the assessment ratio.” tate taxes are properly included as part The ETR is usually provided to the ap- of the operating expenses. How, then, praiser before embarking on the appraisal should the appraiser treat the real es- assignment. In many instances, various tate tax when analyzing income prop- state or county governments publish a list erties for ad valorem valuation? Should of the ETRs for each jurisdiction annu- the estimated income using the real ally. Unlike many items assessors and tax- estate taxes as an expense item be capi- payers disagree on, such as income, va- talized? In ad valorem valuation, the cancy, expenses, cap rates, and so on, the ETR percentage is seldom the subject of an ad valorem tax appeal. However, the application of the ETR could well be the If any two subject of a hearing or trial. Typically, the ETR is added to the over- variables of the all cap rate to provide a loaded cap rate, which is then used to capitalize, or con- vert income into a value. It should be IRV formula are added (or loaded) to the OAR when valuing income-producing properties known, the in which the owner or lessor is responsible for the payment of real estate appraiser can taxes. TYPES OF LEASES determine the In commercial real estate, there are sev- eral terms used to describe leases, includ- missing element. ing gross, gross plus electric, modified gross, net, single-net, double-net, triple- net, pure net, and absolute net. These terms all are meant to convey the inten- phrase “it’s circular” is often employed tions of the lessor and lessee regarding to describe the use of present real es- payment of property operating expenses tate taxes as an expense item. This cir- and replacement reserves. However, use cularity is seldom explained further. of the terms often varies by market areas, How can the value of an income prop- and even within markets, there is not erty be estimated with real estate taxes unanimous agreement as to their mean- in the expenses without knowing for ings. The clearest and most direct certain what the real estate taxes method for an appraiser is to determine should be? Conversely, how can the real simply who pays what, either by interview- estate taxes be estimated if the value of ing the parties or reviewing actual leases the property is unknown? or lease summaries. The most expedient method for form- Apartment rentals and the lease terms ing an opinion of value when property illustrate gross leases. With apartments, Spring 2003 • 63 the tenant usually pays one check to the Effective Gross Income (EGI) = landlord for the use and occupancy of the $270,000 – $27,000 = $243,000 premises, while the landlord pays real Operating Expenses = estate taxes, property management, × casualty insurance, landscaping, rubbish 15,000 sq. ft. $4.50 = $67,500 removal, painting and decorating, and so NOI = $243,000 – $67,500 = $175,500 forth. The further the landlord gets from paying all property expenses and the Loaded cap rate = OAR + ETR closer the tenant gets to paying for these = 9.5% + 2.0 % = 11.5% expenses, either directly or through a Indicated value = NOI ÷ Loaded cap rate reimbursement program, the greater the = $175,000 ÷ 11.5% degree of netness. Eventually, the tenant = $1.525 million is responsible for paying all expenses associated with the property. It should be However, there are triple net tenants, verified that the lease for the subject properties typically occupied by tenants property is typical of market rates and responsible for the payment of real es- terms for similar properties within that tate taxes. This is the norm for single-ten- market, especially if the value being ant, freestanding buildings occupied by sought is the market value of the fee retail tenants such as Walgreens, Kroger, simple, as opposed to the market value of Staples, or similar creditworthy tenants. the leased fee. In the case of a tax appeal, the assessor quite often will be presented with a SMALL RETAIL BUILDING AND model similar to the preceding, with the LOADED CAP RATES The following is an example of how the ETR is added to the OAR. The sample subject illustrated here is a 15,000 square- The application foot, single-tenant retail building. The assessor studies the market for similar of the ETR properties in similar or competing locations and determines that the market could well be rent should be $18.00 per square foot (gross) for this property. It is also determined that the market vacancy and the subject of a credit loss allowance is 10 percent for similar properties, and operating hearing or trial. expenses, exclusive of real estate taxes, are $4.50 per square foot. Analysis of recent sales shows that a capitalization rate of 9.5 percent is appropriate for this ETR added to the overall cap rate to get a property at this location, and the loaded rate, and the NOI capitalized by jurisdiction has a published effective tax the result, producing the illustrated value rate of 2.0 percent. The income approach of $1.525 million. However, this is wrong. to value is illustrated by the following: In cases in which the tenant is responsible for property taxes, there is no need Potential Gross Income (PGI) = to add the 2.0 percent ETR to the 9.5 15,000 sq. ft. × $18.00 = $270,000 percent OAR. To load the ETR to the OAR in this instance would give the tax- Vacancy & Credit Loss = PGI × 10% payer credit for the portion of the operat- $270,000 × 10% = $27,000 ing expenses normally represented by 64 • Assessment Journal real estate taxes. However, the tenant, not there is a tenant paying (or likely to pay) the owner, is responsible for the payment on a gross rental basis—not loading the of the taxes. Loading the cap rate in this overall rate with the ETR when there is a example creates a double-dip for the tenant likely to pay on a net rental basis. property owner, allowing the real estate The single-tenant concept facilitates the tax to be counted twice—once when the central point of the argument. However, tenant pays the taxes, and once when the consider the appraisal of a super-regional ETR is added to the overall rate. Loading enclosed mall with 400,000 square feet the ETR produces an artificially low value of in-line (non-anchor) stores. For a indication in this example. newer, well located mall, it would not be If the local market dictates that the unusual for the NOI to be $30.00 per sample property would most likely be square foot, due to the high base rental rented under terms making the tenant rate per square foot and the high com- responsible for all real estate taxes, the mon area maintenance (CAM) recovery. assessor should use the following: Quite often, the lessor or owner is faced with very few out-of-pocket expenses once PGI = $270,000 the mall has attained stabilized occupancy. Vacancy & Credit Loss = PGI × 10% A 400,000 square-foot newer mall, with $270,000 × 10% = $27,000 an NOI of $30.00 per square foot would EGI= $270,000 – $27,000 = $243,000 have an annual NOI of $12 million. The current overall rate for malls with an in- OAR = 9.50% vestment grade of A is 8.25 percent, ac- ETR = 0.00% cording to the Korpacz/Real Estate Investor Survey (PricewaterhouseCoopers 2003). Cap Rate Used = 9.5% Applying the 8.25 percent to an NOI of $12 million results in a value of more NOI = $175,500 than $145 million. The principle applied Indicated value = NOI ÷ Cap rate in rejecting the loaded cap rate for the = $175,000 ÷ 9.5% 15,000 square-foot, single-tenant retail = $1.85 million store also applies to the newer mall. Us- ing or not using the ETR in the cap rate The difference in the indicated value would affect the value estimate by ap- with the ETR added ($1.525 million) and proximately 21 percent if the ETR were the value without the ETR added ($1.85 2.0 percent. For this sample mall with a million) to the cap rate is $325,000, or value of $145 million, loading the cap rate approximately 21 percent. The differ- unnecessarily lowers the value as well— ence between 11.5 percent (loaded rate) by 21 percent, or $30.45 million. If the and 9.5 percent (unloaded rate) is also sample ETR were faithful to its definition, 21 percent. Therefore, loading the ETR it would truly express the ratio between to the OAR unnecessarily reduces the the annual property tax and the market indicated value of the property by 21 value. Then, with the sample ETR at 2.0 percent when the tenant pays the real percent, the loading of the ETR to the estate taxes. OAR causes a $30.45 million improper reduction in the mall’s value. In this case, SUPER-REGIONAL MALLS AND the loaded cap rate would cause a need- LOADED CAP RATES less $609,000 underpayment in taxes to The above examples are centered on a the community or taxing jurisdiction. 15,000 square-foot, freestanding retail building. This demonstrates the effect of FURTHER REFINING THE CONCEPT loading the OAR with the ETR when To demonstrate this theory in as simple a Spring 2003 • 65 manner as possible, some details that maintained at a certain level—85 percent, might be encountered in real world situ- for example—then the tenants achieving ations were omitted. One such detail is the designated percentage would be re- allowing for vacancy losses to be applied sponsible for 100 percent of the real es- to the ETR. In the clearest example, with a property anticipating a 10 percent vacancy loss, the owner will expect to pay 10 percent of all expenses the tenant(s) Whether the might otherwise pay. With a 10 percent vacancy projection, the owner would an- subject is a two- ticipate paying 10 percent of the real estate taxes or 10 percent of the ETR. Thus, it would be proper to load the overall rate tenant retail by 10 percent of the ETR. In the sample 15,000 square foot retail store, 10 percent strip center or a of the 2.0 percent ETR, or 0.20 percent, would need to be added to the 9.5 per- super-regional cent OAR, resulting in a loaded cap rate of 9.7 percent. Applying the 9.7 partially loaded cap rate to the NOI of $175,500 mall, the same now results in an indicated value of $1.8 million. The difference between the par- vacancy tially loaded rate that provides for the vacancy portion of the ETR produces a value that is not significantly different from the provision for the unloaded 9.5 percent cap rate, which pro- duced a rounded value of $1.85 million. ETR should be A second actual refinement would be in the case of a multitenant property. considered. Whether it is a two-tenant retail strip center or a super-regional mall, the same vacancy provision for the ETR should be considered. If these properties are typi- tate taxes. Despite a 15 percent vacancy, cally tenanted on a net lease basis, but the owner still has no real estate tax li- they are less than an A investment grade ability, and the ETR would not be added or if occupancy is a problem, they are less to the OAR. The unloaded OAR would likely to recover the same degree of CAM capitalize the NOI, and real estate taxes charges than a newer, higher-quality prop- would be excluded from the income, via erty. For example, in the case of a C grade the CAM payments, as well as being ex- mall with a 40 percent vacancy rate, the cluded from the operating expenses. appraiser’s judgment might be that a likely buyer might only expect to recover MASS APPRAISAL IMPLICATIONS 50 percent of real estate taxes due to the AND CAMA MODELING declining quality and creditworthiness of To accurately reflect the proper use of the the tenant mix. In this case, the appraiser ETR in the capitalization process in mass might select 50 percent of the ETR to be appraisal, the modeler must first be per- added to the overall cap rate, producing suaded that there are two mutually exclu- the correct partially loaded cap rate. sive ETR-loading possibilities. The first A third refinement is found when a possibility results when there are income new mall has tenants with lease provisions properties in his or her jurisdiction that stipulating that as long as occupancy is should be valued by loading the ETR to 66 • Assessment Journal the OAR because these typically have gross with five gradients in each, with A as the leases, and the owner pays the real estate best and E as the worst and possibilities tax. The second possibility is when there of using plus and minus for each. This are income properties that should be val- would result in a total of ten possible ued without loading the ETR to the OAR grades or models, each carrying its appro- because these typically have net leases, and priate rent, vacancy, expense ratio (ex- the tenants pay the real estate tax. pense per unit), ETR factor, and cap rate. In many jurisdictions, it would not be These items would be driven by the mar- unusual to find single-tenant retail stores, ket adjustment factors of the age of the newer distribution or storage facilities, warehouse, neighborhood appeal, gross newer strip centers and malls, and some building area, percentage of office space, office buildings where the tenants are wall height, investment grade, and so on. responsible for the payment of real es- However, if the design of the CAMA sys- tate taxes, either directly or via a CAM tem does not permit this number of vari- charge. It would also not be unusual to ables, the modeler may adjust by condens- find older retail stores, older warehouses, ing to fewer variables and still allow for non-investment grade shopping centers the mass appraisal of all warehouses in or malls, and nearly all apartment build- the jurisdiction. This would result in vari- ings, and all hotels and motels where the ables from the new, net-leased, and large owner is responsible for the payment of A grade to the older, gross-leased, low real estate taxes. In the former case, the ceiling, and poorly maintained E ware- ETR would not be loaded, but in the lat- house. One way to achieve this would be ter, it would. to omit the gross aspect of the newer, bet- If there is not a sufficient number of ter grade properties, as well as the net each major property type being appraised, aspect of the lower grade properties in the simplest solution might be to treat markets where newer properties are usu- each property individually, outside of the ally net-leased, and older properties are modeling process. It is in larger jurisdic- typically leased on a gross rental basis. tions, where there might be many thou- sands of each property type, that mass CONCLUSION appraisal is appropriate. This presents a Every appraiser charged with forming an challenge for model construction and accurate and defensible opinion of an calibration. The modeler must consider income property for ad valorem tax pur- not only variations in investment grades, poses needs to assign the correct value to age of improvements, neighborhood or property. This is not only the right thing region, rental rates, vacancy allowances, to do, but the Uniform Standards of Profes- expense rations, and capitalization rates, sional Appraisal Practice requires the ap- but also whether or not the property is praiser in Standards Rule 1-1(a) to, “be suitable for ETR loading. Depending on aware of, understand, and correctly em- the ETR and the OAR used, loading the ploy those recognized methods and tech- ETR when it is not proper can result in niques that are necessary to produce a values that are 20 to 25 percent lower than credible appraisal.” Also, Standards Rule they should be. 1-4(c) (i), (ii), and (iii) require that ap- The possible number of variables for praisers analyze comparable rental data, each major property type may be limited operating expenses, and capitalization by the capability of the computer-assisted rates to estimate the income potential of mass appraisal (CAMA) system used. If the subject (Appraisal Foundation 2002). there is no limit, the modeler’s task is When appraisers stop routinely load- easier. For example, for warehouse prop- ing the cap rate with the ETR in net lease erties, the modeler constructs a series of situations, they also stop reducing the gross-leased and net-leased properties, value of these properties incorrectly. This Spring 2003 • 67 holds true whether the property is a freestanding pharmacy or a super-regional mall. Therefore, appraisers must keep their rates unloaded unless necessary.

REFERENCES The Appraisal Foundation. 2002. Uniform Standards of Professional Appraisal Practice. Wash- ington, DC: The Appraisal Foundation.

Appraisal Institute. 2001. The Appraisal of Real Estate. 12th ed. Chicago, IL: Appraisal Institute.

Appraisal Institute. 1993. The Dictionary of Real Estate Appraisal. 3d ed. Chicago, IL: Appraisal Institute.

International Association of Assessing Officers. 1996. Property Assessment Valuation. 2d ed. Chicago, IL: IAAO.

Kelsall, Dennis D., MAI. (April) 1997. Loading capitalization rates and discount rates for property taxes and other expense items. Appraisal Journal.

PricewaterhouseCoopers. 2003. Korpacz Real Estate Investor Survey. Islandia, NY: PricewaterhouseCoopers.