This is the question we at Wall & Smith Property Consultants ask ourselves and are asked daily as both valuers and property consultants.

The capitalization rate, generally referred to as the cap rate, is the rate of return used to value an investment property i.e. the net income, in Year 1 divided by the cap.rate/return an investor needs or as dictated by market conditions, calculates the price of the property, ignoring VAT, transfer duty, bond repayments and income tax.

• The calculation works out the return on the total investment, but the income is not received at the end of year one, it is received on a monthly basis. The annual effective interest rate of 10% nominal interest (the cap.rate) compounded monthly is approximately 10.47%;
• In addition most of the expenses are paid on a monthly basis;
• A new owner, in the first 12 months of ownership will make every attempt to increase income and decrease expenses;
• Almost without exception comparable investment returns are received in at the end of the investment period;
• Because of changes in monthly income as a consequence of contractual rental escalations, irregular expenses, i.e. insurance, audit fees etc paid annually, the calculation is already distorted.

The answer - Calculate returns every month and calculate an actual return at the end of twelve months.

The consensus of the IPD consultative committee is that the Discounted Cash Flow (DCF) method is the preferred method of valuation, the period being at least five to ten years, lease contract lengths that we don't often see in our day to day valuations.

The discount rate for an individual property may be justified on the grounds of current long bond rates plus a premium for property-related risk. This gives a benchmark as a guide to the discount rate that should be applied i.e. the long bond rate. The DCF requires a lot of assumptions including accurately predicting market rent in 5 years time as well as seling price.

However no such benchmark exists for capitalization rates, IPD suggest that the capitalization rate used in each valuation takes into account, risk, inflation perceptions, rates of return on alternative investments, mortgage bond rates and rates of return of comparable properties.

What the commercial property industry needs is a benchmark for capitalization rates; perhaps start with mortgage rates and a refined researched factor for property related risk. The property related risk is the unknown, subjective aspect of both the Discount Rate and the Capitalisation rate, if the components thereof were researched and factors applied to each component, valuation of commercial property could be more consistent.

Publisher: eProp
Source: W&S