A 2008 paper by Eric Reenstierna argues for the establishment of a standard method of capitalization derivation and he promotes the Appraisal Institute as the organization best suited to set such standards.

Inconsistency in the calculation of net income is the primary source of inaccuracy in cap rate calculations. Commercial real estate practitioners do not always include the same factors in their calculation of cap rates. For example, a broker’s net operating expense (NOE) data for a multi-family unit may not take into account (or sufficiently take into account) vacancy deductions, replacement reserves or management costs.  In the case of a net-leased property, a seller may leave out a vacancy factor (useful for accuracy in the event the tenant defaults), management costs that are not reimbursed by the tenant, administrative costs such as annual accounting or credits for expense reimbursements. The result can be inaccurate cap rates that – when used to appraise a property – will differ from the value derived using comparable sales data. If there is a step rate increase in a long-term lease, an appropriate method may be to take an average that takes into account the step increase and weights the different rates appropriately as opposed to using solely the present rent rate or the future rate.

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The author compares his proposal for an Appraisal Institute-led standardization of cap rate calculations to the BOMA Standard Method for Measuring Floor Area in Office Buildings to stress the value of having such standards and how it will benefit all those involved in this industry.

Last Updated on March 24, 2012 by Ramin Seddiq