How do appraisers determine projected cap rate (in reality!)

[Alexander V.]

Hello,

This has been asked many times, but after reading multiple other forum posts and articles, I still don't feel that I've found a straight answer. The most common appraisal method for commercial properties that I see tossed around on BP is direct capitalization, which essentially divides the NOI by the cap rate to find the market value. While NOI is straightforward, I can't find how that "cap rate" is actually calculated.

Some people say it is based on "market cap rate." Others, both here on BP and elsewhere, insist that there is no such thing as "market cap rate."

Paul Moore wrote a blog here on BP, saying that the most common formula for cap rate is NOI/(current market value). I note that he used "current market value" instead of "purchase price," implying that there are indeed two different cap rates that are used equivocally--one is the actual cap rate for a specific property based on the actual price the investor paid. The other cap rate is a hypothetical figure that relies on what we estimate the property should sell for at a given time in a given location, the "current market value."

My big confusion is that if the actual cap rate is used, then the appraisal is useless since it totally depends on what the last investor paid. For example, if an investor has a junk property with an NOI of $100 but bought it from a friend for a penny, then its value is 100/0.01 = $10,000. The same property purchased by someone who was tricked into paying $100 is valued at 100/100 = $1. Clearly, appraisers don't do this. But if a hypothetical cap rate based on "current market value" is used as in the above blog post, again, we run into problems. The appraiser is trying to determine the market value of the property, but he needs to already know the market value to make that determination since cap rate is NOI/(current market value). Again, this doesn't make sense.

What I think does make sense is that appraisers know what cap rate other investors are typically willing to accept, and they use that as the cap rate when appraising value. But what main factors do they consider when determining what cap rate investors would reasonably accept for the property? 

Thanks

[Greg Dickerson]

Originally posted by @Alexander V.:

Hello,

This has been asked many times, but after reading multiple other forum posts and articles, I still don't feel that I've found a straight answer. The most common appraisal method for commercial properties that I see tossed around on BP is direct capitalization, which essentially divides the NOI by the cap rate to find the market value. While NOI is straightforward, I can't find how that "cap rate" is actually calculated.

Some people say it is based on "market cap rate." Others, both here on BP and elsewhere, insist that there is no such thing as "market cap rate."

Paul Moore wrote a blog here on BP, saying that the most common formula for cap rate is NOI/(current market value). I note that he used "current market value" instead of "purchase price," implying that there are indeed two different cap rates that are used equivocally--one is the actual cap rate for a specific property based on the actual price the investor paid. The other cap rate is a hypothetical figure that relies on what we estimate the property should sell for at a given time in a given location, the "current market value."

My big confusion is that if the actual cap rate is used, then the appraisal is useless since it totally depends on what the last investor paid. For example, if an investor has a junk property with an NOI of $100 but bought it from a friend for a penny, then its value is 100/0.01 = $10,000. The same property purchased by someone who was tricked into paying $100 is valued at 100/100 = $1. Clearly, appraisers don't do this. But if a hypothetical cap rate based on "current market value" is used as in the above blog post, again, we run into problems. The appraiser is trying to determine the market value of the property, but he needs to already know the market value to make that determination since cap rate is NOI/(current market value). Again, this doesn't make sense.

What I think does make sense is that appraisers know what cap rate other investors are typically willing to accept, and they use that as the cap rate when appraising value. But what main factors do they consider when determining what cap rate investors would reasonably accept for the property? 

Thanks

Appraisers use CAP rate, Replacement cost and Comps to value commercial and multifamily properties (more than 5 units). Smaller properties and residential income properties are valued using comps.

Market value can also be interpreted as the asking price or cost of the asset so that is a relative value since anyone can ask whatever they want for a property. 

Bottom line is forget the CAP rate and look at the actual property itself. Location, condition, age, occupancy, income, expenses etc. Then determine if the actual income and or potential to increase income is acceptable to you and satisfies your return requirements.