Newbies: Cap Rates and Yield Rates

[Paul Ness MAI]

Following are URL's from the Commercial Real Estate Investors Forum that I frequent. They are two posts (I originally wrote for my local Realtors newsletter) regarding cap rates and yield rates. They were written more for the layperson, but might also help some of the commercial newbies on this forum.

Cap Rates

http://www.creonline.com/commercial-real-e...sages/1298.html

Yield Rates

http://www.creonline.com/commercial-real-e...sages/1407.html

 

[Fred]

I remeber reading that when you posted it!! This forums are worse than watching too much TV.

 

[Paul Ness MAI]

You can always change the channel 8O

 

[Austin]

Paul:
How do you reconcile your band of investment method with Akerson's format? How about what Akerson calls the basic rate ® as opposed to OAR ( R ). The books show it both ways. Your method is OK in stable markets when equity rates are the controlling factor. This must confuse a lot of people. "Somestimes you do it this way, and sometimes you do it that way," to quote the books. Discounting at the yield rate is much more accurate, but you have to be a real insider to get that degree of data. This is another one of those cases where R=Y sometimes, and sometimes R does not equal Y. The real difference between the two depends on how you define the word: “sometimes.” As they use to say in class: “This ain’t rocket science.” At least if it is, I will say on the ground.
Maybe this is the theory USPAP is based on: "Sometimes you must do it this way, but other times you may do it differnt. It all depends." If you get questioned about your method, I guess it all depends on who you know on the state appraisal boards that belongs to the same club that you do. As an MAI you don't have to worry about it, but us poor peons are fair game, Tom Hilderbrandt to wit. In NC, your definition of the direct cap band of investment method could get a non AI guy into deep you know what. Especially if he is operating on somebody's private turf.

 

[Paul Ness MAI]

Austin, I understand your point. But I'm not sure what reconciliation is needed between the simple B-o-I and Ellwood (or Akerson's version). They are two methods to conclude the same thing (Ro). Ellwood/Akerson expands the simple B-o-I concept by using Ye instead of Re, which as you suggested is more real world for many situations. But as you also said, it has to do with the strength of the market data you have to support either method, and the sophistication of the investor.

How about Ro and r? They are two different animals. When using Ellwood and Ye, you have to adjust for equity build-up to reach "r". This basic rate "r" corresponds to a simple yield rate with no change in value, so then you have to account for appreciation to reach Ro. Re reflects all those things implicitly. Ellwood requires more assumptions than the simple B-o-I's use of the equity dividend, which is fine if you again have the supporting data and have investors who understand the difference between Ye and Re and have an idea of anticipated appreciation. In practice as a review appraiser, I see a very small percentage of appraisers using Ellwood/Akerson, and every one I've seen has abused it in order to get a low cap rate. There's nothing wrong with using it, as long as it is used properly. Same goes for the simple B-o-I.

As far as the rest of your post, there is a ton of political stuff packed in there that I'm not touching. :twisted:

 

[Austin]

Paul:
This thread makes the points I am trying to make. Some of the USPAP gurus on this and other forums are constantly arguing that the appraiser must explain the meaning of the cap rates so the client can understand them and not be mislead. You stated in your last thread that you saw abuses in your reviews. How many times do you think appraisers know Ye, or Re, or the stability of the income, or can support a future change in price. Y=R and Y cannot =R depending on equity build up, unstable income streams from various patterns, change in future prices, etc. How many appraisers much less clients do you think know or understand the subtle differences in R’s? The answer is none, zero, nada. How can you know Ye and not know the cap rate? Probably when most people do appraisals and use the band of investment method they have already extracted the range of cap rates from the market from experience, but rather than spend hours and pages explaining and supporting the rate just use a band of investment to support what they already know so they will be in compliance with USPAP or in general to CYA. Appraisal is a circular reference with many shortcomings. That is bad enough, but you have people, like you, reviewing the work of others and being paid to find something wrong to justify their fee, and the system is subject to serious abuse.
That is why I made the statement you labeled political. State boards are taking away peoples right to make a living for doing less than what you did in your B o I example. That is not a criticism of you. I don’t disagree with anything you have said. The point is that the nature of this business is such that when you throw in USPAP and state appraisal boards like the notorious NCAB for example; it is a recipe for gross abuse. Do you think these people know the subtle nuances and different shades of overall rates and what they encompass? Talk about arbitrary and capricious? In your example of B o I, why didn’t you explain the nuances of unstable cash flows etc.? You could have confused a lot of people and caused them to mislead others. I write this stuff and point all of this so called “political stuff” in hopes that somebody in authority with half a brain will wake up and correct this fiasco before any more damage is done. Hell, I have gotten to the place that I won’t do a commercial appraisal for people I don’t know. It ain’t worth the risk. We only have about 10 local appraisers (two qualified to do commercial) here and three of the most experienced will be retired in five years. None of them including me are willing to take the risk of taking on a trainee because of the risk. It ain’t worth it. Out of the remaining 7 appraisers, one is pretty good. The other six couldn’t even find their way to this forum much less read and understand what we are talking about. I ask, is the system as it exist protecting the public now or in the future? The answer is no. It is just another can of worms.

 

[Fred]

Austin, you write,
"Some of the USPAP gurus on this and other forums are constantly arguing that the appraiser must explain the meaning of the cap rates so the client can understand them and not be mislead."

I have never seen such an argument put forth and I would not concur. An appraisal report is a technical report. It is a fools errand to think there some degree of explanation that can make all lay readers understand ideas that (as we have been posting) most appraisers do not – to wit – the inability to distinguish conceptually and mathematically between the first years investment return rates the return rates for the life an investment.

But this one:
"Appraisal is a circular reference with many shortcomings"
I would take exception to this as well, especially the circular reference part. While the "textbooks" are full of methods that smack of circular reasoning, like the cost approach, it is not necessary that I incorporate any defective reasoning into my scope of work.

There are clearly two sources of variability in appraisals: the market and the appraiser. Nothing can be done about the first, but the second can be managed. It is a fallacy to say that because one or more appraisers employ circular reasoning that appraisal itself is, by definition, deficient.

 

[Austin]

Steven wrote:

“I have never seen such an argument put forth and I would not concur. An appraisal report is a technical report.”

Steven, I can’t believe you said that after all of the discussions on this forum about this. I know people, including one of the past chairmen of the Virginia Appraisal Board that contends that the reader must understand everything in a report. The infamous NCAB enforces such a policy and if I am not mistaken, that is one of the things they hit Tom Hilderbrandt with. In my numerous discussions of regression methods I am constantly hit with the charge: “Cannot do it that way because the reader can’t understand what you are doing,” to which I usually reply: “Does the reader understand that you can’t support a most probable price with three comp sales?”
I know it is stupid, but that is what USPAP says and that is what some regulators and reviews swear to.

 

[Fred]

"I know it is stupid, but that is what USPAP says "
You mind quoting that? Because mine says "sufficient information" and does not say "reader." Besides, I thought the whole point of the many threads dealing with Hildebrant was that the NCAB was hitting him with things incorrectly. How can you cite them now as the USPAP all-knowing? Wasn't there a post around here about a judge ruling (at least in part) that the board was wrong in the Hildebrant case?

I would take it even further. It is not just lay people, but even appraisers who may not understand a report. Some state laws explicltly preculde residential appraisers from capitalizing income, which calls into question the reasonable expectation that they would understand the difference between yield and direct capitalization. I have taken Ag appraisal courses, but I do not for a moment believe that I can automatically understand one of those hog farm or chicken farm appraisals that Terry Shields talks about - no matter how well-written the report is. As a "city boy" the only hogs and chickens I have seen are in cartoons. :lol:

 

[Bill_FL]

Steven,

SR2-1

B) contain sufficient information to enable the intended users of the appraisal to understand the report properly; and

This is the line in USPAP that many regulators are focusing on.

At this point, the key, I would assumed would be the intended user of the reoprt and their level of understanding. If you are doing an appraisal for a competent commerical investor or banker, you could perform a limted-restricted use appraisal and disclose that the intended user is known to be a knowledgable reader of the appraisal and such indepth explantions are not contained in your appraisal, but are in your workfile. (Workfiles must contain enouch data and reasoning to produce a summary report)

On the flip side, if the intended user of the report is a lay person, you would be required, by USPAP, to write a very detailed explanation of the work you did, the analysis of that work and the reasoning behind your conclusions.

I have read on this forum where some regulators have said that it is not just the intended user, but any reader of the appraisal. While I do not agree with this based on the above line from USPAP, this is the thought of some regulators.