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Yield Rate versus Direct Capitalization Rate

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Don Jones

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Need some help please !!

In reviewing an appraisal recently the following statement was presented in an explanation of the Income Approach:

"This analysis uses a method of capitalization commonly known as Direct Capitalization. This method uses an overall yield rate. An overall yield rate is a rate of return on the total capital invested and can be viewed as the combined yield on both the debt and equity capital."

Is this statement correct? Is a Direct Capitalization Rate and an Overall Yield Rate one and the same?

Direct Capitalization is used to convert an estimate of a single year's income expectancy into an indication of value in one direct step. The rate simply shows a relationship between a sale price and income, or income and value.

Is it not correct that yield rates must consider other components of an investment in a more individualized manner ... such as the specific amount of equity, debt, and reversionary value?

If some of you highly experienced commercial appraisers would straighten me out on this, I'd be most grateful.

Thank you !!!
 

Paul Ness MAI

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A yield rate and a cap rate are two completely different animals. In the income approach, you can employ two methods, yield capitalization and direct capitalization. Direct cap divides one year of "stabilized" net operating income by an overall cap rate to estimate value. Yield cap utilizes a discounted cash flow analysis, where net income is estimated for multiple years into the future and discounted back to present value at an appropriate yield rate. Also, the reversion value (value at the time of future sale of the property) is discounted back to present value and added to the present value of the cash flows.

The overall cap rate is a tool applied to one year in a single snapshot. It represents the simple relationship between value and one year of income. However, it does reflect the blended effects of anticipated return on and return of investment. It can be extracted from market sales or built up through the band-of-investment which breaks out the mortgage and equity requirements of a particular investment.

The yield rate is the required rate of return on the total investment. It is applied in a manner that can provide a more detailed analysis of cash flow and reversion. It reflects the time value of money as well as the relative risk associated with the cash flow. although it can be extracted from the market from the sale and resale of a proeprty with detailed multi-year income information, this is then historic data of the actual performance of an investment, and does not reflect current "anticipated" investor requirements.

There is a very distinct relationship between the yield rate and the going-in cap rate, but this forum is not conducive to get into too much more detail. I wrote an article on cap rates adn yield rates and the relationship between the two, and would be glad two email it to you if you like.

In the course of your review - first, did the appraiser just use the wrong name but correctly apply direct capitalization? Or is he/she completely incompetent and really mixed the direct captalization methods with yield capitalization? As a review appraiser I have seen plenty of both.
 

Austin

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Jan 16, 2002
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Virginia
Paul pretty well summed up the AI’s view of the subject and I got my view from the same source so I will second everything he said with one other amplification. As Paul stated, yield is a measure of return on capital and direct capitalization is based on income/value ratios both of which are highly pregnant numbers. By highly pregnant numbers I mean there is a vast amount of information embedded within both yield and direct cap rates. In my mind that is the beauty of the income approach.
My beef with both the cost and sales comparison approach is that in the cost approach all forms of depreciation are all covariant factors that cannot be separated out and treated separately and can only be dealt with in the aggregate. The so-called accepted cost approach methods don’t do it that way though. Same thing in the sales comparison approach. All value-influencing factors are covariant variables; again, meaning the individual items cannot always be separated out and must be dealt with in the aggregate, which the accepted method conveniently ignores. So, when you compare the results of the cost and sales comparison approach to the income approach you have a problem. The income approach reflects the covariance of all variables measured in the aggregate and the cost and sales comparison approaches shows value derived using methods completely devoid of any measure of covariance because they ignore covariance of factors.
Also, have you ever noticed in published data on yield & cap rates that the difference is always about 2.3%, which just happens to be the rate of inflation built into the system, which raises even more questions such as: What came first, the chicken or the egg? If the system is that structured, then why bother with the cost and sales comparison approach in the first place in invest/income properties? To further confuse the subject, when the equity market is in total chaos, the interest rate market is showing a range shift on the order of 4% points within a six months period, are any existing methods relevant anyway, and are market derived yield and direct rates relevant under these conditions.
 

Paul Ness MAI

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Pennsylvania
Yes, the spread between the two is generally consistent among similar property types. It is good to look at the spread (and trends in spreads) as a check of reasonableness between the two rates. That goes back to the basic relational equation Y = R + delta (change). Austin, I also agree with your last few lines as well regarding our current rate environment.
 

Don Jones

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Missouri
Paul, Austin ... Thank you gentlemen for your responses to my question. You have answered it very well.

Thanks !!
 

Bill_FL

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Aug 23, 2002
Professional Status
Certified General Appraiser
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Florida
Just to play devil's advocate, Paul, when you write a narrative report, do you capitalize the rate? Such as the Direct Capitalization Rate, or the Overall Yield Rate.

I wonder if perhaps, in the report being described, the writer was attempting to discuss an investments "yield" to the reader. Perhaps a better word or phrase could have been used. I have talked to investors about their properties and how they buy them. I often hear things like, "For the yield I need, I use a cap of .105." While we may consider the terms two different animals, sometimes the investors do not.
 

Paul Ness MAI

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Pennsylvania
No, I don't capitalize them because I don't consider them proper nouns, but I may be wrong. Anyhow, your point is well taken that investors often use terms differently and interchange them. That's why it's a good idea to define what you are asking for when you talk with investors. I know many investors and real estate agents often mix the terms cap rate and yield rate. Most small investors are self-taught and do not have to write formal reports for third parties, clients or reviewers. However, as trained professionals, real estate agents and appraisers should consistently use and apply the correct terminology.
 

Austin

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Bill’s question from above and this general discussion of cap rates remind me of an interesting experience. About 10 years ago my dad and me went to visit my brother-in-law in Atlanta, GA, to go to the Atlanta NASCAR race. My brother-in-law told me that one of his good buddies was going with us, and that this guy and me had a lot in common. He said you are a real estate appraiser and he is one of the biggest commercial brokers in the Atlanta area.
So on the way to the race we pick this guy up and head for the racetrack. I was thinking to myself: “this is a gold mind of potential information if I can get this guy to talk. Maybe I can even deduct the trip as a business expense!” As we are riding through Atlanta the broker points out the various multi-story office buildings he has sold in recent years. I asked him what was the cap rate range for this type multi-tenant office building? He looked at me kind of funny and said: “What is a capitalization rate?” I never could get it across to him so I decided to try another angle. I asked: “What criteria do most investors and sellers use to decide what price at which to sell or purchase a property?” His answer was: “I have no idea. They just tell me what they want for the property and that is what I sell it for.” Another of many reasons that I take this USPAP crap and appraisal business with a grain of salt. You can’t make order out of chaos. When you have sale agents that are setting prices based on pure blissful ignorance, then give the lenders power over appraisers to get the number to make the deal work, and then they try to correct the problem by plugging up the holes in the dike with annual changes in USPAP, can you call this adult supervision? Maybe I have been in this business too long and need a change. It seems the more they stir this USPAP pot, the worse it stinks.
I remember reading an article in the AI’s “Appraisal Journal” in the late 1980’s. It was written by a scholar from Canada who was an MAI, had spent 40 years teaching at a Canadian University, was regarded as one of the vanguard in the appraisal education-field, and who basically stated in the article that after 40 years in this business, he really didn’t see the point of it all. At the time I thought this old dude is senile and was just long past retirement age. Now I now the rest of the story.
 

Bill_FL

Senior Member
Joined
Aug 23, 2002
Professional Status
Certified General Appraiser
State
Florida
Paul,

I agree that we should know the difference and correctly define them. I have seen in appraisals where the appraiser attempts to include as much "information" as possible by quoting bankers, stock brokers, etc and the term yield gets thrown around alot.

Austin, the important question is, did you get to deduct it? Who won?
 

Fred

Elite Member
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Jan 15, 2002
Professional Status
Retired Appraiser
State
Virgin Islands
Austin writes."
Maybe I have been in this business too long and need a change. It seems the more they stir this USPAP pot, the worse it stinks."

No, it sounds like you have been in the business just the right amount of time and are hitting your prime.

Just to throw a little more tripe in the Pepper Pot, would you believe that another name for NOI is EBITDA - Earnings before interest, taxes, depreceiation and amortization - as opposed to EBITD, EBIT (and then there is dilluted and fully-dilluted).

Like Paul says, capitalize the names or don't, but explain it. Try to tailor your explanation to your target audience and quote when necessary. Either your audience understands it or they don't.

About 18 months ago, I had a little go-round on an assignment with present value calculations. One of the appraisers insisted that the yield rate, the discount rate and the IRR were three different rates. Anyone care to hold forth on that one.
 
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