# The stabilized capitalization rate.

Abstract

The capitalization rate is a common part of any discussion involving real estate transactions, but does anyone really know exactly what is being talked about? This article attempts to define a standard point of reference so that "cap rate speak" may develop a new clarity. The methodology discussed works well with the core property groups (office, retail, industrial and multifamily) but may be challenging to apply to properties with moving stabilized targets such as hotels, golf courses, marinas, etc.

Introduction

One of the most common discussion points about commercial real estate transactions is "what's the cap rate?" However, this can be among the most miscommunicated concepts as market participants take for granted that they know what they are talking about and that other people actually have the same understanding of what they are saying.

The mathematics for the calculation of the capitalization rate (R) is rather simple:

Capitalization Rate = Income/Value R = I/V

The difficulty comes with the assumption that everyone is on the same page with their definition of income and how it relates to value. The purpose of this discussion is to propose one standard definition, among the many, as a benchmark. This would establish a common point of reference from which "cap rate speak" can become a more universally understood concept and a more useful valuation tool.

Let's start by demonstrating why it is questionable that people understand each other when discussing capitalization rates. When a buyer states that the property sold at an 8% capitalization rate, which of the following points were considered?

1. Was net operating income (NOI) based on current occupancy divided by the sale price or based on stabilized occupancy divided by the sale price? (1)

2. Were reserves for replacements included in the NOI calculation?

3. Was the NOI based on the operating statement for the year before the sale (trailing twelve-month NOI), the year after the sale (going-in or forecast NOI), or the full calendar years ahead or behind the date of sale?

4. Is the capitalization rate really a cash-on-cash rate? (NOI less leasing and capital costs divided by sale price.)

5. Is the capitalization rate based on the total gross transaction price, or does it reflect the cash equivalency of any atypical leverage in the value denominator?

In addition to these various points of reference, the published capitalization rate data generally has varying definitions, too. While all the capitalization rates correctly utilize the relationship R = I/V, the definition of income varies considerably, not providing a common point of reference. The following are the most commonly referenced sources of capitalization rates.

* National Council of Real Estate Investment Fiduciaries (NCREIF)

* Real Capital Analytics (RCA)

* PwC Investor Survey

* CoStar

* RERC Real Estate Report

* American Council of Life Insurers (ACLI)

* Realty Rates

* CBRE Cap Rate Survey

* REIS

Their specific, individual calculation definitions are shown in the addendum at the end of this article. Because of this lack of consistency, reported capitalization rates are basically artifacts of the transactions depending on a specific definition of NOI, not really a pricing indicator used in the general market vernacular. The CBRE Cap Rate Survey (2) is the only report that attempts to address stabilized capitalization rates and establish a common point of reference, but the denominator utilized is the nominal sale price. Therefore, in that instance the income numerator and value denominator may not come from the same point of reference. Other than transaction-specific capitalization rates reported by RCA, CoStar, and REIS, or the averages of specific property data as defined by NCREIF, the surveys generally produce large ranges that do not really even correlate to each other. Unfortunately, this opens the door to use of a fudge factor, adjusting the capitalization rate without providing a quantitative rationale. In order to be useful as a direct pricing factor there must be a common point of reference so that the various nuances of each transaction can be put onto a common playing field.

This article addresses development of a common point of reference, defined as the overall "stabilized capitalization rate" ([R.sub.0]). The term has been used in various forms, but typically in a prospective sense, referencing capitalization rates at some point in time when a property achieves stabilized operating performance. The premise presented here uses this stabilized operating performance as of the current date, and the resulting expectation of the stabilized value in today's dollars to establish this standard point of reference.

Direct Capitalization versus Discounted Cash Flow

For investment-grade real estate, the income capitalization approach has evolved into two separate forms of analyses: direct capitalization and discounted cash flow (DCF). The DCF analysis is a cash-based financial model where the various prospective assumptions and specific timing of contractual events are explicit inputs. The direct capitalization analysis is an accrual-based financial model where the prospective assumptions and timing of contractual events are implicit in the analysis through the capitalization rate selection. If completed appropriately, the resulting values estimated should approximate each other. (3)

Direct capitalization analysis employs an overall capitalization rate ([R.sub.0]) and discounted cash flow analysis employs an overall yield rate ([Y.sub.0]) or what is referred to as the discount rate in DCF analysis. Their relationship is generally stated in the equation:

[R.sub.0] = [Y.sub.0] +/- [DELTA] ([DELTA] = constant ratio change in income and value)

This is a very simplified model that needs a more in-depth analysis to equate the two approaches. While either approach can use income at various points in the operating statement, typically direct capitalization estimates value using NOI prior to capital costs while DCF analysis uses cash flow after accounting for items such as tenant improvements, leasing commissions and capital expenditures. Also, when analyzing the link between [Y.sub.0] and [R.sub.0], direct capitalization infers that growth in income and value occur on a constant ratio basis. (4) In the DCF model, the growth in income and the growth in value differ due to differences between the going-in and the terminal capitalization rates and the deduction for cost of sale in calculating the reversion estimate as well as specific timing issues involved with cash flow receipts. Nonetheless, the basic premise is that value equates to the present worth of future benefits. By addressing the differences in direct capitalization and DCF methodologies, a more quantitative method of defining and selecting the appropriate [R.sub.0] can be developed for use in the direct capitalization method.

There will always be a subjective element to selecting a capitalization or discount rate. While a number of factors can be quantified that are implicitly reflected in the capitalization rate, certain elements of risk are dealt with through the buyer's judgments. The investment decision with respect to the risk related to the credit rating of the existing tenants, lease renewal probability, or anticipated market growth rates for rents and expenses are three subjective considerations that potential buyers make in determining what they are willing to pay. Also, depending on where a particular market is in the real estate cycle, the impact of that risk can be perceived entirely differently. In a declining market, longer remaining lease terms may be seen to have less risk than leases with shorter remaining terms as longer terms help buffer vacancy risk and weather declining rents. Conversely, in a recovering market cycle shorter remaining lease terms may be perceived as beneficial, as shorter lease terms allow for the capture of rising market rates. More risk generally translates into higher required capitalization or discount rates, while lower perceived risk may be reflected in lower initial capitalization or discount rates.

The overall reliability of the value estimate improves if some quantifiable factors can be taken off the table when making judgment calls with respect to rate selection. The factors that make up the majority of considerations can be categorized as subjective and quantifiable factors. Subjective factors include the following:

* credit rating of existing tenants

* lease renewal probability (or lease option exercise probability)

* perceived market growth in rental rates and expenses

* terminal capitalization rate

Quantifiable factors include the following:

* above- or below-market contract lease rates

* scheduled rent escalations

* remaining rent concessions

* weighted average remaining lease term

* atypical occupancy issues

** rent loss until stabilized occupancy is achieved

** cost of tenant improvements and leasing commissions

* near-term capital expense requirements

* value of excess land

* impact of seller-funded guarantees

The Stabilized Capitalization Rate

Establishing a standard definition of capitalization rate for the direct capitalization analysis would provide a common point of reference and present a clearer picture of how the value is estimated. The following is the proposed definition of the stabilized capitalization rate:
```   The stabilized capitalization rate is calculated by estimating
the NOI for the numerator using market rental
rates, stabilized vacancy and credit loss, and expenses
grossed-up to the stabilized level. The denominator is
the nominal, cash equivalent sale price adjusted for the
quantifiable short-term aberrations in contract leases
relative to market, and other perceived short-term capital
costs.
```

Many of the explicit elements in the DCF analysis are implicit in the direct capitalization analysis. Small changes in half a dozen assumptions can greatly impact the final DCF answer. In fact, the following assumptions are the old standbys for tweaking a DCF value estimate:

* market rental rate growth

* tenant retention rate and downtime between tenants

* replacement reserves for multifamily

* reversion estimate:

** terminal year vacancy rate

** selling costs

** terminal capitalization rate

Any one or more of these assumptions can be (and are) manipulated to justify purchase decisions where the discount rate and capitalization rates have perceived nominal constraints placed on them by investment committees. Probably the most egregious of these is the terminal capitalization rate. By addressing the near-term aberrations in the lease structure and capital costs when adjusting the sales data, and letting the residual sales comparable information reflect the cumulative impact of the longer-term assumptions, the number of subjective assumptions become fewer and clearer as to their influence on the price paid for the asset.

If four properties in the same location were fully leased at current market rents, had identical expense structures, and were in identical physical condition, then the simultaneous sale of all four properties would most likely reflect almost identical capitalization rates. If the capitalization rates did vary, it might be reflective of differences in the average remaining lease terms or creditworthiness of the lease portfolio. Investor perception of these factors could be reflected in a subjective adjustment to the capitalization rate in the mind of the individual investor. If the four properties did have different specific issues (such as lease contracts, occupancy rates, current physical condition, or atypical financing) the differential impacts on value of those factors could be quantified. Understanding those items can describe the majority of pricing differentials between the four properties allowing them to be placed on a more level playing field for analytical purposes.

Establishing the common point of reference among sales requires mirroring the thought process of market participants. Investors demonstrate a fairly consistent pattern when deciding the price they are willing to pay for a property. Investors theoretically purchase investment-grade real estate for the present value of the existing contract lease portfolio, and the right to get the building back empty when the leases expire. The relative importance placed on the lease portfolio will depend on where the particular market is in its real estate cycle. Generally, the sooner the new owner of a stabilized property can begin improving on the existing operational characteristics the better. The buyer of a property that is not stabilized will have a plan to get the property to stabilized occupancy at market rent levels and an understanding of the time and cost it is going to take to get there. One cannot overemphasize the importance of good quality sale confirmation. (5) A market transaction requires a willing seller, but the buyer is the one who ultimately finalizes the price by writing the check. The buyer's analyses of all the qualitative and quantitative assumptions are what went into the sale price decision. Therefore, the buyer's opinion and assumptions are involved in stabilizing the sales data. If this thought process is applied in the analysis of various comparable transactions, stabilized consistent units of comparison can be developed.

This process is illustrated in Exhibit 1, which shows that comparables not currently operating at a stabilized level are adjusted to a stabilized level. Also, the subject property is first valued at a stabilized level and then adjusted to its as is operating level as of the date of value.

Case Study

The following case study demonstrates the use of the stabilized adjustment process. The case study compares three recent sales to a hypothetical subject property to produce a value estimate for the subject property using direct capitalization. It should be noted that this methodology works well with the core property groups (office, retail, industrial and multifamily) but may be challenging if applied to properties with moving stabilized targets (hotels, golf courses, marinas).

To make the analysis simpler, the assumption is made that the three comparables and the subject property are all multistory, Class A office buildings of similar age. The dates of sale for the comparables are all within the past few months, and there was no atypical financing involved. The local market is in the expansion phase of the real estate cycle. The long-term average and stabilized occupancy rate for the market is 95%. Exhibit 2 presents basic data on the subject and comparable properties.

Based on discussions with the buyers of the three comparables, their individual assumptions used in their underwriting of the purchases are summarized in Exhibit 3. Also, based on market research, the assumptions pertinent to the subject property are also summarized. Exhibit 4 summarizes the current (year-1 forecast) and stabilized operating statements based on the data presented in Exhibits 2 and 3.

Utilizing the data presented we can begin to adjust the transaction prices to reflect a common stabilized point of reference. The first part of this process is to make any required transaction adjustments, (6) including real property rights conveyed, financing terms, conditions of sale, and market conditions. For simplicity's sake, the subject property and all the comparables in the case study involve the transfer of 100% of the leased fee interest, at terms equivalent to cash, with both the buyer and seller typically motivated, and the transactions all occurred in the current time frame. As a result, the stabilized adjustment process will only focus on the differences between the properties.

The quantifiable factors listed earlier can either have a positive or negative impact on the nominal transaction price. These adjustment factors that could cause the nominal transaction price to be adjusted are discussed next. (7)

Positive Stabilized Adjustments to Comparables' Transaction Prices

A number of quantifiable factors can have a positive impact on the nominal transaction price of comparables. These factors include below-market rent, near-term capital requirements, remaining rent concessions, income loss until stabilized occupancy, and costs related to lease-up to stabilized occupancy levels.

Present value of below-market rent. The present value of any below-market contract rental rates for the remaining lease term need to be considered. The adjustment would be the difference between the market rent for the property and the contract rental rate discounted for the number of months remaining on the lease agreement(s). The adjustment is positive because it represents a rent loss from what would be received if the lease were at a market rate. This has the effect of increasing the value to reflect stabilized operations. This is a temporary condition that causes the going-in capitalization rate to be lower than it would be for a property with market rate leases. For example, case study Comparable 3 has a \$27.50 per square foot contract compared to market rent of \$30.00 per square foot, and the lease has 24 months of term remaining. Therefore, the present value of the below-market rent for Comparable 3 would be computed as follows:
```Market rent                 \$30.00/SF/annum

Contract rent               \$27.50/SF/annum

Area effected (77%)         173,250 SF

Offset for management       4%
fee savings

Rent loss                   \$2.40/SF/annum
(\$0.20/SF/month)

P.V. factor for 24 months   22.053315

Present value of            \$764,147
below-market rent
```

Near-term capital requirements. Near-term capital expense requirements also would require a positive stabilized adjustment since it represents deferred purchase price. In the instance of the three comparable properties, the anticipated amounts indicated by the buyers are \$2,000,000, \$2,000,000, and \$3,000,000 respectively for capital improvements (Exhibit 3).

Present value of remaining rent concessions.

The present value of any remaining rent concessions would also require an adjustment to the nominal price. The price would be adjusted upward because the rent concessions have the impact of discounting the nominal purchase price in the cash flow analysis. For example, case study Comparable 2 has six months of free rent remaining, requiring a positive adjustment of \$3,918,750.

Present value of income loss until stabilized occupancy. If the property is not operating at or above the stabilized occupancy rate, an upward adjustment must be made to the nominal purchase price. The adjustment reflects the anticipated rent loss during the period necessary to achieve stabilized occupancy. The calculation is basically the present value of the lost NOI based on the buyer's assumption of the time required to lease the excess vacant space. This analysis must also take into account not only loss of rental revenue, but the effect of changes in variable or occupancy-sensitive expenses during the lease-up period. In the case of Comparables 1 and 3, the occupancy rates of 80% and 77%, respectively, need to be adjusted to the assumed stabilized occupancy rate of 95%. Exhibits 5 and 6 present a summary of this analysis. Technically, if the property is operating at an occupancy level above the stabilized occupancy level a negative adjustment should also be applied.

Present value of tenant improvements and leasing commissions. In connection with the rent loss adjustment described above, another positive adjustment must be made for the corresponding cost of tenant improvements and leasing commissions in connection with the lease-up to stabilized occupancy levels. Exhibits 5 and 6 also summarize this analysis.

Negative Stabilized Adjustments to Comparables' Transaction Prices

Some quantifiable factors can have a negative impact on the nominal transaction price of comparables. These factors include above-market rent, excess land, and seller-funded guarantees.

Present value of above-market rent. As in the case with below-market leases, an adjustment must be made to reflect the impact of above-market lease contracts. An above-market lease is a temporary asset, the value of which diminishes over time as the lease comes closer to expiration. The excess revenue is reflected in the nominal sale price and has the impact of increasing the going-in capitalization rate. Therefore, to reflect stabilized operating levels a negative adjustment must be made for this factor. For example, Comparable 1 has contract rent of \$35.00 per square foot per annum versus the market rate of \$29.00 per square foot per annum, and the above-market rental contract is to continue for another 12 months. Therefore, the present value of the above-market rent can be computed as follows:
```Market rent                 \$29.00/SF/annum

Contract rent               \$35.00/SF/annum

Excess rent                 \$6.00/SF/annum
(\$0.5 0/SF/month)

Leased area impacted        240,000 SF

management fee

Net excess rent             \$0.48/SF/month

P.V. factor for 12 months   11.520675

Present value of            \$1,327,182
above-market rent
```

Value of excess land. The existence of excess land provides the opportunity for the buyer to sell the excess for additional income. Consequently, the sale price must be adjusted for that additional asset. This adjustment must be based on a solid highest and best use analysis. In the case study Comparable 3 has twice the normal land area compared to the other comparables and the subject property, and a portion of the land area is severable. Therefore, a negative adjustment is made to the nominal sale price, with the excess land value estimated at \$2,600,00.

Seller-funded guarantees. In some circumstances the seller will set aside funds to pay for capital items, provide income guarantees for a certain period of time, or set up an escrow for other purposes. This has the impact of supporting a higher nominal sale price, and must be adjusted accordingly. In the instance of Comparable 2, the seller set aside \$2,000,000 to offset the near-term capital costs.

Applying these various adjustments to the nominal sale prices of the comparables produces an adjusted sale price (or stabilized sale price) to form the basis of the denominator for calculating the stabilized capitalization rate. Exhibit 7 presents a summary of this analysis.

The going-in capitalization rates, based on the nominal sale prices of the comparable sales, range from 3.63% to 7.19%. After making the adjustments to the nominal sale prices, and applying that denominator to the stabilized net operating income (see Exhibit 4) for each property, the resulting stabilized capitalization rate range is 6.58% to 6.70%. An additional comparison can be made using the resulting price per square foot of the adjusted sale prices and the stabilized NOI per square foot of the comparables. A simple linear estimate is performed indicating an R2 of 0.9033. In other words, 90.33% of the differences in the comparable properties are explained with the stabilized adjustments. Exhibit 8 presents a summary of this analysis.

Subject Property Value Estimate

As illustrated in Exhibit 1, once the comparables are adjusted to a stabilized level the subject property is valued at that stabilized level. Next, specific adjustments are made to reflect the current operating conditions and to arrive at the current as is value of the property. Exhibit 4 presents both the current and stabilized NOI estimates for the subject property. Based on the analysis presented in Exhibit 7, a stabilized capitalization rate of 6.65% was selected for the subject property from the indicated range of 6.58% to 6.70%. The resulting estimate of the stabilized value for the subject is calculated as follows:
```Stabilized net operating
income                              \$3,549,500

Selected stabilized
capitalization rate ([R.sub.0])          6.65%

Stabilized value estimate          \$53,375,940
```

To obtain the current as is value for the subject property, the adjustments applied to the comparable properties are applied to the subject stabilized value estimate, only in a reverse direction. These are summarized as follows based on the data presented in Exhibits 2 and 3.

Negative As Is Adjustments to Subject Property

Near-term capital requirements. For the case study subject property, a negative adjustment of \$1,500,000 is made for near-term capital requirements.

Present value of income loss from stabilized occupancy. Since the subject property is currently only 70% occupied, a deduction must be made from the stabilized value to reflect the rent loss that will be incurred from the current valuation date to the anticipated date to achieve stabilized occupancy. Exhibit 9 shows these calculations.

Present value of tenant improvements and leasing commissions. In connection with the rent loss adjustment described above, a negative adjustment must be made for the corresponding cost of tenant improvements and leasing commissions in connection with the lease-up to the stabilized occupancy level. Exhibit 9 also shows these calculations.

Positive As Is Adjustments to Subject Property

Present value of above-market rent. An adjustment must be made to reflect the impact of above-market lease contracts on the value of the subject. An above-market rate lease is a temporary asset, and its value diminishes over time as the lease comes closer to expiration. The present value of this excess revenue has a positive impact on the current sale price since it is an additional asset being acquired compared to stabilized market rent contracts. Therefore, a positive adjustment must be made to reflect the current property status compared to stabilized operating levels, as illustrated below.
```Market rent                 \$29.00/SF/annum

Contract rent               \$32.00/SF/annum

Excess rent                 \$3.00/SF/annum
(\$0.25/SF/month)

Leased area impacted        175,000 SF

management fee

Net excess rent             \$0.24/SF/month

P.V. factor for 18 months   16.905025

Present value of            \$710,011
above-market rent
```

The total as is adjustments to be applied to the stabilized value estimate for the subject property are a negative \$3,293,070, summarized as follows:
```Summary of Subject Property Adjustments

Near-term capital requirements       (\$1,500,000)

Present value income loss from         (\$977,358)
stabilized occupancy

Present value tenant improvements    (\$1,525,723)
and leasing commissions

Present value above-market rent          \$710,011

Subject Property Operating Status
```

The direct capitalization process for the subject property is presented in Exhibit 10.

Exhibit 11 presents a comparison of the capitalization rates often quoted when confirming sale comparables (the going-in capitalization rate) compared to analyzing the sale data on a stabilized basis (the stabilized capitalization rate). The going-in capitalization rates indicated a range of 356 basis points with an average of 5.70%. The stabilized capitalization rates indicated a range of 12 basis points with an average of 6.64%.

Conclusion

The stabilized value methodology described in this article mirrors the thought process of most institutional buyers in the marketplace. The methodology provides an analysis with considerably more quantitative adjustments in the direct capitalization process than arbitrarily attempting to adjust capitalization rates from various comparable sales, using various survey indicators, or constructing them from hypothetical mortgage terms and equity return rates.

An added benefit to this analytical process is that it can be used in the sales comparison approach. Since it establishes a common point of reference, once the comparable sales are adjusted to that point they can be used in future analyses, essentially having only to adjust for conditions of sale that may have changed between the date of sale and the new valuation date. Differences in location, condition, quality, etc. have already been taken into effect based on the contract and market rent and the expense differentials for each property. For those factors the tenants in each building have effectively voted on the value of those differences through their pocketbooks. Once the stabilized value for the new subject property has been estimated, and adjustment to as is value can be accomplished. The units of comparison used (price per square foot, price per room, etc.) do not matter since the process is the same.

D. Richard Wincott, MAI, CRE, FRICS, is a senior executive vice president at Research, Valuation and Advisory, Altus Group US, Inc. He has been active in the institutional-grade real estate valuation and counseling business for over forty years. He has previously published articles in The Appraisal Journal and other prominent industry publications. Wincott is a Fellow of the Homer Hoyt Institute, serves on the President's Council and Board of Directors of the American Real Estate Society (ARES), and is a member of the real estate Reporting Standards Council (NCREIF/PREA). Contact: richard.wincott@altusgroup.com

Addendum Definitions of Capitalization Rate and Net Operating Income

1. National Council of Real Estate Investment Fiduciaries (NCREIF). (http://www.NCREIF.org)

* Transaction Cap Rates: (Previous Quarter Actual NOI X 4)/Sale Price

* Current Value Cap Rates: (Previous Quarter Actual NOI X 4)/Current Market Value

* 4 Quarter Rolling Average: Rolling 4 quarter average of the Current Value Cap Rates

2. Real Capital Analytics (RCA), (https://classic.rcanalytics.com/glossary/all/all.aspx)

* Cap Rate: The initial annual un-leveraged return on an acquisition.

* NOI (Net Operating Income): The income stream generated by the operation of the property, independent of external factors such as financing and income taxes. A property's yearly gross income less operating expenses. Gross income includes both rental income and other income such as parking fees, laundry and vending receipts, etc. Operating expenses are costs incurred during the operation and maintenance of a property. They include repairs and maintenance, as well as insurance, management fees, utilities, supplies, property taxes, etc. The following are not operating expenses: principal and interest, capital expenditures, depreciation, income taxes, and amortization of loan points.

* Cap Rate Qualifiers (These are descriptive of the data presented.)

* In-Place: Cap rate is derived from the net income generated from current tenancy agreements.

* Pro forma: Cap rate is derived from anticipated net operating income from first year of ownership.

* Prior year: Cap rate is derived from prior year or actual income at time of sale.

* Underwritten: Cap rate is derived using owner-provided NOI divided by a current financial institution appraisal as reported via CMBS tapes.

* Quoted: The assumed cap rate a property has traded at. Usually derived from published reports referencing a local professional not directly involved in the property's trade, but knowledgeable of factors affecting the price of a particular property.

3. PwC Investor Survey. (PwC Real Estate Investor Survey, Fourth Quarter 2014, p. 100)

* Overall Capitalization (Cap) Rate--Initial rate of return in all-cash transactions; the overall cap rate reported in this Survey reflects investors' expectations of property performance and are applied to one of the three net operating income levels noted ... All-cash refers to either all cash or market financing; unleveraged return.

* Net Operating Income (NOI)--Income remaining after deduction of all property expenses (including real estate taxes). In direct capitalization, investors capitalize one of the following:

i. NOI after capital replacement reserve deduction but before TIs and leasing commissions

ii. NOI before capital replacement reserve deduction, TIs and leasing commissions

iii. Cash flow after capital replacement reserve deduction, TI's and leasing commissions

4. CoStar. (http://www/costar.com/products/costar-comps)

* Overall or Total Cap Rate--The income rate of return for a total property that reflects the relationship between one year's net operating income expectancy and the total price or value. Calculated by dividing the net operating income by the sale price or value.

* Net Operating Income (NOI)--The actual or anticipated rental income remaining after all operating expenses are deducted from effective gross income, but before debt service and capital expenditures are deducted.

* Each comparable transaction shows the calculation of the cap rate, and specific qualifiers about source.

5. RERC Real Estate Report. (RERC Real Estate Report, RERC Scope and Methodology, Spring 2010, p. 63; quote from Kenneth Riggs, October 16, 2014)

* Going-in capitalization rate is usually defined as the first year NOI (before capital items of tenant improvements and leasing commissions and debt service but after real estate taxes) divided by present value (or purchase price). The survey has a table that indicates the reserve treatment for each property type. "To use the report:

(1) The appraiser must view the rates within the context of that table for reserve treatment;

(2) Adjust: Make adjustments to their view of the rate and their intended application; and,

(3) Apply: Apply in a consistent manner to what the appraiser intends for their valuation."

6. American Council of Life Insurers (ACLI). (ACLI Investment Bulletin, Appendix B, Scope and Methodology of the Survey; definition supplied by Harsh Sharma, Head of Research ACLI, October 16, 2014)

* Capitalization rate--Derived for each loan by dividing net stabilized earnings by property value.

* Stabilized net income before interest and taxes--The stabilized net income of the mortgaged property, after leasing commissions, tenant improvement, vacancy allowance, operating expenses and property taxes, but before income taxes, depreciation and debt service. The figure reported should be the income figure used in the appraisal process.

7. Realty Rates. (Investor Survey, RealtyRates.com, Third Quarter 2014, pp. 13, 39)

The reported cap rates are determined as follows:

Analysis of prevailing mortgage terms and resulting built-up overall capitalization rates (OAR's) via debt coverage ratio and band of investment techniques, together with OAR's from consummated transactions as reported by survey respondents based on actual net operating income (NOI) exclusive of reserves and actual sale price exclusive of deferred maintenance.

8. CBRE Cap Rate Survey. (CBRE Cap Rate Survey, Second Half 2013, pp. 45-46)

* Stabilized Cap Rates (Office, Industrial, Retail, and Hotel)--Cap rate ranges are best estimates provided by CBRE professionals based on recent trades in their respective markets as well as recent communication with investors. The ranges represent those cap rates that a given property will trade at in the current market assuming that the asset is leased at current market rents with typical market lease terms.

Use this assumption of leasing to current market rents to calculate gross rent potential, and then subtract the standard economic loss factors, including vacancy, that would be considered representative of a stable property in your market to achieve the effective gross income estimate. Reduce the effective gross income by the projected stabilized expenses to derive the NOI. The cap rate is then calculated as the NOI divided by the purchase price.

The going-in cap rate refers to the initial yield and is calculated as the ratio of the projected net income in the first year of the holding period over the acquisition price of the property. This measure also represents the investor's income return in the first year. Cap rates within each subtype will vary, occasionally falling outside of the stated ranges, based on asset location/quality and property-specific opportunities for NOI enhancement.

* Stabilized Property--A property that has an occupancy level at or above the local average and is leased at market rents.

9. REIS. (REIS, Inc., Transaction Reports, 2015.)

* Net Operating Income--On a transaction level REIS is leveraging its property level database and general market knowledge to generate an estimated NOI.

* Capitalization Rate--Reported sale price/estimated NOI.

Suggested by the Y. T. and Louise Lee Lum Library

Appraisal Institute

* Education

* The Discounted Cash Flow Model

* General Appraiser Sales Comparison Approach

* Lum Library External Information Sources [Login required]

Information Files--Special-purpose properties, office properties

CapRates.net--Commercial real estate cap rates http://www.caprates.net/

CBRE--2016 US reports http://www.cbre.us/research/2016-U-S-Reports/Pages/default.aspx

CoStar--Commercial real estate database http ://www.costar.com/products/costar-comps

Integra Realty Resources (IRR)--Viewpoint report http://www.irr.com/Publication-PubllcationLlst/lndex.htm

National Council of Real Estate Investment Fiduciaries (NCREIF)--"Cap Rate: Please Explain!" https://www.ncreif.org/globalassets/public-site/research/ncreif-insights/research-corner-oct-2011-cap-rates-flnal.pdf

PricewaterhouseCoopers--Publications http://www.pwc.com/us/en/asset-management/real-estate/publications.html

Real Capital Analytics (RCA) https://www.rcanalytics.com/

RealtyRates.com--Quarterly reports http://www.realtyrates.com/

REIS Reports--Commercial real estate data https://rr.reis.com/

Situs RERC--Real Estate Report and DataCenter http://store.rerc.com

Society of Industrial and Office Realtors--Resources http://www.sior.com/resources

(1.) Stabilized occupancy is the occupancy of a property that would be expected at a particular point in time, considering its relative competitive strength and supply and demand conditions at the time, and presuming it is priced at market rent and has had reasonable market exposure. A property is at stabilized occupancy when it is capturing its appropriate share of market demand. Appraisal Institute, The Dictionary of Real Estate Appraisal, 6th ed. (Chicago: Appraisal Institute, 2015), s.v. "stabilized occupancy."

(2.) See for example, http://bit.ly/CBRE_Survey.

(3.) D. Richard Wincott, Kevin A. Hoover, and Terry V. Grissom, "Capitalization Rates, Discount Rates, and Reasonableness," Real Estate Issues 21, no. 2 (August 1996): 11-15.

(4.) Charles B. Akerson, Capitalization Theory and Techniques Study Guide, 3rd ed. (Chicago: Appraisal Institute, 2009), 64.

(5.) D. Richard Wincott, "A Primer on Comparable Sale Confirmation," The Appraisal Journal (July 2002): 274-282.

(6.) Appraisal Institute, The Appraisal of Real Estate, 14th ed. (Chicago: Appraisal Institute, 2013), 391-392.

(7.) Certain calculations in the case study require present value estimates. For purposes of Illustration, the assumption is made that the appropriate discount rate (Vo) for all of the comparable properties and the subject property is 9%. In actual practice this could vary between properties based on the buyers' underwriting assumptions.
```Exhibit 1 Stabilized Value Adjustment Process

Stabilized Occupancy Rate 95%

Comp 1    80%
Comp 2    95%
Comp 3    77%
Subject   70%

Note: Table made from bar graph.

Exhibit 2 Subject Property Data and Comparables Data at Time of Sale

Subject     Comp No. 1
Property

Purchase price                              \$62,500,000
Net rentable area (SF)           250,000        300,000
Land area (acres)                   1.75           2.00
Land-to-building ratio              0.30           0.29
Floor area ratio                    3.28           3.44
Occupancy rate                       70%            80%
Weighted average remaining          2.25           2.20
lease term (yrs.)
Contract rent (per SF)            \$32.00         \$35.00
Remaining term on above-/             18             12
below-market rent (mos.)
Remaining free rent (mos.)            --             --
Fixed expenses (per SF)           \$10.00         \$10.00
Variable expenses at               \$2.25          \$2.25
stabilized occupancy
(per SF)(excluding mgt. fee)
Percent variable                   75%            75%
Management fee (% EGRM)               4%             4%
Current NOI                        \$9.79         \$15.00
EGR                             \$27.55         \$27.55
Total expenses                  \$12.25         \$12.25
Mgt.                             \$1.10          \$1.10
Expenses as % of EGR            48.46%         48.46%

Comp No. 2     Comp No. 3

Purchase price                   \$53,000,000    \$44,500,000
Net rentable area (SF)               275,000        225,000
Land area (acres)                       1.75           4.00
Land-to-building ratio                  0.28           0.77
Floor area ratio                        3.61           1.29
Occupancy rate                           95%            77%
Weighted average remaining              4.50           2.50
lease term (yrs.)
Contract rent (per SF)                \$30.00         \$27.50
Remaining term on above-/                N/A             24
below-market rent (mos.)
Remaining free rent (mos.)                 6              -
Fixed expenses (per SF)               \$11.00         \$11.00
Variable expenses at                   \$2.50          \$2.50
stabilized occupancy
(per SF)
(excluding mgt. fee)
Percent variable                       75%            75%
Management fee (% EGRM)                   4%             4%
Current NOI                           \$13.99          \$7.29
EGR                                 \$28.50         \$28.50
Total expenses                      \$13.50         \$13.50
Mgt.                                 \$1.14          \$1.14
Expenses as % of EGR                51.37%         51.37%

EGR--Effective gross revenue. EGRM--Effective
gross revenue multiplier

Exhibit 3 Buyer Assumptions and Market
Information on Subject Property

Subject     Comp No. 1
Property

Stabilized occupancy rate              95%           95%
Market rent (per SF)                \$29.00        \$29.00
Months to achieve stabilized            12             6
occupancy
Tenant improvements (per SF)        \$20.00        \$20.00
Leasing commissions                  4.00%         4.00%
Deferred maintenance            \$1,500,000    \$2,000,000

Comp No. 2    Comp No. 3

Stabilized occupancy rate              95%           95%
Market rent (per SF)                \$30.00        \$30.00
Months to achieve stabilized           N/A             9
occupancy
Tenant improvements (per SF)        \$20.00        \$20.00
Leasing commissions                  4.00%         4.00%
Deferred maintenance            \$2,000,000    \$3,000,000

Exhibit 4 Financial Operating Data

Subject       Comp No. 1
Property (\$)       (\$)

Current Operating Statements
Current gross revenue                        5,600,000      8,400,000
Fixed expenses                             (2,500,000)    (3,000,000)
Variable expenses                            (451,480)      (595,066)
Management fee                               (224,000)      (336,000)

Current NOI                                  2,424,520      4,468,934
Current NOI (per SF)                              9.70          14.90

Stabilized Operating Statements
Potential gross revenue *                    7,250,000      8,700,000
Stabilized vacancy and credit loss           (362,500)      (435,000)

Effective gross revenue                      6,887,500      8,265,000
Fixed expenses                             (2,500,000)    (3,000,000)

Variable expenses at stabilized              (562,500)      (675,000)
occupancy (per SF) (excluding mgt. fee)
Management fee                               (275,500)      (330,600)

Stabilized NOI                               3,549,500      4,259,400
Stabilized NOI (per SF)                          14.20          14.20

Comp No. 2     Comp No. 3
(\$)            (\$)

Current Operating Statements
Current gross revenue                        7,837,500      4,764,375
Fixed expenses                             (3,025,000)    (2,475,000)
Variable expenses                            (687,500)      (482,566)
Management fee                               (313,500)      (190,575)

Current NOI                                  3,811,500      1,616,234
Current NOI (per SF)                             13.86           7.18

Stabilized Operating Statements
Potential gross revenue *                    8,250,000      6,750,000
Stabilized vacancy and credit loss           (412,500)      (337,500)

Effective gross revenue                      7,837,500      6,412,500
Fixed expenses                             (3,025,000)    (2,475,000)

Variable expenses at stabilized              (687,500)      (562,500)
occupancy (per SF) (excluding mgt. fee)
Management fee                               (313,500)      (256,500)

Stabilized NOI                               3,811,500      3,118,500
Stabilized NOI (per SF)                          13.86          13.86

* 100% NRA lease at market rent

Exhibit 5 Absorption/Rent Loss Analysis, Comparable 1

Net rentable area                        300,000   SF

Current vacant space                      60,000   SF

Current occupied space                      80%

Stabilized occupancy rate                   95%

Absorption required to                    45,000   SF
achieve stabilized occupancy

Absorption timing                     Quarterly

Absorption periods to reach                   2
stabilized occupancy

Average space absorbed per period         22,500   SF
once absorption commences

Beginning                           End of
Period      Space     Remaining    Period
Absorption   Occupancy   Absorbed    Vacant     Occupancy
Period         (SF)        (SF)     Area (SF)      (%)

1             240,000     22,500     37,500        88
2             262,500     22,500     15,000        95

Totals

Revenue Loss

Occ.
Sensitive
Rent      Expense     Expense       P.V.     P.V. of
Absorption    Loss     Recapture   Adjustment    Factor    Revenue
Period         (\$)     Loss (\$)       (\$)        9.00%     Loss (\$)

1            326,250     0.00       -32,034     0.977995   287,741
2            163,125     0.00       -16,017     0.956474   140,705

Totals       489,375     0.00       -48,052                428,446

Leasing Cost Analysis

Leasing                     Total
Absorption      Tenant      Commissions   P.V. Factor    Leasing
Period       Imprmts. (\$)       (\$)          9.00%      Costs (\$)

1              450,000        130,500      0.977995       567,726
2              450,000        130,500      0.956474       555,233

Totals                                                  1,122,960

Present Value of Revenue Loss       \$428,446
Due to Absorption

Present Value of Leasing Cost      1,122,960

Total Value Impairment Due to     \$1,551,406
Below-Market Occupancy

Exhibit 6 Absorption/Rent Loss Analysis, Comparable 3

Net rentable area                        225,000   SF

Current vacant space                      51,750   SF

Current occupancy rate                       77%

Stabilized occupancy rate                    95%

Absorption required to                    40,500   SF
achieve stabilized occupancy

Absorption timing                      Quarterly

Absorption periods to reach                    3
stabilized occupancy

Average space absorbed per period         13,500   SF
once absorption commences

Beginning                           End of
Period      Space     Remaining    Period
Absorption   Occupancy   Absorbed    Vacant     Occupancy
Period         (SF)        (SF)     Area (SF)      (%)

1             173,250     13,500     38,250        83
2             186,750     13,500     24,750        89
3             200,250     13,500     11,250        95

Totals

Revenue Loss

Occ.
Sensitive
Rent      Expense     Expense       P.V.     P.V. of
Absorption    Loss     Recapture   Adjustment    Factor    Revenue
Period         (\$)     Loss (\$)       (\$)        9.00%     Loss (\$)

1            303,750     0.00       -31,134     0.977995   266,617
2            202,500     0.00       -20,756     0.956474   173,833
3            101,250     0.00       -10,378     0.935427    85,004

Totals       607,500     0.00       -62,269                525,454

Leasing Cost Analysis

Tenant      Leasing       P.V.       Total
Absorption    Imprmts.   Commissions   Factor      Leasing
Period          (\$)          (\$)        9.00%     Costs (\$)

1             270,000      81,000      0.977995     343,276
2             270,000      81,000      0.956474     335,723
3             270,000      81,000      0.935427     328,335

Totals                                            1,007,334

Present Value of Revenue Loss         \$525,454
Due to Absorption

Present Value of Leasing Costs       1,007,334

Total Value Impairment Due to       \$1,532,788
Below-Market Occupancy

Comp No. 1     Comp No. 2

Nominal Sale Price                         \$62,500,000    \$53,000,000

Real property rights conveyed                      0              0
Financing terms                                    0              0
Adjustment for non-realty items                    0              0
Market conditions                                  0              0
Present value of below-market rent               0              0
Near-term capital                        2,000,000      2,000,000
expense requirements
Present value of remaining                       0      3,918,750
rent concessions
Present value of income loss until         428,446              0
stabilized occupancy
Present value of tenant                  1,122,960              0
improvements and leasing
commissions
Present value of above-market rent      -1,327,182              0
Value of excess land                             0              0
Seller-funded guarantees                         0     -2,000,000

Nominal sale price per square foot             \$208.33        \$192.73
Going-in (Current) NOI per square foot          \$14.90         \$13.86
Going-in [R.sub.O]                               7.15%          7.19%
Stabilized sale price per square foot          \$215.75        \$206.98
Stabilized NOI per square foot                  \$14.20         \$13.86
Stabilized [R.sub.O]                             6.58%          6.70%

Comp No. 3

Nominal Sale Price                         \$44,500,000

Real property rights conveyed                      0
Financing terms                                    0
Market conditions                                  0
Present value of below-market rent         764,147
Near-term capital                        3,000,000
expense requirements
Present value of remaining                       0
rent concessions
Present value of income loss until         525,454
stabilized occupancy
Present value of tenant                  1,007,334
improvements and leasing
commissions
Present value of above-market rent               0
Value of excess land                    -2,600,000
Seller-funded guarantees                         0

Nominal sale price per square foot             \$197.78
Going-in (Current) NOI per square foot           \$7.18
Going-in [R.sub.O]                               3.63%
Stabilized sale price per square foot          \$209.76
Stabilized NOI per square foot                  \$13.86
Stabilized [R.sub.O]                             6.61%

Exhibit 8 Comparable Sales Regression Analyses

Sale No.             NOI/SF   Price/SF   Predicted   Variance

Subject              \$14.20
1                    \$14.20   \$215.75     \$215.75     0.00%
2                    \$13.86   \$206.98     \$208.37    -0.67%
3                    \$13.86   \$209.76     \$208.37     0.66%

Average *            \$13.97   \$210.83

Regression Output:
Constant           (\$94.12)
Coefficient        21.82455382
R-Squared          90.33%

* Averages do not include subject property

Exhibit 9 Absorption/Rent Loss Analysis, Subject Property

Net rentable area                    250,000   SF
Current vacant space                  75,000   SF

Current occupancy rate                   70%

Stabilized occupancy rate                95%

Absorption required to achieve        62,500   SF
stabilized occupancy

Absorption timing                  Quarterly

Absorption periods to reach               4
stabilized occupancy

Average space absorbed per            15,625   SF
period once absorption
commences

Beginning                           End of
Period      Space     Remaining    Period
Absorption   Occupancy   Absorbed    Vacant     Occupancy
Period         (SF)        (SF)     Area (SF)      (%)

1             175,000     15,625     59,375        76
2             190,625     15,625     43,750        83
3             206,250     15,625     28,125        89
4             221,875     15,625     12,500        95

Totals

Revenue Loss

Occ.
Sensitive
Expense     Expense
Period            (\$)        Loss (\$)       (\$)

1                 453,125        0.00     (44,492)
2                 339,844        0.00     (33,369)
3                 226,563        0.00     (22,246)
4                 113,281        0.00     (11,123)

Totals       1,132,812.50        0.00    (111,230)

Revenue Loss

P.V.      P.V. of
Absorption    Factor     Revenue
Period         9.00%     Loss(\$)

1            0.977995    399,641
2            0.956474    293,135
3            0.935427    191,123
4            0.914843     93,459

Totals                   977,358

Leasing Cost Analysis

Tenant      Leasing       P.V.
Absorption   Imprmts.   Commissions    Factor    Total Leasing
Period         (\$)          (\$)        9.00%       Costs (\$)

1            312,500      90,625      0.977995         394,254
2            312,500      90,625      0.956474         385,579
3            312,500      90,625      0.935427         377,094
4            312,500      90,625      0.914843         368,796

Totals                                               1,525,723

Present Value of Revenue Loss Due to Absorption         \$977,358
Present Value of Leasing Costs                         1,525,723
Total Value Impairment Due to Below-Market Occupacy   \$2,503,081

Exhibit 10 Subject Property Direct Capitalization

Stabilized net operating income                          \$3,549,500

Selected stabilized capitalization rate ([R.sub.O])           6.65%

Stabilized value estimate                               \$53,375,940

Total adjustments to reflect current                   \$(3,293,070)
property operating status

Current Value by Direct Capitalization                  \$50,082,870

(Rounded)     \$50,100,000

Estimated value per square foot                             \$200.40

Going-in (Current) NOI per square foot                        \$9.70

Going-in [R.sub.O]                                            4.84%

Stabilized estimated value per square foot                  \$213.50

Exhibit 11 Comparison of Capitalization Rates

Comp 1   Comp 2   Comp 3   Subject Property

Going-in [R.sub.O]     7.15%    7.19%    3.63%         4.84%
Stabilized [R.sub.O]   6.58%    6.70%    6.61%         6.65%
```