Support in a Commercial Appraisal
Try as you might. You will never reduce the process of appraising real estate to a science. But you can provide more support for your reasoning in a commercial appraisal report. For example, I was recently asked to provide additional support for an equity dividend rate in an appraisal report of a large retail/warehouse building I appraised. Ever tried that? Supporting an equity dividend rate, that is.
Equity Dividend Rate Defined
First, it may be helpful to understand exactly what an equity dividend rate is. The Dictionary of Real Estate Appraisal, Fifth Edition, defines an equity dividend as “The portion of net operating income that remains after total mortgage debt service is paid but before ordinary income tax on operations is deducted.” In theory, the net operating income for an income producing property should be adequate to satisfy the debt service and also provide a return to the equity investor – to reward them for risk. Ideally, the rate used should be the result of surveying local market participants expectations. In practice, few buildings are actually bought and sold in anticipation of a specific return to the equity investment, unless of course, you are dealing with an investment grade property…say, for example, a multistory office building in a large metropolitan area.
Extracting an Equity Dividend Rate from Sales
But there is a way to extract an equity dividend rate from the sales of similar properties if you have the actual or estimated overall capitalization rate for your comparable sales and market oriented financing terms on the respective sale date for each sale. Because the Band of Investments method for calculating an overall capitalization rate allocates the overall rate between the debt and equity components, extracting an equity dividend rate becomes a simple math problem. Here is an example. (For a downloadable spreadsheet click here.)
Assume that the overall captialization rate for a sale is 7.00%. Market oriented lending rates on the date of sale include an 80% loan-to-value ratio, a 20 year term amortization term, and a 5.00% annual interest rate. The portion of the overall rate allocated to meet debt service may be calculated as: LTV x Mortgage Loan Constant = 80% x .079195 = .063356 or 6.34%. In other words, 6.34% of the overall captialization rate (used to convert a single years’ income into a value indication) is allocated to satisfy debt service. What remains of the overall capitalization rate is allocated to the equity component and may be calculated as:
.070000 – .063356 = .006644
One final calculation is necessary to extract an equity dividend rate from your sale. Simply divide this allocated percentage of the overall capitalization rate by the equity percentage. Here is the calculation: Overall Capitalization Rate Allocated to the Equity Component/Equity % = .006644/.20 = .03321 or 3.32%.
A Final Word
So what’s the bottom line? Well, the bottom line is this: While investors’ may not have an explicit rate in mind, the implicit rate derived from the sale indicates a rate of approximately 3.32%. While a single sale does not a market make, extracting an equity dividend rate from sales is at least some market support for your estimate of an appropraite rate.
And that, my friends, is how you support an equity dividend rate. Plus, it makes for a better appraisal. In my opinion, anyhow.
Have more questions? See if we’ve answered them in our other blogs!