Changing cap rate spreads may inflate property taxes.

"Accurate capitalization or cap rates (the ratio between the annual net operating income of an asset and the capital cost or market value) enable an appraiser or investor to calculate an asset's value from its net operating income..."

By Michael Shalley, as published by Shopping Center Business, March 2013

A scarcity of comparable sales data is driving many property tax assessors to rely on historical rules of thumb that may threaten inflated tax bills for shopping center owners. Studying the problem requires a clear understanding of the events that have weighed down transaction volume, how mass appraisal software works, and how extrapolations from the few property sales available today can lead appraisers astray.

A Recipe for Confusion

The recent credit crunch may be regarded as one of the worst in American history. The crisis hit hard in March 2008, as investment bank Bear Stearns became the first of dozens of major American financial institutions to fail or be bailed out by the Fed. The causes were many, starting with subprime mortgages and extending to consumer credit, commercial mortgage backed securities and credit default swaps. But one of the greatest impacts for the commercial real estate market came in the form of uncertainty regarding property values and future access to credit.

This vast uncertainty that followed the crisis halted or cratered most transactions in commercial real estate, making it almost impossible to accurately appraise property and peg asset prices. Appraisers and property tax assessors struggled to find comparable sales, and many times looked back to historical rules of thumb to extrapolate data gathered from a few current sales for application in a wide range of assessments. It is the use by property tax assessors of these old standards in mass appraisal valuation models that may overburden some property owners.

Accurate capitalization or cap rates (the ratio between the annual net operating income of an asset and the capital cost or market value) enable an appraiser or investor to calculate an asset's value from its net operating income. So an assessor who knows the cap rate from a recent property sale can use that data in assessing similar properties.

In normal and functioning commercial real estate markets, the spread in capitalization rates between Class A, B and C properties has generally held a consistent range. Historically, the variance or spread in cap rates between Class A or investment-grade properties and Class B properties typically averaged between 75 basis points and 150 basis points. A similar cap rate spread existed between Class B and C properties. However, these old rules of thumb have become at least temporarily obsolete.

There has been a flight to quality among investors and well-leased Class A shopping centers' cap rates are getting really aggressive," says Rafi Zitvar, a principal at Global Fund Investments LLC, which specializes in retail real estate. On the other hand, "Class B and B-minus centers have to be priced very attractively, say 200 to 300 basis points above Class A centers, for us to even look at them." The PWC Real Estate Investor Survey — compiled quarterly by PricewaterhouseCoopers and formerly known as the Korpacz Real Estate Investor Survey — reveals this widening trend for cap rates among asset classes in the national strip shopping center category. The survey data confirms that the average cap rate spread between institutional grade and non-institutional grade properties has increasingly widened for the past six years (as shown in the chart).

Modeling Mishaps

Many property tax assessors use a mass appraisal income approach model that uses cap rates to assess shopping centers. The model breaks down various components of each shopping center that are usually predicated on the classification of the center. The rental income, expenses and a corresponding cap rate for each shopping center are driven by the class inputted into the valuation model. Cap rates for each classification of shopping center are calculated off a sliding scale, where the base rate is usually a Class A cap rate supported by a sale or sales in the market, and then all other classes are modeled out using a scale based on typical spreads. It is the scaling or setting of cap rates for Class B and C shopping centers using a Class A cap rate that can result in overvaluation.

Clearly, the cap rate spreads between the top-quality shopping center assets and other classes have significantly changed over the past few years. Therefore, when assessors use historical cap rate spreads between different classes of shopping centers, the mass appraisal model overvalues properties from all but the highest class. It takes some experience, diligence and a detailed understanding of the assessor's model to ensure that a shopping center is being accurately appraised using today's standards.

Michael Shalley is a principal at the Austin, Texas, law firm of Popp Hutcheson PLLC., which focuses its practice on property tax disputes, and is the Texas member of American Property Tax Counsel, the national affiliation of property tax attorneys. He can be reached at This email address is being protected from spambots. You need JavaScript enabled to view it..