Every year, municipalities assess the market value of all real property within their jurisdiction for the purpose of collecting real estate taxes. Due to the vast number of properties, assessors conduct mass appraisals. Real property is divided into classes based on property type and further stratified based on its unique characteristics. Assessors then use the most appropriate valuation model and apply collected market value indicators to calculate value. Most commercial properties are income-producing and, therefore, the income capitalization approach is primarily used because it provides the most accurate and pertinent approximation of market value.
Because the purpose of the assessment process is to determine value for the purposes of taxation, assessors are left with a Catch-22 dilemma. The direct capitalization approach calculates value by dividing a property’s net operating income by the market cap rate. Net operating income is calculated by subtracting all costs of ownership from the property’s gross revenue; including real estate taxes. Real estate taxes are ad valorem taxes; meaning their amount is based on the value of a transaction or, for the purposes of this article, a property. This means that if assessors were to use the traditional direct capitalization approach they would have to subtract real estate taxes from the gross revenue to establish the net operating income in order to calculate the value which would determine the real estate taxes that would need to be subtracted from the gross revenue to calculate the net operating income to calculate value which would determine the real estate taxes… You get the point.
So, how do assessors escape this circular logic? Simple, by loading the cap rate used to establish value.
Loading the cap rate involves adding the municipality’s ad valorem tax rate to the market cap rate for a particular property (class, type, etc.). Assessors then remove real estate taxes from the property’s net operating income and divide that amount by the loaded cap rate to calculate the property’s market value. I’ve provided examples below (with actual real estate tax rates) to show how calculations using loaded cap rates arrive at the same valuation as when real estate taxes are included in a property’s net operating income and the “unloaded,” market cap rate is used.