The Capitalisation Rate Conundrum: Principles, Practice and Conquering Industry Problems

Abstract

Capitalisation rates are central to a very popular short cut valuation method used widely around the world for investment property valuation. In the hands of an experienced valuer, the capitalisation rate provides a useful heuristic but very small changes in the rate may make very large differences in capital value. This paper explores the theoretical foundations and practical applications of capitalisation rates together with potential errors in capitalisation rate implementation.

Despite warnings about the shortcomings of the capitalisation of income method of valuation in the Greenwell Report of 1976, the method remains extensively used for a wide range of investment property types around the world. The capitalisation rate conundrum is how to effectively apply the capitalisation of income method in markets with incomplete or unreliable data.

The principles or theoretical foundations of the capitalisation of income method are often overlooked when the method is selected for application resulting in the inappropriate application of the method. This problem may be compounded in practice by practitioners attempting to apply the capitalisation of income method despite incomplete or unreliable data, leading to a valuation conclusion that may be erroneous.

Conquering industry problems may be contended to be based in only using the capitalisation of income method when it is fit for purpose and its theoretical foundations can be supported, perhaps through a more consistent and sophisticated approach to analysis. If not fit for purpose, alternative income valuation methods or alternative valuation approaches should be considered and, in markets where incomplete or unreliable data is an underlying problem, it may be contended that an opportunity exists for professional data providers to offer solutions.