(This archived article was published in 2012. More recent data is found in the articles section of our web site.)
When appraising a property for ad valorem assessment purposes in the Chicago area and all of Illinois, the properties are to be assessed in "fee simple" estate which assumes the property is not encumbered by any existing leases. According to Jeffrey Fisher, Ph.D. and A. Scruggs Love, Jr., MAI, CRE:
"Surveys like the Korpaz Investor Survey reports capitalization rates based on surveys of "equity real estate market participants" who are investing in properties subject to leases. As such, their perception of a property capitalization rate is from the perspective of the owner of a leased fee estate in the real estate."
The very fact that a lease is on a property can dramatically lower the risk to the owner which should result in a much lower capitalization rate. If you were looking at two identical industrial buildings and one had a 5-year lease at $5.00 per square-foot and the tenant had already been in the building for several years with a good payment history you would pay much more than for another building with a simple imputed market rent. The risk differentials can be night and day. The leased fee property would have a lower capitalization rate than the comparable fee simple building. Another major issue is that owners of leased properties are often willing to renew leases to existing tenants at lower levels because they won't have to pay marketing commissions or spend as much money on tenant improvements. The owners also know their tenant's payment history and could we willing to provide a discount for a lower default or rent payment risk. Investor surveys are also based upon reported rates by the investors or market participants. When buildings sell that have above market vacancy rates they would be expected to have a much lower NOI thus a much lower capitalization rate. These distressed or partially impaired buildings can skew the reported capitalization rates down in the survey.
Dr. Fisher and Mr. Love, MAI described similar factors as indicated above in the article Issues in Comparing Capitalization Rates for Leased Fee and Fee Simple Estates. They concluded, "All of the above factors imply a higher capitalization rate should be used to value a fee simple estate - even higher if the additional TIs and leasing commissions associated with fee simple estates are not explicitly deducted from NOI."
Determining the correct capitalization rates is one of the most critical elements in appraising an income producing retail, office or industrial property. The propensity to confuse leased fee survey capitalization rates with a fee simple appraisal can result in the over-appraisal of property values, particularly for tax assessment purposes. Peterson Appraisal Group focuses on the appraisal of retail, office, industrial and multi-family apartment buildings in Chicago and its suburbs as well as all of Cook County Illinois for tax assessment purposes.