Many cities and towns use a simple formula involving the capitalization, or “cap rate” to calculate property tax assessments. 8840139_s[1]The cap rate is determined by dividing the property’s net operating income by its sales cost.

But what sounds easy and fair on the surface can actually work against the unwary property owner. Here’s why: Although the cap rate equation involves only straightforward math, the variables going into net operating income and sales figures can make applying the formula a challenge.

 No Two Properties are Exactly Alike

To calculate a building’s valuation, the assessor first chooses several properties that seem comparable to yours and then, using those properties’ net operating income and sales price, calculates a typical cap rate for the property type in your market.

 The trouble is, no two properties are exactly alike. They carry unique financing (or none at all), have a different mix of tenants, and generate different expenses. They’re never managed the same and, unless they’re both fully occupied, they won’t have the same vacancy rate. There can also be differences in the accounting used. And the sales price may, or may not, have included business value.

 The Complexities of Calculation

Net Operating Income: The trickiest component of cap rate calculation is net operating income. Net income should include earnings, but not depreciation, business taxes or interest expense. Taxes paid and depreciation taken are excluded because depreciation depends on the initial cost paid for the property and taxes paid are often influenced by depreciation taken. Interest expense is also excluded so the property’s value isn’t influenced by the type, terms and amount of financing used to purchase it.

Rental Income: Rental income is a primary component of earnings. But which income should the assessor use? Both in-place current rents (based on current leases) and estimated rental values (open market rents) should be identified.

Expenses: There are many variables that may, or may not, be included in the expense calculation — Do the managers pay themselves a fee to run the building? Is that fee reasonable? Do they have on-site maintenance personnel who receive discounted or free rent as part of their compensation package, or do they use outside contractors to do the work? What’s included in the list of expenses that appear on tax forms, such as office expenses and supplies?

When the property being valued is retail, industrial or office, the complexity of calculating net operating expenses increases dramatically. In addition to having more complex lease terms, commercial tenants build out their spaces individually. A sub shop and an upscale restaurant may both serve food, but they entail different business risks and would finish their interiors quite differently.

 Working with Your Assessor and Your Advisors

Correctly determining a cap rate can be mind-numbingly complex. And yet, it’s important that your assessor get it right when calculating property values for tax assessments. Get your financial advisor involved so you pay no more than your fair share of property taxes.