Determination of the capitalization rate in the selected areas of the Czech Republic

© 2022 Published by VŠB-TU Ostrava. All rights reserved. ER-CEREI, Volume 25: 69-75 (2022). ISSN 1212-3951 (Print), 1805-9481 (Online) Determination of the capitalization rate in the selected areas of the Czech Republic Hana JANÁČKOVÁa * , Josef KAŠÍKb a Department of Economics, Faculty of Economics, VŠB - Technical University of Ostrava, Sokolská třída 33, 702 00 Ostrava, Czech Republic. b Department of Business Administration, Faculty of Economics, VŠB - Technical University of Ostrava, Sokolská třída 33, 702 00 Ostrava, Czech Republic. Abstract This article aims to calculate the capitalization rate in selected areas of the Czech Republic based on data obtained from actual sales in the real estate market. The purpose is to make a spatial comparison and determine whether areas with higher risk levels also show higher capitalization rates in line with theoretical assumptions. For selected urban districts of Ostrava, a comparison over time was also undertaken following similar research carried out four years ago. As the capitalization rate is also part of the valuation ordinance, a comparison was made between the capitalization rate stated in the ordinance and the calculated values. Keywords Capitalization rate, income approach, real estate, valuation JEL Classification: R310, R210 * hana.janackova@vsb. cz (corresponding author) Ekonomická revue - Central European Review of Economic Issues 25, 2022 70 Determination of the capitalization rate in the selected areas of the Czech Republic Hana JANÁČKOVÁ, Josef KAŠÍK 1. Introduction The valuation of real estate is a topical issue that is of interest to many people, not only in the Czech Republic (Bradáč et al., 2009, 2016; Ort, 2014; Zazvonil, 2013) but also worldwide (Betts and Glickman, 2013; Wiedemer and Baker, 2012; Wiedemer and Goeters, 2011). At the same time, it is a topic with significant practical application because, every day, it is necessary to value many pieces of real estate for various reasons. These reasons for the valuation of immovable property include, for example, transfers of ownership and inheritance proceedings, which are associated with a property’s entry into the land register, the entry of immovable property into a commercial establishment, a pledge to a bank, insurance, expropriation, settlement of damages, and so on. Depending on the reason for the valuation, the methods of valuation are defined according to the current Act No. 151/1997 Coll. on the Valuation of Property. Valuation is mainly carried out using the comparison method. However, if a suitable sample is not available on the market for comparison and/or the property does not bring the owner income/rent, one of the main methods is the income approach, which uses the capitalization of net operating income (net profit/rent) to calculate the usual price (market value) of the immovable property. One of the key factors in calculating value using this method is the appropriate determination of the capitalization rate. Even though many articles and papers have been written on this topic (Ardielli et al., 2016; Slavata et al., 2014; Stefanovová and Peterková, 2014; Stefanovová and Procházka, 2014), the vast majority of them have based their calculations not on actual prices achieved but on offer prices in advertisements. However, it is clear that the price actually paid may differ significantly from the original offer price (the value demanded by the seller). We can see a reduction but also currently an increase (when there are so many interested parties that the property is sold at a higher price than the originally advertised offer price). Thus, further research that is being intensively conducted in the world, focusing not only on the calculation of the capitalization rate but also on the main determinants of the capitalization rate, seems to be interesting (Larriva and Linneman, 2022). This paper determines the capitalization rate using unbiased input data of actual prices based on price data available from the Land Registry and rents over a certain period in a selected city to minimize the inaccuracy in its calculation. This capitalization rate for market real estate valuation (specifically flats in selected parts of Ostrava and in the cities of Karviná and Kladno) can subsequently be used in their specific business activities not only by appraisers or real estate agencies operating in the Czech Republic under Act No. 455/1991 Coll. on Trade Licensing (Trade Licensing Act) but also by valuer experts, appraisal offices and appraisal institutes operating under special regulations (Act No. 254/2019 Coll.). The objectives of this article can be divided into three areas. The first objective is to answer the research question of whether, in line with theoretical assumptions, areas with higher levels of risk (in terms of longrun achievement of expected rents) also exhibit higher capitalization rates than areas with lower levels of risk. The second objective is to compare the current level of the capitalization rate in selected urban areas of Ostrava with the previously calculated level (specifically in 2018) in the same urban areas (Kašík and Janáčková, 2018). Finally, the third objective is to compare the calculated values of the capitalization rate with the capitalization rate established in Valuation Decree No. 441/2013 Coll. as amended for the legally required administrative valuation purposes. 2. Theoretical basis of real estate valuation Before we proceed to specific cases related to the issue of real estate valuation, we consider it necessary to define the fundamental concepts and to list the basic approaches currently used in the valuation of real estate not only in the Czech Republic but also across the world. 2.1 Basic concepts The first concept is real estate or, more precisely, immovable property, which is defined in Section 498(1) of Act No. 89/2012 Coll., the Civil Code. According to this law, immovable property is “land and underground structures with an independent purpose, as well as property rights to them, and rights that are declared by law to be immovable property. If the law stipulates that a certain thing is not part of the land and if such thing H. Janáčková, J. Kašík - Determination of the capitalization rate in the selected areas of the Czech Republic 71 cannot be transferred from place to place without violating its essence, such thing is also immovable.” Other important concepts to distinguish are price and value. The price of immovable property is the financial amount negotiated in the real estate market through the interaction of supply and demand. Value is a more general term than price. The value of an immovable property derives from the degree of utility, that is, the ability of the asset to satisfy individual human needs, wants or desires. Value in the individual subjective sense indicates that each property may have one or more utility values. Firstly, there is the utility value for the owner: the fulfilment of the purpose of the immovable property for which the real estate was acquired; secondly, there is the emotional value for the owner (the property was inherited or donated, the property is tied to memories, etc.). The immovable property also has value for other subjects as it is set in and influenced by its environment. In meeting the needs of nonowners, immovable properties can have social value (hospitals, schools), cultural value (theatres, cinemas, galleries), sports value (stadiums, swimming pools), historical value (castles, chateaux), religious value (churches, monasteries, chapels), public value (roads, infrastructure, sewage treatment plants, public buildings – offices, parliament, municipal offices) and, last but not least, aesthetic value (architectural buildings and landmarks). Thus, value reflects the proposition, while price is the reality achieved in the market. Value, therefore, expresses the utility or benefit on the date on which the estimate of value is made. The opinion of the value of a single immovable property is expressed by several parties, for example interested parties, appraisers and sellers, whose ideas may differ and only in the course of negotiations and at the time of the exchange will these ideas result in a specific price. The realization of the exchange in a market environment leads to the fulfilment of the parties’ expectations regarding the exchange value, which results in the formation of a market price. At the same time, as indicated above, there are several categories of value depending on how they are defined and on which property of the immovable property they focus (e.g. book value, utility value, income value, market value, social value, offer value, etc., each of which can be expressed in a different monetary amount). Therefore, when not only valuing real estate, it is always necessary to define the value that is being determined (Dušek, 2010). When defining the market value, it is possible to rely on the International Valuation Standards, in which the market value is defined as “the estimated amount for which an asset should be exchanged at the valuation date between a willing buyer and a willing seller in a transaction between separate and independent partners after appropriate marketing, in which both parties would act in an informed, reasonable, and non-pressured manner”. The current Czech legislation as of 1 January 2021 also already knows the concept of market value. Act No. 237/2020 Coll., amending Act No. 151/1997 Coll., defines the category of value as follows: “For the purposes of this Act, market value means the estimated amount for which the property or service should be exchanged on the valuation date between a willing buyer and a willing seller, in a commercial transaction carried out in accordance with the market detachment principle, after proper marketing, where each party has acted in an informed and prudent manner and not under duress”. In this context, it is worth mentioning that, in the Czech Republic, it is possible to distinguish two basic types of valuation (more precisely, appraisal) of real estate. According to the currently valid practices, they are called: • administrative or official valuation, which results in a price determined (administrative) according to the applicable price regulation of Act No. 151/1997 Coll., as amended; • market valuation, which most often results in a usual price (market value). Another concept is the capitalization rate, which is generally defined in the International Valuation Standards as “the divisor (usually expressed as a percentage) used to convert returns to value” (International Valuation Standards Committee, 2007). This divisor is very closely related to the familiar process of discounting future returns, in which there is mathematical correspondence between the capitalization formula and the discount formula for the so-called perpetual annuity, that is, a theoretically never-ending stream of income of a constant amount. Thus, in the context of calculating the income value of immovable property, it is the number by which we divide the future annual net operating income (net profit) from rents to obtain the income value of the immovable property. From a different perspective (if we know the value of the immovable property and the net income, as in the case of our analysis), it is the net rate of return or profitability of the investment (in our case, the profitability of the immovable property). The rate of capitalization for administrative valuation purposes is set in the current price regulations in Annex 22 at 5.5% for flats in standard blocks of flats and 4.5% for flats in non-standard blocks of flats, with the possibility of an increase of up to half a percentage point. However, these values are without distinction regarding location in the Czech Republic (Decree No. 441/2013 Coll.). Ekonomická revue - Central European Review of Economic Issues 25, 2022 72 The last concept to be defined as necessary for calculating the capitalization rate is the net operating income, in this case from rent. The net operating income can be defined as the difference between, on the one hand, all the income or revenues that can be expected to arise from the ownership of the property and, on the other hand, the expenses or costs that are likely to be associated with the ownership and use of the property, always related to a certain period, usually one year (Zazvonil, 2004). The potential rent (contractual or potentially achieved) that can be expected to be achieved at a given time and place is subtracted from the potential rent and operating expenses. These costs are the periodic, foreseeable, reasonable, objective and total costs necessary for the proper operation of the immovable property, which can be expected to continue to be incurred after the change of ownership. These costs may be divided into fixed and variable costs. Fixed costs are property tax, insurance, waste charges, management costs, renewal fund and so on. Variable costs can include payments for utilities, heating and the like. 2.2 Basic approaches used in the valuation of immovable property The basic approaches that can be used for real estate valuation include: • cost approach, • income approach, • comparative approach. The basic idea of the cost approach is that the value of an immovable asset can be derived from the amount that we would currently have to spend to build the particular immovable property, taking into account its physical and moral depreciation. The income approach focuses on the amount of the achievable future income stream from the immovable property (net rental income or profit), which is discounted to the present value using a capitalization rate. The comparative valuation (appraisal) approach is performed by comparing the property with similar freely saleable properties sold at the same time and place based on a number of aspects: type and purpose, layout, materials, technical parameters, quality of design, availability, size, usability, location in the area and manifestations of the surroundings. For the usual price, the comparison includes the sale prices, and for the market value, it includes the offer prices (values) from real estate servers. This paper will use the comparative and income approaches, specifically the income value and comparative value methods, which are described in detail in the following section. 3. Methodology and data used This article will use the actual achieved prices of real estate (specifically flats in private ownership), which have been derived from achieved price data from the Land Registry, to determine the capitalization rate used in income property valuation. A comparative approach will be used to select the sample of dwellings. A basic relationship can be used to calculate the income value: 𝑉𝐻 =𝑧 𝑢 (1) where 𝑉𝐻 is the calculated income value of the property, 𝑧 is the net rental income per year and u is the annual capitalization rate at a given location and time. The capitalization rate can then be derived by knowing the actual prices of specific properties at a given place and time and the amount of net rental income (Bradáč, 2008): 𝑢𝑖=𝑧𝑖 𝐶𝑃𝑖 (2) where 𝑢𝑖 is the calculated capitalization rate, 𝑧𝑖 is the net rental income and 𝐶𝑃𝑖 is the sale price (all for the specific property). Based on these individual calculations, we can then calculate the average capitalization rate at a given location and time as: 𝑢 = ∑𝑢𝑖 𝑛 𝑖=1 𝑛 (3) where 𝑛 is the total number of properties. For the analysis, actual data on real estate prices achieved in the second half of 2021 and the first half of 2022 in selected areas of the Czech Republic were used from negotiated prices available from the Land Registry. Industrial cities were included in the comparison. Specifically, the statutory towns of Karviná and Kladno and selected districts of Ostrava were included. Karviná and Kladno have a 30-minute (approx. 30 km) commute to a major city (Ostrava and Prague). Selected urban districts of the Statutory City of Ostrava (Poruba and Ostrava South) were included for comparison over time with 2018, when similar research was conducted. For the calculation of the capitalization rate, privately owned one-bedroom or two-bedroom flats ranging from 53 m2 to 78 m2 (suitable for families) in high-rise panel blocks of flats with a lift built from the 1970s and 1980s onwards (this is the so-called second-hand market for flats) were selected in all the cities. We excluded sales associated with the effects of extraordinary market circumstances, the personal circumstances of the seller or buyer and the effects of special consideration, no stated price or transfers of cooperative ownership to personal ownership. Table 1 shows the number of flats in the selected areas that were included in the calculation of the capitalization rate. H. Janáčková, J. Kašík - Determination of the capitalization rate in the selected areas of the Czech Republic 73 Table 1 Number of selected flat sales in selected areas of the Czech Republic Area Number of sale prices of flats Karviná 25 Kladno 25 Ostrava – South 30 Ostrava – Poruba 30 Total 110 We used similar criteria to those employed to sample sales prices to compare rents. The area of the flat in m2 and the net rent per m2 were available; we obtained these data through our research from offers from estate agents and concluded rental agreements. 4. Results Table 2 clearly shows the results, i.e. the calculated average prices, rents, and capitalization rates in the selected areas. Table 2 Average capitalization rates in selected regions of the Czech Republic Area Average selling price (CZK/m2 ) Average monthly. rent (CZK/m2 ) Average capitalization rate (%) Min. and max. capitalization rates (%) Karviná 23,208 113 5.80 4.30-8.60 Kladno 74,286 249 3.90 2.40-5.20 Ostrava South 43,590 164 4.50 3.53-5.92 Ostrava – Poruba 54,128 160 3.75 2.83-4.35 Ostrava South (2018) 21,411 80 4.522 3.98-5.69 Ostrava – Poruba (2018) 24,956 80 3.885 3.18-4.48 Source: The authors’ own elaboration and calculations, data on request from the Land Registry, KAŠÍK, J., JANÁČKOVÁ, H. (2018) The following conclusions can be drawn from the above table. A comparison of the statutory cities of Karviná and Kladno shows that the city with the higher average capitalization rate is Karviná. This conclusion is consistent with the theoretical assumptions that real estate located in areas with a higher risk level (in this case, the risk associated with achieving the expected rent) has a higher capitalization rate. Statistics from the Ministry of Labour and Social Affairs show that, in June 2022, the share of unemployed persons (SUP) in Karviná was 9.9%. In contrast, in Kladno, the value of the same indicator in June 2022 was 5.1%. The average gross monthly salary in the Central Bohemian Region in Q4 2021 was CZK 40,501 and was more than CZK 4,000 higher than that in the Moravian–Silesian Region, where it was CZK 36,463. The statistics also show a higher number of offences and selected crimes registered by the Police of the Czech Republic in the city of Karviná, namely one crime offence per 1,000 inhabitants in Karviná and 96 offences per 1,000 inhabitants in Kladno (Police of the Czech Republic, 2022). As far as the selected parts of Ostrava are concerned, the area with the highest prices per m2 and the lower capitalization rate is Poruba, and this has not changed over time. It is a highly desirable area. It is a cadastral area in the western centre of the regional city, with excellent accessibility to all classes of roads and widespread and frequent public transport (trams and buses), all civic amenities, including offices, court and an indoor and an outdoor swimming pool as well as relatively clean air due to its higher location on the hill and distance from LIBERTY Ostrava a.s. (known as “Nová huť”). The capitalization rates relative to the net rent level are lower than in the second selected area, Ostrava South. Ostrava South has lower prices per m2 and, at the same time, higher capitalization rates. It is the southern part of the regional city. This area also has all the amenities and quick access to the regional city centre. However, there are infamous residential hotels housing a socially weak and maladjusted population due to the development of the housing supplement system in the Czech Republic. Ostrava South is also closer to a large industrial enterprise emitting air pollutants and has a lower altitude (and hence a higher frequency of smog than Poruba). In the selected cities, the riskiest areas have a capitalization rate of up to 8.6% and thus a payback period shorter than 12 years. The lowest capitalization rates today are 2.4%, and the payback period for buying a home is over 40 years. When comparing the calculated values with the capitalization rate, which is set at 5.5% in Annex 22 of the current price regulation for flats in standard blocks of flats for the purposes of administrative valuation, we find that the closest to this value is in the city of Karviná, where the calculated average capitalization rate reaches 5.8%. In the city of Kladno, the capitalization rate in the price regulation is only close to the upper range of the calculated values. In addition, in the selected districts of Ostrava, the calculated values of the capitalization rate differ relatively from the value officially established by the valuation decree. As far as the Ekonomická revue - Central European Review of Economic Issues 25, 2022 74 comparison over time in this area is concerned, it can be deduced from the calculated values that the prices of flats have more than doubled in four years and the offer prices of rents have doubled. The capitalization rates have remained almost unchanged over time in the selected areas of Ostrava. 5. Discussion The results obtained are difficult to compare with those reported in some previously published studies on a similar topic (Ardielli et al., 2016; Stefanovová and Peterková, 2014; Stefanovová and Procházka, 2014). As already mentioned in the introduction, unlike the research mentioned above, our analyses are based on actual prices obtained from the Land Registry data. Furthermore, it should be pointed out that some studies (e.g. Ardielli et al., 2016) focused on the calculation of gross capitalization rates; that is, they did not include the costs associated with holding real estate (maintenance, insurance, real estate tax, etc.), and this is one of the reasons why their results are higher (e.g. this gross capitalization rate is between 4.1% and 8% for Poruba and between 8.1% and 12% for Hrabůvka and Výškovice). Another important factor is time, with the economy having experienced a reduction in base interest rates in the past, which ended at the beginning of 2021. The growth in property prices is slowing and is gradually being accompanied by an increase in rental prices, primarily due to the long-term nature of time-lagged leases. Since 2020, the Czech Republic has been facing fiscal expansion in the form of large state budget deficits. From 2021 onwards, economic entities have faced a global increase in energy prices, which has also led to the collapse of Czech providers with a significant market share. Last but not least, the Czech Republic is experiencing an external shock stemming from the effects of the war in Ukraine. The facts mentioned above and pressures in the labour and property markets are pushing consumer price growth to 17.2% (annual rate as of June 2022 as measured by the Czech Property Investment), the fastest in three decades (Czech Statistical Office, 2022). With the current high inflation rate and the Czech National Bank raising interest rates, we can see a cooling of the mortgage market in 2022, which is associated with a slowdown in property price growth. This has reduced the real return on most current investments and thus also on residential investments, which may be negative in the short term. It appears that the objective of real estate investors at the moment may remain the appreciation of invested funds through rental income and thus the protection of available funds against falling inflation rates but also possible speculation linked to the increase in the price of real estate over time and the increase in the return on the sale of real estate in the future, which, however, may be highly unpredictable given the current inflation and the associated uncertainty in the markets. 6. Conclusion The capitalization rate is a necessary input in the calculation of the income value of property. The authors of the paper determined the capitalization rate for privately owned flats in selected cities (Karviná and Kladno) and selected urban districts of Ostrava (Poruba and Ostrava South) based on actual prices and net rents as well as the capitalization rate for the given type of real estate in 2021 and 2022 using the direct capitalization method. The purpose was to compare the calculated capitalization rates in the selected areas and to explain any differences in their amount in terms of space and time in the urban districts of Ostrava. The results confirmed the influence of price (the level of demand for real estate in a given area) and risk (the more attractive the area, the lower the risk) on the capitalization rate. In less risky areas, where prices are relatively higher, the capitalization rate is lower than in relatively riskier areas. This fact is reflected both when comparing the cities of Karviná and Kladno and when comparing parts of Ostrava. 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