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Estimating Capitalization Rates – Part III

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In the first two parts of this series, we have introduced and defined four different methods of estimating capitalization rates. In this part of the series, we will take a detailed look at market-derivation methods and the factors that should be considered when extracting market-derived capitalization rates. As has already been discussed in the previous two installments of the series, market derivation is the most reliable and applicable approach in most cases. The band of investment and debt coverage ratio methods are the next best options, and the investor survey method can be a reliable check for the other methods.
The market derivation method is important because it is closely tied to market activity and it can easily be understood my market participants. It provides the best insight into how investors in the subject’s unique market are actually making decisions. Most of the drawbacks of a market derived capitalization rate occur when the appraiser does not consider that these rates are being extracted from comparable properties. The comparable sale that the capitalization rate is being extracted from should share similar characteristics with the subject property. The appraiser must consider if the comparable is similar to the subject in terms of quality, location, investment grade, and occupancy.
The date of sale of a comparable must be considered, in case conditions related to income rates and supply and demand may have changed. Since market derivation is partially a sales analysis, financing terms and conditions of sale should also be considered. Additionally, it is important that the income sources for the comparables be considered. The appraiser should analyze if the leases are at market rates, as well as the credit quality of the current tenants. Another important consideration is the type of buyer. Different types of buyers may have different expectations in regards to return requirements. For example, a real estate investment trust may have different requirements than and institutional buyer. When these factors have been fully considered and similar comparables can be produced, the market derivation rate is very reliable and the other methods can be used as a check. When market extracted capitalization rates are not available, the appraiser can turn to the other methods to produce a capitalization rate. In the final part of this series we will take a look at the factors that must be considered in the reconciliation of a capitalization rate.

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Supporting Capitalization Rates – Part II

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In the first part of this series we talked about the importance of accurately estimating the capitalization rate within a direct capitalization analysis and briefly introduced four common methods used to estimate a capitalization rate (OAR). In this part of the series we will more thoroughly describe and define these four methods which include market derivation, band of investment, debt coverage ratio, and investor’s survey. As we discussed in the first post, deriving capitalization rates from comparable sales is the favored method.

A market-derived capitalization rate can be characterized by several factors. It is the rate of return on the entire purchase without taking into consideration who contributes the funds (i.e. bank or REIT). The market derived rate is not influenced by the structure of debt and equity. The market derived rate indicates the connection between one year’s net operating income and the total purchase price. The market derived rate does not clearly consider projected future income or changes in property value. The market derived rate represents a going-in rate of return. The reciprocal of the market derived rate is a net income multiplier. If a market-derived capitalization rate is not able to be estimated, the next most credible methods include the construction of an OAR through component parts. The band of investment and debt coverage ratio methods represent two ways to construct an estimated OAR.

Band of investment analysis, by definition, “is a technique in which cash flow rates attributable to components of a capital investment are weighted and combined to derive a weighted average rate attributable to the total investment.”  Because most investments are purchased with debt and equity capital, the overall capitalization rate must satisfy the return of both investors.  The debt coverage ratio method, or DCR method, is based upon standard underwriting guidelines determined by commercial lenders. It is based on lender’s debt coverage ratio which represents the amount of net operation income needed to cover the debt associated with a property.

Finally, the Investor’s Survey can be used to estimate the OAR and is considered a good check on market-derived and constructed rates. Investors surveys are published by several different outlets and can provide good support in estimating a capitalization rate. In the next part of this series, we will look at the strengths and weaknesses of each of these approaches.

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Supporting Capitalization Rates – Part I

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The Income Approach is the main approach to value when appraising a property that is purchased for its income producing ability. This series will take a look at one of the key components of the direct capitalization analysis, a common technique used within the Income Approach to value. Direct capitalization is based on the simple formula of Value = Income / Overall Capitalization Rate. The estimation of an appropriate capitalization rate is probably the most critical step in the direct capitalization analysis, since in most cases the historic income data for a property is readily available and fairly reliable, and the future income can be easily estimated. Therefore, the capitalization rate plays a large role in determining the value of a property. Small differences in an estimated capitalization rate can lead to large differences in market value.

For example, let’s consider a 4,000-square-foot office building that is producing an annual net operating income of $50,000 per year. If an overall capitalization rate of 8% is considered it produces a value of the property of $625,000, or $156 per square foot. If an overall capitalization rate of 9% is considered it produces a value of the property of $555,556, or $139 per square, which is almost a $70,000 dollar difference (-11%) in value. This example clearly shows the importance of estimating an accurate and reliable capitalization rate. If a capitalization rate is not property developed it can lead to misleading results. Luckily, there are several methods an appraiser can use to estimate a reliable capitalization rate.

The overall capitalization rate is typically estimated using the market extraction method, the mortgage/equity band of investment method, the debt coverage ratio method, and the investor survey method, all though there are several other ways capitalization rates can be estimated. The most desirable and most reliable method is the market extraction method because the method is based on actual capitalization rates from actual comparable properties. If a market derived rate can be produced it should be still tested against other methods such as the band of investment of debt coverage ratio method. The market extraction method should be used as the primary method, while the other methods should only be considered if no meaningful capitalization rates can be extracted from the market. In part II of this series we will define each of these methods in further detail.

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Extraordinary Considerations When Appraising a Commercial Condominium

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When appraising a commercial condominium, the appraiser has additional considerations compared to the appraisal of a non-condominium real estate property. The appraiser must consider the land ownership, type of property, the strength of the association, and what things are covered within the association fee. Properly handling these issues is essential to providing an accurate valuation of a commercial condominium.

The major consideration is that the underlying land is not owned in fee simple by the condominium owner, but is owned by the condominium association.  However, when describing the property, the appraiser will usually include the Site Description in the appraisal report for informational purposes. It is inappropriate to consider land value if the appraisal is of a single commercial condominium.

When identifying comparable properties, the appraiser must consider the type of property, since retail, office and industrial uses can all have condominium-type ownership.  Also, the square footage of the unit is important, since smaller condominium properties generally sell for higher unit prices, and vice versa.  The general condition of the property, especially the exterior, is an important consideration, since the exterior condition is usually beyond the control of the unit owner, and a poor exterior presentation can significantly alter the value of the property, even if the condominium unit’s interior is of excellent quality and condition.

 Another important aspect of the condominium ownership is the "strength" of the condominium association, which is responsible for maintaining the common areas, imposing special assessments, paying for common area utilities, enforcing rules, along with many other duties. In effect, the condominium association is a form of government that the condominium owner must comply with, or else be fined and/or liened. A poorly run association could have a significant adverse effect on the valuation of a commercial condominium.

Another major consideration when appraising commercial condominiums is which services the association fees cover. The fees could cover the cost of tenant unit utilities, common area utilities, common area maintenance, insurance, and many other things. A proper understanding of what the association fees cover and who is responsible for paying the association fee (tenant or owner) is crucial to providing an accurate Income Approach to valuation.

Other important consideration in the appraisal of commercial condominiums include the number of units leased, as opposed to owner-occupied; any current litigation associated with the property; and the number of parking spaces included with each unit.  If you need a commercial condominium appraisal, it is important to select a competent appraiser who understands the intricacies of the assignment. For more explanation on appraisal methodology, visit our website at www.commercial-appraisers.com.

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Commercial Real Estate Appraisal and Estate Settlement

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Although estate settlement can be stressful to the relatives of the deceased, it is an important task that requires conscientious decision making throughout the process. The executor of the estate has been given the duty to fulfill the desires of the deceased in a swift and committed manner. The real estate appraiser must also perform swiftly, being sensitive to those involved that have lost a loved one. Two things that appraisers need to clearly identify with the client in an estate settlement appraisal are the intended users and the report type.

An appraisal is often used to settle an estate in order to determine the Fair Market Value of the commercial real estate assets owned by the deceased. Since the date of death precedes the date that the appraisal services are solicited, a retrospective forensic appraisal is usually performed by the appraiser. Data regarding comparable sales, comparable rents, occupancy rates, expenses, capitalization rates, etc. that occurred on or before the date of death is gathered by the appraiser, and data that occurred post-date-of-death is usually ignored.

Users of estate settlement appraisals can include receivers of the estate, lawyers, trust-administration specialists, estate facilitators, will executors, accounting professionals, court-appointed administrators, business owners, partnerships, and enrolled mediators. Due to the many possible users of an estate settlement appraisal it is critical that the appraiser works with a client to clearly identify the intended user of the appraisal, assuming the intended user or users may have unintended consequences for the appraiser. For example, the client may only represent one party in a contentious estate settlement and the client may wish to limit the appraisal’s intended user to just himself. In this situation, if the appraiser made the assumption everyone involved in the settlement was and intended user it could have serious consequences.

Additionally, it is critical that the proper report format be selected. If the report only has one intended user who has a good understanding of the property, then a Restricted-Use Report may be sufficient. However, the report will more than likely have more than one intended user that may not be knowledgeable about the subject property or surrounding market.  In this case, an Appraisal Report will more than likely be the best report option (based on the new USPAP reporting options beginning in January of 2014, which will only include a Restricted-Use Report and Appraisal Report formats.)  Due to the emotion surrounding an estate settlement appraisal, the appraiser must clearly identify the answer to these questions in order to not add any more stress to a difficult situation.  For more explanation on appraisal methodology, visit our website at www.commercial-appraisers.com.

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Lodging Facilities and Average Daily Rate

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When appraising a lodging facility such as a motel, hotel, extended-stay hotel, campground, or destination resort one of the key issues an appraiser faces is determining the potential gross income within the Income Approach to valuation. A lodging property can offer a wide variety of room configurations, stay lengths, and payment options.  One of the most common ways for an appraiser to calculate potential gross income is to calculate and an average daily rate for the property. In this blog, the difficulties of finding the potential gross income of a lodging facility and how to calculate average daily rate is discussed.

Lodging facilities are typically comprised of rooms with varying sizes and varying nightly rates. Additionally, rooms may be offered nightly, weekly, monthly, or some other duration of time. Rooms rented for longer durations offer a discount when compared to the nightly rate. Additionally, rates may vary depending on things such as purchase date or if the room was purchased through a discount website.  Due to these factors, it can be difficult to estimate the potential gross income for a property, since the percentage of stays for each category (nightly, weekly and monthly) and the rates paid for each night can be difficult to track.  However, calculating an average daily rate (or ADR) is an acceptable way within the lodging industry to channel all of the room income into one rate for analysis.

Average daily rate is “the average rate per occupied room”.  The average daily rate for a lodging facility is calculated by dividing the total room revenue achieved during a specified period by the number of rooms sold during that same period.  For example, I recently appraised a small destination resort property that offered one bedroom, two bedroom, and three bedroom configurations on a nightly, monthly, and weekly basis. Based on the different room configurations and lengths of stay, there was not an easy way to calculate the potential gross income for the subject’s rooms. However, the owner of the property provided us with their room revenue and occupancy rates by room type.  From the occupancy rates we were able to calculate the total number of rooms sold, which allowed me to find the property’s average daily rate by dividing the total room revenue by the number of rooms sold.  Finally, I was able to estimate the property’s yearly potential gross income by multiplying the average daily rate by the total number of rooms by 365 days.

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Office Property Appraisal and the Proper Valuation Techniques, Part 3

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In the third part of our look into the appraisal of office building properties, we will focus on some important issues related to the selection of comparable rental properties within the Income Approach. In order to have a reliable valuation, it is important to select comparable properties that could be substituted as an alternative to the subject property. Not every office space is the same and it is important for the appraiser to select comparable properties that are similar to the subject in terms of expense structure, quality, condition, and utility.

It is common to find office properties that are close to each other in proximity, but are not comparable to each other in any other way. For example, in downtown business districts of some metropolitan areas it is common to have several different types of office properties. One office property may consist of a recently completed Class A LEED-certified high-rise office building while another office property two blocks away may consist of a single-family residential home built in 1925 that was converted into an office building. Both of the properties are close in proximity but it would be unlikely that both properties could be used as comparables in the same valuation due to their differences.

Another important consideration when choosing comparable office properties is expense structure. The expense structure of a lease determines who is responsible to pay the real estate expenses, including the real estate taxes, insurance, management, utilities, janitorial, repairs and maintenance. It is possible that the lease may be on a full-service (gross) basis with the owner paying all the expenses related to the real estate, a NNN (triple-net) basis with the tenant responsible for all the expenses related to the real estate, or a modified-gross basis with tenant responsible for some expenses and the owner responsible for some expenses. If the subject property is currently leased, the best comparables would be properties with the same expense structure as the subject. Any differences in lease structure would have to be accounted for through expense adjustments.

If either of these issues is overlooked within the Income Approach, it could limit the reliability of the valuation. It is important that an appraiser consider all the factors that make up an office building market when selecting comparable rentals.  If one factor is ignored, it could have a significant impact on the subject property’s valuation. For more explanation on appraisal methodology, visit our website at www.commercial-appraisers.com.

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Office Property Appraisal and the Proper Valuation Techniques, Part 2

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In the second part of our look into the appraisal of Office Building properties we will begin to take a look at some of the major issues to be addressed within the Income Approach of valuation. In the Income Approach, the appraiser needs to consider expense structure, appropriate procedure for predicting office rents, occupancy rate, and the proper method for choosing capitalization and discount rates. The first decision within the Income Approach the appraiser must consider is what type of analysis to use. Typically, either direct capitalization analysis or discounted cash flow analysis is used.

The direct capitalization method converts a single year's income or an average of several years’ income expectancy into an indication of value in one direct step by dividing the income estimate by the appropriate income rate, also called the direct capitalization rate.  A capitalization rate ties property value to earning ability. Direct capitalization is suitable for properties unencumbered by leases; properties encumbered by short term leases; and/or properties encumbered by leases that reflect terms similar to the market.

In the discounted cash flow analysis, income and expenses are analyzed for each year of the projection or holding period, and the net income is discounted to the present value indication by applying an appropriate yield rate (discount factor).  The value for the subject is estimated by summing the present values of cash flows during the projection period and the present value of the reversion at the end of the holding period (less typical sales costs). Discounted cash flow analysis is appropriate for properties with terms that differ from the market; erratic lease structures; or multi-tenant properties with a wide range in lease terms.

Typically, direct capitalization is appropriate for owner-user properties or smaller multi-tenant office properties while larger office properties typically require using a discounted cash flow analysis. Determining the correct analysis method within the Income Approach can make a significant impact in the final value of an office property. After determining the correct analysis method, the appraiser’s next step is to analyze extracted market income and expense data. In the next section of our look into the office property appraisal we will continue to look at some more issues an appraiser must address within the Income Approach.

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Office Property Appraisal and the Proper Valuation Techniques, Part 1

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When performing a real estate appraisal for an office property, the appraiser must first understand the theories, distinctive terminology, ideologies, and analytical methods associated with office building valuation. Distinctive emphasis should be given to the income capitalization approach and the intricacies of determining a value for properties with several tenants. The appraiser should be familiar with the attributes associated with the various styles of office buildings, significant inspection concerns, and industry measurement standards. This should be followed by a detailed investigation of the income approach by examining substitute lease types, appropriate procedures for predicting office rents, vacancy rates, and operating expenses, as well as suitable methods for choosing capitalization and discount rates. The appraiser should also consider the important concerns associated with the Cost Approach as well as the Sales Comparison Approach when undertaking an appraisal of an office building. In the first part of this series we will take a look at a major issue that should be addressed when using the Sales Comparison Approach in the valuation of an Office Building.

Generally, there are number of different types of office properties in a market; therefore, it is important to be thorough when researching comparable sales within the Sales Comparison Approach. For example, there could be two sales of office building properties that are of identical size. However, one of the buildings may contain an open build-out that is intended for a single user while the other building may contain heavy partitioning and be better suited for use as a multi-tenant property.  If the appraiser was working on a real estate appraisal of an owner-user office property it would mostly likely not be appropriate to use the sale of a multi-tenant property that was fully leased at the time of the sale. An adjustment could be considered to account for the difference but it would be better to find sales that were also owner-user properties.

As seen in the previous example, the applicability of any individual valuation approach in an office building is usually a function of the current or intended use of the office building. The Sales Comparison Approach is the most applicable approach in the case of an owner-user office property while the Income Approach is the most applicable approach in the case of a multi-tenant office property.  Generally, the Cost Approach would not be the most applicable valuation approach unless the property consists of a new building in an emerging market with limited comparable sales and comparable rental data. In the second installment of this series we will take a closer look the use of The Income Approach in the valuation of an office building.

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Quantitative vs. Qualitative Adjustments

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Since two properties are usually not identical, especially in commercial real estate, it is essential for an appraiser to make adjustments within the Sales Comparison Approach. The adjustments made by the appraiser should imitate the market. For example, adjustments could include location, size, and topography for a property, if these are characteristics that the average buyer in the market would consider when making a purchase. Appraisers can use either quantitative or qualitative adjustments (or a combination of both).  Generally, quantitative adjustments consist of making either percentage or dollar adjustments to account for the differences between the subject and the comparable sales. Qualitative adjustments require the appraiser to rank the comparable sales in terms of inferiority/superiority to the subject. Each of these techniques has its own weaknesses and strengths.

Quantitative adjustments are considered useful because they provide an actual quantifiable and measurable adjustment. Since the adjustment is quantified, it is more objective in nature than a qualitative adjustment. The result is a more scientific and precise analysis of the comparable data. However, the major weakness of the quantifiable adjustment is that it is rare to find the data to support quantitative adjustments. For example, the most common way to find a quantitative adjustment is to use a paired data analysis. In this analysis, two properties are compared two each other that are similar in all their attributes besides the one difference being analyzed. An example would be two lots that are identical except that one lot is a corner lot while the other is an interior lot. If the corner lot is $10,000 and the interior lot is $8,000, the appraiser could conclude a corner lot adjustment of $2,000, or 25%.  The problem is that there is not typically enough data to provide paired sales for all the required adjustments for the subject property.

On the other hand, the biggest weakness of qualitative adjustments is that they are more subjective in nature because they do not include direct quantification. However, their biggest strength is that they match the typical behavior of most market participants. It is often more common for the typical buyer to compare property attributes on a scale of superior or inferior than to calculate market-derived adjustment factors. Both types of adjustments have their own strengths and weaknesses and when determining the applicability of using quantitative or qualitative adjustments the appraiser needs to consider the dependability of the market data in support of an adjustment and how market participants would make similar adjustments. Due to the imperfect nature of the real estate market, the judgment and experience of the appraiser is always a factor in determining what type of adjustments to use.