September 9, 2020
Topics: KC's Column
Appraisal Concepts Refresher during COVID-19
The stock market’s volatility during COVID-19 with greater than 2% up then down patterns is reflecting investor confusion over valuations. That same uncertainty over stock and bond valuations extends to commercial real estate. Thirty-five years of experience, combined with a legacy of growing up in a real estate developer family, has ingrained in me the principle that “when markets depart from fundamentals, valuations get distorted and corrections soon follow.” This week’s WIN examines this risk related to commercial real estate valuations. Three fundamental concepts rooted in appraisal theory dating back nearly three-quarters of a century can serve as valuable during COVID-19 as they have through every previous disruptive cycle since the 1970s. The difference today is we have history and established valuation principles to lean on to avoid the valuation mistakes of prior real estate crises.
Appraisal Concept #1 - Market Value:
Market Value seems like a simple enough concept – what does the “market” think the value is based on transactions? Unfortunately, it is much more complex. Market Value has been a confusing term in real estate valuations dating back to the 1950s. In the first Encyclopedia of Real Estate Appraising published in 1959 with contributions by all the National Appraisal Society Affiliations (including the predecessor to today’s Appraisal Institute, the Appraisal Institute of Real Estate Appraisers – AIREA), it identified the innumerable kinds of value used in the appraisal and lending industries. It identified seventy-six value definitions in use back then. Some of the definitions that survive today included Fair Market Value, Going Concern Value, Insurable Value, Intangible Value, Stabilized Value, and yes - Market Value. However, some value types not so common today that are among my favorite from this inaugural source text on real estate appraisal include:
- True Market Vale – defined in 1959 as “an improper qualification of the term market value designed to promote the impression that there is more than one market value.”
- Equitable Value – An improper term designed to promote a special concept of fairness and equity whose roots were based in condemnation. It implied that “just compensation” was somehow not adequately reflected in market value.
- Face Value – An accounting term in the 1950s generally denoting the stated dollar worth of a formal document evidencing indebtedness.
- Full Value – An improper term implying under certain conditions that there is an element of worth over and above that contemplated in market value.
- Junk Value – A price concept reflecting worth of materials in a structure to be dismantled and sold as scrap. Synonymous with scrap value.
This first Encyclopedia of Real Estate Appraising is a great resource. Unfortunately, it is not available on Amazon or in reprint anywhere, but it should be. This foundation text is available in a few rare complete appraisal libraries, like the LUM Library at the Appraisal Institute or mine that I inherited from my late father and grandfather. One would think we would have narrowed the value terminology list and cleared up the confusion over the past 75 years, but it is as bad today as in the 1950s.
In the legal profession, for example, Black’s Law Dictionary asserts a definition of market value that asserts as long as a property interest is “inheritable,” it has market value and the property rights (be it fee simple, leased fee or leasehold) are irrelevant to the determination of market value. That theory is now promulgated by tax assessing authorities as a basis for their “new fee simple” definition of value in the “Dark Store” theory that suggests a dark or vacated Big-Box retail store is worth the same as an occupied one, and that leased fee and fee simple values are synonymous.
In the lending and accounting industries there are multiple definitions of market value to address how to treat intangibles or value at various stages of construction. And then states have varying definitions of market value in their statutes for everything from condemnation to property tax assessment. In Alabama, for example, market value is defined as “fair and reasonable value” and does not even reference the concept of property rights and fee simple versus leased fee value. That was relevant in a case decided earlier this year that I testified in between the Alabama Affordable Housing Association (AAHA) and the Alabama Department of Revenue. The case was decided in favor of AAHA and hinged on the definition of value.
But do not lose hope. Below is an exert from some recent expert witness reports I have testified from that bring market value back into focus. Regardless of the industry sector or valuation purpose, if appraisers, brokers, investors and lenders adhere to the following they are likely to avoid getting lost in determining the market value of commercial real estate:
Understand and Apply the Correct Definition of Market Value
(Source: K.C. Conway, MAI, CRE, CCIM)
“The valuation of all real property starts with understanding the appropriate definition of value for the appraisal at hand. That requires an understanding of six key elements before commencing any research, analysis, selection of transaction or rent comparables, or determination of applicable approaches to value. These definition elements are: i) time (current; retrospective – frequently the case in property tax appeal; or prospective as in the case of a construction loan for a bank); ii) condition (“As-Is” - typical in financing and tax assessment; “As-Complete” in cases of renovation or construction; and “Hypothetical” in cases of environmental contamination, insurance claims, or a non-conforming zoning use); iii) property rights, “Fee Simple” (as defined in the Appraisal of Real Estate – Eighth Edition through current 14th Edition as all rights available for transfer including the right to use and occupy which are limited only by the four powers of government – police, eminent domain, taxation and escheat), or “Leased Fee” (as “Less-than-complete estates that result from partial interests that are created by selling, leasing, or otherwise limiting the bundle of rights in the fee estate”) iv) transaction medium (cash or subject to financing, as is the case with most Net-Lease retail properties or Low-Income Housing Tax Credits in cases involving multifamily property); v) buyer & seller motivations and knowledge of the market (the respective parties’ buying or selling without duress or atypical market motivations, and each acting with full knowledge of any market impacting item (like an impending ingress/egress change, or retail tenant bankruptcy, etc.)); and vi) tangible real estate (exclusion of personal property, contracts such as leases, or other intangibles in restaurants, hotels and frequently uniquely themed and designed Big-Box retail with user-specific fixtures or design). “
Putting these six elements together, the starting point for any CRE valuation should be the following definition of market value.
Market Value in the As-Is condition (current condition with deferred maintenance and any functional/design obsolescence deducted) of the Fee Simple interest (assuming all the bundle of rights in place) as valued by the market (not a specific investor, tenant or user) on a cash basis, excluding any intangible property.
The respective partial interests, specified dates of value (like retrospective), and intangible elements can then be segregated from the aforementioned market value so that an investor doesn’t over pay, lend, or transact on the value of a part – in essence confusing a part of the property for the market value of the whole. Page 406 in the current Appraisal of Real Estate -14th Edition states that:
“If the sale of a leased property is to be used as a comparable sale in the valuation of the fee simple estate of another property (the requirement in Interagency Appraisal Guidelines for all banks), the comparable sale can only be used if reasonable and supportable adjustments for the differences in property rights can be made.”
And how can an appraiser do that without the lease in hand for the leased fee transaction to adjust for credit of the tenant, lease duration, rent escalations, amortization of fixtures and intangibles, etc.? They can’t!
Appraisal Concept #2 – Highest & Best Use:
All valuation analyses of market value commence with a Highest and Best Use (“HBU”) analysis. This concept does not assume that current use (leased or not) is still economically feasible or maximally productive. What makes that determination is an analysis of the market before determining the value of the property. Appraisers became complacent pre-COVID-19 with regard to HBU, and have generally assumed that the current use for retail malls, Big-Box retail stores, hotels, auto dealerships, restaurants, office buildings, etc. is continued use. In other words, they have assumed the current use still checks the four HBU boxes of being: i) legally permissible; ii) physically possible; iii) economically feasible; and iv) maximally productive (creates the most profit from the range of economically feasible uses). Now comes COVID-19 and shelter-in-place orders, occupancy restrictions and an explosion in e-commerce everything, remote work, digital school, etc. Investors, lenders, brokers, and appraisers now need to ask basic HBU questions like:
- Is a restaurant or hotel economically feasible with 50% occupancy restrictions?
- Is retail a continued use when all goes online and retailers no longer have the same dependence on physical stores to sell merchandise? What does a record 9,300 store closings in 2019 and a forecast 20,000 foretell for the HBU of Big-Box retail stores, malls and even grocery stores?
- What does a 75% reduction in business travel airline passengers foretell for the HBU of convention centers, airports, car rental facilities, etc.?
Determining HBU for a i) vacant “Big-Box” store; ii) hotel impacted by occupancy restrictions that may persist beyond 2020; iii) closed restaurant among hundreds in the neighborhood or MSA; iv) high-rise office building where the employee density ratio is reduced by 35%-50%; etc., requires an understanding of the COVID-19 impacted market. Hotels, office buildings and retail stores are all undergoing a change in highest and best use. They are suffering from both functional and economic obsolescence that must be accounted for in the valuation process. Dust off your cost approach appraisal skills while you are taking a refresher on HBU.
Analyzing quarterly corporate 10(q) earnings filings is one of the best ways to understand and document this change. Retailers are telling us about how “Click It & Pick Up” needs to be a component of the “physically possible” element of HBU. Hotels are conveying that occupancy restrictions are an element of “legally permissible” that needs to be re-evaluated in HBU and “economically feasible” elements of HBU. “Control-Alt-Delete” the boiler plate HBU analyses in pre-COVID-19 appraisals and start from scratch. COVID-19 is a reminder that HBU does change, and that one can’t just assume that the current use is the highest & best use.
Appraisal Concept #3 – Contract Rent and Economic Rent are not Market Rent:
Contract Rent refers to that rent which is agreed upon between the property owner and tenant which may be different than the economic rent for the real estate alone and may include compensation for atypical items such as tenant improvements (signage and layout), equipment (racking systems, shelving, e-commerce systems), initial store opening inventory, above market standard utility usage/expenses or even above standard life-expectancy, such as wear-and-tear on physical property elements like parking lots and loading docks, etc.
Economic Rent is the rent necessary to make a profit off of a particular piece of property, and is generally tied to a specific tenant, landlord, and business taking place on the property so that all parties can profit from the transaction – it is not tied to the actual market value of the property itself. Economic rent often incorporates amortization for improvements and personal property that are unique to the specific tenant at the site and not beneficial to any future purchaser or user of the property.
Market Rent is the rent that a property can earn for the site and building without regard to atypical construction costs, above market tenant improvements, amortization of tenant-unique fixtures or equipment, etc. “Market Rent” must be based on the general market for the property at issue; it should not be tied to a specific property owner’s desired investment return on total costs for a specific tenant, the specific creditworthiness of the tenant, or the unique external influences on that particular tenant in selecting a particular site.
This fundamental concept of market rent influences NOI and ultimately value when a Cap Rate is applied to that NOI. Underwriting Contract Rent or Economic rent results in a value that is more consistent with investment or Going-Concern value. As an investor, lender or appraiser it is critical that market rent is understood and derived when performing a market value of the fee simple interest of a property or what results is a “misleading” valuation. USPAP frowns on that and companies net worth can be impacted by getting this concept wrong. The new ASC 842 “Lease Accounting” changes in 2022 will bring this even more into focus as leases and contract rent agreements will have to be reported as liabilities on company balance sheets unlike the past.
In summary, the three appraisal concepts of market value, highest & best use and market rent versus contract rent have become more in focus during COVID-19. It is time to refresh one’s understanding of these concepts and investors to revisit their policies and protocols for valuation of CRE assets in this era of more e-commerce, more digital work, occupancy restrictions, and COVID-19. Pay closer attention to CRE valuations in 2020 and 2021 to avoid mistakes of the past that required response like FIRREA, USPAP, Interagency Appraisal Guidelines, etc.
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