4 Reasons Why This Commonly Used Statement in the Appraisal of Special Purpose Properties is Often Misleading
It is not uncommon for some real estate appraiser to attempt to appraise a restaurant, gas station, car wash or even a bowling alley without analyzing the business revenues. The arguments to support their position usually goes something like, "Only the real estate is being appraised to it would be unnecessary, or even wrong, to analyze existing business."
On the surface, this may seem like a plausible argument since considering the income of that business could, indeed, potentially introduce an element of business value into the equation. However, digging a little deeper reveals the feebleness of that argument.
Here are the 4 major problems with this reasoning:
1. The market rental rate conclusion becomes less reliable without such an analysis of the business income, which is vital to supporting an affordable rent burden for the existing or projected business revenues.
Ignoring the income generating capacity of the specific property dramatically increases the odds of estimating a lease rate that is either unsustainably high, or artificially low, for a business in that location, undermining the credibility of the traditional income approach.
Although it is the future anticipated income that is most relevant, most appraisers would agree that the review of historical financial data, for purposes of analyzing trends and income levels achieved, can significantly fortify future projections for most income generating property types.
This is true and relevant for real property going concerns, also.
A lease rate that is too high would materially endanger the viability of the business by burdening it with too much overhead expense. This also over-values the real estate and increases the odds of default if the appraisal is for lending purposes. In contrast, estimating a lease rate that is too low results in undervaluing the real estate.
Relying on lease comparables alone is often unreliable because it fails to consider the realities of the business that needs to support that lease rate. The lease rates that can and will be paid by retail and business tenants are strongly correlated with the cash flow from those businesses. Lower performing locations achieve lower lease rates in most cases. Locations that are conducive to higher revenues to the business garner higher achievable rents. And otherwise good retail locations that are impacted by excessive supply of competing properties may suffer from temporary external obsolescence. As a result, rental rates can vary widely even for the same type of use.
2. The cost approach faces a significant problem in quantifying depreciation.
This includes not only physical deterioration for aging buildings, but also functional obsolescence and economic obsolescence.
Special purpose properties tend to be specialized constructions and can be more susceptible to functional obsolescence than a simple office, warehouse, or retail building. Additionally, if there is any oversupply of a particular property type in a market, it is likely that existing properties of that type exhibit external obsolescence due to market conditions.
For the above reasons, the use of the Age / Life method for estimating depreciation is simply not reliable for capturing all elements of depreciation. Similarly, the market extraction method will typically have limited utility in accurately capturing total depreciation for the property being appraised if the comparable sales are not impacted by similar externalities.
In contrast, the development of a feasibility rent, based on an analysis of business revenues, can provide a reasonable basis for measuring total depreciation.
3. The sales approach for these property types includes inherent challenges:
A.) Analyzing sales of other going concerns in the sales approach typically results in a going-concern value indication. However, solving the allocation challenge still remains.
Assuming that the sales are truly comparable, the value indication can be useful, particularly if it can be reconciled with independently developed data and analysis from the other approaches.
For example, reconciling a properly completed sales approach for the going concern value with a cost approach, which does not include any intangible business value, can provide an indication of the intangible value component. Additionally, reconciling the results of the above with an analysis of the historical and projected operating history of the property, would materially enhance the reliability of the conclusion.
B.) Sales of non-operating properties can potentially have the benefit of reflecting real estate only value, however, they must be analyzed with caution, as they more frequently reflect:
a. distress situations
b. changing or different highest and best uses
The sales comparison approach must be used with a great deal of care. It also requires greater efforts in verifying transaction details, due to the complexity of the property type and related complexity in transaction structures and details.
The combination of real estate, which generally reflects a lower risk profile, combined with intangible business value, which represents a dramatically higher risk profile, and is generally much more difficult to finance, results in a level of complexity that does not exist with traditional property types.
Additionally, the tax considerations related to each value component within the enterprise, frequently result in transaction decisions being driven by tax considerations, rather than by fair market value.
4. Last, but certainly not least, is the common practice of relying on allocated values in the Sales Approach.
Often, but not in every transaction, the recorded deed will reflect the value of the real estate component, in accordance with an actual purchase price allocation of a completed transaction. Additionally, CoStar frequently indicates that their reported values represent allocated values for the real estate only, though it is often questionable whether there is any actual support for this.
For the sake of this article, let’s make an assumption for a moment that all allocations accurately and reliably reflect the value of the real estate only. In addition, let s say that those allocations neatly and reliably exclude any values associated with tangible personal property or intangible business value. (Yes, this a VERY significant assumption- and one that is not very reasonable to presume correct as a general practice.) Clearly the overall analysis becomes dramatically simplified under such an assumption.
Under such a presupposition, the appraiser is able to complete a familiar and traditional sales comparison approach, typically based on the physical characteristics of the property. Under such a supposition, the resulting value indication would represent the real estate component only.
The attractiveness of this approach on the surface is readily apparent. Unfortunately, the reality is far more complicated.
Just how reliable are those allocations?
Values reported by CoStar are not standardized and often not even fully defined. The reported values:
May reflect the consideration recorded in the deed or in some cases may be a broker reported sale price. While in other cases, it may represent allocated real estate values In yet another situation, it may Include real estate, together with FF&E and intangible business values. Or, the reported value may include some combination of real estate and just FF&E, or real estate and business, but where FF&E was paid for separately Starting with the first scenario. Assume for a moment that there was an allocation as part of the transaction, and that the amount recorded on the deed represents the allocated value of the real estate only. In this situation, the reported sale price would represent a ‘clean’ real estate only value, right? We would not have to worry about business value, FF&E or anything else.
However, there are some troubling assumptions hidden in the above scenario. First and foremost is - who determined the allocation?
Appraisers must recognize that purchase price allocations have tax implications for both the buyer and the seller. Additionally, it is not uncommon for there to be a misalignment between the most favorable allocations for tax purposes between each party.
For example, the seller commonly favors a higher allocation toward goodwill and going concern value since that asset benefits from long term capital gain treatment, and also may reduce transfer tax on the real estate. Conversely, for some buyers, a higher allocation toward the real estate will be favorable for purposes of obtaining financing. For other buyers less concerned with financing, a higher allocation to the business may be favorable since it can be depreciated over 15 years instead of 39 years.
Importantly, both the buyer and the seller will need to handle the allocation among asset classes in the transaction consistently in their reports to the IRS for income tax purposes. As a result of these considerations, the final allocation is subject to negotiation between the two parties. Thus, it is frequently not carefully arrived at by a formal valuation developed by professionals whose primary intent is to provide an accurate and unbiased allocation of the values. Instead, the final allocation is often driven by tax considerations. It is also driven by the relative negotiating positions and abilities of the parties, rather than by economic realities.
Going a step further, who made the determination of how much the real estate was worth in the allocation?
While accountants are often well versed in financial matters, they are rarely real estate appraisers. They do not have the license, training or experience to reliably and accurately appraise the real estate component.
In addition to the question of buyer and seller motivations that often influence the allocation results, even if buyer and seller endeavored to allocate as close to actual market value for each component as possible, how likely is it that a professional real estate appraiser with adequate training was involved with the allocation process. And if they weren’t, who concluded to the real estate value?
Finally, because allocations are not a matter of public record, the ability to obtain the critical details for every transaction tends to undermine the voracity of the total data set. Because, the fact is, it is not uncommon for the parties to the transaction to never discuss an allocation prior to the closing.
It is not uncommon for either the buyer or the seller to focus the negotiations on a total overall sale price. And it is also not uncommon for less experienced attorneys to take the total aggregate sale price and record that amount on the deed.
THE BOTTOM LINE
Real property going concerns present unique valuation challenges and considerations. It must be considered that these are real estate centered business enterprises, where the real estate generally represents the largest asset, but which commonly include a blend of personal property along with a business enterprise component. The value of each must be considered as part of an intertwined whole.
The value of the real estate for these properties is a function of its contribution to the enterprise. Thus, the premise of the appraisal explicitly considers the value in use, in contrast to the value in exchange premise that is more commonly associated with general purpose properties.
However, that value is not subjective.
The maximum value in use is replacement cost less physical depreciation, while the minimum value is what the property would be worth if the business were to shut down and the real estate was available for either redevelopment or repositioning of the improvements for an alternate use.
Most importantly, it is crucial to consider the business enterprise in the valuation of these properties. While the physical assets represent a component of that total enterprise, buyers and sellers tend to focus first and foremost on the economics of the business, including business volumes.
The real danger of imposing strictly traditional appraisal methods on special use properties is that it tends to divert attention away from the economic elements of the enterprise and instead to primarily consider the physical elements. This is contrary to how the market reacts to these properties, making it inherently less reliable.
The focus of buyers and sellers for these businesses is primarily on the economic considerations. So they focus on demand in the local market area relevant to their business. They pay close attention to local demographics, particularly within the primary trade area surrounding the property. They also analyze the local demand drivers, and consider the location and relative competitiveness of the subject in relation to those demand drivers and local demographics.
They also consider the demand side of the equation. How much total current competition there is, as well as any planned additions to the market. As well as the location, visibility and access of the subject in comparison to that competition.
These locational concerns reflect the fact that these are location dependent businesses. Poor locations often cannot be overcome simply through superior management or marketing skills. And locations that become temporarily saturated with too much competition tend to be far more impacted than other more traditional property types.
The physical building improvements are clearly important, as they house the activity and play an important role in fulfilling the demand. However, the amount that buyers or tenants are willing to pay to occupy a space is more strongly correlated to the property’s contribution to the total enterprise. Thus, business volumes represent a key metric to measure how much can be paid for the space.
For all of these reasons, the analysis of historical business revenues, along with a careful consideration of the business realities of the property, as a component in the real property going concern, is critical to arriving at a credible value conclusion. While the physical characteristics of the property are certainly relevant, they are generally secondary to the overall business.