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Classifications for commercial real estate.

Real estate appraisers are routinely required to complete market research studies when appraising income properties. Much of this research involves the study of the income characteristics of comparable properties. While such properties may or may not be in the immediate area, they must be located in a market with similar conditions. In any case, properties that are comparable to the appraised property must be identified and examined. For example, when appraising a high-rent, excellent quality office building (class AA), past trends and current data for such characteristics as rent, expense, and occupancy for class AA buildings as a group must also be examined. Thus, a classification procedure that categorizes properties in a systematic, consistent manner would be extremely useful.

Although properties are often identified by class, a detailed classification procedure that may be readily applied by real estate professionals is not available. In fact, most existing classification procedures identify only class AA or class A buildings and are used primarily by major institutional investors. This article presents a detailed classification system for several types of apartments, office buildings, retail centers, and warehouse buildings.

To establish classification uniformity for reporting purposes, a system for commercial real estate has been developed. Commercial property is defined to include office, industrial, retail centers, and apartment properties. The major emphasis is on market data, identified most easily in the form of rents; however, other minimum features such as age, condition, and location also must be considered. The following guidelines, as outlined in Table 1 through Table 4, are flexible. While most buildings will clearly fall into a distinct category, proper classification of any exceptions requires the insight and judgment of professional real estate agents, developers, and analysts.

GENERAL GUIDELINES

Apartments

The following five categories are deemed most important for a systematic classification procedure for apartments.

Rental rates/occupancy rates

The most important guide for classification purposes is market rent. The rents for class AA buildings are assumed to rank in the top 10% of all local properties (based on per-square-foot rent of similarly sized units). Rents for class A buildings generally rank from 80% to 90%, for B buildings from 50% to 80%, for C buildings from 20% to 50%, while rents for D buildings would rank the lowest, from 0% to 20%.

Although market rents are assumed to be excellent indicators of quality level for classification purposes, exceptions may still occur based on the judgment of real estate professionals. For example, a building in the 85th percentile might receive B classification if its construction quality were judged average. Extreme care must be taken to adjust rentals before comparing rental rates to provide identical assumptions for 1) the party responsible for operating expenses; 2) the existing rent concessions; and 3) the special lease terms. This will ensure that market rent terms are consistent for comparison purposes.

Occupancy is also considered an important factor. Class AA and class A apartments are expected to have greater than average occupancy, class B to have at least average occupancy, while class C and class D apartments may be expected to have lower than average occupancy rates. An exception could occur for new buildings during the rent-up stage.

Although the previously mentioned rent percentages provide an initial basis for classification, additional minimum requirements for characteristics such as age, construction features, and location must be considered as well.

Age/condition

For certain classifications, a minimum level of improvement condition is necessary in most cases. For example, the condition of a building must be excellent to be rated class AA. Generally, a building must be 10 years old or newer to receive a class AA or class A rating; however, an older building that would otherwise be class B may retain the A classification through renovation or modernization. In such a case, a subscript "r" would be added to designate that the renovation replacement or rehabilitation have occurred as needed to restore the building to an effective age of 10 years or less. For example, [A.sub.r] denotes a building that has a physical age that is actually older than allowed by the age class (10 years), but has been renovated (e.g., painting, carpet, and roof replacement). An [A.sub.m] rating signifies that a property has been modernized (e.g., obsolete kitchen equipment has been replaced). [A.sub.e] indicates known environmental hazards, either interior or exterior; [A.sub.h] refers to a historic property (e.g., National Historic Register), while [A.sub.u] means that the property is under construction, and [A.sub.p] refers to planned construction. The same subscripts could apply to class B properties as well (i.e., [B.sub.r], [B.sub.m], [B.sub.e], [B.sub.h], [B.sub.u], and [B.sub.p].

Construction quality

In general, quality of construction is of major importance. A class AA property, for example, must have excellent ratings for finish and functional features, including highly efficient mechanical systems, floorplan layout, amenities, and parking. While a class A property is also well-constructed, it does not generally contain as many special features as are associated with the AA classification. Class B, with average rents, is usually considered "middle of the road" for most attributes and characteristics. While a class C building would generally lack special features, represent minimum construction standards, and may have parking problems, class D is more closely associated with structures that have substantially deteriorated as a result of age or lack of maintenance. These buildings are at or near the end of their economic or functional life and usually have a comparatively lower occupancy rate, a low quality of maintenance, and tenants with high collection losses. A class D property, however, could also be a newer building of poor quality construction and in a poor location.

Location

Class AA apartments must be located in an excellent neighborhood with good shopping centers nearby. Significant offensive, hazardous, or dangerous characteristics should not be evident in the immediate environment. Surrounding residential or commercial uses should reflect a stable and attractive neighborhood.

The rating of class AA is given to buildings with the same ratings as AA buildings, except that the rent rank must be at least 95% and the building must be located in a Tier 1 metropolitan area of a least 1,000,000 people that is located in a given Metropolitan Statistical Area (MSA). Table 1 provides a detailed chart of uniform apartment classification characteristics.

The application of the apartment classification procedure is demonstrated in Figure 1, Figure 2, and Figure 3. Figure 1 provides a breakdown by percentage of total apartments in the Shreveport--Bossier, Louisiana, MSA. Figure 2 provides the average rent per unit by class and type, while Figure 3 depicts the average rent per square foot by date and class. [1] The collection and reporting of rent data by class on a consistent basis provides a valuable resource for appraisers and others involved in measuring real estate market trends. While some apartments in this sample had 10 or more of the amenities, none met all of the AA requirements, a few lacking only excellent quality finish to qualify.

Office buildings

The office building classification standards, shown in Table 2, are similar to the apartment standards. The class AA rating is given to properties with the highest quality construction, in excellent condition, and with the highest quality tenants in the local office market.

[TABULAR DATA OMITTED]

Rents rank in the top 10% for class AA office buildings. New buildings in the rent-up stage, however, may be exceptions to the class AA occupancy guidelines.

However, 10% of the market will not necessarily be class AA. In fact, the quality for this rating must be the highest, and few if any properties may qualify in many smaller cities. For example, Shreveport, Louisiana, has only four class AA office buildings. As shown in Figures 3, 4, and 5, class AA office space represented 23% of the market, was 90.3% occupied, and had an effective rent of $10.94 in October 1990 for the Shreveport--Bossier area.

Retail centers

The following retail definitions are outlined in Table 3 and have been developed by the Urban Land Institute and the International Council of Shopping Centers. (2)

* A super regional center "provides for an extensive variety of general merchandise, apparel, furniture, and home furnishings." To be considered a super regional center, it must contain three or more department stores of 100,000 square feet or greater. The gross lessable area is typically 800,000

[TABULAR DATA OMITTED]

square feet, but can range from 600,000 square feet to 1,500,000 square feet.

* A regional center "has one or two full-line department stores, generally not less than 100,000 square feet. It provides for general merchandise, apparel, furniture and home furnishing." While typically containing 450,000 gross square feet of leasable area, it may range from 300,000 to 850,000 square feet.

[TABULAR DATA OMITTED]

* A community center "provides a wider range of facilities for the sale of wearing apparel, hardware and appliances and is built around a junior department store, variety store, or discount department store." Ranging feet to 450,000 square feet of gross leasable area, it is usually about 150,000 square feet.

* A neighborhood center "provides for the sale of convenience goods and personal services for the day-to-day living needs of the immediate neighborhood." A supermarket is generally the main tenant. This type of center generally has a 50,000-square-foot gross leasable area, although actual size may range from 30,000 to 100,000 square feet.

In addition to these four standard types of centers, the following four special types of centers do not meet the criteria and do not have a minimum size.

[TABULAR DATA OMITTED]

* A power center includes either one or two major credit tenants. These tenants occupy at least 80% of the center, with the remaining space occupied by a few small retail tenants. Such centers are usually distinguished by the high national credit strength of the major tenants.

* A specialty center has good to excellent construction and includes small specialty retail stores that supply higher quality retail goods and personal services. However, specialty centers do not include a supermarket, a major drug store, or any other anchor tenant.

* A strip center usually has average to poor construction and includes small retail stores that supply average to low-quality retail goods and personal services. Strip centers do not include an anchor tenant of any kind.

* A freestanding store, while not a center because it includes only one tenant, may be an outparcel of a shopping center or otherwise be included in a grouping of retail buildings in a centralized area. It may also share parking and driveways, and in such a case may be considered a part of the retail center for analysis purposes.

Retail stores are further divided into classes similar to those previously described for offices (see Table 3)

Warehouse buildings

Warehouse properties are also divided into classes AA, A, B, C, and D according to rent/occupancy, physical, and locational charateristics and attributes. The classification procedure, as detailed in Table 4, is similar to the other property types.

CONCLUSION

This article presents a workable method for systematic classification of apartments, office buildings, retail centers, and warehouse buildings. The procedure, designed to promote uniform categories, should be useful to real estate professionals, especially those involved in the valuation of income-producing properties.

(1) These graphs and the office graphs (Figure 4 and 5) are taken from A Summary Report for Shreveport & Bossier City Real Estate (Louisiana State University at Shreveport Professorship. College in Business, March 1991), 21, 25, 27, 33, 34, 35.

(2) Michael D. Beyard, Dennis W. Burr, Deloitte & Touche, and Algorists, Inc., Dollars & Cents of Shopping Centers: 1990. A study of Receipts and Expenses in Shopping Center Operations (Washington, D.C.: The Urban Land Institute, 1990), 5.

Marshall F. Graham, MAI, is president of Multifacts Research Center in Shreveport, Louisiana, and is chairman of the board of Argote, Derbes, Graham, Shuffield, Stegall, and Tatje, Inc., a real estate appraisal company with offices in Shreveport, New Orleans, and Baton Rouge. He has previously published articles in The Appraisal Journal and Environmental Watch.

Douglas S. Bible, PhD, is the Oscar E. Cloyd Professor of Real Estate at Louisiana State University--Shreveport. He has published numerous articles on real estate investments, finance, and valuation.

The financial assistance provided by the Louisiana Real Estate Commission is greatly appreciated.
COPYRIGHT 1992 The Appraisal Institute
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1992 Gale, Cengage Learning. All rights reserved.

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Author:Graham, Marshall F.; Bible, Douglas S.
Publication:Appraisal Journal
Date:Apr 1, 1992
Words:2075
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