Distressed property valuation issues.
Characteristics of Distressed Real Estate
Downturns in the economy often result in distressed property. In general, distressed real estate represents those properties suffering from higher than normal vacancies. Distressed real estate also includes those properties where effective rents or prices have declined significantly for lease-up or sale.
Distressed real estate is typically characterized by a decline in the property's rental income. The most prevalent ways owners address distressed market conditions is to lower rent and to offer concessions. (1) Rent concessions or incentives can take many forms, such as vacation trips or flee or reduced-cost amenities.
The prelude to property distress is often financial difficulty, and the resulting lack of funds tends to lead to deferred maintenance of building components such as the roof; ventilating and air-conditioning systems; plumbing; parking areas; and landscaping.
Lack of funds may be very apparent in the case of neglected landscaping, paving repairs, or painting. Other deferred maintenance items can only be discovered through inspection of maintenance logs or discussion with maintenance personnel. Because many owners do not understand that mechanical equipment can suffer significant damage if not periodically maintained, they tend to neglect this area of operations.
The fixed costs of a distressed property may change because of its distressed state. Real estate taxes on distressed real estate may decline or be eligible for a reduction. (2) Conversely, insurance expenses may increase significantly for a distressed property due to the risk associated with vacancy.
Appraising Distressed Real Estate
Distressed real estate represents unique challenges for real estate appraisers. These challenges may be complex or simple depending on the severity of the problem or problems affecting the real estate. A further challenge is that the distressed real estate may not necessarily be a vacant property. Although the term distressed property may conjure up images of abandoned buildings, a fully occupied property can be "distressed" if rents have been lowered significantly to attain the lease-up.
Highest and Best Use
The key section of most property valuations is the highest and best use analysis; for distressed real estate, this section is equally important, if not more so.
Highest and best use analysis of distressed real estate requires a review of the font basic tenets of highest and best use: physical possibility, legal permissibility, financial feasibility, and maximum productivity. Unfortunately, numerous appraisals include a highest and best use conclusion on improved distressed real estate that simply states "the existing improvements contribute value over and above land value; thus, continued use is the highest and best use and demolition is not warranted."
This conclusion is insufficient, as it does not address financial feasibility and the property's maximally productive use. For some properties and in some markets, it is easily discernible that the existing use is not feasible. A quick comparison of the cost of construction versus the subsequent value created will provide the essential conclusion that the property's current use is not feasible.
The appraiser of a distressed property should examine the categories of problems that have caused the property to become distressed and the steps necessary for the property to recover.
Distinguish and Delineate Why a Properly Is Now a Problem. Distressed real estate may suffer from a myriad of problems including market issues, capital availability, property-specific issues, and incompetent or undercapitalized ownership or management. The appraiser should explain why these problems have adversely affected the property in its current use. Market issues primarily relate to an imbalance between overall supply and demand, often referred to as spatial analysis in real estate market studies. Capital (debt and equity) availability issues relate to both the cost of capital plus the overall availability for capital allocations to real estate. Property issues primarily relate to specific problems associated with the physical structure of the real estate. Incompetent or undercapitalized ownership or management is often hard to quantify, but it is frequently related to ownership that is inexperienced with a particular product type.
Discuss Necessary Steps, if Possible, for the Property to Recover. The following questions should be asked to determine the necessary and appropriate steps for a property to recover:
* Should rents be lowered either through concessions (e.g., free rent) or possibly higher tenant improvement allowances?
* Should additional advertising be incurred or leasing commissions be increased to a higher percentage. Often, owners of distressed properties will incentivize brokers through promotions (e.g., a Harley-Davidson or a cruise) or special bonuses.
* Are cosmetic improvements necessary to the property to cure deferred maintenance, or is a major redesign of the improvements necessary? Careful attention to the condition of the distressed real estate is paramount. As previously noted, frequently proper maintenance is the first expense reduced or cut when property or market conditions suffer. A review of an updated property condition report will provide tremendous insight into potential physical plant deficiencies.
Specific Valuation Considerations for Distressed Real Estate
The highest and best use section sets the foundation for the valuation. All real estate valuations should reflect provisions for profit, including valuations of distressed real estate. Excluding profit in a valuation assignment compromises the concluded final value and overstates the value. Analyzing profit on distressed real estate requires a review of various profit considerations for this type of property. Three factors must be considered in the profit analysis:
1. Entrepreneurs, not institutions, typically buy distressed real estate.
2. Forecasting profit requires judgment.
3. The dollar amount of the profit forecast is dominant.
Entrepreneurs Typically Buy Distressed Real Estate
The Dictionary of Real Estate Appraisal defines entrepreneurial profit as
a market-driven figure that represents the amount an entrepreneur receives for his or her contribution to a project and risk; the difference between the total cost of a property (cost of development) and its market value (property value after completion), which represents the entrepreneur's compensation lot the risk and expertise associated with development. (3)
Entrepreneurial profit is sometimes given the more descriptive name entrepreneurial reward. Entrepreneurs require an incentive--namely a monetary reward--for the risks associated with this type of real estate purchase. This monetary reward is analogous to someone who buys a used car for $20,000 and then invests $10,000 to upgrade the car; that person would want to receive more than just $50,000 for the upgraded car, and instead may accept no less than $35,000. If the person knew that $30,000 was the maximum sale price following the upgrading of the vehicle and that $10,000 was required to improve the car, then the individual would not pay $20,000 for the ear in its "as is" condition (prior to being upgraded), but rather something less, say $15,000. This same profit concept holds true when analyzing the appropriate "as is" value or "as is" purchase price for distressed real estate.
Forecasting Entrepreneurial Profit Requires Judgment
Forecasting entrepreneurial profit requires both judgment and probability analysis as to what incentive would be necessary to entice an entrepreneur to buy a distressed property. The amount of the entrepreneurial reward is not always obvious; moreover, the profit an entrepreneur requires will vary depending on the relative bargaining power of the market participants. The forecast will be further influenced and tempered by the perceived risks for a particular property.
The Dollar Amount of Profit is Paramount
The dollar amount, as opposed to a percentage amount, is paramount in any entrepreneurial profit estimate. The dollar amount must be large enough to justify the risk. For example, a 25% profit may not be sufficient on a small project where the dollar amount of profit is calculated to be $50,000; in other words, the $50,000 figure, regardless of the percentage it represents, may not be sufficient to entice an entrepreneur to undertake the risks associated with a given property. Conversely, a profit percentage below 10% may be more than enough on a large property if the indicated dollar allocation is sufficient to entice an entrepreneur to undertake the necessary risk.
"As Is" Market Valuation Methods
Valuing distressed real estate requires an appropriate analysis of the property's "as is" value. "As is" market value is the price at which a third-party purchaser could acquire a property in its "as is" condition and then cover all the remaining costs associated with completing construction, sellout, or lease-up and earn a market-based level of profit for doing so. (4) This definition of market value recognizes that entrepreneurs demand compensation for purchasing distressed real estate. Appraisers and many real estate market participants have historically advocated that an "as is" market value is calculated by deducting rent loss, leasing commission, and property/tenant improvements costs from the "as stabilized" market value. Figure 1 depicts the traditional "as is" market valuation methodology whereby rent loss, leasing commissions, and tenant and property improvement costs are deducted from the "as stabilized" value.
[FIGURE 1 OMITTED]
In this approach, rent loss represents an opportunity cost as a result of foregone income that has yet to be established at a particular point of ownership. Two primary methods to calculate rent loss from an income capitalization approach standpoint are discounted cash flow (DCF) analysis and direct capitalization.
Tenant and property improvement costs include two elements. The property improvement cost reflects both capital improvements and any forecasted expenditures made to cure deferred maintenance. Any benefit associated with making property improvements or curing deferred maintenance should be reflected in the forecast of operating expenses. The tenant improvement (TI) allowance is the amount available to the tenant for the build-out of the vacant space. For distressed real estate, the TI allowance for the vacant space may actually be increased to spur or entice leasing activity.
Leasing commissions can be significant on distressed real estate, which may in fact require additional incentives to entice brokers to a particular property. In general, leasing commissions will represent a full cash-out calculation for the vacant space that must be leased to reattain stabilized occupancy.
This traditional method valuation method, however, fails to account for the compensation required to entice an entrepreneur to purchase a property in its "as is" condition. A properly supported "as stabilized" market value estimate recognizes a market-based level of profit to the entrepreneur. As such, an additional deduction from the "as stabilized" value is needed to entice an entrepreneur to purchase a property in its "as is" condition, even more on distressed real estate acquisitions that require significant entrepreneurial coordination efforts to turn a property around. The expected profit required to entice an entrepreneur to purchase an existing distressed real estate property in its "as is" condition may be even greater than the forecasted profit levels sought in the same property's initial development. Some entrepreneurs will demand what appears to be an obscene profit to turn around extremely distressed or stigmatized properties. As previously mentioned, the dollar amount, as opposed to the percentage amount, is of primary importance to an entrepreneur in any estimate of entrepreneurial profit.
Figure 2 depicts a suggested "as is" market valuation methodology whereby an additional deduction is made for the required profit to turn a property around. (5)
[FIGURE 2 OMITTED]
Various issues must be considered when analyzing and quantifying entrepreneurial profit forecasts because of problems arising from the subjective nature of this component.
Appraisers should remember not to construe rent loss calculations as forecasts of earned entrepreneurial profit. While rent loss represents an opportunity cost as a result of foregone income that has yet to be established at a particular point of ownership, entrepreneurial profit represents reward for the risks associated with a particular investment.
Entrepreneurial profit to the original developer or to the seller of a property is not necessarily always present. Initial profit projections may be eliminated once problems associated with construction, marketing, or financing conditions are taken into account. Purchasers of distressed properties, however, will require compensation for the skills and risks involved in buying such properties; thus they will make a deduction for entrepreneurial profit from the price offered.
The entrepreneurial profit forecast amount varies from property to property depending on the negotiating ability of the market participants and the market conditions. Subjectivity, as occurs in the whole appraisal process, is involved in the estimating of entrepreneurial profit. If based on proper analysis, however, the adjustment applied to entrepreneurial profit will be consistent with the marketplace.
Finally, real estate appraisers should keep in mind two additional factors.
First, the highest and best use analysis may have to address alternative uses in cases of extreme property or market distress. Examples of this phenomenon are occurring in many areas of the United States where older office structures in urban markets are being converted to residential uses (e.g., lofts or condominiums).
Second, the resulting "as is" value conclusions must always be tempered with a comparison of comparable sale properties. Often, market participants are motivated by purchasing distressed real estate at specified points (percentages) of cost of new construction and may ignore resulting "as is" value valuations merely using the income approach.
Distressed property valuations should include a detailed highest and best use study that quantifies why the property is distressed and what, if any, steps are required to turn the property around. Provisions for entrepreneurial profit should be reflected, tempered by the associated relative risks of the particular property If based on proper analysis, the resulting value forecast of a distressed real estate property should be consistent with the marketplace.
(1.) In contrast, steady rent increases and few, if any, rental concessions characterize strong real estate markets.
(2.) An appraiser can check the assessed value of the property to determine the reasonableness of the assessment in light of the current property or market conditions.
(3.) Appraisal Institute, The Appraisal of Real Estate, 4th ed. (Chicago: Appraisal Institute, 2002), 96.
(4.) William L. Pittenger, "Contemporary Applications of Valuation Analysis" (seminar, Atlanta, Georgia, 1990).
(5.) For further explanation and discussion of techniques used to forecast profit amounts, see William Ted Anglyn, "Analyzing 'Unearned' Entrepreneurial Profit," The Appraisal Journal (July 1992): 366-379; or the Appraisal Institute's Online Education Seminar, "Analyzing Distressed Real Estate."
Ted Anglyn, MAI, CCIM, is the Southeast Regional Appraiser for New York Life Investment Management in Atlanta, Georgia. He has published extensively for The Appraisal Journal and is a frequent speaker on valuation trends. Anglyn is the developer of a number of Appraisal Institute seminars including "Analyzing Operating Expenses" and "Analyzing Distressed Real Estate." His educational session, "Forecasting Revenue," will premier at the Summer 2005 Appraisal Institute Conference in Seattle. Contact: email@example.com
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|Title Annotation:||notes and issues|
|Date:||Mar 22, 2005|
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