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Special-design properties: identifying the "market" in market value.

Appraisers are sometimes asked to estimate the market value of a property with a unique physical design, special construction materials, or a layout designed for a specific use or particular user. This type of property is commonly referred to as special-design property, specialized asset, or special purpose property. Frequently, the presence of an actual market for that property is extremely thin or nonexistent. If no market can be identified or if data are not available, the appraiser might conclude that market value cannot be estimated. However, the client's instructions may require that an estimate of market value be produced. This predicament may arise in any number of situations - such as litigation assignments, collateral evaluation for financing purposes, or purchase accounting in business acquisitions, to name a few - but is most often encountered in valuation assignments pertaining to ad valorem taxation.

Recent literature reports that the existence of specialized assets is quite common and that their valuation problems deserve more attention.(1) It is generally recognized that conventional valuation techniques of sales comparison and income approaches are usually not applicable in these instances because of comparable data limitations. When data does exist, physical disparities are often dramatic and would require adjustments of such magnitude that the value indications would be meaningless. Consequently, the cost approach is usually considered the only valid approach to value. Although the cost approach can provide a means to derive a value estimate in these instances, there is still an absence of market data to guide the appraiser's judgment in the analysis of special-design features, even before the actual application of any valuation technique. The suggestion that certain special-design features may be superadequacies that do not contribute to the real property's market value is a familiar concept that has been addressed in valuation literature. Unfortunately, though, methodologies and analytical tools beyond the rudimentary level are all too often delegated to the appraiser's imagination and ingenuity. This has resulted not only in discrepancies in opinions of value but in conflicting interpretations of valuation principles among practitioners in the industry.

This article is not a comprehensive treatise on how to solve every special-design valuation problem, but attempts to fill in some of the void by noting a few of the considerations an appraiser should address before opening the cost guide. This article also explores and critiques some of the conflicting arguments that have been presented in the arena where this issue is most often debated: the property tax court.

RIGHTS APPRAISED

The rights appraised can have a strong bearing on the applicability of a cost approach. There may be quite a large market for rights to income generated from the lease of special-design improvements (leased fee), as opposed to the rights to occupy or lease the improvements (fee simple). If a client's objective is to recapture their capital costs, as might be the case when using the specialized asset as collateral for financing, the client may be well advised to restructure the ownership of the asset to create a leased fee interest. For example, an investment banker may be underwriting the bond financing of municipal improvements where certain civic assets are being offered as collateral. Many government buildings are fraught with superadequacies and would likely have limited utility in the marketplace, even though they are erected at substantial cost. Collateral value might be supplemented by establishing a separate but related ownership entity that leases the asset to the municipality for a long term, similar to a sale leaseback arrangement. A leased fee interest will have been created whose market value could exceed the value of the same improvements owned in fee simple. The valuation emphasis would then shift from the more dubious cost approach to a more market-based valuation of the income stream. In other instances, though, creating a leased fee interest would not be a necessary or appropriate step. For example, in some states assessed values are based on the market value of the fee simple interests, even when a leased fee estate exists.

HIGHEST AND BEST USE

A pivotal issue in appraising any property is determining the highest and best use as improved. In the instance of special-design properties, the highest and best use analysis can be all the more critical. According to The Appraisal of Real Estate, "The highest and best use of a special-purpose property is probably the continuation of its current use, if that use remains viable."(2) While this statement may suggest an easy way out, it should not be construed as a substitute for analysis. Certainly the presence of the improvements or components therein are sufficient evidence to suggest that it is physically possible and legally permissible, or was at the time of development, and perhaps is even financially feasible. But a critical factor, although less obvious, is whether the existing build-out meets the test of maximum profitability. In this instance, the cliche "cost does not equal value" can have genuine implications. Just because a design or construction feature exists and serves the needs of one user does not mean that such a feature is maximally profitable or that it has utility in the marketplace.

Analysis of special-design features requires an evaluation of the component's utility. Because the intricacies of utility are not always fully appreciated, it is helpful to review the definition of functional utility and related concepts:

* Functional utility. "The ability of a property or building to be useful and to perform the function for which it is intended according to current market tastes and standards; the efficiency of a building's use in terms of architectural style, design and layout, traffic patterns, and the size and type of rooms."(3)

* Optimum functional utility. "The design and engineering of a building are considered to be the best in terms of perceived needs at a given time."(4)

* Functional inutility. "Impairment of the functional capacity of a property or building according to market tastes and standards; equivalent to functional obsolescence because ongoing change renders layouts and features obsolete."(5)

* Superadequacy. "An excess in the capacity or quality of a structure or structural component; determined by market standards."(6)

A common denominator among all definitions pertaining to utility is "market standard." It follows, then, that the first step in evaluating utility is to identify an appropriate marketplace.

IDENTIFYING THE MARKET

Market disaggregation refers to the process of dividing a market into smaller, more homogeneous submarkets. A related concept, market segmentation, refers to the process of subdividing consumers into smaller groups according to defined consumer characteristics. Disaggregation and segmentation are the basic techniques that assist the appraiser in providing a focus for market analysis problems, thereby avoiding extraneous data that are not necessary to the study? If a market is disaggregated or segmented to the extent that there is only one possible user, then can it any longer be regarded as a market? The techniques will have been taken to an illogical and self-defeating extreme. The analysis would be too focused if the only potential buyer is the existing user or a hypothetical user identical to the existing user.

Many practitioners view the successful ongoing operation of a particular use as prima facie evidence of highest and best use. Although this may seem plausible when considered in isolation, it is the thrust of this article that such a concept is not viable when examined in the light of other valuation principles. The term "market" connotes plurality and is defined as "a set of arrangements in which buyers and sellers are brought together through the price mechanism."(8) Further, the definition of market value alludes to the price a property would bring in a competitive and open market. A market in which there is just one (prospective) buyer does not suggest competition, nor is it consistent with an open market. Whereas a monopoly is an arrangement in which one person or group controls the supply of goods, a situation where only one person or group controls demand is called a "monopsony." A monopsony is analogous to a monopoly "in that it means the exclusion of competitors, the difference being that in a monopsony other buyers rather than other sellers are excluded."(9)

If a single buyer does not constitute a market, then how many participants are, in fact, necessary to comprise a legitimate market? There are no hard and fast answers to this question. One of the prevailing principles underlying the concept of a market is that of competition. This can exist where there are as few as two parties acting independently to secure the same goods or resource. However, a greater number of participants, both buyers and sellers, provide greater predictability, reliability, and efficiency in both market behavior and market analysis.

Discerning the parameters of the potential market may be accomplished by market segmentation or disaggregation. In the case of special-design properties, however, it may require the inverse process, which might well be called "market aggregation." This would refer to the process of identifying a group of consumers large enough to constitute a competitive market if the improvements are rendered acceptable through physical alteration or pricing incentive.

Nonetheless, even after a potential market has been identified by market aggregation, there may be no market activity within the defined market. In such cases, conceptualizing a marketing scenario can be useful. At this point, the appraiser is in a position to design a research program to evaluate the utility and marketability of the improvements.

EVALUATING UTILITY

If a building is designed and constructed for a particular user, then it is possible that specific components of the building may have limited or no utility to other users. It follows, then, that some alteration of, or accommodation for, that component will render the building acceptable, adequate, or functional for alternative users.

For example, if a facility is being used for production of a particular type of product, say imitation pork bellies, then specifying a highest and best use as "continued use for imitation pork belly manufacturing" may be defining a use too narrow to be considered practical from the standpoint of marketing the building and, therefore, impractical for appraisal purposes. If the existing user were to vacate the subject facility, what would be the most likely marketing scenario? Market aggregation analysis may result in redefining the highest and best use as simply a food manufacturing plant, where there may be a larger population of alternative users.

In this case, the appraiser may need to identify components of the building that were designed specifically to accommodate the special purpose and compare them with more generic components. A given component may be necessary for imitation pork belly manufacturing, but beyond that which might be necessary for a more general food manufacturer. For instance, the HVAC system may provide two functions. The base function might be to maintain comfortable temperatures and general air movement. An auxiliary function may be to handle heat and exhaust created by the custom-built machinery and processing equipment used in manufacturing imitation pork bellies. It is those auxiliary components or capacities which may have value only to a particular user and are, therefore, considered to be superadequate in terms of their functional utility to the general food manufacturers' marketplace. Analysis and cost segregation of these components may require the expertise of an architect, an engineer, or a cost estimator who specializes in that area.

Several potential avenues of investigation make it possible to identify special components and determine if these components have utility to the market. The appraiser could:

* Review appraisal literature pertaining to properties in that product category

* Search for market data on similar or related facilities

* Interview the current or recent occupant and other operators in that particular field (i.e., the alternate users)

* Interview brokers or other appraisers specializing in that product or with experience in that segment of the market

* Interview the project architects and engineers

* Review building plans with a cost estimator or architects/engineers experienced in that general product type

* Review taxation case studies for precedents pertaining to special use property valuation

Literature reviews can sometimes provide insights to procedural precedents pertaining to a product category or address issues surrounding aspects of the appraisal problem in general. Literature can also be used to identify individuals knowledgeable about the product or the outstanding issues, be they authors or market participants, who can be contacted directly for in-depth interviews and possible leads for more data.

Although comparable sales may be nonexistent, there may be transactions, listings, or other market data not directly comparable with the subject that could, nonetheless, shed some light on the appraisal problem. Inferences might be drawn from transactions involving improvements not directly comparable to the subject property but with parallel complications of limited utility or superadequacy. The history surrounding a listing, even though the property may have never sold or attracted any offers, could provide some evidence of market response to a special-design problem.

Interviews with operators in a given industry, potential alternate users, or brokers with experience in that industry, may provide evidence or some form of market support. Case studies may be discovered, some of which may not pertain to sales or listings but that involved alternative internal decisions, such as converting all or part of an existing facility to a new use in lieu of divestment. Attitudes of potential market participants are valid considerations that can give direction to the analysis and provide support for conclusions. Many national firms within a given industry have real estate departments that may have acquisition/disposition strategies, guidelines, procedures, or policies that are revealing and legitimate support, as much as the investor yield surveys that appraisers routinely use to support discount rates.

HYPOTHETICAL SALE: REAL OR CONTRIVED?

When the purpose of the appraisal pertains to ad valorem tax assessment, the issue of utility may already have been decided by the rulings of the local court. Taxation case studies will often reveal a legal precedence. Local courts may differ and conflict with one another's interpretations of valuation principles or interpretations and may support or run counter to the appraiser's opinions. Two examples, one from an East Coast tax court and another from the West, illustrate the disparity that can be found among local jurisdictions and demonstrates the lack of uniformity in opinion among valuation practitioners.

In a New Jersey case, the court rejected a claim of functional obsolescence regarding improvements intended to enhance the prestige of a headquarters office but that would not increase the property's resale value. Recognizing that the improvements would not increase the resale value, the court, nonetheless, contended that such claims of obsolescence overlooked two principles in the valuation of real estate for local property tax purposes:

The first is that the sale contemplated as the criterion of market value is a "hypothetical sale; hence, the would-be buyers are hypothetical buyers, not actual and existing purchasers." From the context in which it was made, we can only understand this reference to a hypothetical buyer to contemplate one whose requirements are reasonably accommodated by the property in question... The second governing proposition bears on the intent and purpose of the taxpayer. Its substance is that no reduction from taxable value will be allowed for special purpose characteristics where these were built into the structure by the taxpayer without regard to the recoverability of their costs and the question of their marketable value is not raised by any realistic suggestion that the property is about to be offered for sale.(10)

In a similar California case, the court ruled that the assessor looked only to the particular use of the subject building as a corporate headquarters and had erroneously failed to consider the value of the property in view of all the purposes to which it was naturally adapted. The court held that using a method of valuation designed solely to capture the specific utility to a particular owner was contrary to law and that the highest and best use of the building in the marketplace was as an office facility. The court concluded that the value of the building in the marketplace is its value to potential purchasers generally, and the normal uses to which potential purchasers could put it must be considered.(11) In another California case, the court decreed that the profitableness, or lack of profitableness, of property to a particular user does not determine value.(12)

The California cases suggest that the functional utility of a property cannot be based on whether it is functional to a particular user, nor whether that particular user is a profitable business. In other words, it would be inappropriate to conclude that if the subject facility were placed on the open market, it would be purchased by an identical entity with requirements identical to the current occupant unless there were a discernible market of such buyers. Rather, evaluation of the functional utility of the subject must be based on how the general market of potential buyers would evaluate the facility. The New Jersey case study provides an exact opposite opinion.

The New Jersey opinion addresses the requirement for a competitive and open market by suggesting that the analyst go beyond hypothesizing a sale to hypothesize a market. In this situation, there is no superadequacy as long as the improvements meet the needs or desires of the party that created or installed it. In other words, cost equals value to he who constructed and paid for it. In such circumstances, the appraiser's task is fairly straightforward: Superadequacy is not a consideration.

In the former situation, the appraiser faces a greater challenge. Research may indicate that there are no alternative users who would purchase the property at a price equal to the value it has to the current user. Practically speaking, then, if the facility were placed on the market, would a prudent seller wait for the ideal buyer, rejecting offers from alternative users? Probably not. Alternative users would probably require a substantial retrofit of the facility. The principle of substitution dictates that a buyer would not pay more for a property than the cost to construct a substitute of equal utility. For practical purposes, the seller of the subject property would be prudent to seriously consider offers from potential purchasers who are not willing to pay for the replacement costs of building components they do not need.

The dichotomous New Jersey and California opinions emerged as a result of disputes between taxpayers and tax collectors. Whether the assignment is for taxation or other purposes, further insight on the issue can be gained by taking the argument outside of the taxation arena and considering it in different environments. In most (if not all) situations, particularly those to which appraisers are accustomed, the requirements and expectations of the appraiser are to assume a hypothetical sale that is more realistic than imaginary. Would a lender be willing to finance a project based on market value assuming "hypothetical buyers, not actual and existing purchasers," as suggested by the New Jersey court? Probably not. A lender would not accept the New Jersey proposition because it goes beyond a reasonable assumption of a hypothetical sale (which is an event that could be brought about by borrower or lender); it makes assumptions about market conditions - something outside the control of borrower or lender. In this respect, it goes beyond assumption to contrivance.

CONCLUSION

Special-design features do not contribute to the market value of real property unless there is competitive demand for such components. Many businesses make decisions to build facilities based on their own business plan, anticipated needs, and personal preferences. They often build facilities without any regard to market value or the principles surrounding market value. In this sense, the value derived by the cost approach may equate to value in use, investment value, or going-concern value, but not market value. However, one must also recognize that the courts may have the final word in how appraisal principles will be interpreted in their jurisdiction. In any event, debate will probably continue indefinitely until taxing entities base their assessment of special-design features on value in use rather than market value.

1. Robert G. Crawford and Gary C. Cornia, "The Problem of Appraising Specialized Assets," The Appraisal Journal (January 1994): 75-85.

2. Appraisal Institute, The Appraisal of Real Estate, 11th ed. (Chicago, Illinois: Appraisal Institute, 1996), 316.

3. Appraisal Institute, The Dictionary of Real Estate Appraisal 3d ed. (Chicago, Illinois: Appraisal Institute, 1993), 155.

4. Ibid., 257.

5. Ibid., 154.

6. Ibid., 357.

7. Neil Carn, Joseph Rabianski, Ronald Racester, and Maury Seldin, Real Estate Market Analysis (Englewood Cliffs, New Jersey: Prentice-Hall, 1988): 3, 66-67.

8. The Appraisal of Real Estate, 19.

9. Armen A. Alchain and William R. Allen, Exchange and Production: Competition, Coordination, and Control, 3d ed. (Belmont, California: Wadsworth Publishing Co., 1983), 337.

10. United New Jersey, etc., Co. v. State Board, etc., 100 N.J.L. 131, 135 (E & A 1924).

11. Pacific Mutual Life Insurance Co. v. County of Orange, 187 Cal. App. 3d 1141, 232 Cal. Rptr. 233 (1985).

12. Bank of America v. County of Fresno, 127 Cal. App. 3d 295, 179 Cal. Rptr. 497 (1981); County of Los Angeles v. McDonnell Douglas Corp., 219 Cal. App. 3d 715, 268 Cal. Rptr. 294 (1990).

David Pool Rothermich, MAI, is a principal of the Keane Rothermich Group, San Francisco, California. His real estate consulting practice includes valuation of special-design and limited market properties. He received a BA in anthropology from the University of California, Berkeley. Contact: Keane Rothermich Group; 475 Gate Five Road, Suite 218; Sausalito, California 94965. (415) 332-6778. Fax 332-6962. DPR-KRGroup@MSN.com.
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Author:Rothermich, David Paul
Publication:Appraisal Journal
Date:Oct 1, 1998
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