Valuation of Real Estate Assets

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Determining the value of a real estate asset is never an easy thing but the historic free fall in real estate values a few years ago and subsequent uneven recovery has made this task significantly more difficult. This month, we are going to discuss how a tumultuous market can impact the traditional approaches to determining value – cost approach, sales comparable approach and income capitalization approach. Before we do, a brief discussion of the three primary types of value is in order.

Market Value. This represents the most probable price, at a specific date, which a property should sell for after reasonable exposure in a competitive market under all of the conditions for a fair sale. There are a couple additional things to note. First, neither buyer nor seller should be under any duress, with both parties knowledgeable and informed. And second, the price should be based on the property’s highest and best use, which may or may not be the property’s current use.

Investment Value. This type of value is all about the value to a specific purchaser, with little regard to the larger overall marketplace. One example of this would be a purchase by an investor involved in a 1031 tax-deferred exchange. Motivated by the deferral of a tax consequence, a trade buyer is typically willing to pay more for a property as compared to a traditional buyer. Another example would be a property owner that controls almost an entire block of property, except for one parcel. The owner would typically be willing to pay more for that outstanding parcel as compared to a traditional buyer.

Value in Use. This type of value is often confused with market value. The key difference is that market value is based on a property’s highest and best use while value in use only considers the property’s current use. This isn’t a problem if the property’s current use is in fact the highest and best use. But if there is an alternative use for the property that would result in a higher value, the value in use would be different (in this case, lower) than the market value.

Market value is the most common and can be determined using any of the following three approaches. All of these approaches can be tough enough to complete in a normal market but the task is more difficult during times of economic transition.

Sales Comparable Approach. The most commonly used approach, the sales comparable approach, correlates the market value of a subject property to the sale prices of similar recently sold properties. But during a choppy market, a few issues can arise. First is a shortage of comparable sales. During 2009 through 2012, there were very few real estate sales. And those that were trading hands usually involved a seller that was under some type of financial distress. Although the general real estate market has improved, some segments have fared much better than others. So when using the sales comparable approach to determine value, be certain to fully understand any nuances associated with each comparable, including the buyer, the seller, the attributes associated with the real estate and the market conditions that are impacting the subject.

Income Capitalization Approach. While any property can be valued using this approach, it is predominantly used when considering incomeproducing real estate and from an investment perspective. This approach is predicated on two components: income, specifically net operating income (NOI) and a capitalization (CAP) rate, which is a measure or index that represents income as a percentage of value. Once you have determined these two components, the actual calculation simply divides NOI by the CAP rate, resulting in a value. However, determining these two components can be anything but simple. Several potential pitfalls can derail an accurate NOI, both on the income as well as the expenses side. It is critical to understand if NOI was derived from historical performance, current performance or anticipated future (often called ‘pro forma’) performance. The CAP rate component should be subject to similar scrutiny. The concept is to apply a CAP rate that accurately reflects the current market and considers sales that involve properties with characteristics similar to the subject property. All too often, nuances associated with these sales, and thus the resultant CAP rate, are not fully understood. Key items to focus on include if the CAP represents current economics or projected economics, the inclusion of incentives such as a master lease or seller financing and any pending events that could dramatically impact rental income, such as a large tenant expiring or a new tenant moving in.

Cost Approach. This method aggregates three components – the value of the land if vacant plus the cost of new construction to replace the existing improvements less depreciation to match the subject property’s condition. The component subject to the most scrutiny is the value of the deprecation, as it becomes significantly more subjective as the age of the subject property increases. But a more subtle issue often arises when value in use is confused with market value. When determining the appropriate deprecation, the most important thing to consider is what the market would deduct due to obsolescence and not what the current occupant would deduct. While this difference is subtle, the impact on value can be significant – especially when considering the cyclical nature of the marketplace.

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Valuing real estate is always a challenging task, especially when the overall market is in transition. But understanding some of the challenges associated with each approach can help form a more accurate end result.

Ira Krumholz

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