Business Components and the Valuation of Real Estate

The Relationship Between Performance and Value

By: William C. Herber and Stephen T. Hosch

In some cases, real estate values are driven by the specific utility an existing or proposed property provides to the industry it was designed to serve. State-of-the-art properties in prime locations, that can generate higher sales volumes than normal for their occupants, are generally priced at the upper end of the range of value for the real estate, while outdated facilities in declining neighborhoods are priced toward the low end of the range of value and may even warrant redevelopment of the site with a change in highest and best use.

Certain types of real estate can be analyzed by using sales volume to develop a percentage rent. When appraising these types of properties, a more accurate appraisal can be completed if the appraiser is aware of trends within the given industry and is able to determine where the subject property's performance fits relative to that industry. Nonetheless, the appraiser must still determine whether above-average revenues are due to the prime location of the real estate or are the result of intangible factors such as name or reputation of the product(s) sold. Demographics, access, traffic counts and visibility are some of the factors which may drive revenues.

Estimating market rent as a percentage of gross annual sales is an accepted method for determining lease rates within many industries. Once the market rent is quantified, it can be capitalized into estimated market value for existing as well as proposed properties. Such an exercise is helpful for long-range planning, feasibility studies and land acquisition. It is common for developers to use this methodology to determine the estimated market value of a proposed project as if it were completed. Development cost estimates for the proposed building are subtracted from the estimated market value to arrive at a land price they can afford to pay.

Examples of some property types that are particularly sensitive to sales volumes are:

• Fast Food and Sit-down Restaurants
  
• Bars/Night Clubs
  
• Hotels/Motels/Resorts
  
• Retail Stores
  
• Retail Banks
  
• Movie Theaters
  
• Automobile, Motor Sports and Farm Implement Dealerships
  
• Gas Stations/Convenience Stores
  
• Oil Lube Facilities
  
• Supermarkets
  
• Golf Courses
  
• Amusement Parks/Race Tracks/Bowling Alleys

A brand new, state-of-the-art, property that is poorly located (not enough demand due to inadequate demographics or poor visibility), may be worth a fraction of the value of an older property of the same type that is situated in a prime location generating strong annual sales volume. As long as the older property is able to meet current corporate standards (in the case of a franchise location), and is kept clean and presentable, its location alone can be significant in sustaining its value, especially if development of its property type becomes more difficult in the immediate municipality due to more restrictive zoning. Some properties, vacated by their original occupants, are still quite functional for their original or intended uses, but lack the key real estate components or intangibles necessary for the use to remain viable. This is one reason why it is not surprising to see relatively new supermarkets, general merchandise stores, restaurants, movie theaters, office buildings, industrial buildings and others close down, sell, change in use and/or redevelop. If the key real estate components are there, the use is more likely to continue.

	Location A	Location B
Land Size:	One Acre	One Acre
Building Size:	4,500 sq. ft.	4,500 sq. ft.
Age of Building Construction:	15 years	5 years
Annual Sales Volume of Occupant:	$1,500,000	$500,000
Multiplied by Assumed Percentage Rent Factor:	x .08	x .08
Equals Annual Base Rent:	$120,000	$40,000
Divided by Assumed Capitalization Rate:	/.095	/.09
Equals Value Indication as a Fast Food Restaurant:	$1,263,158	$444,444
Estimated Land Value as Vacant:	$555,000	$500,000
Highest and Best Use:	Continued Use as Fast Food	Change in Use or Redevelop?

Highest and Best Use Example: Comparing Two Similar Fast-food Restaurants
In order to demonstrate the importance of understanding the performance of a given property type (relative to its industry), within the appraisal process, we provide the following chart which compares two identically-sized fast food restaurants with the same corporate flag; the difference in revenues is due solely to the dynamics of the real property. The two locations perform very differently, which can have a measurable impact on the highest and best use and, ultimately, results in completely different estimated market values.

Although each property appears to be competitive in its appearance, condition, layout and function, the concluded highest and best use is very different. Property A's highest and best use is likely to be continued use as a fast food restaurant given the large spread of overall value over land value as vacant. Property B's highest and best use may be in question. Unless sales volume can be increased by at least $62,500, or 12.5%, to generate an overall value of $500,000 (equivalent to land value), a change in use may be considered to justify a $500,000 value. Alternatively, the underlying land value will likely warrant redevelopment of the property.

Prices for certain property types can easily fluctuate when the corresponding industry is volatile. Errors in valuing this type of real estate are more likely to occur if the appraiser is not knowledgeable about the industry averages at the time of sale. Industry data can be compared to the reported financial statement information for accuracy: average sales price per square foot, for example. Even though sales may be increasing over time within a given industry, profit margins may be shrinking. This, in turn, affects tenants' abilities to absorb rent increases for the properties they lease. Some property types affected by shrinking profit margins in recent years are: gas station/convenience stores and automobile dealerships. Several important questions must be answered during the appraisal process: (1) Are annual sales and profit margins stabilized? If not, why?; (2) Is there increasing or decreasing competition and how has that impacted revenues and profits?; and, (3) Is the property designed to serve industries that depend on discretionary income (such as movie theaters, hotels/motels, golf courses, amusement parks, casinos, restaurants, etc.), which results in the property being susceptible to large fluctuations in revenues and profits over time?

In summary, when the appraiser has a general knowledge of the subject property's performance within the given industry for which it was designed, the resulting appraisal is a more accurate reflection of its value. It is helpful for the appraiser to know whether the subject location's performance (sales per square foot) is above, below or at the same level as the given industry and if the subject's sales are growing, stable or declining relative to the industry. Informed buyers and sellers of certain types of commercial real estate and vacant land often determine price based on the ability of the end user of an existing or proposed property to pay rent. Ignoring such characteristics can result in either an overvaluation or undervaluation of the real estate. Property owners, attorneys, accountants, lenders and financial advisors should consider providing the appraiser with appropriate income statements from the owner, user and/or tenant's business when requesting a commercial real estate appraisal or feasibility study. Doing so indicates an understanding of the relationship between a property's performance and its value.

Back To Top