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By Robert J. Strachota, President; & Scot A. Torkelson, Vice President
Valuing Special Purpose Real Estate or Special Use Real Estate brings a unique set of challenges for the appraiser. Special purpose real estate is defined, in The Dictionary of Real Estate Appraisal, American Institute of Real Estate Appraisers, as "a property that is appropriate for one use or a limited number of uses & also, a building that cannot be converted to another use without a large capital investment." The real estate is therefore uniquely suited and closely related to a particular operation or business. As a result, the values of both the business and real estate can be accidentally commingled within the appraiser's analyses, yielding inaccurate market value conclusions. Inadvertently including income from the business within a real estate valuation and/or capitalizing the wrong income stream are common occurrences in special use real estate valuations; such errors should be carefully avoided. Special use properties are appraised using the same valuation approaches as are used for multi-use real estate: Cost, Market and Income. However, depending upon the type of real estate being appraised and the nature of the business operation, the application of these approaches during the valuation process can be quite different. This is due to the fact that in some special use properties, the business enterprise is actually the operation of the real estate itself, rather than the business' occupation of real estate which is uniquely suited to its operational needs.
This difference is a crucial one for appraisers. In cases where the business enterprise is part and parcel of the real estate and is so specialized that alternate uses of the real estate are not feasible, an examination of the business enterprise (whose focus is the operation of the real estate) is necessary. However, when a business is occupying special use real estate uniquely suited to its operational needs (not the actual focus of the business' operations), the real estate can be more readily separated from the business enterprise and appraised by determining a market rent. We would note, though, that in special use real estate which is uniquely suited to the business' needs, the rent paid is sometimes tied to the performance of the business' operation - most typically on a percentage of revenue rental basis.
One example of special use property is an amusement park: the business focus is the operation of the real estate itself-keeping the grounds clean, maintaining the rides, selling tickets to patrons so that they can enter the property, providing for performances on the grounds, etc. Another example is a grain elevator or grain malting plant where the business is actually the operation of the real estate plant machinery for which there is no other use. These are special use real estate enterprises in which the business is the management or operation of the real estate itself. A very different type of special purpose property is the automobile dealership. In an auto dealership, the business' operations are the buying, selling and repair of automobiles; the real estate, while being uniquely suited to the dealership, is not the focus of the business. It is not the operation of the real estate itself with which the business is concerned, as in the case of an amusement park or a grain elevator. With an auto dealership, the customers are coming to buy or lease cars, for auto repairs, maintenance or warranty work. While such a property is certainly unique, there are a number of other uses for the real estate: alternate brand auto dealerships (Chrysler, Chevrolet or Ford), retail nurseries, auto strip malls or repair centers, implement dealers or retail rental facilities. There are few or no feasible alternatives for the amusement parks, racetracks, hotels, cemeteries, malting plants, grain elevators, gravel/bituminous plants or campgrounds. This is not the case with businesses which operate within special use properties uniquely suited to their own needs (restaurants, auto dealerships, manufacturers, gas stations, etc.). With a relatively small investment, one restaurant may replace another, a manufacturing plant can be converted to a storage facility and the equipment sold, a gas station can be turned into a fast-food franchise, and so on. Because there are such significant differences between these two types of special purpose properties, applying the appropriate methodology within the income approach is tricky. The following specific examples will help to illustrate the process.
Special Use Property-Amusement Park
If the real estate is the operational focus of the business, then an appropriate valuation, within the income approach, requires an examination of the business enterprise, with value derived from the capitalization of profits using the business' income statement. However, when valuing special use real estate only, it is critical to deduct those expenses which are not related to the real estate, but are related to the intangible business value of the operation (a management fee expense). This deduction is necessary even if such an expense is not included in the business' actual income statement. The management fee reflects the intangible business value which is not associated with the real estate. It is usually calculated as a percentage of revenue. For example, 4% to 6% of the revenues of an amusement park may be deducted, as an expense, to reflect the business' management fee related to the amusement park operations. The profit shown on the income statement (net of all expenses including deduction of the market-derived management fee) is then used to estimate the market value, within the income approach, for this special use real estate.
Thus, in the amusement park example, capitalization of the income statement profits (with a deduction for the management fee), yields the market value of the real estate and the capitalization of the management fee yields the market value of the business.
Special Use Property-Auto Dealership
In contrast, when the real estate being appraised is a special use property which is uniquely suited to the business operation, but not itself the focus of the business enterprise, the appropriate valuation within the income approach is based on a market-determined rent. This market rent is derived from similarly developed, mixed use (i.e., not special use) real estate, with some additional distinctions. Special use real estate which is uniquely suited to the business will commonly tie the rent paid to the performance of the business, as mentioned earlier, by calculating market rents as a percentage of revenues. For example, real estate utilized as restaurants will often set rents within the real estate lease at a base rental, plus some rental which is at a percentage of revenue, whichever is greater. Sit-down restaurants use a 5% to 6% of revenues rent, while fastfood operations typically use 7% to 8% of revenues rent. The automobile dealership in our example is a special use property which is uniquely suited to the business, but is not itself the focus of the business' operations; therefore, the income approach will be based upon a market-derived rent, although it is less likely that consideration would be given to revenues on a percentage of rent basis than it would be for restaurants. Thus, in the restaurant and automobile dealership examples, capitalization of market rent yields the market value of the real estate, and capitalization of the business' income statement (with a deduction for the rent expense) yields the market value of the business.
Final Thoughts
Indications that a special use business is operating on land which is suited to its needs, but is not the focus of the business' operations, include the flexibility of the real estate; it is relatively adaptable for a variety of other reasonable uses. In our example, the auto dealership special use property could be adapted for use as an auto strip mall, an outdoor retail nursery, auto repair or collision center, another brand of auto dealership (Chrysler, Chevrolet or Ford), or a variety of other businesses for which a large building with a significant land area would be suitable. One cannot as readily imagine that an amusement park or hotel could be easily converted for alternate uses. When the focus of a business is in fact the operation of its real estate, it is much more time consuming and expensive to adapt that property to suit other users. Special use properties do bring special challenges. An in-depth understanding of the special purpose property being appraised is essential. The method used to capitalize earnings, for the income approach, depends on whether one is dealing with special use property where the focus of the business is the management of the property itself or with special use property where the property is uniquely suited to the business; this, in turn, affects the value conclusion.
