Volume 3, No. 1, Summer 1998

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Issues in Appraising High Profile Commercial Properties

Over the past year we have been asked by lenders, portfolio managers, and owners to appraise a significant number of high profile shopping centers and office towers located in the Twin Cities and the upper Midwest. These properties are regarded as investment-grade quality in their respective marketplaces. The valuations of these properties required the use of the very latest market data which we gathered using our ability to tap into broker networks and other information services, as well as our dialogues with market participants. The knowledge gained through these engagements has broadened our market knowledge and provided insight as to what the "hot buttons" are for those who use these appraisals. This experience has proved to be invaluable when the appraisal engagement has a tight deadline and there has been no room for a learning curve on our part.

Descriptive Data
The descriptive portion of an appraisal should provide the reader with a good mental image of the subject's improvements, its neighborhood and surrounding area. The reader may never visit the subject property but needs to have a clear understanding of the property under evaluation and the outside influences affecting it. Often, our appraisals are used by Wall Street for securitization purposes and there is a strong impetus to correctly identify the dynamics of the nearby area and neighborhood. Two neighborhoods may exhibit identical demographic characteristics, but if one neighborhood is experiencing a declining trend, while the other is experiencing an improving trend, the outlook for identical properties in those neighborhoods may be vastly different. In addition to describing area and neighborhood trends, an appraisal is expected to include recent demographic information for the subject's defined market area. This includes population, number of households, age distribution of the population, types of employment and income statistics. Traffic counts or other neighborhood data may also be pertinent. The descriptive section of the appraisal report should be written to answer all of a reader's questions pertaining to the physical characteristics, aspects of location, and governmental impacts on the subject property.

Highest and Best Use Issues
One of the simplifying characteristics of an appraisal on a high profile property is that the highest and best use of the property is rarely in question. If a structure was built as a multi-tenant high-rise office building, then, in all likelihood, that will be its highest and best use. Although the highest and best use of a high profile property is rarely in doubt, its underlying value may be somewhat volatile. Supply and demand factors in commercial real estate generally tend to be cyclical. Recognizing the early signs of impending imbalances between the supply of and demand for a particular property requires communication among appraisers, brokers, developers, lenders, investors and others in the real estate community. In some ways, the entrance into the marketplace by national equity REITS (Real Estate Investment Trusts) has made identifying these signs on the value curve somewhat problematic. REITS may have longer staying power and deeper pockets in the current real estate cycle than local or national developers may have had in the last real estate cycle. A greater ability to cover losses sustained from increased vacancy rates and/or a xtenant's marketà may allow REITS to mask ownership problems for a longer period of time.

Valuation Issues
As most sophisticated users of appraisals know, several approaches can be used to provide indications of market value. In a perfect world, all of these approaches point to a common market value conclusion.

Cost Approach: Unless the appraised property is new construction, users of high profile commercial property appraisals regard the cost approach as the least reliable indicator of value. One reason for this is the difficulty in accurately estimating accrued depreciation, which may include physical, functional or economic influences. In addition, estimating factors such as a developer's profit or an entrepreneurial profit may not be easy. The rule of thumb is that the developer's profit is roughly 10% of total hard and soft costs. Our experience is that this value may be greatly increased or decreased depending on the economic success of the property. However, despite the minimal weight given to this approach, we have found that our clients generally want to see its inclusion in the valuation process, if for no other reason than that it quantifies the underlying land value of the property. Some users of appraisals are also interested in seeing the difference, if any, between the market value of the property and its replacement cost.

Sales Comparison Approach: The sales comparison approach is usually not the preferred method of buyers and sellers to estimate market value for investment grade real estate. Comparable sales can help establish price limits and ranges if a sufficient number of relevant sales has occurred within a reasonable time from the date of valuation. Adjustments for differences between location, age, quality, tenant mix, occupancy and lease obligations among properties are usually subjective. Comparable sales adjustments are difficult to apply when financial details of a sale are lacking and when an insufficient number of sales exists in a given market to conduct paired sales analyses. Because higher profile investment real estate usually sells for income reasons, in our opinion, the primary reason for adjusting comparable sales should be income related. Purchase decisions are generally made on an investment property's ability to generate cash flow and a particular investor's yield requirements. Potential investors analyze project risk and compare anticipated yields against what could be earned on alternative investments. Less importance is placed on what other buildings sell for on a physical unit basis. Sale prices of high profile commercial properties are generally a reflection of investors' yield requirements and the income characteristics of the property, which is the foundation of the income approach.

Income Capitalization Approach: The income capitalization approach is generally the most reliable approach when valuing multi-tenant properties. Unlike owner-occupied or single-tenant buildings, most high profile investment-grade properties are expected to experience fluctuating cash flows over time as their tenant roster changes. It is very cumbersome, or virtually impossible in some cases, to thoroughly analyze such a property without sophisticated lease software. Variables, such as recovery pools, limits on tenants' expense obligations, management surcharges, and recaptures of overage rent, can be extremely complex and difficult to process. Lease software effectively handles such detailed issues for which the Lotus or Excel spreadsheets are ill-equipped. Lease analysis software applications greatly simplify the management of the mathematics of the cash flows. However, the accuracy of the cash flows depends upon the skill of the individual in correctly entering the data and interpreting the results.

Many of our clients request an electronic copy of the lease files generated in the income analysis. We are glad to provide this in a Pro-Ject or Argus format; two of the most common lease analysis software applications used by real estate professionals. Our preference is Argus, which we believe is more versatile and user friendly. Nevertheless, we have extensive experience with both of these software packages.

Probably the most important decisions in appraising high profile investment properties are the market assumptions, regarding future years, to be made in the income and expense analysis. Simply stated, the closer we are, as appraisers, to the marketplace, the better are our assumptions. All of our assumptions must have at least some substance in fact, and should be explained as thoroughly as possible. Competitive rental analyses, lease transactions at competing properties, market surveys, and interviews with brokers and owners are indispensable in forming sound assumptions for both income and expense forecasts. An important issue when appraising Minnesota properties is the real estate tax rate, which is close to the highest in the nation. Not only should tax rates be correlated to historical levels, they should also take into account any legislative changes impacting future tax levies. We make a special attempt to be certain that future tax liabilities are in balance with indicated values. In appraising high-profile properties, vacancy and credit loss assumptions are sometimes tailored to reflect the creditworthiness of the individual tenants.

Experienced users of appraisals often scrutinize the applied capitalization rates and require a sound analysis which supports the concluded rates. Some users rely more on the discounted cash flow analysis which utilizes internal rates of return consistent with the risks and rewards offered by alternative investment vehicles. Others place greater emphasis on the direct capitalization technique which utilizes an overall capitalization rate, preferably derived from recent comparable sales in the marketplace. Of the two income techniques, it is difficult to generalize which one is preferred by appraisal users.

Summary
The appraisal of high-profile investment properties is similar to other disciplines-that is, the more of them one does, the more proficient one gets. Extensive experience has earned us client respect for our ability to appraise high-profile commercial properties. We find that users of appraisals of high-profile investment properties do not want reports padded with volumes of extraneous material, but are willing to pay for a concise, thorough analysis which shows experience and attention to the valuation question at hand. Often, when we deliver an appraisal to our clients, there are no further questions after the internal reviews. Hearing no questions from a sophisticated client is one of the highest compliments an appraiser could receive.