Regardless of the form of real estate investment, the value of the underlying real estate is critical because the value of any real estate investment is inextricably tied to the value of the underlying real estate. Commercial real estate properties do not transact frequently, and each property is unique. Therefore, estimates of value or appraisals, rather than transaction prices, are used to assess changes in value or expected selling price over time. Appraisals are typically done by individuals with recognized expertise in this area. These can be independent experts hired to do the appraisals or in- house experts.
5.1 Appraisals
Appraisals (estimates of value) are critical for such infrequently traded and unique assets as real estate properties. For publicly traded assets, such as stocks and bonds, we have frequent transaction prices that reflect the value that investors are currently placing on these assets. In contrast, commercial real estate, such as an apartment or office building, does not trade frequently. For example, a particular building might sell once in a 10- year period. Thus, we cannot rely on transactions activity for a particular property to indicate how its value is changing over time.
There are companies, such as real estate investment trusts, that invest primarily in real estate and have publicly traded shares. REITs are available in many countries around the world. REIT prices can be observed as with any publicly traded share. REITs are businesses that buy and sell real estate; often do development; decide how properties are to be financed, when to refinance, and when to renovate properties; and make many other ongoing management decisions that determine the success of the REIT.
Therefore, the prices of REIT shares reflect both the performance of the management of the company that owns the real estate and the value of the underlying properties.
Thus, although it is useful to know how the values of REIT shares are changing over time as an indicator of changing conditions in the real estate market, it does not substitute for the need to estimate the value of individual properties. In fact, knowing the appraised value of properties held by REITs is helpful in estimating the value of the REIT, although, as suggested above, many other factors can affect REIT share prices over time.
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Appraisals can be used to evaluate the performance of the investment or to deter- mine an estimate of price or value if a transaction is anticipated. Even if there has been a recent transaction of the property, because it is only one transaction between a particular buyer and seller, the transaction price at which the property sold may not reflect the value a typical investor might place on the property at that time.1 There may be circumstances under which a buyer may be willing to pay more than a typical buyer would pay or a seller may be willing to accept less than a typical seller would accept. Thus, even when there is a transaction, an appraisal is often used as a basis for estimating the value of the property rather than just assuming that the agreed upon transaction price equals the value. For example, an appraisal is likely to be required if the purchaser of the property wants to finance a portion of the purchase with debt. The lender will typically require an independent appraisal of the property to estimate the value of the collateral for the loan. Even if the purchaser is not borrowing to finance a portion of the purchase, the purchaser may have an appraisal done to help establish a reasonable offer price for the property. Similarly, the seller may have an appraisal done to help establish the asking price for the property.
Properties are also appraised for other reasons. Another important use of appraisals is for performance measurement—that is, to measure the performance of real estate that is managed for a client. For example, a pension fund may have decided to invest in real estate in addition to stocks and bonds to diversify its portfolio. It may have invested directly in the real estate or through an investment manager that acquires and manages the real estate portfolio. In either case, the pension fund wants to know how its real estate investments are performing. This performance can be evaluated relative to the performance of stocks and bonds and against a benchmark that mea- sures the performance of the relevant real estate asset class. The benchmark is used in the same way that a stock index might be used as a benchmark for measuring the performance of a stock portfolio.
Measuring the performance of a real estate portfolio requires estimating property values on a periodic basis, such as annually. Although more frequent measures may be desirable, it may not be practical because appraising property values is a time- consuming and costly process. It may involve an independent appraisal by a firm that specializes in appraising investment properties, or it may be done by an appraiser who works for the investment management firm. In either case, the appraiser is tasked with estimating the value of the property.
5.1.1 Value
The focus of an appraisal is usually on what is referred to as the market value of the property. The market value can be thought of as the most probable sale price. It is what a typical investor is willing to pay for the property. There are other definitions of value that differ from market value. For example, investment value (sometimes called worth) is the value to a particular investor. It could be higher or lower than market value depending on the particular investor’s motivations and how well the property fits into the investor’s portfolio, the investor’s risk tolerance, the investor’s tax circumstances, and so on. For example, an investor who is seeking to have a globally well- diversified portfolio of real estate that does not already have any investments in New York City and Shanghai may place a higher value on acquiring a property in either of those locations than an investor who already has New York City and Shanghai properties in his or her portfolio.
1 The term special purchaser is used in some countries, such as the United Kingdom, to refer to purchasers who are not typical.
There are other types of value that are relevant in practice, such as value in use, which is the value to a particular user—for example, the value of a manufacturing plant to the company using the building as part of its business. For property tax purposes, the relevant value is the assessed value of the property, which may differ from market value because of the way the assessor defines the value. In most cases, the focus of an appraisal is on market value.
Potential sellers and buyers care about market value because it is useful to know when negotiating price. The market value may differ from the value that the potential buyer or seller originally placed on the property and from the price that is ultimately agreed upon.2 A seller in distressed circumstances may be willing to accept less than market value because of liquidity needs, and a particular buyer (investor) may be willing to pay more than market value because the worth (investment value) to that buyer exceeds the value to a typical investor.
Lenders usually care about market value because if a borrower defaults on a mortgage loan, the market value less transaction costs is the maximum that the lender can expect to receive from the sale of the property. But there are some exceptions. In some cases, the lender may ask for a more conservative value, which can be referred to as a mortgage lending value. For example, in Germany the mortgage lending value is the value of the property which, based on experience, may throughout the life of the loan be expected to be generated in the event of sale, irrespective of temporary (e.g., economically induced) fluctuations in value on the relevant property market and excluding speculative elements. In determining the mortgage lending value, the future saleability of the property is to be taken as a basis within the scope of a “prudent val- uation,” taking into consideration the long- term, permanent features of the property, the normal regional market situation, and the present and possible alternative uses.
Some have argued that over the decades in which it has been applied, the mortgage lending value has helped mortgage lending in Germany to have a stabilizing effect on the German real estate market by evening out current, possibly exaggerated market expectations. The mortgage lending value contrasts with the notion of “mark- to- market” or “fair value” accounting, which would value an asset at its market value at the time the loan is made.
EXAMPLE 10
Market Value
A property that was developed two years ago at a cost of ¥60.0 million, including land, is put on the market for that price. It sells quickly for ¥50.0 million. After the closing, the purchaser admits he would have paid up to ¥65.0 million for the property because he owned vacant land next to the property purchased. A very similar property (approximately the same size, age, etc.) recently sold for
¥55.0 million.
1 The purchaser is most likely a:
A typical investor.
B particular investor.
C short- term investor.
2 The market value of the property is closest to:
A ¥50.0 million.
2 For further discussion of the various definitions of value, refer to such publications as the “Uniform Standards of Professional Appraisal Practice,” the Royal Institution of Chartered Surveyors (RICS) Red Book, and “The International Valuation Standards.”
B ¥55.0 million.
C ¥65.0 million.
3 The investment value of the property to the buyer is closest to:
A ¥50.0 million.
B ¥60.0 million.
C ¥65.0 million.
Solution to 1:
B is correct. This investor may be willing to pay more than the typical investor because of his particular circumstances.
Solution to 2:
B is correct. The purchaser paid ¥50.0 million rather than the ¥65.0 million he was willing to pay for the property. However, we have to be careful about using a transaction price as an indication of market value because the market may have been thin and the seller may have been distressed and willing to accept less than the property would have sold for if it had been kept on the market for a longer period of time. The quick sale suggests that the price may have been lower than what a typical investor may be willing to pay. There was a comparable property that sold for ¥55.0 million. Combining these facts and based only on this information, it is reasonable to assume that the market value is closest to
¥55.0 million. Note that what it cost to develop the property two years ago is not particularly relevant. Markets may have deteriorated since that time, and new construction may not be feasible.
Solution to 3:
C is correct. The investment value of the property is ¥65.0 million. The purchaser was willing to pay up to ¥65.0 million, suggesting that his investment value was higher than the amount paid. He paid only as much as he had to, based on negotiations with the seller.
5.2 Introduction to Valuation Approaches
In general, there are three different approaches that appraisers use to estimate value:
the income approach, the cost approach, and the sales comparison approach. The income approach considers what price an investor would pay based on an expected rate of return that is commensurate with the risk of the investment. The value esti- mated with this approach is essentially the present value of the expected future income from the property, including proceeds from resale at the end of a typical investment holding period. The concept is that value depends on the expected rate of return that investors would require to invest in the property.
The cost approach considers what it would cost to buy the land and construct a new property on the site that has the same utility or functionality as the property being appraised (referred to as the subject property). Adjustments are made if the subject property is older or not of a modern design, if it is not feasible to construct a new property in the current market, or if the location of the property is not ideal for its current use. The concept is that you should not pay more for a property than the cost of buying vacant land and developing a comparable property.
The sales comparison approach considers what similar or comparable properties (comparables) transacted for in the current market. Adjustments are made to reflect comparables’ differences from the subject property, such as size, age, location, and
condition of the property and to adjust for differences in market conditions at the times of sale. The concept is that you would not pay more than others are paying for similar properties.
These approaches are unlikely to result in the same value because they rely on different assumptions and availability of data to estimate the value. The idea is to try to triangulate on the market value by approaching the estimate three different ways.
The appraiser may have more confidence in one or more of the approaches depending on the availability of data for each approach. Part of the appraisal process is to try to reconcile the differences in the estimates of value from each approach and come up with a final estimate of value for the subject property.
5.2.1 Highest and Best Use
Before we elaborate on the three approaches to estimating value, it is helpful to understand an important concept known as highest and best use. The highest and best use of a vacant site is the use that would result in the highest value for the land. This concept is best illustrated with an example. Suppose you are trying to determine the highest and best use of a vacant site. Three alternative uses—apartment, office, and retail—have been identified as consistent with zoning regulations and are financially feasible at the right land value. The physical characteristics of the site make construc- tion of buildings consistent with each of these uses possible. Exhibit 4 summarizes relevant details for each potential use:
Exhibit 4 Highest and Best Use
Apartment Office Retail
Value after construction $2,500,000 $5,000,000 $4,000,000 Cost to construct building (2,000,000) (4,800,000) (3,000,000)
Implied land value $500,000 $200,000 $1,000,000
The value after construction is what the property would sell for once it is constructed and leased. The cost to construct the building includes an amount for profit to the developer. The profit compensates the developer for handling the construction phase and getting the property leased. Subtracting the cost to construct from the value after construction gives the amount that could be paid for the land. In this case, the retail use results in the highest price that can be paid for the land. So retail is the highest and best use of the site, and the land value would be $1 million.
The idea is that the price would be bid up to that amount by investors or devel- opers who are competing for the site, including several bidders planning to develop retail. Note that the highest and best use is not the use with the highest total value, which in this example is office. Even though office has a higher value if it is built, the higher construction costs result in a lower amount that can be paid for the land. A developer cannot pay $1 million for the land and build the office building. If they did, they would have a $5.8 million total investment in the land and construction cost but the value would be only $5 million. So that would result in an $800,000 loss in value because an office building is not the highest and best use of the site.
The theory is that the land value is based on its highest and best use as if vacant even if there is an existing building on the site. If there is an existing building on the site that is not the highest and best use of the site, then the value of the building—not the land—will be lower. For example, suppose that a site with an old warehouse on it would sell for $1.5 million as a warehouse (land and building). If vacant, the land is worth $1 million. Thus, the value of the existing building (warehouse) is $500,000
(= $1,500,000 – $1,000,000). As long as the value under the existing use is more than the land value, the building should remain on the site. If the value under the existing use falls below the land value, any building(s) on the site will likely be demolished so the building that represents the highest and best use of the site can be constructed.
For example, if the value as a warehouse is only $800,000, it implies a building value of negative $200,000. The building should be demolished, assuming the demolition costs are less than $200,000.
EXAMPLE 11
Highest and Best Use
Two uses have been identified for a property. One is an office building that would have a value after construction of $20 million. Development costs would be $16 million, which includes a profit to the developer. The second use is an apartment building that would have a value after construction of $25 million.
Development costs, including a profit to the developer, would be $22 million.
What is the highest and best use of the site and the implied land value?
Solution:
Office Apartment
Value on completion $20,000,000 $25,000,000 Cost to construct building (16,000,000) (22,000,000) Implied land value $4,000,000 $3,000,000
An investor/developer could pay up to $4 million for the land to develop an office building but only $3 million for the land to develop an apartment building.
The highest and best use of the site is an office building with a land value of
$4 million. Of course, this answer assumes a competitive market with several potential developers who would bid for the land to develop an office building.
We will now discuss each of the approaches to estimating value in more detail and provide examples of each.