AUTHOR: Steven R. Smith, MSREA, MAI, SRA, Smith Realty Advisors, 936 San Jacinto St., Redlands, CA 92373, Real Estate Appraisals, Consulting, Expert Testimony, Forensic Reviews, Fraud Research and Analysis, Litigation Support, Fraud Training.
I received a private email this morning on the verification step of the Direct Sales Comparison approach and started to respond privately, then realized it was this type of question that spurred creating the InlandCAAppraisers Forum at Yahoo Groups. That, along with an encounter with an appraiser in denial about what the Housing Market was doing. That was 2-years and 19,930 Messages ago.
Here was this morning’s question: “I would like to pick your brain on some of the most informative questions to ask agents (market participants) during research and verification when doing a commercial property.”
There are two elements to verification, transactional, and physical. Transactional deals with motivations of the parties, terms and conditions.
Often when appraisers do verifications, they concentrate on Price Point verifications, not on the transactional aspects. Yet it is the motivations of the parties and understanding whether they were normal or one party was under some kind of pressure or duress that can make a large difference in the price.
We have seen properties sell at a discount because of the owners timing needs. I once had a man that I had been prospecting call me on a Monday and tell me he was ready to sell but he had to close by Friday. We did the deal, putting it in escrow that day at a 17% discount from what I thought it was worth. Other times it is as simple as the buyer being an adjacent owner that needed the property and paid a premium. We have seen more than 20% premiums paid by adjacent owners.
The point is that Motivations can make big differences in the Sales Price. Getting to an understanding of them, cannot really be done by reading our data sources.
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Here is an example of a factor that most would never think about. We had a case where the seller was an apartment investor who had a building on the market. The buyers, after opening escrow, asked that the Sales Price be raised 25% so they could get 100% financing. The seller was afraid, afraid of being involved in a Bank Fraud, and refused. The buyers sued.
I was hired by the defense attorney, whom I had met when he was a prosecutor. He did an interesting thing, put me on the phone with the other attorney and had me lay out what I was going to testify to in court, which included the fact that the appraisal they had gotten, relied upon four out of six sales which were the same 25% pumped Sales Price as the subject and the other two were simply in better parts of town, were better buildings, with better unit mixes. Unwittingly, the appraiser had created an inflated and misleading report. Not on purpose, but most probably because he lacked both geographic and product
competency.
In the kind of market we have been in, there would probably be no concessions on commercial transactions, so that is not the issue. It is much different than what has been happening in the Housing sector for the last two years. When there are little or no vacancies in a sector, and new construction is being absorbed, either occupied or sold, there is no need for concessions.
When any product reaches a certain vacancy rate or level, concessions start to appear. In some formerly hot markets, as vacancy rates approach 10%, concessions will start to appear. By the time most markets reach a 15% vacancy rate, concessions are the norm.
In new commercial properties, concessions can take the form of free Tenant Improvements or rental concessions. If a building sells for $250 per square foot and they gave the buyer $25 per square foot in new Tenant Improvements, what would the adjustment be? What if they gave $50?
In the case of a rental concession, when they start, we see signs on buildings that may say “Move In Special”. There is a building next to my office that was fully rented at the beginning of last year and now has a lot of vacancies, mostly real estate and mortgage related tenants that left. Last year they were full at $1.50 per square foot. Their new sign shows $1.19 per square foot. Most likely this is the effective rate on a multi year lease with a face rate of $1.50, with a several months of free rent each year. When you seen this type of sign or this language in Listings, you know there is an issue in the market.
As a market gets into more trouble, the concessions get larger. Imagine the magnitude of the error if an appraiser used $1.50 per square foot, when the effective rate was $1.19. If you capitalized the difference at 6.5%, pretending for simplicity that it all went to net income, here is what you get:
- Stated Income $ 360,000
- Effective Income $ 278,400
- Difference $ 81,600
- Capitalized at 6.5% $ 1,255,385
Actually what needs to happen in this example from a multi tenant office building is to do a lease by lease analysis of the individual rentals. Not hard to do on our Subject, but what do you do on the Comparables? How do you get to know who relied on what? We did a multi tenant industrial that was a Sale last year. The buyer’s agent had done an income projection such that it made good financial sense in the third year of ownership from a yield perspective, although is seemed like a rich price going in. He had a 1031 Tax Exchange buyer trying to shelter their gain.
When I pointed out that they were over paying now, he said he knew but that he was still in the game and he was a long term investor, and that this was the lowest priced project he could find in the market area. So, that buyer over paid going in but was well informed and was comfortable with a long term view of things. The issue we had was that we could not support the current Sales Price.
As yield rates rise, the same building or income stream will be worth less. If either the Mortgage element or Equity element of the yield rate changes or the assumption of appreciation declines, the Capitalization Rate will increase. Low Cap Rates are a reflection of the anticipation of either rising rents or appreciating property values.
Brokers are reporting income on fewer deals in our commercial databases. Except for apartments, most other products have less than 25% being reported and then most of those only say “sold at a 6.5% OAR”. What we find is that Brokers are not including any allocation for Vacancy, Management or Reserves on the typical Triple Net Leased buildings. When we take out allowances for each, as we have been taught, a 6.5% rate can become. Take a look at an example of a NNN leased building sale, reported at 6.5%, after we take out a 5% Vacancy allowance, 5% management and 3% Reserves, the 6.5% becomes a 5.66% in reality. Which should we use the one as reported by the Broker and as relied upon by the Buyer, or the one we calculated as we are more precise than the market participants?
- NNN Lease Rate $ 200,000
- Vacancy Allowance $ 10,000
- Management $ 10,000
- Reserves $ 6,000
- NOI $ 174,000 6.5% OAR on $200,000
- NOI = $3,076,923 OAR Calculated on $174,000 = 5.66%
Sometimes we can detect things when we Factor the Market Data on an Income per Square Foot, Per Room, Per Unit basis, depending on the product type.
Say we had a range of Price per Square Foot indicators from our 6 Sales, 2 Pending and 4 Listings we are considering as our primary Market Data that ranged from $250 to $325 per square foot. The buildings could be similar, and the variance in price merely Locational. It will usually show up in the Rent per Square Foot... If a building has a Net Income of $2.00 per Square Foot verses $1.75, what kind of a variance in Sales Price per Square Foot can the Leases make? Take a look at an example using the NNN lease income as the NOI as Brokers often do:
- Size 20,000
- NNN Lease $2.00 $1.75 $40,000 $35,000
- Annual NNN Income $480,000 $420,000
- Variance $60,000
- OAR Used 6.50%
- Price Variance 923,077 P$/SF
- Variance $ 46.15
Assume that this was the $350 Per Square Foot Sale Comp. If you subtract $46.15 from the $/SF, it becomes $278.85. Now we have a range from $250 to $278.85 or 11.5% from low to high.
Prior to making verification calls on commercial properties, it is a good thing to digest all of the information you have about the property from a locational and physical standpoint as well as how the income/expense were reported. It can be that we need to recast the NOI on the Comparable and do a comparative analysis as in the 6.5% verses 5.66% OAR example above. I do not have an issue with Brokers misrepresenting the NOI, none at all. Our only issue is to get to an understanding of who relied on what verses what is reality.
There are many examples of why two similarly located and physically similar buildings might trade at differing prices. Think of two older buildings in the Bay Area of San Francisco. They are a block a part. One was build before the 1906 earthquake and one was built after then UB Code change in 1932. One has an un-reinforced masonry construction; the other is reinforced concrete construction. One has no fire sprinklers, the other has. One has a full basement, the other not. They sell at differing price levels, although similar in size and basically older buildings.
In many urbanized areas of older cities, there are older buildings that have several floors vacant, that have been and will remain vacant. Issues of Fire Access, Ingress/Egress, Floor Load Capacities, Plumbing, Electrical, HVAC, Sewer Capacity, can lead to dead upper because the retrofit costs are so high. In Los Angeles there are buildings with gutted floors 2-5, in one case they simply left debris on 5th with 2-4 left vacant, the ground floor and basement occupied.
Often the Sizes reported in our data sources are wrong. Finding out where they came from, if they were measured or is it from an appraisal or public records is a good start. You can have a building with 5 floors of 20,000 each and a 20,000 square foot basement, for a total of 120,000 square feet, of which only 40,000 is being rented or used.
Are buildings trading based on the Rent per Front Foot, or rent per Usable Space, verses the normal Square Foot factor. The market denominator can be location specific, often as finite as to which side of the street the building is located on. There are many buildings in older parts of town that sell based on the size of the first floor and the basement space, with the upper floors setting idle. It is often not economically viable to do anything.
In suburban markets where buildings are newer we are seeing $100 per Square Foot price variances just over the amount of Parking. Identical construction, concrete tilt up, 2 story buildings of identical size, can trade at prices that are millions of dollars apart.
In locations where the elements affect the property value, the orientation of the building or its location within a block can vary the prices. A building that is exposed to heavy winds or one that is in the shade all day, may not trade anywhere near the price of otherwise equal looking space.
Buildings with great visibility and access may trade at large premiums over otherwise equal ones within the same neighborhood.
Distances to rapid transit have been measured and used in court cases as it affects the rents. Buildings closest to a Metro or BART station, within walking distance, rent for higher prices and trade at higher prices.
These are a few of the things to think about when calling agents to verify a sale.
Last week I bid a job that came about as a result of a Verification call I made last October. Often, we find that having a two way meaningful conversation with market participants, leads to work later on. Often if I am making contact for the first time with someone, I will follow up with a thankful email and send a resume and fee schedule.
The bid we put out last week included 13 properties, residential, apartment and commercial with fees that ranged from $1,500 to $4,500 each.
The rewards of doing Verifications include not only finding out about the specific deal you are calling on, but other pending deals or offers, the market conditions, and potentially, more work down the line.
"Appraisal is only hard if you try to do it right, or if the market is going down, or both."
AUTHOR: Steven R. Smith, MSREA, MAI, SRA, Smith Realty Advisors, 936 San Jacinto St., Redlands, CA 92373, Real Estate Appraisals, Consulting, Expert Testimony, Forensic Reviews, Fraud Research and Analysis, Litigation Support, Fraud Training 909-798-8855 , fax: 909-798-0139
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