NAI Ruhl & Ruhl Commercial Company
Original article published by the Iowa Bankers Association on February 26, 2010
The principles of valuing commercial real estate in a recession may be similar to ordinary times, but the importance of being in touch with the market and what its participants are thinking becomes heightened dramatically. Interpreting what terms market participants are willing and able to accept in any given transaction is the key to real estate valuation.The three commonly accepted appraisal methodologies — the Cost Approach, Sales Approach and Income Approach — each represent their own challenges in today’s market.
The Cost Approach is a good check for the Sales and Income Approaches but is not reliable by itself. When speculative developments are not considered feasible, estimating the different forms of depreciation becomes increasingly difficult. Total accrued depreciation is more accurately represented in the Sales and Income Approaches.
Recent sales of similarly-improved properties are an indication of market value after adjusting for differences. This recognizes the availability of competitive substitute properties in the market. Accuracy of the Sales Approach depends substantially upon demand. There must be an active market for the subject property. During stable times sales that occurred 12–36 months ago can still provide a reasonable indication of value. However, a sale that occurred at the market peak in 2007 could be quite misleading today. There is a significant price gap between buyers and sellers today, and as a result, there are few transactions. If your appraiser is using sales that all occurred more than 12 months ago, look for a significant amount of discussion and market support for their market conditions adjustment.
The Income Approach is the best valuation tool we have in our current market. Comparing current lease rates and terms to previous periods provides a good indication of the reduction in gross revenue from the market peak. As an example office lease rates in central Iowa are down 20 to 30 percent. This reduction can be less in prime locations and more in distressed properties. The main premise of the direct capitalization approach is that a market derived overall capitalization rate (OAR) when consistently derived and applied to similarly derived net operating income, provides a reliable tool to estimate market value. Further, if the OAR is applied to net income which includes similar expense, and reversion components as the sales from which it is derived, it also includes investor’s expectations of changes in NOI and reversion value over the future holding period. Consequently, given a stabilized property and anticipated cash flow, direct capitalization provides an analysis tool which can be used in most situations.
Utilizing this method to value a property that has above market vacancy or contract lease rates significantly different than current market rent will result in a substantial error. This is the most common mistake made by real estate professionals in valuing commercial real estate. When cash flows are anticipated to be irregular, or when there is a lease-up period, prior to stabilized occupancy, a discounted cash flow analysis is necessary.
To summarize current market conditions, I believe the market will return to fundamental principles of valuation for income-producing real estate and be primarily driven by fear instead of greed or the “greater fool theory” we experienced over most of the past 10 years. There will likely be a period of 12 to 24 months in which we experience a further reduction in value as investors consider the risk associated with this type of investment to be high. The large number of distressed properties will even have a negative effect on the value of stable, well-located properties.
Once we have realized the bottom of the market, I anticipate a slow recovery ranging from three to five years to achieve what investors will consider a healthy market. The two largest variables in achieving a stable market again, in my opinion, are employment and availability of capital.
About the Author
Tom Knapp is an associate with NAI Ruhl & Ruhl Commercial Company. He earned a B.A. in Finance with an emphasis in real estate from the University of Northern Iowa. He earned his MAI designation from the Appraisal Institute in 1997 and achieved CCIM (Certified Commercial Investment Member) designation in 1999. Contact Tom at tknapp@ruhlcommercial.com.
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