Appraisers' Free Forum

Got a problem, and having a brain stall.

I'm appraising a 5-space multi-tenant prop that sold with three spaces rented. One space (unrented) is bare block walls and no ceiling. GBA 5000 sf. This thing is divided into four 1250sf spaces by block party walls; one of the 1250 sf spaces is divided by a stud wall into two 625 sf spaces.

My problem is I've got only one comp with divided spaces that sold as a leasehold. The other two are single-tenant fee simple purchases. I've got full disclosure from the owner of the multi-tenant comp, except that she's one of the tenants. She bought this last November, and hasn't decided how much rent her real estate agency is going to pay her in rent. (Tentatively, I've estimated her rental space (discounting common areas) at a rate similar to the other two tenants. FYI, it's about $0.91/sf here in the sticks--for prime office property.

The other two sales are open-warehouse type structures that could be partitioned for multi-tenant use. One is the same size as the subject, the other is twice the GBA. These were fee simple sales with no tenants.

How the hell can you adjust for that LH/FS difference in the SCA and the IA? What principles are used to isolate that difference? Can it even be done? Note: There aren't any more similar sales in the subject's market area. Your help and comments will be appreciated.

Just thinking it through, lets state the obvious. What is the benefit of ownership as opposed to lease? As I recall, when furniture and car leasing first became popular, sales people were pitching all kinds of benefits to the leased personal property. There were tax benefits. There was a cash commitment benefit. There was a bookkeeping benefit. There was a flexibility benefit. There was an insurance benefit. OTOH, the cost of providing all such benefits plus a profit increases the actual cost of doing business for the tenant.

I think my first impulse would be to talk to a CPA/PA about the time difference involved in "managing" things like depreciation, maintenance, and other accounting problems. Other than that I can't think of anything right off the bat that would help. But there must be a cost of doing business in there somewhere that can be adjusted for, otherwise no one would ever rent...........or own..........one or the other.........

Funny you bring this up (really) because we had a short conversation at lunch yesterday. No only the factors that you mentioned, but I also believe there a slightly better tax break when it first started but that has died. The holder of the title in the leasehold/leasefee situation has all the benefits - the building typically remains and in average condition. If the occupant of the property sells the property, the buyer is subject to the prior documents for the lease. Not sure what the benefit to lease verses ownership, unless it happens to be a "benefit in use", ie you really really really want to live there.

I know a lot of the Indian Tribes have the land set up and the "lease it" to "X" member at that specific location until such as they do not pay the lease or take care of the property. It provides them with a separation from "white man" law force but not for much longer - seems the Indians are beginning to see that they don't want the "fine - upstanding people" on their land either.

Jim Plante wrote:How the hell can you adjust for that LH/FS difference in the SCA and the IA? What principles are used to isolate that difference? Can it even be done?

Whether or not it can be done depends on several factors, IMO. One of those is the length of the leases. If your subject has short leases or month to month tenancy, then it might be possible to compare them directly. You might be making a mountain out of a molehill. In my area, most multi-tenant properties are intended to be leased. Being leased out at the time of sale would not be a disadvantage for most buyers. Also, if someone is buying a property to occupy, they are considering the cost benefits between leasing and owning... so the two types compete directly within the same market for the same market participants.

Now, I am not necessarily saying that you can compare the two estates directly. In fact, I believe you cannot. However, it might not be that big of a deal to figure out the difference, and it is possible that the difference is negligible.

One other consideration. With the kind of sales data you described, it is possible that you should forgo the sales comparison approach altogether. You didn't say that you are appraising the leased fee estate, but that is what it sounds like you are doing. In a problem like this, you might use a sales comparison approach to forecast the reversion value of the subject and also to determine the site value if you are using a cost approach, which also would be primarily to forecast the reversion value. However, your opinion of value could come entirely from the income approach. Look at it this way: the buyer is not buying a building so much as they are buying a stream of income. It does not really matter too much to the buyer what the market rent is, they will be locked in by lease for a number of years. Your job then becomes primarily to discount that monetary stream back to present value and to similarly discount the reversion of the building to present value.

The hardest part of this deal will probably be determining what the reversion value will be and deciding what discount rate to use. On the other hand, if the leases are short, perhaps you should consider valuing the fee simple estate instead. That depends a lot on your intended user and their intended use. In a bank loan situation, I always point out to the client that if they get it back, it is possible that what they will be getting is an empty building. In this kind of leased-out situation, the most likely reason for the borrower to get into trouble is if the lessee defaults. In such a case, the most conservative position for the bank to take is to loan on the fee simple value only. That way, if the existing leases are far above market (a situation risky for default) you can ignore them for the most part and work a fee simple problem using market rental rates.

Thanks for the thoughts guys. Steve, you've jogged my brain back into gear.

My subject was bought with month-to-month rentals on three of the units, counting the one the buyer was occupying (by far the nicest one inside.) One of my comps was bought fully rented up, but the buyer is occupying 80% of the space. What was bugging me was how to adjust between fee simple, single-tenant ownership and leasehold ownership. What I figure to do is to adjust my one multi-tenant comp for the space NOT occupied by the owner. After all, the extra income reduces her expenses and is worth something. The extracted cap rate is 12%, if I allow $0.91/sf for a paper rent on her own space, deducting for shared/common areas. Would it make sense to adjust the sale price of the comp by the capitalized rent on her tenants' spaces? Is there another way?

Your conclusion that this is a fee simple market is correct. Most buyers buy to occupy and prosecute their businesses, not to lease. All three of the comps were bought that way. My emphasis will be on the SCA for that reason, and that's why I want that FS/LH adjustment to make good sense. (My SOW requires all three approaches to be developed, whether they matter or not. I won't rely on the CA or the IA, but I'll have to show their results.) The cash flows aren't at all irregular, so DCF isn't needed. I plan to use direct cap with an extracted rate, as well as direct with built-up rate, and reconcile any difference. DCF would be showing off, wasting paper, and inviting error.

I might consider doing just one thing differently from what you are suggesting, Jim. From what you posted, it looks like your sales data is relatively weak. However, when I am confronted with this kind of problem, I usually have little trouble getting a large amount of rental data from the market. Even though the primary market is a fee simple market where people are buying primarily to operate their business, the units still have a value as rentals. In this situation, if the sales data is as weak as your first post suggests, I would probably use market rent and a pro-forma income statement to determine value by the income approach, and would likely give that approach the greatest weight in reconciliation.

Good suggestion, Steve. Only problem is the rental market is hosed, too. I can get rental data, but I've got about 15 vacant buildings out of a total of 97 in the CBD. I think it would be hard to argue that rental rates set the value in such a market. What do you think?

I think that you just provided some solid proof that the value is lower than it would be if properties in the market were leased up. Remember that the market of properties for sale competes to some extent with the market of properties for rent. At some point, a buyer will decide it's cheaper to rent and there will be one less market participant for purchase. As this begins to happen a lot, prices of properties for sale must naturally decline.

When you do your income approach, v&c gets taken out before you get to EGI. The value should still be consistent and a good indication of market value. If the rental market is trashed, the sales market will follow. The only exception to this rule is if the rental market is experiencing a short term interruption... you need to take a little bit of a long view.

Thanks Steve. This one's stretching my ability. It's a nearly unique property (not another 5-tenant in the CBD, and mighty few in town at all). Lousy market--almost dead; no job growth. Property values peaked and stabilized in 2003, and not many sales. I'm cutting off my time adjustment in 2003; anything after that hasn't gained or lost value to any degree. (At least sale prices aren't declining--when anything sells.) And I had to pick just now to get the only multi-tenant commercial I've ever had to appraise. Just my luck. To get a halfway accurate v&c rate, I'm going to have to survey back about three to five years. Some of these things--good properties, too--have sat empty for over three years!

Problem with the v&c rate is similar to the one we have with DOM in residential work. Lots of landlords just ask too much for rent for this market. I talked to one old guy about a 2300sf office type space he had for rent. He wanted $900/mo. Wouldn't budge, either. I learned that after another year of vacancy (it had been vacant for 6 months when I asked), he took $400/mo for the same space. His rent wasn't out of line compared to other places; there were just no takers here at that price. But with job growth stagnated, there won't be many takers at any price. The best I can do is an average vacancy rate for the whole market area. When your tenant leaves, the lights will be off for a loooong time. We're not dead yet, but we aren't winning any awards, either.

"Lots of landlords just ask too much for rent for this market."

In my market it's the opposite. A lot of lessors are willing to take too little in order to keep the property leased... it's still part of the market, however. You can adjust for that factor if you think it is appropriate. For example, if evidence, including anecdotal evidence, says that some owners prefer to leave the property vacant rather than take a reasonable rent, then it would be logical to remove a few of those from the vacancy rate... just as you sometimes remove the highest priced house in a neighborhood of moderately prices houses when describing the predominant price. The effect will be to bring the vacancy rate in line with reality in the market... ask yourself if there are enough renters that some of those properties would be filled at a lower rate. Does that lower rate reflect the market rate? If so, it is reasonable to remove those where a much higher rate is being asked from consideration of the area vacancy rate. (Describe your logic, of course.)