My Roots


I wasn’t born a real estate appraiser, but I got there as soon as I could.  It’s a fascinating business and appraisers always seem to be busy.  I started life as an appraiser right out of college, working for my appraisal professor, who was one of the MAI appraisers in Austin, Texas at the time.


The two major paths in real estate appraisal are residential and commercial.  You can also do both, which I have done.  Over the years, I have tapered my residential workload and now focus on commercial, land, and farm & ranch appraisals.


What is an Appraisal


What is an appraisal?  It is simply an estimate of value.  It is an opinion.  It is not exact science, but the appraisal process is a logical systematic approach to solving the valuation problem, which is usually to estimate the “as-is” market value of the fee simple property rights as of the date of inspection. 


Now that’s a handful of words.  Let’s break that sentence down and talk about it over a cup of coffee together…


The appraisal process is a phrase which describes what an appraiser does to solve the value problem or, in other words, to estimate the value of the property.  “As-is” means the condition you find the property in as of the date of your inspection.  The market value is what the property should sell for on the open market to a willing and knowledgeable buyer and assumes a knowledgeable seller under no duress.  The fee simple property rights are assumed to be a free & clear title with no liens, encumbrances, or other title issues which would restrict ownership of the property.


Another term for the appraisal process is the scope of work.  The scope of work reflects the activities undertaken during the course of this appraisal.  There are three major steps in this process, which are to 1) identify the problem  2) determine the solution  and  3) apply the solution to solve the problem.


The problem is usually to estimate the market value.  Determine the solution means to identify the appropriate methodology to the particular type of property being appraised.  The application of the solution is to apply the methodology, which is to use the three traditional valuation approaches in order to estimate the market value.


Appraisal Example of a Small Medical Office Building


Let’s use an example.  Say you are appraising a small medical office building for a lender.  The building is owner-occupied by a doctor.  The problem is to estimate the market value of the property so the lender can make a reasonable loan to the new buyer, who is also a doctor who intends to owner-occupy the building.


If the property appraises for $600,000, the lender will probably make about a $450,000 loan on the property, depending on the credit strength of the buyer.  This loan amount equates to a 75% loan-to-value ratio ($450,000/$600,000 = 75%).  If the borrower is strong, the bank may lend more.  If the borrower puts up a $100,000 CD in the bank, as additional collateral against the loan (in addition to the property), then the bank will lend more.  If the buyer is weak or has credit issues, the bank may lend less. 


How much the bank lends is part of what is called the underwriting process, which is what lenders do to evaluate the credit risk associated with a proposed loan.  Our job as appraisers is to estimate the market value of the property.  We are evaluating the property and the bank is evaluating the borrower and their credit strength.


Now, back to our example.  We have determined that the value problem is to estimate the market value of the property.  Since the property is owner occupied and is being purchased by an owner occupant, the Sales Comparison Approach is probably the most appropriate solution to the valuation problem.  The Income Approach may also be appropriate if properties similar to the subject property are being leased to tenants and the rent levels produce net incomes, which support the value indicated by the Sales Comparison Approach.  The Cost Approach may also be appropriate if the building is new or relatively new, say less than 10 years old with minimal depreciation.  These three approaches are the solutions to the valuation problem.


Finally, we apply the solutions to solve the problem or estimate the value. 


Sales Comparison Approach


In the Sales Comparison Approach, the appraiser identifies sales of similar properties (aka “comparables” or “comps”) and compares them to the property being appraised.  The property being appraised is called the “subject property” or simply “the subject”.  These comparables are adjusted for major financial and physical differences to the subject property.  The comparables are adjusted to the subject.  The subject is not adjusted to the comparables.  After all the adjustments are finished, a value range is indicated for the subject property.  The appraiser considers the comparability and reliability of each adjusted sale and concludes to a final single point value indication by the Sales Comparison Approach.


Income Approach


In the Income Approach, the appraiser identifies several properties that are similar to the subject property that are being rented or leased to tenants.  Using these rental comparables, a market rent for the subject property is estimated.  From this market rent, a vacancy & credit loss is deducted and then normal and typical real estate operating expenses are deducted.  After these deductions are made, the resulting figure is called the Net Operating Income or NOI.  Using overall capitalization rates which are extracted from the marketplace, the NOI is capitalized into a present value.  The mathematical formula for direct capitalization is NOI/Ro = Value, where Ro is the overall capitalization rate.


Cost Approach


In the Cost Approach, the appraiser first estimates the replacement cost of the building and site improvements as if new.  Site improvements include the parking, curbs & gutters, landscaping, porches and walkways, signs, detention/retention ponds, and other non-building improvements located on the subject site.  Next, the appraiser deducts the depreciation from these costs.  Depreciation is categorized into five classifications, which are physical curable, physical incurable, functional curable, functional incurable, and external or economic obsolescence.  The resulting figure is the market value contribution of the improvements.  The land value, as though vacant as of the date of the appraisal, is then added to the market value contribution of the improvements for a total value indication by the Cost Approach.


Reconciliation of Value


Finally, the appraiser reconciles the value indications by the three approaches into a final value conclusion.  This concludes the appraisal process and solving the appraisal problem.  The appraiser then completes writing his appraisal report and delivers it to his client.  This concludes the appraisal assignment. 

 

Residential & Commercial Appraisals


Residential and commercial appraisals are similar in some ways and different in some ways.

Similarities Between Residential & Commercial Appraisals

Both solve a value problem – usually “What is it worth?”


Both apply the appraisal process:

  • Identify the appraisal assignment – the valuation problem
  • Determine the solution – research market data, etc.
  • Apply the solution to solve the problem – analyze and adjust the market data to the property being appraised


Differences Between Residential & Commercial Appraisals

  • Residential is usually a form report compared to Commercial, which is usually a narrative report
  • Residential can be prepared in less time than Commercial, which results in faster completion & delivery to the client than commercial reports
  • Residential fees are less than Commercial, because Residential involves less work (less appraiser’s time)
  • For residential homestead assignments, the buyers are the homeowner(s) who will occupy the house, and are interested in the neighborhood, possibly the school district, the house size, layout (# of bedrooms, etc.), amenities, and appeal of the house.  Commercial buyers include investors and developers, who are more interested in the income stream, the “value add” of the project – how can the income stream and profits be increased, and what is the exit strategy – how long do they have to hold or own the property before they sell it, and how does that holding period compare to the projected forecast of the economic cycle and local market conditions.


Types of Commercial Properties Which Need Appraising

Here are some of the more common types of commercial properties, which are appraised on a routine basis:

Improved Income Property – The four primary improved commercial property types, which are purchased for the income stream which they generate are:  Apartments, retail, office, and industrial.  Other improved types include medical buildings, restaurants, convenience stores, hotels, and other special purpose properties, such as marinas, golf courses, and ice skating rinks. 

If an investor is buying an investment property simply for the income and anticipated property price appreciation, then they are seeking a target “return on investment”, which is usually measured as an overall capitalization rate (the cap rate), a yield, or an internal rate of return.

Improved Owner-Occupied Property – Smaller commercial properties can be purchased by owners for owner-occupancy and not leased out for a return on investment.  Examples of commercial owner-occupied properties include a small to medium size office or condominium, medical office or condominium, or retail building. 

Sometimes an owner-occupy will purchase a building larger than needed for their business and then rent out the remaining space(s) to tenants in order to generate income to off-set their operating expenses and help pay the mortgage payment or provide a return on the investment.

Vacant Commercial Lot – This category covers all unimproved commercial lots.  Investors can buy unimproved or vacant commercial lots as an investment or to construct a new building on the lot, which would be an investment (ie, a shopping center) or an owner-occupied building (their dental office).

Vacant Commercial Land – Commercial Subdivision – This type of property is usually a medium to large acreage tract, which is proposed for a subdivision and development into smaller lots, such as an industrial subdivision.

Vacant Commercial Land – Residential Subdivision – This type of property is usually a medium to large acreage tract, which is proposed for a subdivision into single family residential lots, either a traditional tract home subdivision or small acreage lots if the property is located in the country.

Market Rent – All of the above commercial properties would be appraised to answer the question “What is it worth?” 

In addition to value assignments, the appraiser is sometimes requested to answer the question “What is the market rent of the property?” 

This market rent question can be part of the appraisal of the property in the Income Approach or can be the only value-related question being asked by the client of the appraiser – ie, “I just need to know how much I can rent this retail space for if I list it on the open market for lease.”


Apartment Appraisal

Apartments are almost always income-producing properties purchased as an investment for their income stream and not for owner-occupancy.  The exception would be a duplex or small apartment complex, in which the owner lives in one unit and rents out the other unit(s).

Here are some comments relating to apartments as investments:

Apartments are management intensive.  Even the best run apartments require repairs and on-going maintenance and landscaping.  Tenants sometimes damage their apartment units, either purposefully or accidentally, rents are paid late or tenants have to be evicted, and other problems develop which require the time and attention of management and ownership.

ADA (The Americans with Disabilities Act) requires a certain number of units in an apartment building to be ADA-compliant.  These can be on the first floor, so that an elevator is not required to meet ADA requirements in a multi-story apartment building.  However, for the convenience of all tenants, the developer of a new multi-family apartment project may consider installing elevators.  Elevators are expensive and require routine maintenance, but they are an attractive feature, and generally will off-set their cost in terms of greater occupancy and rents compared to a competing apartment project without elevators.

Parking for suburban apartments is almost always open surface parking.

The older the apartment, the greater the maintenance requirement and repair expense.

Buy an apartment close to stable employers.

Fencing and a gated entrance are good safety features.

Tenants with small pets should pay strong pet deposits.  Tenants with large pets should rent elsewhere.

Exterior security lights are important.

Encourage ACH rent collection by offering a $10/month discount or non-cash promotional.

Roofs should be pitched composition shingles for minimal leaks and cheapest maintenance.  Do not buy an apartment complex with a flat or gravel roof, unless you add a truss system with composition shingle finish on top of the flat roof, after you buy the apartments.


Retail Appraisal
 
Retail comes in various types, including free-standing retail stores, two-tenant and small retail "strip centers", larger neighborhood retail centers, regional malls and other types of retail buildings.  A long multi-tenant retail shopping center is called a “retail strip center” because the layout of the building is a long strip.  Retail centers are almost always income-producing properties purchased as an investment for their income stream and not for owner-occupancy.

Here are some retail investment comments:

The quality of the tenants is all important to stabilize the income stream and reduce the risk of vacancy.

Buy/Build a center in the path of growth. 

Before you sign your lease, ask “Is there enough population base in the immediate area to support the product or service that this tenant is offering?”

Choose your anchor and junior anchor(s) carefully.

Longer leases are better than shorter leases.

Be careful in selecting tenants in this “Age of Amazon”.  Toys R Us appeared to be a solid tenant when it signed leases many years ago and it declared bankruptcy in September 2017.

Access and exposure are all important.  Easy driveway/curb cut ingress & egress, corner location, and plenty of close-in parking.

TPO membrane roofs are much preferred over flat gravel roofs.

 

Texas Commercial Appraisals Blog #5

Here is an example of an office building.  Office buildings can be purchased as an investment and leased to tenant(s) or purchased for owner-occupancy.  Office buildings are suitable for leasing to multiple tenants, 100% owner occupancy, or a mix of tenant/owner occupancy.


Office Appraisal

Make sure your tenants are solid, in businesses for which there will be demand in the future, and that the owner of the business (the tenant) personally guarantees the lease.

Offices, like retail, are being impacted by the Internet, with a lot of owners opting to work at home, and forgoing the commute to traditional office space.

Parking is important.  Covered parking is preferred over open surface parking, in order to provide rain and shade coverage.

Executive suites arrangements can be profitable for an owner, if expenses are managed properly, and amenities and services are offered and included, in a reasonable rental rate.

Access and exposure is important for offices, as customers of the office tenants need to be able to easily find the office building in the field, and park and walk to the office suite easily and quickly.  Both day-time and night-time safety are important.


Industrial Appraisal

Industrial buildings can be purchased as an investment and leased to tenant(s) or purchased for owner-occupancy.  Industrial buildings are suitable for leasing to multiple tenants, 100% owner occupancy, or a mix of tenant/owner occupancy.

Prior uses and ESA (Environmental Site Assessment) reports are important to obtain, prior to the purchase and closing of an industrial property.

Multiple tenants are generally lower risk to the income stream than a single tenant.

As with retail and offices, the property owner should evaluate the impact of the Internet on both the tenant’s business, as well as the tenant’s customers.

If the tenant is involved with hazardous materials, then additional precautions, insurance, and security deposits should be undertaken.

Industrial buildings are relatively inexpensive to build compared to other commercial property types, so be careful that local developers are not planning or actually building a lot of competing industrial product nearby.


Example of a Commercial Appraisal Table of Contents
 
TABLE OF CONTENTS


Title Page.................................................................................................................................
Photographs of Subject Property.............................................................................................
Letter of Transmittal................................................................................................................ 
Table of Contents.................................................................................................................... 
Executive Summary.................................................................................................................

Appraisal Report......................................................................................................................
   Overview & Neighborhood Analysis.......................................................................................

   Subject Property Description................................................................................................. 
   Highest and Best Use............................................................................................................
   The Appraisal Process........................................................................................................... 
   Valuation of the Subject Property..........................................................................................

   Sales Comparison Approach..................................................................................................
   Cost Approach.......................................................................................................................

   Income Approach.................................................................................................................. 
   Correlation & Final Value Reconciliation.................................................................................

   Appraisal Format...................................................................................................................
   Purpose of the Appraisal & Definition of Market Value...........................................................
   Property Rights Appraised.....................................................................................................

   Date of the Appraisal............................................................................................................. 
   Intended Use of the Report & Intended Users.......................................................................


   Exposure Time & Marketing Period........................................................................................
   Appraiser Acknowledgement.................................................................................................
   History of the Subject Property..............................................................................................
   Tax Assessment Summary.....................................................................................................
   Continuing Education Program of the Appraiser......................................................................


   Scope of Work.......................................................................................................................
   Hypothetical Conditions & Extraordinary Assumptions.............................................................. 

Certification of the Appraiser................................................................................................... 


Assumptions, Limiting Conditions, and Recommendations........................................................ 

Addendum.............................................................................................................................. 

Photographs of Subject Property.............................................................................................
Area Map................................................................................................................................
Location Map #1 ......................................................................................................................
Location Map #2......................................................................................................................
Neighborhood Map.................................................................................................................

Aerial Photograph – Neighborhood..........................................................................................
Aerial Photograph – Close-Up..................................................................................................
Travis County Plat Map.............................................................................................................

Building Floor Plan – Furnished by Owner................................................................................. 
Building Floor Plan – Appraiser Measurements.........................................................................

Floodplain Map........................................................................................................................
Subject Tax Record..................................................................................................................
Improved Sales & Listings Summaries.......................................................................................
Land Sales Summaries..............................................................................................................
Land Listings Summaries...........................................................................................................


Signed Lease Comparables.......................................................................................................

Qualifications of Steven L. Adams, MAI, SRA.............................................................................
State Certification of Steven L. Adams, MAI, SRA......................................................................

CoStar Detailed Underwriting Report for Subject Property........................................................

Austin Area Analysis.................................................................................................................


Capitalization Rates

Austin, Texas capitalization rates have trended downward since late 2011 - early 2018, which was the upward turn into the current real estate cycle.  Capitalization rates are measured as simply the net operating income divided by the sales price of a comparable sale, or alternatively for the subject property (the property being appraised), the division of the subject property net operating income by a market-derived capitalization rate.

Overall capitalization rates are also called capitalization rates or simply cap rates.  Typically, the lower the risk associated with the net operating income stream, the lower the cap rate, and conversely the higher the risk associated with the income stream, the higher the cap rate.  This is because the net income is divided by the cap rate, not multiplied by the cap rate.  Here is an example:

Newer retail center with a $200,000 NOI * and a market-supported cap rate of 6%.  The capitalized value is:

$200,000 NOI / .06 Ro (symbol for overall cap rate) = $3,333,333

Older retail center, which is smaller than the newer retail center, but generates the same $200,000 NOI (due to lower rents but bigger square footage) and a market-support cap rate of 7.5%.  The capitalized value is:

$200,000 NOI / .0750 Ro = $2,666,667

Conclusion:  Two retail centers, which produce the same NOI, but the older center is worth less than the newer center (makes sense) because it has more depreciation and repairs needed.

*NOI = Net Operating Income – this is the income stream generated by the project from the rents collected from the tenants less all of the operating real estate expenses paid by the owner to operate the center.


Adjustment Table


Here is an example of an actual adjustment table for an industrial building:





























The adjustment process “puts the appraiser in the shoes of an informed and prudent marketplace buyer”.  The adjustment grid illustrates how a market buyer would react to the major economic and physical characteristics of each comparable sale.  The unit of comparison chosen was the price per square foot of building area, which is the most common unit of comparison for this property type in the Austin marketplace.

The sales are adjusted to the subject property for differences in financial and physical characteristics.  If the comparable sale had a characteristic which was superior to the subject, then the sale was adjusted downward.  If the comparable sale had a characteristic which was inferior to the subject, then the sale was adjusted upward.  The following narrative explains the adjustment process to the adjusted sales.

Property Rights – This category recognizes the type of property rights being appraised.  The subject is owner-occupied, with no lease in place, therefore the property rights appraised in this report are the fee simple estate.  The sales were either fee simple or leased fee, with no known long-term leases in place at below market lease rates, therefore the property rights can be fairly compared and no adjustments are necessary to the sales in this category.

Financing (Cash) – The subject value definition is based on a cash value.  This means that the market buyer brings cash to the seller at closing, either cash or via a third party lender loan.  The sales were all cash to the seller and therefore no financing adjustments are necessary.

Conditions of Sale – The adjustments in this category, if any, recognize any unusual or atypical motivations between the buyers and sellers.  No atypical motivations or distressed situations were identified and no adjustments are necessary in this category, except sale Nos. 1,2, and 4 were part of larger portfolio closings, and each of these sales is adjusted +5% based on paired sales comparisons with the other non-portfolio sales.

Market (Time) Conditions – The time adjustment is made based on paired sales comparisons between the sales and numerous time studies prepared by this appraiser, which are updated on a continuous basis.  As of March 2018, market conditions are considered good for industrial buildings.  Based on the market data, each of the sales is adjusted +6% per year to recognize appreciation in the marketplace since June 2016, the date of the oldest sale.

Location/Access – The subject location is considered good, and the location of the sales are all in north Austin, with similar overall locational appeal, and no location adjustments are considered necessary to this data set except to Sale Nos. 1 and 2.  Sale No. 1 is located very close to a hard corner of two arterials in north central Austin and, although built as an industrial/flex building, has some retail appeal and is adjusted at -20% for this superior location and appeal compared to the subject location, which has a greater industrial appeal.  Sale No. 2 is part of a five-building portfolio, which has an inferior location/access project appeal compared to the subject single building on a corner lot.  All five of these buildings are stacked north/south on two large adjacent shared lots.  This sale is adjusted +5% for this inferior appeal difference compared to the subject property.

Building Size – In this category, the appraiser adjusts for building size differences.  Typically, larger buildings sell for less per square foot than smaller buildings, comparable in other characteristics, due to an economies of scale function.  Conversely, smaller buildings tend to sell for more per square foot than larger buildings, comparable in other characteristics. 

Based on numerous building economies of scale studies completed by the appraiser, and the experience of the appraiser, the appraiser has adjusted the sales appropriately for building size differences.  Sale No. 7 is relatively small compared to the subject, but was included because it is a year 2018 closing, and this sale was helpful in illustrating current market conditions and assisting in the time trend analysis.

Building Quality/Finish-Out – In this category, the appraiser compares the overall quality and finish-out of the sales to the subject.  Minimal adjustments were required in this category. 

Building Condition/Age – In this category, the appraiser compares the age of construction, effective age, condition, and overall appeal of the sales compared to the subject.  Since the effective ages may not correspond to the chronological ages of the sale buildings, overall condition comparisons are made, and adjustments made appropriately.  Minimal adjustments were required in this category. 

Site Size & Type – In this category, the appraiser recognizes the differences in the sites.  Although the Sale No. 2 CoStar write-up shows 13.74 acres as the site size, this is the total size for 3 buildings, with allocation of 4.58 acres to each building.  This 4.58 acre allocation is similar in size to the subject 4.784 acres and therefore no site adjustment is necessary to this sale for size.

Office Finish-Out – The subject building has about 10% office finish-out, which is considered average for a building of this type in the subject industrial park.  The sales vary somewhat in their percentage of office finish-out and are adjusted based on the information available.

Ceiling Height – Ceiling height is important for industrial/flex/manufacturing buildings, and based on the appraiser’s past studies regarding ceiling height adjustments, the comparable sale buildings are adjusted accordingly.

Other Characteristics – No other adjustments are necessary to this sales data set and none are made.

Selection and Adjustment of Capitalization Rates

The selection of the cap rate is based on a review of the cap rates extracted from the market sales data, real estate services which survey cap rates routinely such as CoStar, Realty Rates, CB Richard Ellis, PricewaterhouseCoopers, and other services, and the experience of the appraiser.

Typically, the appraiser will review the cap rate from the above sources, and select a cap rate which reflects current market conditions, projected market conditions, and the specific risks associated with the property being appraised.

In the Sales Comparison Approach, the closed sales (the comparables) are adjusted for differences between the sales and the subject.

In the Income Approach, the rental comparables are adjusted for differences between the rentals and the subject.

Just like the above adjustments, the cap rate can be adjusted to the subject.  Some examples of cap rates adjustments are shown below.  These cap rate adjustments should not necessarily be used in your appraisals – they are simply examples to illustrate possible adjustments to cap rates for various characteristics and to adjust for risk differences:

Example #1

The market indicates the cap rate for apartments similar to the project being appraised is 6%, however, the subject apartments need a new roof and about $100,000 in repairs that are not needed for the comparable sale apartments.  The appraiser adjusts the cap rate upward to 6.25% to reflect the inferior condition of the subject apartments compared to the sales, and the slightly higher risk associated with the occupancy and income stream. 

The cap rate adjustment is held to only 25 basis points because the subject rents should also reflect the condition differences, and therefore, the condition adjustment is spread between the rent difference (which is reflected in the net income) as well as a small adjustment to the cap rate.

Example #2

The local market sales all point to a cap rate for the retail center of 7%, however, the subject retail center has a 100% occupancy with a waiting list and the sales average 90% occupancy.  Market conditions are stable.  There is less risk associated with buying the 100% occupied subject property than one of the sale properties at 90% and then having to lease out the 10% vacancy and paying leasing commissions. 

The appraiser consults with some investors, and makes some calculations, and estimates that the 10% extra occupancy of the subject is worth 25 basis points, so the appraiser discounts the subject NOI at 6.75%, because the subject income stream has less risk than the income streams of the comparable sales.

Example #3

The local sales indicate a 7% overall rate for the office building being appraised.  The office building is located in one of the top three strongest real estate markets in the United States.  Realty Rates, a national survey, indicates an average for office buildings this quarter of 9%.  The difference in cap rates is 2% or 200 basis points. 


This means that the subject market is a lot less risky than the national average, as measured by the 2% difference.  Be careful in using national averages to compare to local market conditions, because local markets can be stronger or weaker than the national averages.  It is best to use local closed sales instead of national surveys, however, national surveys can be a useful tool in some cases, especially lacking adequate cap rates, establishing cap rate trends, etc.


Cap Rates vs. Interest Rates


As of 2018, the question on every investor's mind is "Since the Fed is now raising interest rates, will cap rates increase also, driving down real estate prices and values?"  A good article, which includes graphs and is a fast read, is shown at the following link:


https://www.reit.com/news/blog/market-commentary/property-prices-and-cap-rates-rising-interest-rate-environment


According to this article, the short answer is "No" - the recent increases in interest rates are not having an immediate impact on increasing cap rates.  Cap rates are comprised of multiple components, and do not necessarily move in proportion with the direction of interest rates.  However, the general trend over the next several years will probably be for interest rates to increase, therefore, investors should carefully monitor interest rates, cap rates, supply & demand, new construction, trends, and pricing, in order to make sound investment purchase decisions. 


In a cycle of rising interest rates, real estate investments may have to be held longer to reduce risk and achieve target yields.  More equity may be required.  Don't reverse leverage and buy an income-producing property at a cap rate which is lower than your cost of mortgage money - meaning if the asset is throwing off a Year 1 cap rate of 5%, then don't borrow money at 6%, because the mortgage will reverse leverage the asset, magnifying the negative cash flow.


More to Come

There are a lot more stories to be told.  Check back for my next valuation blog, coming soon to your computer.  Books and software are being written and will be published in the near future.  Check out the Daily Tips tab.  Email me with your questions and comments.  I am here to help you with your valuation and real estate consulting needs.




 Steve's Blog


Appraisal in Austin

Commercial appraisal in Austin

Real estate appraisal


Commercial Appraisal in Austin

Texas COMMERCIAL APPRAISALS