Have you ever been entirely convinced of a theory only to have it disproven once the actual evidence is found? For instance, it would seem probable that the Minnesota Twins would be very competitive in 2013 with superstars such as Joe Mauer, and Justin Morneau – but sometimes the seemingly likely outcome proves unattainable.
Our real estate market works in much the same way. One would think that a retail center located in a high income and traffic count neighborhood will sell for more than others in less desirable locations. Once the actual sales are found, the evidence could produce the opposite result. Appraisers encounter these dilemmas on a daily basis. Every sale or lease is unique with complex negotiations and motivations negating any trends that may otherwise be present. This problem has been intensified in recent years as fewer typical, arms-length transactions exist and lease terms continue to evolve.
An appraisal is a property value estimation based on data inputs with varying degrees of reliability. Inputs that are likely to have questionable reliability due the cyclical business cycle and recent lack of investment activity include forecasting vacancy and lease-up periods and determining capitalization rates. In reality, appraisers should state the confidence levels associated with their value conclusion, with a range of values and an analysis of its reliability. In practice, however, a point estimate of market value is what users of an appraisal report require. 1
Appraisers are often forced to simplify information in order to make comparisons and adjustments between the subject and the comparables. As any commercial real estate practitioner knows, transactions are rarely “typical & market-based”; there is always some “hair on the deal”. Opinions of market value and the outcomes during negotiations are judged differently between the opposing parties. Attempting to reconcile all the complex negotiations a single “conditions of sale” adjustment lead some to question the accuracy of an appraisal. However, the complex negotiations are “typical & market-based”. It is only when there are motivations outside of the typical that warrant adjustment. For instance, an adjustment is warranted if the sale involved a distressed seller or was between related parties. Interviews with the relevant individuals may provide an indication of direction of the adjustment, but the appraiser often must judge the degree of magnitude and the reliability of the source.
Incomplete and/or inaccurate information can be the most frustrating discovery for an appraiser and their client(s). Often an owner or property manager does not have all the information and it must be tracked down from several third parties. These sources may either lack familiarity with the particular piece of real estate or could be bias toward steering the value to a particular conclusion. For example, obtaining information from a broker or agent who is familiar with the property probably has an interest in the value conclusion. Appraisers and their clients would benefit greatly if there was a central location where credible information could be stored and distributed.
Determining capitalization rates in today’s market is the most difficult task of the appraisal assignment. This is especially today because any transaction that has occurred recently is likely fraught with excessive vacancy, atypical financing arrangements, and/or distressed sellers. The lack of credible market evidence calls into question the influence actual transactions should have in determining a cap rate. Interviews with potential buyers and their return expectations is often more credible. Due to the perceived risk of any commercial real estate asset, buyers are demanding higher returns. Sellers may argue that well-leased, strong credit-tenant properties should have cap rates only slightly higher from a few years ago. While these properties are still a relatively safe investment, all real estate is affected by the external market and likely deserves higher capitalization rates.
The following is an example of how the investment market has changed. A few years ago it would have been absurd to think that Starbucks would be closing shops; they were seen as a strong, growing company and a safe investment. Today, due to a five-year termination clause written in many 10-year leases, Starbucks is closing stores. Investors, lenders and appraisers ignored this clause and we are suffering the consequences today.
Appraisal reports with credible value estimates are an important tool to gauge the long-term recovery in the commercial real estate industry. The sales and leasing activity of recent months is not normal and should be viewed with a degree of skepticism. Investors and appraisers can no longer ignore certain lease clauses – we all know that the unthinkable can happen. The best way to produce credible values is for appraisers to obtain reliable information from the brokers, developers and investors on the street. Incorporating their opinions with real estate collaboration tools such as Asset Record will help begin the process of a return to a stable retail real estate industry.
1 Vernor, James D. Shopping Center Appraisal and Analysis (2nd Addition). 2009. Appraisal Institute.