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International Real Estate Appraisal,
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Consulting & Advisory Services

THE ROLE OF AN APPRAISER:


"VALUATION TECHNIQUES
FOR COMMERCIAL REAL ESTATE AMIDST A WORLD OF
CHANGE"

PGP VALUATION, INC


110 SW Yamhill, Suite 200
Portland, Oregon 97204
503.226.0983 - Main

W. Grant Norling Jeff Grose, MAI


Managing Director Managing Director
503.542.5416 503.542.5411
grant.norling@pgpinc.com jeff.grose@pgpinc.com
INTRODUCTION

There is broad sweeping change in the mindset of the World economy caused by the credit
crisis, economic downturn and long-term uncertainty, which is having a profound impact on the
real estate market. Our job as appraisers is to interpret what is occurring in the economy
including supply/demand conditions, unavailability of financing, rising unemployment and
alternative investment vehicles in order to credibly estimate the value of real property. The
following information provides an introduction to the commercial real estate appraisal process,
and summary statements with regard to how we are adapting our analysis to the changing
economic conditions.

Appraisal: (noun) the act or process of developing an opinion of value; an opinion of value.
(adjective) of or pertaining to appraising and related functions such as an appraisal practice or
appraisal service.

Appraiser: one who is expected to perform valuation services competently and in a manner
that is independent, impartial, and objective.

Appraisal Process
1) Define the problem
Identify the real estate
Identify the rights to be valued
Establish the intended user of the appraisal
Determine the definition of value
Determine the effective date of the appraisal
Identify the scope of the appraisal
Establish any assumptions and limiting conditions
2) Preliminary Analysis and Data Collection
3) Highest and Best Use Analysis
4) Land Value Estimate
5) Apply the Appropriate Valuation Techniques (Cost, Income, and Sales)
6) Reconciliation of Value and Final Value Conclusion
7) Report the Defined Value

Scope of Work: the type and extent of research and analysis in an assignment.
The scope of work is defined by the appraiser and the client. However, the appraiser
can not limit the scope of work to such a degree that is jeopardizes the reliability of the
value conclusion.

The most common value scenario requested is the As Is Market Value. Market Value is
defined below:

The most probable price which a property should bring in a competitive and open market under
all conditions requisite to a fair sale, the buyer and seller each acting prudently,
knowledgeably, and assuming that the price is not affected by undue stimulus. Implicit in this
definition is the consummation of a sale as of a specified date and the passing of title from seller
to buyer under conditions whereby:

1. Buyer and seller are typically motivated;

2. Both parties are well informed or well advised, and acting in what they consider their own
best interests;

COPYRIGHT © 2009 PGP VALUATION INC. ALL RIGHTS RESERVED


3. A reasonable time is allowed for exposure in the open market;

4. Payment is made in terms of cash in United States dollars or in terms of financial


arrangements comparable thereto; and

5. The price represents the normal consideration for the property sold unaffected by special
or creative financing or sales concessions granted by anyone associated with the sale.1

The scope of work may be defined by the appraiser, however, the scope of work must meet or
exceed 1) the expectations of parties who are regularly intended users for similar assignments;
and 2) what an appraiser’s peers’ actions would be in performing the same or similar
assignment.

Appraisal Reporting Options

An appraiser has 3 options for written reports:


Self Contained
Summary
Restricted Use

Three Approaches to Value

Cost Approach
Income Approach
Sales Comparison Approach

1
Office of Comptroller of the Currency (OCC), Title 12 of the Code of Federal Regulation, Part 34, Subpart C - Appraisals, 34.42 (g);
Office of Thrift Supervision (OTS), 12 CFR 564.2 (g); This is also compatible with the RTC, FDIC, FRS and NCUA definitions of
market value.
COPYRIGHT © 2009 PGP VALUATION INC. ALL RIGHTS RESERVED
COST APPROACH

The cost approach is based upon the principle that the value of the property is significantly
related to its physical characteristics, and that no one would pay more for a facility than it would
cost to build a like facility in today's market on a comparable site. In this approach, the market
value of the site is estimated and added to the estimated depreciated value of the
improvements.

Or

Replace Cost of Improvements w/ profit – Depreciation + site value = Cost Approach Value
____________________________________________________________________________

Replacement Cost New


All costs to construct
-Direct Cost (materials, labor, contractor overhead)
-Indirect Cost (perm. financing, marketing, professional reports)
Sources for Data: Developer’s Budget, Cost Comparables, Marshal Valuation, Bids
(+) Profit
Sufficient entrepreneurial incentive to compensate risk
-Varies based on market sector
Developers (10-20%)
Users (5%)
Sources: Market survey, alternative investments
(–) Depreciation
Three Types
-Physical (typical wear & tear)
-Functional (obsolescence due to design)
-Economical (surrounding influences)
(+) Land Value
Cost of equivalent substitute site
-Valuation techniques
Sales comparison (most typical)
Residual analysis

= Cost Approach Value


____________________________________________________________________________

Most Applicable for:


New or proposed construction
Owner/user properties
Special purpose properties

Limited Application for:


Investment properties
-mostly to test financial feasibility
Older construction
-difficult to measure accrued depreciation

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COST APPROACH SUMMATION TABLE

M ARSHA LL V ALUA TIO N S ERV ICE CO ST ESTIM ATE


Dir ec t Co sts $ 1,665 ,5 05
In dire ct Costs $ 651 ,5 50
T ot al Co s ts $ 2,317 ,0 55
Per Sq uar e Fo ot $18 8.84

CONCL UDED DIRECT & INDIRECT IM PROV EM ENT COS T $ 2,317 ,0 55


P e r Sq uar e Foot $18 8.84

Ent re pre n e ur ia l Pr ofit 20.0% of Imp ro veme nt Cost & Lan d V alue $ 699 ,4 11

Re plac e m e nt C os t Ne w $ 3,016 ,4 66

DEPRECIATION
Cur able De pr eciation $0
Mar ket Extr action Me th od
Ef fec tiv e A ge 5 Y ea rs
Total Eco no mic L ife 4 5 Y ea rs
% De pr ecia te d 4 .0 %
S ubtotal ($ 120 ,6 59)
Tot al De pr e ciat io n ( $1 20,65 9)

De pr e ciat e d Re place m e n t Cos t $ 2,895 ,8 07

Site V alue $ 1,180 ,0 00

V ALUE INDICAT IO N BY THE COS T A PPROA CH $ 4,075 ,8 07


Round e d $ 4,080 ,0 00
P e r Sq uar e Foot $33 2.52

Cost Approach in a Declining Market

Many new projects are not financially feasible. The lease-up or absorption/sell-out of a project
becomes extended. Many projects appraised 18 months ago that are nearing completion are
no longer profitable due to extended marketing periods.

Replacement cost becomes a less reliable indicator of market value.

Land value assumptions change. In an active construction market, land is purchased for
immediate development. If a development parcel is purchased now, the buyer’s assumption
would be to hold until development is feasible. Additional holding costs may require a
downward adjustment to the land sales that sold in 2007.

COPYRIGHT © 2009 PGP VALUATION INC. ALL RIGHTS RESERVED


INCOME APPROACH

In the Income Approach a property’s capacity to generate income is analyzed, which is in


turn capitalized into an indication of present value. Two fundamental methods are used in
this approach, Direct Capitalization and Yield Capitalization, which are described below:

Direct Capitalization Method - The advantages of direct capitalization are that it is


simple to use, easy to explain, often expresses market thinking, and provides strong
market evidence of value when adequate sales are available. Direct capitalization is
most commonly applied by applying an overall capitalization rate to relate value to the
entire property income (i.e., net operating income).

Yield Capitalization Method - This method is typically referred to as a Discounted Cash


Flow Analysis. Market supported assumptions and projections are made for future
changes in occupancy, rents, income, and expenses to arrive at periodic cash flow. The
property’s eventual reversion is also estimated, incorporating anticipated changes in the
property and market conditions. The resulting cash flows are discounted to a present
value indication using an appropriate market supported yield rate.
_________________________________________________________________________

Direct Capitalization – Most Commonly Used

The following steps create a basic outline of the income approach:

• Estimate income
• Estimate Vacancy and Expenses
• Derive an estimate of Net Operating Income (NOI)
• Derive a capitalization rate from a) market sales, b) band of investment analysis
• Divide the NOI by the Capitalization rate to estimate the value

The fundamental principle in this approach if anticipation. The anticipated risk associated
with the income stream is implicit in the cap rate.

A basic Income Approach is:

Potential Income – Vacancy = Effective Gross Income

Effective Gross Income – Expenses = NOI

NOI /Capitalization Rate = Value


______________________________________________________________________

Limitations—The limitations of this approach include:


Lack of recent, directly comparable rental rates
Lack of market transactions from which to derive a reliable capitalization rate

Common Mistakes—Common mistakes made by market participants include:


• Understanding the difference between current income and potential income and
between fee simple and leased fee value
• Estimating appropriate expenses
• Understanding the structure of the leases in order to measure appropriate expense
reimbursements when applicable
• Deriving an appropriate capitalization rate based upon the risk factors of the property
COPYRIGHT © 2009 PGP VALUATION INC. ALL RIGHTS RESERVED
DIR EC T CAP ITALIZATION S UMMATION TAB LE
Sq uar e M ar k e t M on thly Ann ual
In com e Ite m s Fe e t Re n t PSF Re nt Re nt
Re nt al Inc om e
S uite 7 07 - 5 ,0 00 SF 5,00 0 $ 24.00 $10 ,000 $1 20,00 0
S uite 7 37 - 1 ,4 00 SF 1,40 0 $ 26.00 $3 ,033 $ 36,40 0
S uite 7 43 - 5 ,8 70 SF 5,87 0 $ 24.00 $11 ,740 $1 40,88 0
Tot al Re nt al Inco m e 12,27 0 $ 24.23 $24 ,773 $2 97,28 0

Additiona l/Ot he r Inc om e


Expense Reimbu rsemen ts $3 ,782 $ 45,38 6
Tot al Ad ditiona l/Ot he r Inco m e $3 ,782 $ 45,38 6

POTENTIAL GROSS INCO ME (PGI) $ 27.93 /S F $342,666

V ac ancy & Cr e dit Lo s s


Rental Inco me 5% $1 ,239 $ 14,86 4
A dditiona l/Other Inco me 5% $189 $2,26 9
Tot al 5 .0 % $1 ,428 $ 17,13 3

EFFECTIV E GROSS INCOM E (EGI) $ 26.53 /S F $325,533

Est im a te d Expe ns e Ite m s % o f PGI % of EGI T ota l Per S F


Real Es ta te Taxe s* 5.9% 6.2% $20 ,232 $1 .6 5
In sur an ce* 1.1% 1.1% $3 ,681 $0 .3 0
Commo n A re a Mainten anc e* 6.3% 6.6% $21 ,473 $1 .7 5
Mana geme nt Fee 3.1% 3.3% $10 ,580 $0 .8 6
Reserv es 0.5% 0.6% $1 ,841 $0 .1 5
Tot al 16 .9% 17 .8 % $57 ,806 $4 .7 1

NET OP ERATING INCOM E ( NOI) $ 21.82 /S F $267,726

V aluat ion of Incom e NOI Div ided b y Ca p. Rate Eq uals V alue


$ 267 ,726 ÷ 6 .5 0% = $4,1 18,86 8

ESTIM ATED V ALUE ( ro unde d) $3 35.78 /S F $4,120,00 0

* Reimbur sab le e xpens es

Income Approach in a Declining Market

The Income Capitalization Approach is the best measure of value for income-producing
investment properties. One challenging task in the current economy is accurately estimating
market rents, which requires the appraiser to measure the impacts that softer market
conditions are having on rents.

Without a doubt, the most difficult and important modifications to our appraisals are
occurring in the capitalization and discount rate analysis. Due to the drastic decline in
investment sales over the past year, it takes a lot of creative analysis to reasonably estimate
current capitalization rates. We look in the rearview mirror on past transactions, consider
current listing and review national trends in order to provide the most reasonable estimate.

COPYRIGHT © 2009 PGP VALUATION INC. ALL RIGHTS RESERVED


SALES COMPARISON APPROACH

The Sales Comparison (Market) Approach is based on the principle of substitution, which
asserts that no one would pay more for a property than the value of similar property in the
market. In this approach, the subject property is compared directly with other recent sales of
similar properties in the marketplace. This comparison is typically accomplished by extracting
“units of comparison,” for example, price per square foot, and then adjusting these units of
comparison for the comparable sales for differences between the subject and each comparable.
The reliability of an indication found by this method depends on the quality and quantity of the
comparable data found and the ability of the appraiser to make reasonable and supportable
adjustments. In active markets with a large number of sales that are physically similar
comparables, this approach is generally a good indicator of value.

Sources of Comparable Data


 Buyer
 Seller
 Brokers
 Public records
 Professional data companies
 Multiple listing services
 Other appraisers

Typical Units of Comparison


 Price/SF of gross building area
 Price/SF of net building area
 Price per unit (apartments, self storage, hotels, health care)
 Price per seat (restaurants and theaters)
 Price per door (truck terminals and distribution centers)
 Price per boat slip (marinas)
 Price per parking space (parking decks)
 Price per hole (golf courses)
 Price per lane (bowling alleys)
 Price per lot or pad (subdivisions, mobile home parks, RV parks)
Most Applicable for:
Owner/user properties
Special purpose properties
Any property (retail, office, etc.) where sufficient data is available
Sales Comparison Approach in a Declining Market

Limited sales activity is making the sales approach more difficult. Investment sales are off 60%
to 80%. As much as 50% of those sales now include assumed debt.

The factors affecting value and pricing have changed. This includes buyer’s assumption on the
future. For example, capitalization rates at 6% and investors IRR of 15% imply substantial
increases in income over a holding period. With flat rents, higher vacancy costs to ownership,
difficulty financing, the conditions in which sales took place in 2007 are much different that they
are today.

Appraiser now need to do a better job interviewing brokers, analyzing active listings, and
drawing a conclusion from possibly older sales prior to 2007.

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