How the Market Views “Value-Add” Properties Norm Bruns & Michelle DeLappe, Garvey Schubert Barer Andy Robinson, Kidder Mathews

What Does “Value Add” Mean? Some properties involve higher risks and the potential for higher returns due to problems present at the time of sale, for example, low occupancy, deferred maintenance, and operational problems. They require an investor with a strategy to create additional value. The market value should reflect the analysis buyers and sellers use to determine the sale price, for example, of commercial property with below-market occupancy.

Example: Below-Market Occupancy Fully Leased, Multiple Tenants, Market Rents 100% Vacant Which sells for a higher price?

Non-Sale Appraisal Contexts for Value-Add “Federal or state law often requires appraisers to value leased properties as fee simple estates, not leased fee estates, for eminent domain and ad valorem taxation. When the fee simple interest is valued, the presumption is that the property is available to be leased at market rates.” TARE at 441 (14th ed.) In some jurisdictions, fee simple may mean valuing as vacant and available, so both could have the same value--the value of the vacant property. In other jurisdictions, fee simple means valuing as if leased at market rents as of the valuation date, but a property with below-market vacancy should not be taxed as though it had market occupancy.

What Buyers & Sellers Do: 2 Steps Analysis that buyers and sellers use to negotiate the selling price of a value-added property: Estimate the value of the subject property based on a stabilized level of market occupancy (i.e., estimate the “stabilized value” of the property). Estimate the amount of vacancy shortfall to deduct from the stabilized value indication to account for the costs and risks required to bring the subject property to stabilized occupancy.

Step 1: Estimate Stabilized Value For vacancy shortfall to be feasible to cure: the value with below-market occupancy + the cost required to stabilize occupancy > the value of the property with stabilized occupancy

Highest & Best Use To estimate value as stabilized, first determine the highest and best use. Typically, the highest and best use of commercial property is assumed to be as improved, with stabilized occupancy.

What Approach to Valuation? All three real property valuation approaches can be used to estimate the stabilized value of a subject property. Data for stabilized properties are typically more readily available than data for distressed properties.

Income Approach: Rents & Occupancy Use market rents and stabilized occupancy rates. The subject property’s actual contract rents may be higher or lower than market rents. Market rents can be estimated based on an analysis of comparable property lease rates near the valuation date.

Income Approach: Capitalization Rate Capitalization rates should be derived from market-based data of comparable, stabilized properties. Note: Some appraisers increase the capitalization rate to reflect the higher risk of value-add properties and the higher return expected as entrepreneurial incentive. We prefer to account for this separately in Step 2...

Sales Comparison Approach Comparable sales will reflect who the most probable buyer is for the subject property. For most income-producing properties, sales of stabilized properties far outnumber sales of unstable properties, so sales of stabilized comparable properties are generally better to use for Step 1.

Sales Comparison Approach What if the comparable sales include both stabilized and value-add properties? Then make upward adjustments to the sales of unstable properties to reflect a stabilized value consistent with vacancy shortfall analysis.

Evidence from the Market Income and sales comparison approaches offer the only opportunities to follow how buyers and sellers negotiate selling prices for value-add properties. Discuss with the buyer and seller the effect on the sale price caused by unstable occupancy. Each party to the sale may have a different view of that effect.

Cost Approach Consider the subject property’s cost new, including an entrepreneurial incentive profit margin and all forms of depreciation. High vacancy can be cured by leasing the property, unless the high vacancy is the result of incurable obsolescence. The effect on value of curable high vacancy is addressed in the second step of the analysis.

What Is "Stabilized Occupancy"? Occupancy level of a new property that is reached after the initial lease-up period, and that is reasonably expected to continue into the future with the proper marketing, management, and maintenance expenditures. Highly dependent on the property market, property type, and property location. Lenders’ underwriting assumptions of stabilized occupancy are often an acceptable market indication of stabilized occupancy.

Reconciliation Completes Step 1 Reconcile to conclude the value of the property as though it enjoyed stabilized occupancy. By assuming stabilized occupancy as the basis of each value indication, the appraiser can reconcile values that are directly comparable to each other.

Step 2: Determine the Vacancy Shortfall The vacancy shortfall consists of the costs that would be required to bring the property to stabilized occupancy, including an appropriate margin for entrepreneurial incentive.

Costs Required to Stabilize Occupancy Lease-up costs Tenant improvements Rent loss due to vacant or dark units Lost expense recoveries Concessions, such as free rent

Units That Are Leased But Dark Consider the income from the tenant until the end of the lease term. Adjust the absorption period estimate if needed to account for interim occupancy—inability to show the unit to prospective tenants lengthens the absorption period.

Occupancy Percentage in Step 2 What percentage occupancy should be used to model the vacancy shortfall? Follow what buyers and sellers are doing in the market. Consider the specific property: if vacancy is in a single unit, leasing up only a percentage of that unit may not be practical. Example: vacant anchor space.

Entrepreneurial Incentive Required to compensate the most probable buyer of the subject property for the risks, skill, and effort associated with investing in a distressed property. If missed, transaction costs could result in investors losing money on subsequent sale after stabilization. Federal guidelines governing financing-related real estate appraisals require consideration of entrepreneurial incentive for properties with vacancy problems.

Entrepreneurial Incentive Percentage The percentage of entrepreneurial incentive appropriate for a given property should be supported by market evidence from comparable transactions. The entrepreneurial incentive profit margin typically can range from as low as 20 percent to over 100 percent of the lease-up costs.

Conclusion See article’s case studies on how to extract market evidence from specific transactions: Sale of property facing large vacancy; resale of the same property after stabilization Negotiations leading to sale of property with 60% vacancy The risk, skill, and effort required of the buyer for value-add properties requires a higher return, i.e., a lower sales price. The analysis of buyers and sellers shows how to calculate that effect on value.

Questions? Norm Bruns nbruns@gsblaw.com Michelle DeLappe mdelappe@gsblaw.com Andy Robinson andyr@kiddermathews.com