Casualty Loss Valuation Patrick OConnor, MAI OConnor & Associates

Myth I was insured, so there is no casualty loss. I was insured, so there is no casualty loss. Perception of most owners Perception of most owners Perception of many tax professionals Perception of many tax professionals

Casualty Loss Similar to bonus depreciation Similar to bonus depreciation Can be 10 – 20%+ of market value prior to the casualty Can be 10 – 20%+ of market value prior to the casualty Likely applies even if you are fully insured Likely applies even if you are fully insured

Casualty Loss Deduction Market value immediately before the casualty, Market value immediately before the casualty, Less the market value immediately after, Less the market value immediately after, Less insurance proceeds Less insurance proceeds

Example Market value before$5,000,000 Market value before$5,000,000 Market value after 3,000,000 Market value after 3,000,000 Difference 2,000,000 Difference 2,000,000 Less insurance proceeds 1,200,000 Less insurance proceeds 1,200,000 Net casualty loss 800,000 Net casualty loss 800,000 Tax savings at 35% $ 280,000 Tax savings at 35% $ 280,000

MV before Casualty Routine valuation assignment Routine valuation assignment

MV after Casualty Complex Complex Limited data Limited data Many issues to consider Many issues to consider More subjective than many assignments More subjective than many assignments

MV after Casualty Issues Physical damage Physical damage Obligations to tenants Obligations to tenants Litigation with tenants Litigation with tenants Tenant options to cancel Tenant options to cancel Market value of leaseholds Market value of leaseholds Outlook for metro area (ie population and employment on Galveston in 1 – 3 years) Outlook for metro area (ie population and employment on Galveston in 1 – 3 years)

MV after Casualty Issues Time to settle insurance claim Time to settle insurance claim Time to rebuild Time to rebuild Time to release Time to release Tenant improvements to lease Tenant improvements to lease Leasing commissions Leasing commissions Reduced level of revenue until stabilized income is reached Reduced level of revenue until stabilized income is reached

MV after Casualty Is market rent higher or lower? (Lower population / employment?) Is market rent higher or lower? (Lower population / employment?) Has stabilized occupancy changed Has stabilized occupancy changed Are expenses different? Insurance? Are expenses different? Insurance? Entrepreneurial profit to induce a buyer Entrepreneurial profit to induce a buyer Different cap rate due to changes in population / employment? Different cap rate due to changes in population / employment?

New Orleans after Katrina City of New Orleans at 72% of pre- Katrina population City of New Orleans at 72% of pre- Katrina population New Orleans metro area at 87% of pre- Katrina population New Orleans metro area at 87% of pre- Katrina population Source: Greater New Orleans Community Data Center, July 2008 Source: Greater New Orleans Community Data Center, July 2008

Valuation Example Before After Before After Gross potential rent$16$15 Gross potential rent$16$15 Stabilized occupancy90%85% Stabilized occupancy90%85% Other income PSF$4$3.3 Other income PSF$4$3.3 Operating expensesPSF$8$8 Operating expensesPSF$8$8 100,000 SF retail center 100,000 SF retail center 90% occupied before 90% occupied before

Valuation Example Lower rent and stabilized occupancy less likely as distance from Galveston increases Lower rent and stabilized occupancy less likely as distance from Galveston increases I.e. long term impact on revenue and expenses diminishes as distance from area affected catastrophically increases I.e. long term impact on revenue and expenses diminishes as distance from area affected catastrophically increases

Valuation Example PGI$1,600,000 $1,500,000 PGI$1,600,000 $1,500,000 Less vac 160, ,000 Less vac 160, ,000 Plus other inc 400, ,000 Plus other inc 400, ,000 EGI 1,840,000 1,655,000 EGI 1,840,000 1,655,000 Expenses 800, ,000 Expenses 800, ,000 NOI 1,040, ,000 NOI 1,040, ,000 MV (9%) $11,555,556 9,500,000 MV (9%) $11,555,556 9,500,000

Valuation Example Casualty loss of over $2 MM without considering lost rents, leasing commissions and entrepreneurial profit Casualty loss of over $2 MM without considering lost rents, leasing commissions and entrepreneurial profit

Valuation Example Remaining issues: Remaining issues: Lost rents Lost rents Leasing commissions Leasing commissions Entrepreneurial profit Entrepreneurial profit

Lost Rents 1 year to negotiate insurance claim and rebuild; 15% occupancy 1 year to negotiate insurance claim and rebuild; 15% occupancy Reach 85% occupancy 1 year later (24 months after casualty) Reach 85% occupancy 1 year later (24 months after casualty) $1,575,000 $1,575,000

Leasing Commissions Lease 70% of space at $15 PSF for 5 year term; 5% commission Lease 70% of space at $15 PSF for 5 year term; 5% commission Leasing commissions $262,500 Leasing commissions $262,500

Entrepreneurial Profit How much profit (% of value after rehab at stabilized occupancy) would you want? How much profit (% of value after rehab at stabilized occupancy) would you want? Guarantee construction loan Guarantee construction loan Lease up risk Lease up risk Assemble capital Assemble capital Supervise construction Supervise construction Supervise leasing Supervise leasing 5% or 10% or 15% ($475,000 or $950,000 or $1,425,000) 5% or 10% or 15% ($475,000 or $950,000 or $1,425,000)

Valuation Example Entrepreneurial profit Entrepreneurial profit 5% = $475,000 5% = $475,000 10% = $950,000 10% = $950,000 15% = $1,425,000 15% = $1,425,000

MV after Casualty Stabilized value$9,500,000 Stabilized value$9,500,000 Less lost rents 1,575,000 Less lost rents 1,575,000 Less leasing commissions 262,500 Less leasing commissions 262,500 Less entrepreneurial profit 475,000 Less entrepreneurial profit 475,000 Net value after casualty $7,187,500 Net value after casualty $7,187,500

Casualty Loss Deduction MV before casualty$11,555,556 MV before casualty$11,555,556 Net MV after casualty 7,187,500 Net MV after casualty 7,187,500 Casualty loss 4,368,056 Casualty loss 4,368,056 Tax savings at 35% $1,528,820 Tax savings at 35% $1,528,820

Process Request a preliminary review of whether you qualify Request a preliminary review of whether you qualify No value, but can determine whether it is worthwhile No value, but can determine whether it is worthwhile No cost for preliminary analysis No cost for preliminary analysis Review with your CPA / tax return preparer Review with your CPA / tax return preparer

Process Obtain appraisal (before and after) Obtain appraisal (before and after) Tax return preparer claims casualty loss Tax return preparer claims casualty loss

Conclusions Legitimate Legitimate Assumptions are reasonable Assumptions are reasonable Valuation would withstand peer review Valuation would withstand peer review