Real estate valuation inherently relies on comparable data or comps. The three types of widely used comps are cost of construction, price from sales and income from known leases.
Whether we use the cost, sales or income approach, we are always comparing the subject property to other, hopefully similar, properties. This seems obvious when using the sales comparison approach, where we contrast our subject property to others that have sold or are listed for sale. We can adjust the sales or listing prices, taking into account how the comps differ, to arrive at an estimate of what our property might sell for.
The same logic applies to the cost approach. We start with the known costs to construct similar buildings and make appropriate adjustments. For the income approach, we consider the income and expense numbers for similar buildings and adjust them to estimate the net operating income for our property. From this, we can derive a value.
So, as long as properties are being sold, built and rented, we have relevant comps on which to base our estimates. In the current market, however, there is not a lot of building, very few sales (although lots of listings) and not many rentals to use as comparable data. How, then, do we derive a realistic valuation with very few comps to go on?
Many would argue that the sales market has been more negatively impacted during this downturn than the new construction or rental markets.
The few sales that have taken place in the past year to 18 months aren’t really useful in current valuations because they tend to share certain characteristics.
Many have been at the low end of the price structure for commercial property, mostly in the $1- million to $25- million range. This is partly because balance sheet lenders, such as regional and community banks, are the only ones that can and want to finance such purchases, and their lending limits typically restrict them to transactions of this size.
Many recent trades have been viewed as distressed, or “stressed,” sales because of the inability to refinance maturing debt, the loss of an anchor tenant or the financial weakness of the seller.
However, while the depressed economy has lowered asking rents for most property types, rental activity is still taking place and comparable data exists. Operating expenses are also widely available. While construction activity is down and land sales are at an all-time low, the cost of construction is still being closely tracked by many sources.
So, it is primarily sales activity of completed buildings and vacant land that is not readily available. Fortunately, the other sources of data can help. The income approach can help determine the value of many existing properties. Estimating the cost of construction and deducting that from the total property value, via the income approach, can also help in determining the land value.
Typically, we would develop a cash flow model, including expected costs of development, income generated through rental or sale of the property, and the time to complete, rent or sell the property. We would then apply an appropriate discount rate to develop an estimate of the current value of the land, or the partially completed project.
For companies experienced in development and construction, time to complete is not that difficult to estimate. Expected sale prices and/or rental rates are more difficult, largely because of the need to estimate the difference between current rates and the expected new “normal” prices or rental levels.
Similarly, the length of time it will take to sell or rent the whole project after completion is difficult, but not impossible, to estimate. A long backward view of price levels and absorption of the particular property type in the local geography can be very helpful. The challenge for those conducting real estate valuations in the current market is that there is not as much comparable data available as before. However, for those willing to look for it, there is data out there. The challenge is not so much identifying the data, as knowing how to analyze it properly.
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