So, How Much Is this Worth, Anyway?

By Christopher Steele, President, CWS Group LLC

I’m going to once again divert from the topic we were originally going to cover to a topic now regularly in the news – real estate valuation.

Determining the likely price or value of a real estate asset comes back to methods of valuation taught in basic finance classes: simple forms and approaches that provide a sound basis in most markets. Unfortunately, these methods assume an existing market for the assets. Right now this market is – to be understated about it – constrained.

The problem lies in the definition of “value; ” that “value” is an estimate of the price at which an asset could be bought or sold on the open market between a willing, informed buyer and seller. However, willing buyers are hard to come by right now, and information is sketchy at best. As a result, it is increasingly difficult to know how much assets are truly worth.

Approaches to value
Appraisers typically use several approaches to determine the value of a real estate asset: comparables, capitalized net operating income (NOI), and replacement value. By examining all three, the appraiser can develop a consensus as to the likely true value.
In the comparables approach, the appraiser or analyst examines similar land or facility transactions and uses these to develop an estimate of value for the property in question. For example, an appraiser might gather recent transaction data on sales of 50-100 acres of industrial land in a particular submarket. The appraiser then uses this data to determine an appropriate per-acre price range for a parcel of 75 acres in that same submarket.

NOI capitalization is useful for properties already in use, as it builds a value based on the property’s current revenue. In this approach, the analyst determines the capitalization rate – the rate at which the capital cost of an investment is paid off – by examining industry trends. While similar to the comparables approach, the NOI capitalization method uses the property’s actual performance as a key component in the equation. For example, a property with an annual NOI of $1.5 million with a 6 percent cap rate would produce an estimated value of $1,500,000 / 6 percent = $25 million.

Finally, the replacement value method estimates the cost to replace the asset or otherwise build it from scratch. Through assembling land, infrastructure, and building costs, the appraiser attempts to derive a reasonable facsimile of the building’s value.
Each of the above requires some judgment on the part of the appraiser or analyst. Whether through choosing the right comparables, cap rate or adjusting the replacement cost components, there is a range of error. On the other hand, there is usually a good base of experience that informs and guides the selection and adjustment of each of these factors.

Implications for the current marketplace
Unfortunately, these methods don’t work well when deal activity slows. Comparable transactions don’t exist, are in the wrong market, happened too far in the past, or are otherwise different in some significant fashion. Accelerating foreclosure rates and declining revenue force wide variations in cap rates. The lack of new building, coupled with fluctuations in the global market for fuel and building materials, introduces significant unknowns into even the replacement cost approach.

Valuation has – as a result – moved into a very conservative arena. In addition to true market-based factors, the book values of assets around the world have dropped significantly due to the simple lack of available data and the smaller active marketplace. Since there are fewer willing buyers, appraisers are forced to lower their estimates to enter a range of safe value.

The need to mark values to market conditions carries a variety of accounting impacts. Assets may be re-valued to market to ensure that mortgages maintain their proper loan to value ratios. This results in further apparent loss of total market value. So, even as mortgages are dutifully repaid and buildings remain active, the paper value of properties in the marketplace appears significantly lower than what was paid for the asset. Likewise, many projects now face the prospect of losing financing as their loan-to-value ratios balloon at just the time when they need to secure bridge or permanent financing.

Of course, these reduced values present a significant opportunity for investors with access to independent capital and a long-term view. At the same time, the current troubles do appear to have some of their roots in a valuation methodology. Perhaps this also reflects a need to change valuation methodology to better present a long-term view?

Sorry for the detour, but hopefully you’ve enjoyed the ride. Next month, we’ll return to the concept of alternative sources of development financing, particularly public-private partnerships and how these can be used to “unstick” the development process.

In This Issue

News, Trends & Analysis
New Items

Don’t Get Carried Away

Supply Chain
So, how much is this worth, anyway?

Compliance Corner:
Service Providers and Trade Compliance Freight Forwarders need apply!

Five things you should know about auto and logistics software

Distorted Web Sites

Supply Chain product review
Security Software Solutions

Features
Gateway at a Glance – Gulf Coast

Supply Security Investments: A Balancing Act

Ports & infrastructure
Major retailer to Southern Cal ports: Requirements are many, costs are high

Port Product Review
Security Equipment

Commentary
Security Issues Impacting the Supply Chain

Who, What, Where, When

Final Say