Condo Sell-out Analysis

[Ken B]

If I understand this correctly, I believe that it is the type of issue that is solved by a conversation with the client. They may have a reason for preferring one route over another. Whether it is non-refundable has some bearing on how it is handled. If it is fully refundable, I'd be inclined to simply put the full selling price at the time that the sale is completed, as that is when the rights are transferred. Depending on what the client prefers, what effective date is used, and if it is non-refundable, the deposits could be a time 0 cash flow. Either way, it offers support for absorption and perhaps your discount rate-if 50% of the units are pre-sold and non-refundable deposits are paid, I'd feel a little more confident of its prospects than if it were 5% pre-sold

Reportedly, the client has no complaints with the methodology.

They are just now breaking ground and the property is almost 50% sold out. It is typical that buyers pay cash.

 

[Howard Klahr]

What does the purchase contract state about the buyers ability to obtain the 20% back in the event that the transaction doesn't close?

While the developer is often the entity handling the closing process of the pre-sales, your specified assignment condition presupposes a " hypothetical purchaser upon completion". That situation potentially exposes the "hypothetical purchaser" to not only to receiving lower proceeds upon closing but also even being in the position of having to potentially refund money for deposits not in their possession.

 

[Ken B]

I don't have access to the contracts. I am assuming they are non-refundable deposits. But we are digressing from the specifics of the scenario. Upon completion, if the buyer does not honor the contract, I would expect that they forfeit their deposits. With 50% +/- of contract paid as deposits in stages prior to completion, there is strong incentive for the buyer to honor the contract. If I was an investor who bought the property upon completion, I might actually hope that half the buyers do not honor their contracts..

 

[Gobears81]

That's all we really need to know to discuss the methodology. Assume 100% of units are contracted prior to completion, but closings will take 12 months. Don't get sidetracked by issues not related to whether or not an investor would value based upon 100% contract price or 80% contract price, such as whether or not we need to actually apply a discount rate for a 12-month sell-out period.

Here is why I ask. I am reviewing a report where this adjustment (20% of total contract price for all units) is deducted from the DCF conclusion in which the model utilizes 100% of the contract price in the analysis. The explanation provided is that, upon completion, a hypothetical investor who would simply be responsible for closing contracts would not receive the entire contract price from each sale as 20% of the contract price paid as deposits prior to completion of construction are sunk into the construction of the property rather held in escrow.

I have never seen this methodology before. Four of us with about 100-years combined experience have never seen this methodology before. The appraiser says he has been doing it this way for decades when contracts permit deposits to be used to cover construction costs.

I kind of understand the reasoning behind the methodology. I'm just trying to see if anyone else has seen this or has reasoned thoughts on it one way or the other. Does the methodology provide a net realizable value or market value indication?

So do you mean that he is essentially appraising the property for 80 cents on the dollar (or some discounted value that doesn't include the deposits paid)? I've admittedly never done it like that, but around here, most of the deposits are quite a bit lower so it is not as much of a consideration. I'd think that it is an effective date issue and maybe even a property rights issue. If it transfers before the units have closed but after they have paid deposits, would the buyer "purchase" the deposits also? If it is non-refundable, would you pay $100,000 more so that you can obtain $100,000 back in deposits? From a valuation standpoint, it would make more sense to present a value including transfer of the deposits, but would it reflect buyer/ seller behavior? I don't have a good answer to that. But, if I were in a scenario like this where such a significant portion is in deposits, I'd probably be pretty clear of exactly what my value does consist of.

 

[Howard Klahr]

I understand the logic presented by the appraiser in deducting the 20%. It is similar to TI's that have been paid prior to the date of value. The property benefits from the higher collected rent and yet the cost to build out the space have already been expended. Your situation is a little in revers but the valuation needs to relfect the actual contractual payment as of the effective date for the reported value.

 

[Ken B]

In the report under review, the cash flow to the hypothetical investor buyer of the property, in its entirety, upon completion of the project is being valued. A unit buyer (end user) agrees to pay $1 for the fee simple rights to a unit. Upon completion, the end user has already paid $0.50 of the $1.00 total for those rights. But the developer has already spent $0.20 of those $0.50, as permitted by the contract. Thus, only $0.30 of the $0.50 already paid by the end user is available for disbursement upon closing. From each end unit contract closing, the investor will only receive $0.80, gross, from each unit sale, of the $1.00 paid by the end user for the fee simple rights to that unit. The developer retains $0.20 of the $1.00 paid by the end user for those rights. I suppose it doesn't make any difference what the developer does with those $0.20, it only matters that the investor who acquires the property, in its entirety, upon completion, does not receive that $0.20.

The question is, does the value of the cash flow to that investor represent market value for the property, in its entirety, upon completion? Or is it some other type of value?

 

[Meandering]

The question is, does the value of the cash flow to that investor represent market value for the property, in its entirety, upon completion? Or is it some other type of value?

No.

In the report under review, the cash flow to the hypothetical investor buyer of the property, in its entirety, upon completion of the project is being valued.

A unit buyer (end user) agrees to pay $1 for the fee simple rights to a unit. Upon completion, the end user has already paid $0.50 of the $1.00 total for those rights. But the developer has already spent $0.20 of those $0.50, as permitted by the contract.

Thus,
The question is,
Where is the pricing in of the risk to the buyer, that the builder will remain financially viable until the completion of the project? Typically, that pricing is recognized in a price discount - due to the associated risk for not completing the project. So, the $1.00 being paid might be $1.50 to other units that are not pre-sold. What does your market say? But 20% seems high for risk of any investment, especially an unsecured investment in a pre-sale unit.

.

 

[Ken B]

I had almost talked myself into the reasonableness that the price an investor would pay to a developer to receive 80% of the price paid per unit by an end user did represent market value, but after "talking" it through in Post 16, I talked my way back out of it. I just need to be able to rationally explain to this very experienced MAI, who says he has been doing it this way for decades, that the value of the cash flow from the contracts, less the 20% held back by the developer, does not represent market value of the property. It is an investment value to the hypothetical investor. Or perhaps a net realizable value.

 

[Ken B]

Where is the pricing in of the risk to the buyer, that the builder will remain financially viable until the completion of the project? Typically, that pricing is recognized in a price discount - due to the associated risk for not completing the project.

.

Upon completion of the property, the property is complete. It doesn't make any difference if the builder will remain financially viable after that. The property is complete upon completion.

 

[Howard Klahr]

The question is, does the value of the cash flow to that investor represent market value for the property,

Yes, in that the purchaser is buying the pre-sale contracts and the completed improvements. Its a property rights issue as opposed to value definition issue. Similar to fe Simple vs Leased Fee