Is the Income Approach always viable?

[Kathy in FL]

I, too, work in a rural market without much commercial rental activity. Lots of times, a property is unique and has no competitors around here. (Say, the only marina in a small fishing village.) If I've examined all of the other little fishing towns within about four counties, and still haven't found a marina sale...I've been known to rely on the cost approach alone. Ditto obviously for churches and other unusual properties. (You'd be surprised how many weird subjects there are.) Ever done a sawmill? A dairy? A bowling alley? A place that makes those little concrete statues? A shopping center that has some rental units in singlewide mobile homes? A 60,000 square foot former clothing factory being used by a charity as a food distribution center in a town of less than 2,000? Sometimes, there just aren't any comps and no rental data and you have to do the best you can. Too bad there's nothing in USPAP about that.

Kathy

 

[Steve Owen]

I think USPAP does cover that. When there is absolutely no data, then the approach is not applicable. However, in some cases, a little creative thinking can produce the data. A C-store miles from nowhere can still be compared to ones in more populated areas, perhaps based on gallonage or gross sales. The church might be easily converted to daycare space (I've seen them be converted to a number of different things) and, unless its a value in use appraisal it might be appropriate to compare it with something like that. Even if you have no marina sales, you still might be able to develop income data. In the case of the shopping center in mobile units you might compare it with somewhat better space, especially if you could also find something that was poorer as well. My thought on the subject is that using an approach with data that is not very good is generally better than abandoning the approach, with the caveat that you want to discuss the credibility of the data and consider that in the weight you give the approach. I'm not saying you did wrong in any particular situation; I don't know your market and therefore don't know whether the various approaches are applicable or not in the situations you described. However, I do think that in many cases there is a possibility of developing data that would allow the approach to be used. As I said before, you might not weight it very heavily if the data is not too good.

 

[Terrel L. Shields]

>>However, if the owner is willing, I have used the books of the current business to provide a projected reasonable rent....<<
You mean the "real" books or the "cooked" books provided the IRS? I bet more than 1/2 small businesses keep double books or the cooked variety to reduce taxes. They are very reluctant to show the "real" books.

Steve, I live 75 mi. S of Joplin, I know what you are saying about the market, though I don't work Mo.

 

[Fred]

The income approach appraises the leased fee interest. When the property is owner-occupied there is no leased fee interest. Isn't property rights one of the first items on the typical sales grid? It seems like a confusion of Use Value with Exchange Value, but I suppose you could extract an implied cap rates or multiples from user purchases. However, it's a bit like using income capitialization for SFR's. What would be the typical reaction to an SFR appraisal based on direct capitalization with a well-suppored, market-extracted 2.5% cap rate? Should the typical reaction be different for using income capitalization on an owner-occupied building?

This does raise a recurring question for me. My market is also small, but there is an obvious difference in prices paid by investors and the prices paid by users - which is "market value"?

Terry, to answer your question about the difference between a location adjustment and depreciation in the cost approach - One is an extrapolation from an actual price from the sale of a real property. The other is an extrapolation from an amount that is not a price from a property that does not exist.

 

[Paul Ness MAI]

If you complete an income approach based on the terms and conditions of an existing lease, then it represents the leased fee interest. If you are completing an income approach based on market rent, vacancy and expenses, then you are appraising the fee simple interest.

All three approaches can be used to estimate either the leased fee interest or fee simple interest. In both the sales and cost approaches, a line item adjustment can be made by calculating the increase or reduction in value caused by an existing above-market or below-market lease.

 

[Fred]

"If you are completing an income approach based on market rent, vacancy and expenses, then you are appraising the fee simple interest."

One of these day when I get a chance, I will have to think this over. For now, it doesn't quite set right. It may be possible that fee simple and leased fee at market rent are 'mathematically equal,' but they are not the 'same thing.' not the same set of sticks out of the bundle of rights. Fee simple means no encumberances. A lease is an encumberance. So, one would find the unencumbered value by first assuming an encumberance that does not exist ??

"All three approaches can be used to estimate either the leased fee interest "
The idea of appraising leased fee by replacement cost makes no sense to me whatsoever.

"a line item adjustment can be made by calculating the increase or reduction in value caused by an existing above-market or below-market lease."
Why would I want to do that? Leased fee is the right to receive money and perhpas a reversion. Why would I care what the property is worth unencumbered? It's not unencumbered. If, for some reason, someone wants to know the unencumbered value, then why would I appraise the lease and make an adjustment; in that case why not just appraise as if the lease does not exist?

 

[Paul Ness MAI]

When you appraise the fee simple interest and apply an income approach you are estimating the "potential" gross income for the property, less market vacancy and operating expenses. You are estimating the income "potential" of an unencumbered property. The value by the income approach when used to appraise the fee simple interest reflects the present worth of "potential" future income and reversion. Yes, direct capitalization includes both the return on and return of equity - which can be applied to both the leased fee and fee simple interests. This is all stuff from "Appraisal 101".

Regarding the other two approaches, when you are appraising the leased fee interest of a lease encumbered property, the cost and sales comparison approaches will not reflect the leased fee interest unless an adjustment is made for the interest appraised. You said yourself that one of the first adjustment lines on a sales approach grid is for "interest appraised". That can go both ways.

I've got to run to an 8:30 appointment. Anyone else out there care to help Steve on this one?

 

[Fred]

Paul,
After years of raising the same questions, I have become convinced that I probably beyond "help."

Perhaps, I should have said that property rights are an item on the comparison grid, rather than adjustment grid - because it is the necessiaty, method and reasonableness of the adjustments that I am questioning.

A recent assignment for me involved commercial land subject to a 30 year lease. During the orignal negotiations, the land tenant entered a contract with a government agency to construct and sublease an office building to the agency. Some 20 years into the leases, the agency is considering buying out the divided interests because the building has air quality problems and they are reluctant to invest in curing the problem as sub-tenants.

It seems to me that there are two things that I do not care about in making this appraisal: 1) the replacement cost of the building and 2) the fee simple market value of the property (as a whole or divided) - because I am appraising a leased fee; the present value of income streams. This idea that I can "adjust" replacement cost of this building into the present value of future benefits, an income stream that innures to the land tenant, is not part of any Appraisal 101 that I comprehend or remember. If, for example the replacement cost of the building is $1.4 million and the present value of land tenant's income stream is $1 million. are you arguing that one "adjusts" the repplacement cost to leased fee value by subtracting the 400k difference; and that having done so, one has substantiaed or supported the $1 million income capitalization? I can understand that one can adjust cost into adjusted cost and one can adjust value into adjusted value, but adjusting replacement cost into the present value of an income stream...?

On your example of using direct cap for fee simple of an unrented building, I am unclear which property rights that "appraised value" represents. If you are talking about a 10% cap and 12% yield sub-market, your appraised value would not represent that market, because a rent-up adjustment would still be necessary to satisfy those investor criteria. Also, in my questionable experience, owner-users pay more than an amount equal to market rent capitalized. So the "investor" would pay less than the appraised value and the owner-user would pay more; and the appraised value would represent the "most probable" outcome of neither transaction.

Still crazy after all these years.
Steve

 

[Paul Ness MAI]

I will reiterate the facts. First, the full cost approach (land and building) in an appraisal normally would reflect the fee simple interest. If you are appraising the leased fee interest of a property and the income approach is based on the terms and conditions of that lease, then the income approach reflects the leased fee interest. Unless you make an adjustment in the cost approach, you will then have two approaches reflecting two different ownership interests. The adjustment would be made by calculating the present value of the difference between the “contract” net cash flow over the remaining term of the lease and the “market derived” net cash flow during the same period. If the contract cash flow is greater than the market, you would add the amount to the cost approach. If the market is greater than the contract, then you would deduct. What I am trying to get across is that the two approaches are concluding different ownership interests. Bottom line – are you saying that you never complete an income approach on an unencumbered property?

Regarding your recent assignment, you could appraise the leased fee interest of the land owner, the sandwich leasehold of the building owner, and the leasehold interest of the agency (if any). You could also appraise the fee simple interest. Or should you do all the above? Here is what I am getting at – what should the agency pay? Should they even buy? After they purchase all the property rights, they will own the property in fee. Perhaps if you provided all the numbers, they could more accurately complete their due diligence and take into consideration the cost of curing the building problems versus the loss of value they may end up with if they buy out the land leased fee and the building sandwich leasehold ending up with the fee simple (I’m assuming the sum is greater than the whole, which may or may not be the case).

This stuff is too heavy to worry about on a beautiful warm Friday afternoon right before a three-day weekend. By the way, are you the Steve Santora MAI with Wells Fargo or are you the Steve Santora in the Virgin Islands? If you are the latter, do you have any job openings? I’ll do the income approach any way you want me to!!!

 

[Fred]

Paul, asnwering your points in reverse

As far as I can tell, the US Postal Service and the Appraisal Foundation think I am boh from the VI and at Wells Fargo. Kudos to your attention to detail. As far as employment, I usually charge appraisers to come down from the cold and work here. I am sure your capitalization is first rate, it's the theory that one can miraculously turn the 'water' of repplacement cost' into the 'wine' of net present value that needs demystifying.

I understand your point about the capitalized difference between contract and "market" - but unless there is some special purpose and intended use, why would this difference matter? It is only the contract rent stream that would be sold, not the market rent stream, so why would I be adjusting? If the problem entailed discounting, I might project a change at option renewal time. I would be concerned if the difference between contract and market is significant. If contract is too high, then there may be default. If contract is well below market, then a lower cap rate may be indicated. To answer your bottom line quesion, I would say (almost) never, would I be doing a "cost approach" on leased fee interest. However, if a situation arose where building a new one was a real alternative to buying an existing one, I would consider it.

On the assignment I mentioned, I even offered them listings that would make moving a competing alternative to buying or continued renting. I offered to do a feasibility study for them to make the decision, but as usual, they said no.

I worked on a leased fee and sublease yesterday. (I don't care for "sandwhich.") The current owner purchased the rented property last year. The building replacement cost is about $90/sf. Last year's leased fee purchase price was over $1,300/sf. So that one would require adjusting the cost approach about 1,000% - that is if one believes in miracles.

Enjoy your holiday. I will spend some time with my son, but I still plan to generate three ROW reports over the weekend. Come rain, shine or wine.