Valuation of a partially completed building

[Roger Murdock]

Suppose you are appraising a new apartment building, currently under construction. Say it is 50% complete. Client wants prospective as-stabilized, prospective as-completed, and current as-is market values. Figure that it will be 6 months to completion and another 6 months to stabilization.

In the income approach, you project that the as-stabilized value (using direct capitalization) will be $1,000,000. Now, in working backwards to the as-completed value, most appraisers, to my knowledge, would deduct - among other things - an expected loss of rent (possibly discounted for time) during the lease-up period prior to stabilization. For example, suppose the annual rent income is $100,000, and you expect a straight-line lease-up during the 6 months following completion, then you might take around $50,000 off the as-stabilized to come to an as-completed value of $950,000 (assuming 100% stabilized occupancy, for simplicity).

Now, to arrive back at the as-is value (based on the income approach), you would typically subtract the remaining construction costs from the as-completed value, in order to work down to the as-is value. The question is, should the loss of rent during the remaining construction period (i.e. the first 6 months, from current date until completion) be deducted as well? I have not seen this done, but to me it seems logical, given that there is certainly no rental income during this time. Have you seen this done?

Thanks!

 

[Howard Klahr]

You are on the right track for the "As Completed" value. If it is only 6 mos (or less than a year) you don't need to discount the rent loss as the present value factors here would be negligible. But be sure you can support the absorption rate if it is forecasted to be less than a year. I don't know how many units the assignment involves but with the current economic climate, newly developed rental property has a lot of competition out there.

As for the "As Is" value, you would not deduct rental income here since it is not possible to occupy the property. There are holding costs during the construction period that need to be accounted for such as real estate taxes, interest for the construction loan, marketing/promotional costs to attract the initial tenants upon completion, etc.

By the way, these deductions apply to all three approaches in order to arrive at the "As Completed" and "As Is" values

 

[Roger Murdock]

As for the "As Is" value, you would not deduct rental income here since it is not possible to occupy the property. There are holding costs during the construction period that need to be accounted for such as real estate taxes,

Howard, I beg to differ with these points. Yes, it is not possible to occupy the property. So? That means there is a loss of rent for that time, compared to a stabilized property, which is ultimately the underlying basis for the value via the income approach (using direct capitalization). To ignore this loss of rent simply because there is not building that could be rented at all during this time. It's no different than having a loss of rent due to renovations or the like. To be sure, I have heard other appraisers take your approach, but I think it is a fallacy. If the property was to be appraised using a DCF, there would certainly be no rental income during the construction period.

Similarly, I would not take a special deduction for real estate taxes during the construction period, as real estate taxes are assumed in the expense side of the income capitalization to begin with. To the contrary, it might be necessary to add in the difference between the current real estate taxes and the stabilized real estate taxes, as the current real estate taxes are probably lower since there is no completed building in place yet.

By the way, these deductions apply to all three approaches in order to arrive at the "As Completed" and "As Is" values

Sales Comparison Approach - agreed, assuming the comparable sales were all stabilized buildings (typical).

Cost Approach - normally reflects an as-completed building; to arrive at stabilized value, one would ADD the rent loss amount (etc.). To arrive at as-is value, one would deduct the remaining construction costs, and (according to me) the rent loss amount during the construction period.

Thanks for your input, Howard!

 

[Howard Klahr]

Mark,

Your point with regard to deducting rent loss during the construction period would be like deducting rent loss in valuing vacant land as it is not rented at this point either.

When valuing improvements, the improvements are generally considered to be completed first before deducting for rent loss.

The real estate taxes in the income approach are for the stabilized operation of the property, the real estate taxes in a DCF addressing the construction period reflects the vacant land, as applicable and the incomplete status of the improvements. This is very similar to how a subdivision analysis is performed and this expense item is one of the costs included during the construction period. You need to remember that the "As Is", "As Completed" and "As Stabilized" values all reflect different periods of time.

You comments about the cost approach are basically correct. Typically the cost approach would include an allowance to address obtaining the initial occupancy of an improvement and I was referring to this point in the process with regard to the deductions.

 

[Roger Murdock]

Mark,

Your point with regard to deducting rent loss during the construction period would be like deducting rent loss in valuing vacant land as it is not rented at this point either.

Vacant land is typically valued using comparable vacant land sales, so there's nothing to deduct. In this case, the partially complete building is being valued based on the capitalized income of the stabilized completed building, so I believe that all interim rent loss until stabilization - from day one - should be deducted.

 

[Ryan Bailey]

Also, on a somewhat unrelated item, if the project is in financial distress and you don't know the full history of the project yet, make sure that the improvements can be finished. We have done a couple of projects that have set for sometime in an unfinished state and according to the engineers involved in both projects the improvements are junk because they have been exposed to the elements for to long... the foundations and iron work all have to be torn down!

In both cases the banks were unaware of the issue and are now responsible for the removeal of the current improvements per the city.

http://www.azcentral.com/business/articles/2008/04/16/20080416cr-elevation0416.html

 

[Roger Murdock]

There is a USPAP Advisory Opinion that states that any prospective valuation of proposed improvements must, at the very least, include an extraordinary assumption that the improvements will be completed as proposed by the date of valuation.

 

[Howard Klahr]

Marc,

1) Collection of rent implies that the property is capable of being occupied for the purpose/use for which it is intended. A lease agreement would be contingent upon obtaining a certificate of occupancy and you can't get the CO unless the property was completed.

2) Not that I agree with your position, but if I were to assume that is was valid, you would need to adjust the market rent applied to the space for condition.

 

[Lost Cause]

Now, to arrive back at the as-is value (based on the income approach), you would typically subtract the remaining construction costs from the as-completed value, in order to work down to the as-is value. The question is, should the loss of rent during the remaining construction period (i.e. the first 6 months, from current date until completion) be deducted as well? I have not seen this done, but to me it seems logical, given that there is certainly no rental income during this time. Have you seen this done?

Have I seen this done? No, never, and this bank does a lot of construction lending meaning I have reviewed hundreds of appraisals on proposed developments. I can see the logic behind your point, but the difference between as completed and as stabilized is not the same as the difference between as is and as completed. The former is based on income capitalization and the latter is based on cost.

 

[Roger Murdock]

Have I seen this done? No, never, and this bank does a lot of construction lending meaning I have reviewed hundreds of appraisals on proposed developments. I can see the logic behind your point, but the difference between as completed and as stabilized is not the same as the difference between as is and as completed. The former is based on income capitalization and the latter is based on cost.

I have never done it myself, nor have I seen it done. Nonetheless, I still think it should be done. If the basis for the as-completed value is the stabilized income being capitalized, and the as-is value is then being based on the as-completed value, the lack of rent during the remaining construction period should be deducted. I have yet to hear one good reason why it should not be so. Yes, there is no building to be rented at that point. So? No rent is no rent.