When Market Conditions and Buyers Expectations Differ

[Gobears81]

What I am seeing is increasing rents and property prices but more businesses having issues with paying for it all out of proceeds. Although gross tax receipts are increasing, it's clear cost is leaving a narrower margin to the businesses.

Interesting - I have been hearing how commodity prices are going down, so depending on the industry, that might help, but some price competition (on products, not real estate) is slowly trickling back in also. Still waiting to see how interest rates will impact conditions when the bulk of borrowers have to refinance the balloons at higher rates.

 

[Terrel L. Shields]

Interesting - I have been hearing how commodity prices are going down, so depending on the industry, that might help, but some price competition (on products, not real estate) is slowly trickling back in also. Still waiting to see how interest rates will impact conditions when the bulk of borrowers have to refinance the balloons at higher rates.

Some like auto dealers went from high premiums to low sales and falling prices. But restaurants etc. are continuing to see high labor, high food costs, and higher rents, utilities, etc. I talked to a mechanic who said he is wasting time replacing defective "new" Chinese parts and real OEM parts are hard to get. The companies are subbing out these parts to the Chinese. And a while back a guy told me the parts he gets to fix electrical motors are commonly defective. He was ready to close shop over it. It's hard to keep a store open. Anything popular is on backorder.

 

[George Hatch]

Commercial values can be manipulated.
I can give the tenant many freebies like several months of free rent and credit in remodeling in exchange for higher future rents.
Then when tenant pays the higher rents (fooling the appraiser and investor), I can get higher valuation based on cap rates.

You literally don't know what you're talking about. We perform rental surveys for the specific purpose of identifying those trends. Then we take rent loss/bonus rents into consideration.

Let's say you overstate your net income on your multi-tenant retail. I only capitalize that portion of the net income that is attributable to the market rents/expenses. If there's additional income that isn't supported in the market I just tally the dollar amount over the remainder of those leases and tack that on as an adjustment. I don't include it in the direct calitalizatin.

For example, you might report a net income for your 10000 sf retail property at $200k whereas the market rents/vacancies are pointing to $140k. Even if I were to believe the additional $60k was real I'm not going to value it by assuming its continuance in perpetuity and therefore using a cap rate on it. I'm going to tally the rents based on their current lease option. If the average length of time on those leases is (let's say) 24 months then the total of those bonus rents only amounts to $120k. Not $60k / .06 cap rate = $1M.

It won't look like this
$200k / .06 cap rate = $3,333,333

But rather like this:
$140k / .06 cap rate = $2,333,000
+_(sum of bonus rents)_$120,000
--------------------------------------
________________________$2.45M

(I also state that the reported rents are not supported in the market and use an EA that they are accurately being reported, so the lender knows to check up on them)


I could run a DCF on the bonus rents (or rent loss) but the outcome would remain the same except perhaps for some rounding due to the increased flexibility in the DCF to consider the rents individually.

 

[Joe Flacco]

Looking at that, the cap rate is such a big number. Difference between 6% and 5% is 20% difference in indicated value.

How do you guys develop the cap rate and how much time is spent on that versus developing market rent?

 

[George Hatch]

My point being that we don't do rent surveys because the forms are set up that way. We do it in order to compare the contract rents or stated rents with the prevailing trends in the market. If I have low rents in a multi-family property that is subject to rent controls which limit annual rent increases then that translates directly into its value to those buyers. Same if I have a govt rent on an office building which is paying above market rents - the investors are buying the income stream.

 

[George Hatch]

Looking at that, the cap rate is such a big number. Difference between 6% and 5% is 20% difference in indicated value.

How do you guys develop the cap rate and how much time is spent on that versus developing market rent?

There are several ways to do it, but the one method I use the most is to extract them from the comparable sales data. Obviously to include the less directly comparable comps besides just the ones I present in my report.

Another variation that's common is that sometimes the brokers depict an unreasonably low expense ratio, or fail to include the new tax assessment that would be based on the current value. If all my comps are reporting expenses in the 35% range and one of them reports 20% then that will explain why the reported cap rate for that one is so low.

As well, if a property has vacant units, those will usually be projected at the market rate because that's how we expect the buyers to handle those units. That's another reason why we take rental surveys very seriously, even for 2-4s. Look at everything we can find, pick the most similar comps and look for the trends. I'm commonly looking in several databases for rental comparables because none of them have it all. I sometimes spend 2x longer looking for good rent comps than I spend looking for sales comps, and I spend a lot of time looking for sale comps.

 

[Joe Flacco]

Is it standard practice to round to 6%? Or is it more like 6.1% or 5.7%?

 

[George Hatch]

These are all great questions to be asking. Personally, I round to the 0.0025. Most CGs I see do it that way, although a relative few will use closer rounding.

When I reconcile, I take into consideration how close my subject's contract rents are to market rents and I keep tabs on which comps have such rents. So if my subject and some of the comps have lower-than-average rents that would make them more similar, income-wise, to the subject. Another thing I sometimes do is to weight the cap rate based on how much/little upside there is for a buyer to increase the rents. If my subject is already at the top of the range then I'll use a higher end of the range (more conservative result) for the cap rate, and vice versa if the rents are low and there's a lot of room for short-term increases.

All RE is local, but in my region and in my experience, the relationships between income expectations by the buyers and the values for multi-family are so close that I adjust my value indicators by income multiplier. I don't grid those sales out and make line item adjustments. That's not the only way to do it but it is one way.

FTR, I despise the adjustment grid on the 1025 form (it's my least favorite form ever). It works okay if your subject and all the comps are of similar type, unit count and room count but that isn't possible in most market segments, even in this region.

 

[Fernando]

Even in same neighborhood, different tenants have different cap rates. AAA tenants have long term leases and generally increase say 5% or 10% every year thus contract rent is set.
Appraiser needs to find appropriate market rent for different quality tenants. Yet these days even large firms like Red Lobster can go bankrupt.
We're not in a stable commercial market.

 

[Ricky LaFleur]

Is it standard practice to round to 6%? Or is it more like 6.1% or 5.7%?

The lower it gets, the more precision will matter. Lack of sufficient data and a wide indicated range argues for less certainty in the final cap rate IMO. Ag land cap rates for cropland may indicate from a set of sales a typical range of say 2.00%-2.15%. I'll weigh the similarities and differences of those sales and resulting cap rates to support the final cap rate for subject of say 2.12% or whatever is supported. Ask Terrel about poultry cap rate ranges if you want to hear about a wide range (pun intended ). Can be similar with a mobile home park (mobiles included) or motels. If your extracted cap rates vary from 10% to 16%, opining a supported cap rate to the thousandth decimal will look about as silly as rounding an opinion of value from $3,499,142 to $3,499,000.