Comments on "You Can't Get the Value Right If You Get the Rights Wrong".
We, the cosigners of this response, read with great interest the article by David Lennhoff, MAI, SRA, entitled "You Can't Get the Value Right If You Get the Rights Wrong" (Winter 2009). The following comments are not an official position of the Maricopa County Assessor's Office, but are a reflection of the thoughts and concerns we have over what is being proposed in the article.The premise of the article appears to be that single-tenant, built-to-suit (or custom) commercial real estate can be overvalued if an appraiser focuses solely on property-specific factors, rather than general market forces, to estimate market value. The article then goes on to assert that "the best support for the components of both the sales comparison approach and the components of the income capitalization approach is second-generation space." To automatically default to valuing first-generation space as if it were second-generation space ignores the market's acceptance of the property.
However, before we address the methodology suggested in the article, we must point out that anytime an appraiser suspends reality (as suggested by this article) he or she has by definition created a hypothetical condition. Hypothetical condition is defined in the Uniform Standards of Professional Appraisal Practice (USPAP) as "that which is contrary to what exists." We understand that using comparables that do not exactly mirror a subject property does not constitute a hypothetical condition; however, when you intentionally set out to value the subject under a set of conditions that do not exist there is no choice but to call this a hypothetical condition. When you utilize comparables that do not reflect the subject's condition, you must be sure to account for all of the potential differences.
We would also caution all appraisers that whenever a hypothetical condition is made, appraisers must make sure they have met the use and disclosure requirements found in USPAP. While appraisers are required under USPAP to report that the use of the hypothetical might have affected the assignment results, they are not required to report on the impact of the assumption. However, we would suggest, depending on the use of the report, that the failure to disclose the impact might render a report misleading.
The article states that all built-to-suit properties are sold or leased solely on the basis of recouping the original cost to develop and never on market conditions. We would respectfully suggest that there is a direct relationship, particularly with relatively new properties, between sale price or lease amount and the cost to develop. This relationship is not absolute, but tempered by market conditions. This is why it is important that all appraisers make sure they understand the motivation of the market and the market participants. Please do not misunderstand what we are saying here. There certainly are times where built-to-suit properties are sold or leased solely on original cost to develop ignoring market conditions, but to make a blanket statement that this is always the case appears unrealistic. This is why a market analysis is so important and why we have Standard 1-3 in USPAP.
The real question that must be answered for all single-tenant, built-to-suit properties is how have they been accepted in the market? If the property is brand new and there is nothing similar in the marketplace, then the risk that the market may not accept the subject is higher. But if the subject has been successful in the marketplace for a number of years without substantial modifications then this is a demonstration of market demand/acceptance for the property. This demand/acceptance is strengthened when there are similar properties in a marketplace continuing for a number of years as first-generation space even when these properties do not change hands. The demand/acceptance is further supported if there is new construction of similar properties. All of these factors are exactly what Standard 1-3 envisions when it states an "appraiser must, identify and analyze the effect on use and value of ... economic supply and demand ... and market area trends; and develop an opinion of the highest and best use of the real estate." This analysis is the foundation of making any appropriate adjustments for custom-developed properties.
Utility is one of the four elements of value. Utility is the ability of a product to satisfy a human want, need, or desire and generally the greater the utility a property has, the greater its value. You cannot simply assume that utility and uniqueness are inversely related from a market standpoint. The fact that a property is unique does necessarily have an impact on its value one way or the other. Measuring the utility of a unique property is not easy, but there are certainly reasonable benchmarks that can be set up to quantify this factor.
The more unique a property is, the more important it is to establish reasonable ranges that the subject's value must fall between. It is easy to get too fancy and outsmart oneself with complicated ways to measure obsolescence and superadequacy. This is one of the great values of the cost approach. The cost approach with only depreciation for wear and tear can provide a reasonable upper end of such a range quickly and easily. The bottom end of this range can also easily be established by examining second-generation space.
Second-generation sales may have a utility equal to or less than first-generation space. The original user, for whatever reason, is no longer utilizing the property. This difference in utility may be big or small, but must be recognized, quantified, and if appropriate, adjusted for. Therefore, all other factors being equal, a second-generation development sets the bottom end of the reasonable range of value. Again, utility is the key.
If the second-generation space is able to capitalize on all of the utility of the development, the difference between it and first-generation space may be minimal or nonexistent. However, if the second-generation user, for whatever reason, is not able to capitalize on the utility of the development an adjustment to reflect this difference must be attempted. To automatically default to utilizing second-generation space to value first-generation space without accounting for the potential difference in utility is like saying you must adjust the best location in town downward because no other property has the same attributes. It punishes the owner of the property for its unique nature.
We also wish to caution readers to make sure they have adequately accounted for all applicable laws and ordinances that may impact this type of work. The article specifically talks about these types of properties being valued for tax assessment purposes. Depending on the state or jurisdiction in which the assignment will be utilized there may be additional factors to consider. Courts and legislatures frequently redefine familiar appraisal terms, creating connotations that are very different from that to which the appraiser may be accustom.
For example, valuing property for tax assessment in Arizona requires the appraiser to take into consideration the subject's current use not just highest and best use. Arizona Revised Statutes state:
42-11054. Standard appraisal methods and techniques
C. In applying prescribed standard appraisal methods and techniques:
1. Current usage shall be included in the formula for reaching a determination of full cash value. (Emphasis added)
The article states the "current use value" estimate would be higher than a "value in exchange." We would suggest that depending on the particulars of the subject property, its value in use could be higher, lower, or similar to market value.
We also would like to bring to readers' attention the following courts cases, which may be of use to appraisers who are considering assignments for tax assessments.
In STC Submarine v. Department of Revenue (320 Or. 589.890 P.2d 1370 (1995)) the Oregon Supreme Court relied on and quoted twice the following statutory language: "If the property has no immediate market value, its real market value is the amount of money that would justly compensate the owner for loss of the property." To paraphrase: the market value of the current use is to be interpreted as the value in use.
In Sperry Rand v. Department of Revenue (112 Ariz. at 581, 544 P.2d at 1096) the court stated that a "special purpose building with little or no value on the market but having great value in use to the owner should not be assessed by use of the market technique but, instead, by a cost less depreciation method."
Similarly, in New York Stock Exchange Building Company v. Cantor (223 N.Y.S. 64 (1927), aff'd mem., 162 N.E. 514 (1928)) the court indicated that a "stock exchange building, which could be used only by stock exchange, had no value on the market and was to be assessed at reproduction cost less depreciation; owner's argument for zero valuation rejected."
In conclusion, while some of the ideas presented in the article have merit, we would caution the reader to be careful. First, be careful with complicated valuation methodologies that may lead you to a conclusion that more straightforward analysis will not support. Second, be careful to understand the landscape of your environment, i.e., make sure you are aware of any applicable statutes or court cases that may impact your analysis.
Charles Krebbs
Deputy Assessor
David Gillies
Deputy Assessor
Kim Kobriger, MAI
Manager Internal Audit
Michael G. Husij, MAI
Deputy Assessor
Keith E. Russell, MAI
Assessor, Maricopa County
Phoenix, AZ
Author's Response
I must say, in the 20+ years I have been publishing in The Appraisal Journal I have never had an article generate as much response as this one. It is quite gratifying that so many are reading it. I sincerely appreciate it.
I will try to address the issues raised by the Maricopa County assessors in the order they appear in their letter.
The first comment suggests I espouse automatically defaulting to valuing first-generation space as if it were second-generation space. This is not the case. What I am saying is that once the analysis is made, it will be obvious that some of these properties can only be properly valued in terms of their market value by using second-generation space. However, there is nothing automatic about it. The analysis must be made.
The next comment refers to my statement that "appraisers must suspend reality." They suggest that this would require a hypothetical condition, and cite USPAP as the basis for this. This is not correct. When a property is leased and it sells, what sells is the leased fee estate. However, if the assignment is to estimate the market value of the fee simple interest, then the appraiser is going to estimate something that is unreal in terms of what would actually transfer. This does not require a hypothetical condition however. It is very much like estimating the land underlying an improved property. USPAP, in fact, specifically addresses both of these issues in the USPAP Frequently Asked Questions (2008-2009 ed.). FAQ 113 addresses the question of valuing just land and answers, "Yes, you can perform this type of assignment in compliance with USPAP. Appraising the land component of an improved property does not necessitate the use of a hypothetical condition." FAQ 139 effectively says the same thing about valuing the fee simple interest for a property that is currently leased.
Their next comment is that "we would respectfully suggest that there is a direct relationship, particularly with relatively new properties, between sale price or lease amount and the cost to develop." Of course there is. That is why the sale price, which is driven by the lease rate, which is driven by the custom cost to build, is rarely useable in the context of a market value opinion of the fee simple interest. I would ask, how many fast-food restaurants or bank branches have the Maricopa County assessors seen that were built speculatively? The answer is none.
In the comment about depreciation they say, "It is easy to get too fancy and outsmart oneself with complicated ways to measure obsolescence and superadequacy. This is one of the great values of the cost approach. The cost approach with only depreciation from wear and tear can provide a reasonable upper end of such a range quickly and easily." Thorough depreciation analysis is neither too fancy nor complicated. However, if it is not properly estimated, the conclusion by the cost approach is not going to be right. The cost approach, with only depreciation from wear and tear, is of little use and potentially misleading when the purpose is an estimate of the market value of the "as is" property. Only when depreciation of all types--physical, functional, and external--has been properly estimated will the cost approach provide a meaningful and credible indication of market value. Remember: Cost new depreciation (all types) = value.
The letter also states that "second-generation development sets the bottom end of the reasonable range of value"; however, this is if the value sought is market value of the leased fee interest. The assessors say using second-generation space "punishes the owner of the property for its unique nature." Unfortunately, market value opinions must be blind to the specific owner. Investment value takes the specific ownership/buyer into consideration, but that is not the question being asked. An appraiser cannot be concerned about the correct answer's effect on the owner. His or her only concern must be finding the correct answer. House appraisers have been comfortable with this for years. They freely recognize that often homeowners customize their houses at a cost that does not have a chance of being recouped in the market through a sale. This is simply functional obsolescence at work.
The assessors caution the readers about different laws in different states. I make the same observation in footnote 1 of the article. They state that the article claims value in use would be higher than value in exchange, and note that it would depend on the particular property. I could not agree more; in fact, the article states, "A property that has been custom built for the current occupant--be that an owner-occupant or tenant--will usually (emphasis added) have a value in use that is higher than the property's market value."
Their final comments cite several court decisions that seem to confuse the distinction between the difficulty in finding market value with the acceptability of using value in use in its place. Inasmuch as I am not a lawyer, I asked an Arizona lawyer with whom I have worked and for whom I have much respect to provide comments about these assertions. He has indicated with respect to the Sperry Rand case, the Arizona Supreme Court expressly upheld a large reduction in value that was arrived at using primarily the sales comparison approach. More importantly, the court expressly rejected the County's claim that the property at issue had to be valued under the cost approach because it was a "special purpose building." According to the court, "The [County] maintains that the cost approach was the only valid method of appraisal because the Sperry Rand plant is a special purpose building which has no market or rental basis." County of Maricopa v. Sperry Rand Corp., 112 Ariz. 579, 581, 544 P.2d 1094, 1096 (1976). However, the operative language of the court's holding, which affirmed the trial court's reduction in value, states, "While [the County] contend[s] that the only proper approach was the cost approach, the issue necessarily depended upon a resolution of the facts concerning the nature of the property in question. The trial court necessarily concluded that the subject property was not of such a nature that the cost approach was the exclusive method of arriving at full cash value. From the evidence presented, we cannot say that his findings are unreasonable." Full cash value, which is the mandate in assessment valuation in Arizona, is defined as being synonymous with market value under Arizona law. A.R.S. [section] 42-11001(6).
As I state at the conclusion of my article, sometimes with these types of properties, "it is very difficult to find support for market rent, market sales comparables, and market overall capitalization rates. However, the value in use to a specific tenant or owner does not become market value just because support for the latter is hard to find." As stated in the 13th edition of The Appraisal of Real Estate (page 28), "If a property's current use is so specialized that there is no demonstrable market for it but the use is viable and likely to continue, the appraisers may render an opinion of use value if the assignment reasonably permits a type of value other than market value. Such an estimate should not be confused with an opinion of market value.... However, it is sometimes necessary to render an opinion of market value in these situations for legal purposes. In these cases, the appraiser must comply with the legal requirement, relying on personal judgment and making explanations and disclosures that are relevant and that can fully inform the intended users of the appraisal. Note that the type of value developed is not dictated by the property type, the size or viability of the market, or the ease with which that value can be developed. Rather, the intended use of the appraisal determines the type of value to be developed."
David C. Lennhoff, MAI, SRA
Rockville, MD
David Lennhoff's article in The Appraisal Journal, "You Can't Get the Value Right If Your Get the Rights Wrong" (Winter 2009), raises some interesting points.
The most important, in my opinion, is that appraisers need to be careful that they understand the property interest involved in the assignment. Since a leased fee estate is involved in the example given, the second point might be to state in the transmittal letter that the assignment involves a leased fee estate, and the value may not equal the value in fee simple.
One point needs clarification. In his discussion of the sales comparison approach relating to the leased fee value, Lennhoff states, "These are not arm's-length leases." The Dictionary of Real Estate Appraisal's definition of arm's-length transaction is "a transaction between unrelated parties under no duress." These are, in my opinion, arm's-length leases, but the income was not based on market rents. The strength and credit rating of the tenant is much more important than the real estate value to a typical purchaser of these type properties.
Another important point Lennhoff makes is that the cost of the improvements needs to be based on reproduction cost. I agree with Lennhoff that the cost approach does not produce an independent indication of value. However, the approach would be very important to a lender or purchaser of the leased fee. The owner would need to ensure adequate insurance is in place to reproduce the improvements, in case of their destruction, in order to avoid cancellation or modification of the lease.
Even if the client does not request a fee simple value, it would still be desirable to provide one, especially in light of the present economic conditions. Most of our lending clients request both indications.
One last suggestion. In my opinion, the leased fee value should always be broken down into components. To illustrate, using the figures in Lennhoff's article:
Total property value $22,970,000 Broken down as follows: Land value $3,500,000 Value of improvements $8,250,000 Total fee simple value $11,750,000 Plus value of lease $11,220,000 Total leased fee value $22,970,000
I hope this adds something to the discussion of Mr. Lennhoff's article.
Henry C. Entreken, Jr., MAI, SRA
St. Petersburg, FL
Author's Response
I appreciate Mr. Entreken's comments and hope to sufficiently respond to them.
My statement about leases in a sale-leaseback not being arm's length reflects the fact that these properties are not put on the market. Rather, they are leased to the party that had them built. This is simply not representative of an arm's-length deal in which the property is offered for rent to people with no connection to it.
With respect to Mr. Entreken's comment, "Another important point Lennhoff makes is that the cost of the improvements needs to be based on reproduction costs," the article does not include such a statement. It does not matter whether replacement or reproduction cost is used. Both will result in the same indication of market value assuming depreciation is properly handled.
I disagree with the idea that an appraiser should provide cost new and a market value of the fee simple even if it is not part of the scope of work, which is a function of the intended use and intended users. The fact that additional information might be useful for other purposes and by other people, such as insurance and lenders, should not drive what is included in the report. In my opinion, the solution provided should be tailored to the question asked. Sometimes providing more is just as dangerous as providing less. It can confuse the client and the issue rather than proving helpful.
David C. Lennhoff, MAI, SRA
Rockville, MD
I have several items of concern and differing opinions on the article by David Lennhoff, MAI, SRA, "You Can't Get the Value Right If You Get the Rights Wrong" (Winter 2009). The rhetoric in this article is questionable; statements like "These properties are never built speculatively and then put on the market for sale," when applied to a wide range of properties such as drug stores, branch banks, and fast-food restaurants, are not reasonable.
Custom-Built Commercial Properties. Built-to-suit properties are not always special use and may be representative of market value. A Life Time Fitness club is a special use property, but a Walgreens drug store is not. Mixing these two distorts the valuation concepts and is misleading.
Sale leaseback transactions are used to gain favorable mortgage terms and 90% to 100% financing. The credit of the lease is a significant item to the lender and the subsequent buyer. The amount of the lease is in fact the feasibility rent as it is based on the building's cost and land value.
The value in use relates to a narrow market for the user type like the 110,000-square-foot health club, while a 15,000-square-foot drug store retail box has a wide range of potential users.
A custom-built property can be the highest and best use; the drug store is an example of this. A drug store is built to suit, but not a specialized value-in-use property.
Sales Comparison Approach. The concept that leases for drug stores, branch banks, and fast-food restaurants are not arm's length may not be correct. I believe they are market based in most cases. The tenant does not want a rent that falls outside of reasonable percentage of sales volume. In fact these net lease deals are based on significant market research to estimate potential sales volume and market share.
The sale of these net-leased properties must be carefully analyzed. During the past few years many transactions involved 1031 exchanges. These buyers pay more for the credit lease due to their favorable tax situation. Foreign buyers are another example; these buyers would be looking at the security of U.S. real estate, but they do want an inflation hedge as well. Most foreign investors would not consider the flat long-term leases on drug stores a wise investment.
The use of only second-generation sales and leases for estimating market value may be a mistake. I would recommend using both new and second-generation data and focus on the buyer's and tenant's motivation in verification of the transaction. Certainly new shopping center sales and rents are also a reasonable option to consider.
Income Capitalization Approach. Again, we see the use of custom built as a reason to eliminate newly signed leases from consideration as market rent indicators. New leases are one of the best evidences of market rent. Using only second-generation leases may not be a good practice. The reason a net-leased drug store, branch bank, or fast-food property is being leased to a second user is that the initial concept failed. This may be due to a weak location or oversaturated market for the use. If the anticipated sales volume was not achieved then yes, this is a secondary location and the call center or second-user market rent may be applicable. However, if the sales volume is strong and increasing, the initial rent might be below market.
Feasibility Rent Analysis. Earlier this year, Life Time Fitness stock was trading at $10.41 per share, down from $40.00 per share in September 2008, due in part to the financial crisis and lack of available financing for sales/leaseback transactions. The health club example looks very different using the company projections for rent and revenue shown in the following table.
Health Club Example
Size/SF Unit/SF Cost
Cost New 110,000 $177.00 $19,470,000
Site Value 522,720 $6.70 $3,502,224
Total Cost New $183.70 $22,972,224
Contract Rent $29.90 $3,289,000
Capitalization Rate 14.32%
Revenue $154.55 $17,000,000
The use of feasibility rent for the special use property results in over stating depredation in the example. The article indicates that depredation would be 55% for the two-year-old building based on the use of the feasibility example. The functional/external obsolescence was estimated to be $10,756,666. The applied feasibility rent of $18.79 per square foot and the market rent from secondary users of $9.60 per square foot both seem contrived. The actual rent from four sale/lease back transactions in 2008 was $29.91 per square foot; this seems to be the real feasibility rent. The second-user rent may in fact be much less than the indicated $9.60 per square foot, due to the special use features of the large health club. A look at the company business plan projects a three-year period to reach stabilization for the typical center. The example assumes sales revenue of $120 per square foot, or $15,200,000, while the business plan projects revenue of $17,000,000 to $20,000,000 per location.
Business Plan
Memberships 8,500-11,000
Revenue $17-$20M
EBITDA 40%-43%
Investment $27-$35M
Membership 2-6 Year Year
Ramp Opening Months 1 2
30%-35% 45%-50% 60%-65% 90%
Source: life Time Fitness Web site, www.lifetimefitness.com
Conclusions. The appraisal of market value and leased fee can be similar for new properties if the contract rent is within the range of market rent. Eliminating all net lease transactions data may be a mistake and results in underestimating the values. Value in use computation may be justified when
1. The property is fulfilling reasonably identifiable economic demand for the service it provides or which it houses.
2. The property improvements have a reasonable remaining economic life expectancy.
3. There is responsible ownership and competent management.
4. Conversion of the property to an alternative use would not be economically feasible.
5. Continuation of present use is expected.
(See, Society of Industrial Realtors of the National Association of Realtors, Industrial Real Estate, 4th ed. (Washington, DC: S.I.R. Education Fund, 1984), 426.)
This definition would not apply to out parcels with drug stores, fast-food restaurants, or branch banks.
John Blazejack, MAI
Miami, FL
Author's Response
Mr. Blazejack makes several points. I will try to address the important ones in the order they appear in his letter.
With respect to his objection to my statement, "These properties are never built speculatively and then put on the market for sale," I would simply ask, how many freestanding drug stores, bank branches, or fast-food stores has he seen built speculation? I have never seen any, ever.
His sales comparison and income capitalization comments deal with the same issue, but both miss the point. The rent in a sale-leaseback is strictly a function of the cost to construct, and the construction is done to the tenant's custom specifications. The property is never on the market for rent. Although completely legitimate and for good reason--usually to allow the occupant to free up the cost spent on construction so it can build other stores--the rent bears no relationship to market rent. It is typically considered just a financing device. Thus is created the need to consider second-generation space, which would be the reality in terms of rent if the property were placed on the market. This is the foundation of the concept of market rent and/or market value.
As concerns the health club example, it sounds contrived because it is. I made up the numbers to illustrate the point. The example is not a real Life Time Fitness Club, and the numbers cannot be compared to Life Time Fitness business plans.
The last comment is revealing: sure there are legitimate reasons why value in use may be justified. It just is not when the assignment question--the intended use of the appraisal--is asking for market value.
I respect Mr. Blazejack's thoughts and appreciate his interest. Few take the time to respond in writing to an article in the Journal. Those that do, regardless of whether I agree or not, are to be commended.
David C. Lennhoff, MAI, SRA
Rockville, MD
This letter is in response to the article by David Lennhoff, MAI, SRA, "You Can't Get the Value Right If You Get the Rights Wrong" (Winter 2009). In this article, Mr. Lennhoff attempts to rationalize why brand new stores are worth half what it cost to build them. He does this with a cost approach that he admits is not independent, and ignores the fact there are first-generation sales and a current trend toward big-box conversions.
One wonders how these companies became so large by paying twice what their competition pays. His answer, using a fast-food restaurant example, is that they are not in the real estate business, but in the hamburger business. However, there is a reason they want to sell hamburgers at 5th and Main rather than 5th and Nowhere. Why do some big-box locations thrive and others fail when they have the same corporate management and sell the same merchandise? It is not because of the interest being appraised, but rather (as always) because of the location.
This debate continues to swirl in the courts. Unfortunately, the courts (as always) will not be unanimous, causing more problems for appraisers and attorneys.
Thomas J. Scheve, JD
Cincinnati, OH
Author's Response
I am afraid Mr. Scheve has missed probably the primary point of the article: value in use and market value are rarely the same. To try to pass off the former as the latter is exactly why "the debate continues to swirl in the courts." As stated in The Appraisal of Real Estate, 13th edition, "the type of value developed is not dictated by the property type, the size or viability of the market, or the ease with which that value can be developed. Rather, the intended use of the appraisal determines the type of value to be developed" (page 28). If the intended use calls for market value, then value in use is not acceptable, ever.
David C. Lennhoff, MAI, SRA
Rockville, MD
The Appraisal Journal is a publication that presents the competition of ideas in the appraisal field. As such, there will be many articles that present cutting-edge and even provocative ideas. However, I must object to the inclusion of the article by David Lennhoff, MAI, SRA, entitled "You Can't Get the Value Right If You Get the Rights Wrong" (Winter 2009).
The article advocates that custom-built commercial properties (fast-food restaurants, pharmacies, banks, and fitness clubs according to the article) are worth significantly less than they cost to construct. This assertion is made despite the fact that these properties continue to be built (at relatively high costs) and are leased and sold in every major market. While these properties many times involve built-to-suit and sale-leaseback situations, these are not indications, by themselves, that massive amounts of functional or external obsolescence exist in the marketplace. Actually, they are indicative of a healthy market with plenty of activity.
The methodology espoused in this article appears to undermine fundamental appraisal concepts, and advocates the confusion of property rights and obsolescence. The idea that one must "suspend reality" in order to appraise a property is an unthinkable choice of words. As appraisers, we try to incorporate as much reality (market thinking) in our work as possible so that our clients can understand the complex world in which property exists and is valued.
Three major items in the article need to be addressed.
1. The article advocates obsolescence without understanding. I would not be writing this letter if the article had not included the following statement: "It is not particularly important in this situation to identify how much of this amount is functional obsolescence and how much is external obsolescence." In appraisal it is vitally important to understand whether the obsolescence is functional or external. External obsolescence arises from outside of the property and is generally locational or economic in nature; the article does not discuss either situation. This leaves only functional obsolescence as a source for the amount of depreciation estimated in the article.
An appraiser cannot deduct functional obsolescence (or any obsolescence) unless it is supported by observation, logic, or both. In this case, observation of the market appears to indicate that buyers are willing to pay more than the replacement cost of the property. In such cases, it is not impossible that large amounts of depreciation/obsolescence exist, but the appraiser must lay down firm logical footing prior to making such a deduction.
Mr. Lennhoff discusses functional obsolescence due to superadequacy. However, when the cost approach is discussed, he rejects the breakdown method of calculating depreciation--despite the fact that it would be the ideal method by which to examine a superadequacy.
The valuation of a particular fee does not in and of itself create obsolescence. If the leased fee estate is worth more or less than the fee simple estate, an advantage exists to either the lessee or the lessor. This advantage or disadvantage is created by a lease and cannot (by definition) be the source of obsolescence in valuing the fee simple estate. It simply does not exist.
The statement that "the problem with the age-life method is that appraisers frequently select an effective age equal or close to the actual age based solely on the physical condition" denigrates the skill and experience of appraisers. This statement implies that the appraisal community is willfully violating both the Uniform Standards of Professional Appraisal Practice and the Code of Professional Ethics and Standards of Professional Appraisal Practice of the Appraisal Institute.
2. The article has little to do with property rights. The article makes the case that branch banks, fast-food restaurants, fitness clubs, and pharmacies are custom-built commercial properties because they are built to their owners' specifications. Any property that is built for a particular user (as most owner-occupied properties are) contains special features that are custom built for that particular user or class of users.
The article also incorporates the complicated concept of market value versus value in use. These are vitally important concepts for the appraiser to consider; however, there is little discussion of how value in use impacts property rights. The inclusion of value in use appears to be focused on summarily excluding the current use from consideration. Fee simple ownership contains the right of use, lease, and sell; thus, the current use should be considered as one potential use of the property.
3. The article advocates the minimization of relevant approaches to value. The article discusses all three approaches to value, pointing out the limitations (and only the limitations) of each. For example, it points out that properties that are encumbered by a lease are the sales of the leased fee, not the fee simple estate, and he argues that this makes the sales comparison approach less reliable. Appraisers commonly adjust for property rights, why minimize the sales comparison approach just because an adjustment is necessary?
As an alternative, the article suggests that the appraiser use sales of second-generation properties in the sales comparison approach. For branch bank, fast-food restaurant, fitness club, and pharmacy properties, there is a vast difference in utility between first-generation and second-generation properties. (An appraisal valuing a new, state-of-the-art fitness club relying primarily on comparable sales of older or out-of-position properties is unlikely to arrive at a credible indication of value.) The article also advocates using rents of second-generation space or noncomparable space (i.e., retail space when valuing a health club) in the income capitalization approach and for estimating feasibility rent. These recommendations would likely result in flawed indications of value.
Mr. Lennhoff states that all "out of the market" capitalization rates are too low because they are based on the rent being paid by the existing occupant. I have yet to find a pure capitalization rate in the market that is not based on the rent being paid by a particular tenant. As appraisers, we understand the limitations of capitalization rates out of the market, as well as capitalization rates from other sources. Certainly, all rates out of the market cannot be too low.
In the discussion of the cost approach, Mr. Lennhoff indicates that the replacement costs of custom-built commercial properties are too high and depreciation estimated by normal methods is too low. Such a broad generalization, and without examination of a particular property, appears to be advocacy.
Conclusion
Mr. Lennhoff argues that the fee simple values of custom-built commercial properties are well below replacement cost adjusted for observed physical and functional items. According to the article, the primary reason for this is that the difference between leased fee and fee simple creates external/functional obsolescence to the fee simple estate.
The article advocates deducting functional and external obsolescence to account for the difference between the leased fee and fee simple estates. This difference would not typically arise in a properly conducted cost approach because no lease would be analyzed. Functional and external obsolescence can and do exist in many properties, but neither is directly tied to the difference between fee simple and leased fee.
The difference between the leased fee and fee simple estate should be addressed in the income capitalization and sales comparison approaches. In these two approaches, the appraiser researches and analyzes sales and leases in the marketplace. Thus, they can observe the effects of leases on sale price. The problems associated with above- and below-market leases and their impacts on sale price occur in nearly all markets and must always be considered in an appraisal, if present.
Appraising the market value of the fee simple estate of a particular property is challenging. This is true whether the property in question is a custom-built commercial property or a run-of-the-mill office warehouse. Unfortunately, this article further clouds a difficult conceptual situation. The methods and logic expressed in this article are likely to cause problems for appraisers both in ethics and practice and should be avoided.
Joseph E. Mako, MAI
Apple Valley, MN
Author's Response
Mr. Mako's letter makes several points. First, he takes issue with my choice of the words, "suspend reality." I used these words in an attempt to emphasize the common confusion appraisers have when asked to value the fee simple interest in a property that is leased. When leased properties sell, they are priced based on the leases in place, and the price represents the value of the leased fee estate. When appraising the fee, however, the appraiser has to ignore what the property would actually sell for and estimate its worth as if available to be leased at market rates. Because this is not the "reality," I characterized the assignment as I did. I stand by the characterization.
The next comment objects to the statement that, "It is not particularly important in this situation to identify how much of this amount is functional obsolescence and how much is external obsolescence." There are three basic methods of estimating depreciation: age/life, market extraction, and breakdown. Of the three, only the breakdown method separates the depreciation into its components. The other two do not require it or recommend it. This is not to say the appraiser is unaware of potential causes of functional or external, just that the methods do not require dividing to total up.
The third point taken is that the article has little to do with property rights. In fact, the article has everything to do with property rights, thus the title.
Finally, Mr. Mako suggests the appraiser of these types of properties could use sales of leased fees and adjust them. Because there are no sales of fee interest properties, I argue sales comparison is less reliable. It is. I am not saying the appraiser cannot attempt to adjust the leased fee transactions for rights appraised, but without any sales of fee properties quantification of the adjustment is problematic. If the adjustment cannot be supported, these sales cannot be used.
David C. Lennhoff, MAI, SRA
Rockville, MD
 Printer friendly
 Cite/link
 Email
 Feedback
| |
| Author: | Krebbs, Charles; Gillies, David; Kobriger, Kim; Husij, Michael G.; Russell, Keith E. |
|---|---|
| Publication: | Appraisal Journal |
| Article Type: | Letter to the editor |
| Date: | Jun 22, 2009 |
| Words: | 6847 |
| Previous Article: | Noteworthy valuation-related papers from the American Real Estate Society Annual Meeting. |
| Next Article: | Comments on "Relationships between the Overall Property and Its Parts, and the Three Approaches to Value". |
| Topics: | |