REAL ESTATE APPRAISAL: ART OR SCIENCE?

In my years as an appraiser, I have often heard it said that property valuation is a blend of art and science. I don’t think it has necessarily been said as a complement but I embrace the description. The work we do as appraisers is a combination of careful observation, data collection & confirmation, statistical analysis, and mathematical calculations coupled with professional judgement that is reflective of years of experience with various property markets. The science side of the work is the research and calculation; the art side is the professional judgement. While both are always evident, the balance can swing from one side to the other depending on the property type.

Real estate valuation is heavily weighted to the art side with properties such as high end residential estates. The buyers of these properties are often making very emotional decisions. Comparable sales data can establish broad value ranges but the ultimate value of a specific property is reflective of highly subjective perceptions and decision-making processes on the part of typical market participants. It takes the seasoned judgement of an experienced professional to understand how a typical buyer would react to a specific high end residence.

At the other end of the spectrum could be, for example, a commercial property leased long term to a quality tenant. The typical buyer for these properties tends to be more dispassionate. At the end of the day, decisions to buy are based on pretty objective assessments of the quantity, quality, and durability of projected incomes and what constitutes a reasonable rate of return. Generally, market activity provides clear indications as to what is market rent and what capitalization rate ranges are appropriate. While there is some art involved in selecting the various factors, the ultimate value calculation is a mathematical application of the overall capitalization rate to the net operating income – pretty cut and dry.

Of course, I have over simplified. Even in the most straight forward commercial valuations, judgments are made at every turn. For example, if contract rent appears to be below market rent, the appraiser must decide how typical market participants would react. Would they make value decisions based on market rent? Would they apply some sort of discount for lost rental income opportunity? Would they use the contract rent and adjust the overall capitalization rate to reflect that there is better than typical potential to increase rental income when the lease expires? And each of these judgements is made in concert with various other judgments. I have often said that the valuation process can be likened to fitting together the pieces of a Chinese puzzle.

Appraisal text books tend to focus on the science side of valuation.This is not surprising; it would be difficult to write a book about professional judgement.However, the text books do not tell the whole story.It is foolhardy for an appraiser, or a user of appraisals, to think of property valuation as simply a scientific exercise.I will never forget the advice of a teacher I had early in my appraisal education.He was a Columbia grad school educated Texan.He had a sharp analytical mind clothed in good old boy veneer.He told us, “after you’ve done all your research, your analyses, and your calculations, go sit on the curb across the street from the property and ask yourself, ‘What’ll it fetch?’ ”

Mr. Arnold is a principal at Hammock, Arnold, Smith & Company. They are a general practice appraisal firm providing valuation and evaluation services to a variety of clients including corporations, government agencies, the legal community, financial institutions, private individuals and others.

The Truth About Cap Rates

Cap rates are used by market participants, brokers, and appraisers in estimating value of income producing properties. In professional valuation, the cap rate is formally referred to as the Overall Capitalization Rate (OAR). The Overall Capitalization Rate is an expression of the relationship between value and income. The “IRV” diagram is sometimes used to illustrate all the relationships that exist between income, rate and value.

To summarize; I (income) divided by R (rate) equals V (value). I divided by V equals R. And finally, R times V equals I. Therefore, to develop an indication of the OAR, the net operating income (NOI) of a property is divided by the sale price.

The best source of general cap rate information is the market. Appraisers and commercial brokers keep track of sales and their indicated capitalization rates. Different property types tend to have different cap rate ranges. At the time of this writing, cap rates in the Santa Barbara area generally fall in the range of 4.0% to 7.0%

The overall capitalization rate is not a property rating. Rather, the OAR is a rating of the perceived quantity, quality, and durability of the projected income. When considering the projected income, the valuer takes into account the balance between the exposure to risk and the potential for gain. The exposure to risk is an assessment of the likelihood that the projections will not be met. The potential for gain is an assessment of the likelihood that the projections will be exceeded. The perception of lower potential risk and/or higher potential for gain results in downward pressure on the rate.

In an all cash transaction, the OAR is a direct reflection of the return to the property owner. However, the market is dominated by situations where the potential return must be allocated between the buyer (equity position) and the lender (mortgage position). Therefore, looking at the return requirements of the two positions can be helpful in estimating an appropriate capitalization rate. This is called the “Band of Investment” method of evaluation of an overall capitalization rate.

Currently, mortgage interest rates are in the area of 4.0% to 4.5%. For a typical commercial property, the mortgage ratio is often in the area of 70%. Investors have two sources of potential return. They are the annual “cash-on-cash” return and the potential for equity growth through mortgage pay down and property appreciation. The two are related; the equity dividend rate (cash-on-cash return) used in the analysis is influenced by property appreciation expectations. Currently equity dividend rates are judged to be in the area of 7.0% to 8.0%. Mathematically, the calculation is expressed as follows:

Position Ratio Rate Extension

Mortgage 70% x 4.25% = 2.98%

Equity 30% x 7.5% = 2.25%

Total 5.23%

There is no empirical method of calculating an overall capitalization rate. From the point of view of a professional valuer, the analyses undertaken are helpful in pointing in the direction of what would be an appropriate capitalization rate to use in a particular situation. But, at the end of the day, the selection is careful professional judgement.

Mr. Arnold is a principal at Hammock, Arnold, Smith & Company. They are a general practice appraisal firm providing valuation and evaluation services to a variety of clients including corporations, government agencies, the legal community, financial institutions, private individuals and others.

Sometimes It Is Rocket Science

I stood awestruck at the base of a Delta IV Heavy Rocket. The Delta IV Heavy is one of the highest capacity rockets in the world. It was poised for launch inside the facility known as SLC (“Space Launch Complex”) 6 at Vandenberg Air Force Base. The size and sense of power associated with these big rockets is beyond description. To stand so close is a humbling experience. SLC 6 is probably the best known of the launch sites at Vandenberg. It was originally developed for the space shuttle. It is huge and was built to be able to completely enclose the shuttle and attached rockets while they were being prepared for launch.

There is an area of valuation that is little known even within the appraisal profession. That is valuation associated with property tax assessment of possessory interests. A possessory interest is somewhat like a leasehold interest. It is the interest of a private vendor operating on government owned property. These uses range from privately owned enterprises in national parks to vacation cabins in national forests to rocket launch sites on military bases. These for-profit undertakings have value associated with their right (their possessory interest) to occupy the space on government owned land. And this value is subject to property taxes.

Possessory interests are usually created by use permits. The use permit is a contract granting certain rights to the permittee for a specific period of time. It is similar to a lease. An example would be a use permit for a site on which to build a cabin in a national forest. (Think of the cabins up at Paradise.) As is often the case with new construction, until proven otherwise, the Assessor assumes that the amount spent on construction is equivalent to the value added as a result of the construction. So, if a person built a cabin on national forest land, the Assessor would assume that the cost to build the cabin was equivalent to the value of the possessory interest in the property.

If there is reason to question the value, the valuation process gets more complicated. The value of a possessory interest can be seen as a reflection of the difference between the fees paid to the government and market rent. For example, say the builder of the cabin pays a use fee of $500 per month to occupy the cabin site. Further, assume that market rent for the cabin would be $2,000 per month. The vendor therefore enjoys an advantage of $1,500 per month. The present value of this advantage for the remaining term of the agreement is an indication of the value of the possessory interest.

So, back to SLC 6 and why I was standing at the foot of the Delta IV Heavy. The operator of the facility was a private entity formed to launch rockets as a for-profit enterprise. When they took over SLC 6, they needed to adapt the facility for the launch of Delta rockets. Ideally, they would probably have scraped the site and constructed a modern state-of-the-art facility. However, the Air force considered the shuttle launch capability to be a “national asset”; something that needed to be preserved. Therefore, the operator had to work around the existing structures and systems so that they could be reconstituted at a later date. The total amount spent was hundreds of millions of dollars. A significant part of the cost was associated with adhering to the Air Force requirements. All of the expenditures were applied directly to the assessment for their possessory interest. The property tax ramifications were extraordinary.

A team was assembled to work on an assessment appeal. The team consisted of attorneys, economists, and appraisers. The appraisal issues included underlying values, functional obsolescence, and assessment procedures. The focus of our evaluations was the difference between cost and value. To say the least, the value of a rocket a lunch site is elusive. However, due to the inefficiencies in the construction and the rapidly changing industry (Space X is to the rocket launch industry what UBER is to public transportation), it was clear that the cost of construction was far more than the value added. By looking at regional land values, rents, and other value indicators along with current industry operating standards and construction indicators, we were able to develop alternate value indications that were persuasive. After several years of hearings, meetings, and communications, resolution was achieved. The process was a combination of formal appeal, negotiations, and working together with the Assessor’s team.

Maybe using the term “rocket science” is taking liberty but it does suggest the uniqueness of the valuation issues we encountered.

Mr. Arnold is a principal at Hammock, Arnold, Smith & Company. They are a general practice appraisal firm providing valuation and evaluation services to a variety of clients including corporations, government agencies, the legal community, financial institutions, private individuals and others.