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Office Buildings
> Fee Simple Income Analysis
> High Rise Office Buildings
> Market Rent
>Influence and Importance of Sales, Including
Sale of the Subject
Fee Simple Income
Analysis
Because commercial buildings generally trade based on income, the most
reasonable and accurate way to derive an opinion of value for ad valorem
tax valuation is to apply an income model.
The Texas Property Tax Code is the guideline for
establishing Market Value for real and personal property in Texas.
The more universal concept of Market Value, however, is not the tax code
definition. Case law comes from the case City of Mesquite
vs. Martin; the principle is commonly called fee
simple value (as opposed to leased fee
value). It means that you apply market rent and other indicators
as of the assessment date and, essentially, ignore the actual income and
expense. We believe that it means that the appraiser should evaluate the
real estate and not any other effect on rent and value, including credit
and other intangible influences.
In this discussion and among these pages we will review
the various components of fee simple analysis. We believe that there are
five fundamental components of a fee simple economic model.
I.
Class
– the nature and physical status of the property including
consideration of
a. Location – accessibility,
visibility,
b. Use – universal usefulness -
measure of functional obsolescence
c. Age / Life Expectancy
d. Allure - Quality of construction and
finish materials
e. Coefficient of necessary contemporary
amenities
II.
Income
.
Rental
rate for each of the rent stratas
i.
According
to size of tenant and location of space
ii.
According
to Market Standard Improvement Allowances
iii.
Effect
of large tenant requirements as of assessment date
a. Expansions
b. Rights of First Refusal
c. Storage
a. Analysis of real-estate-only
influences on rent
III.
Expenses
& Reserves
.
Are
current actual expenses (without taxes) typical and reasonable?
a. Evidence of trends in maintenance,
janitorial, utilities
b. Reserves for repairs, maintenance and
recapture of the income stream
.
Major
building maintenance and capital items
i.
TI’s,
leasing commissions, legal fees, incentives, etc.
IV.
Occupancy
Rate
.
Actual
occupancy at current mix of rents
a. Predictable occupancy rate at
assessment date
b. Absorption rate reports – trends
of rental rate and occupancy rate
V.
Capitalization
rate
.
Any
evidence of sales with full supporting data
a. Relative risk according to status of
rents
.
Establish
rate at which rents are moving up or down
i.
Correlate
market rent with market risk
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High Rise Office
Buildings
There are three basic approaches to value which should be considered when
appraising a high rise office building.
I.
Cost
– Whereas cost is generally not a basis by which major office
properties trade, one can use portions of the cost approach to equate buildings
in a class. By grading the set of buildings in the general marketplace for
such things as finish materials, ceiling heights, etc. (and the relative
rents in competing for similar tenants) the appraiser can establish a set
of comparison components. By comparing, then, the assessments in an
adjustment grid, an equitable value may be determined.
II.
Sales
– It is more difficult to measure value by a sales comparison than
what you might think. Because any leased property is necessarily a leased
fee sale and the tax code requires that no contracts exist in a fee simple
analysis, the appraisal must extract leases, contracts, credit influences,
and various components of business enterprise value and an assortment of
intangibles and business personal property in order to get to the
appropriate number. Because there are so many unknowns in a leased fee
sale, the task is generally too formidable to be reliable.
III.
Income
and expense analysis. It is far more reasonable to value a major building
by the income approach and the data is more accessible than for sales. By
reviewing deals made and their effective rents derived from the balance of
tenant improvement allowances, incentives (free rent, etc), commissions,
etc., the appraiser can get to a meaningful range of rents for the
collection of stratas for the subject building and its class.
Class - In order to
adequately and appropriately appraise a major high rise office building,
one must first identify the class of buildings and the peers in the class,
and then gather all pertinent data, analyze leases made in or near the tax
year date, and derive a lease rate for the various rent stratas in the
subject and its peers. The class should be as broad as the general lease
market perceives when seeking competitive bids for space. Tenants generally
move between classes when the rent range is adequately great –
choosing lesser building for their lower rent – but as the market
rent narrows, higher class buildings absorb space at a faster pace. There
must necessarily be a balance among the income value components – the
rent must reflect the correct TI and commissions – and the cap rate
should consider the relative level of rents and occupancy – a
building fully leased at market rents will not sell at the same cap rate as
a building leased below market rent.
Rent – there is
not one rent but a collection of rents in any one building and within the
class. The smallest tenants pay the highest rent and the largest tenants
the lowest. There will always be a predictable and definable set of stratas
within a building and a calculable correlation between the rents in each
stratum; moreover, there will be a predictable size for each stratum
depending on the size of the building and the relative demands of lenders
with regard to risk in any given year. For example, a building of 1.5
million square feet will be leased to a set of two or three tenants who
occupy, say, 40% of the building and they will pay the lowest rent. There
will be two or three more sets of incrementally smaller tenants paying 5-10%
more rent and occupying, together, another 40% of the building. Finally,
there will be a group of tenants – perhaps 20 or more – who
will pay the highest rent and occupy between 1.25% and 3% of the building.
Occupancy –
Overall market class occupancy is fairly easily derived. Rising rents
predict falling occupancy for the top class, and vice versa.
Expenses – one
must assume that a primary property will be managed well and that the
operating expense will reflect the quality of the property and the intent
of the overall marketplace and, thereby, will be at market. Expenses must
also include a provision for capture and replacement of the income stream
including commissions, tenant improvements, and incentives.
Cap Rate – the
level of risk is dictated, for this class, by the biggest investors,
insurance companies, and pension funds. Falling rents indicate a
predictably lower cap rate – and vice versa. The must be a balance
among rent, occupancy, expenses and cap rate.
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Market Rent
In economic analysis, rent is the crux of all decisions in the valuation
process. Many Appraisal Districts apply the rental rate that they are
quoted over the phone or as published in office reporting guides, and,
thereby, they dramatically overstate the value.
Rent is not a single number but a collection of rates
that apply to the universe of tenants in the marketplace – a rent
stratification. As we all know, the bigger and better (i.e. more
credit-worthy) the tenant (and the better the broker), the lower the rental
rate and the greater the bundle of rights afforded that tenant. In any
given marketplace, as of any given assessment date, there is a state of
affairs that defines market rent.
Those hard factors influencing rent are components of
economic modeling which include:
I.
Market
occupancy and absorption rate. As market demand absorbs space and vacancy
falls, the supply is diminished and rents rise. (It should be noted that
market-high occupancy and market-high rental rates are incompatible in the
same model unless and until the market has stabilized for a long period
– 2-3 years)
II.
Market
Business Conditions
a. State of the Economy – A
generally good economy with no evidence of change supports realized rental
rates. Evidence of a falling economy supports lower rents, higher vacancy,
or higher cap rate – not all three; but the anticipation of change
flows to investor expectations.
b. State of industry in the immediate
marketplace – If the marketplace is made up largely, for example, of
energy companies, and there is a significant change in the industry, there
will be a flow-through to rental rate and occupancy.
III.
Large
tenants demand and get expansion rights and controls over significant
amounts of space. Even when the market is good (and these tenants pay
higher rent) the effect on the building is a downward pressure on
achievable rate. A tenant in a smaller space wanting to lease burdened
space (large tenant expansion space) will not pay the same rate for
short-term use and minimal tenant improvement allowances. Also, because
there is always a collection of rights of refusal on various spaces, the
velocity at which the space can be leased is hindered; a prospective tenant
must await the hierarchy of decisions from others on whether to take the
space. More often the rights include rates and terms more favorable to the
right holder than the new tenant might pay, and the owner loses potential
rent when the right holder takes the space to retain control. Large tenants
are also able to lease storage space which otherwise might qualify
as higher rent office space.
IV.
Sublease
space. Depending on prior year market conditions, there may be a
significant amount of sublease space available from growing tenants who
exercised rights and have not yet absorbed the space. These deals are
generally below market but have an immediate impact on rents any building
can achieve. There have been years when the sublease market drove overall
market rental rates dramatically downward.
V.
Tenant
improvement allowances and incentives. Depending on supply and demand (and
relative hard costs), there is generally a level of allowance afforded
tenants. Small tenants get less TI – large tenants, and perhaps those
with good brokers, get relocation allowances, excess TI, architectural
services, and a variety of fees, free rent, and accommodations to attract
their tenancy. We refer to this as a bundle of goods, and on any given
assessment date there is a market standard package which complements the
achievable rental rate.
There are numerous influences on rent which come from sources other than
real estate and the standard bundle of goods. These influences produce intangible value.
I.
TI
and incentives - Any package which exceeds the standard and for which there
is a definable increase in the rental rate would be considered non-real
estate – a loan, per se. The rental rate, then, can be broken down
into its components – the real estate rent and the loan rent.
II.
Resources,
ingenuity and superior marketing and management skills of the owner and
manager Just as bad buildings should not be rewarded with lower
assessments for their bad management so should exceptional properties not
be penalized for superior performance. An owner with multiple locations and
a reputation for excellence carries a flag not unlike a hotel chain. There
is synergy from dealing with large national tenants and a respect from
tenants which transcends to rent and occupancy exceeding the market
standard.
III.
The
existence of large or influential tenants who consume services and products
from others in the immediate marketplace may affect over-market rents. For
example, banks and law firms align; a bank that owns a building may draw
tenants seeking to do business with the owner, and the decision to choose a
building and pay a certain rent may be business related. This is a common
occurrence in shopping centers with anchors attracting side shops.
We believe that there is an annual market correlation
between the various rent stratas. The relationship of rate among stratas
and the high and low rate varies from year to year but stays in relative
proportion.
In order to determine market rent for downtown
properties, our approach has been, first, to identify deals made in each
strata as defined herein and to determine who made the best deal in each
strata. We also look at deals that were lost and which went to competitive
properties to see if other buildings might be making better deals. (The
ideal scenario would be to log submissions from all property owners to
illustrate deals made, but of course that won’t happen.) For any
property, however, one should array the rent roll, with tenant name, area,
date, and rental rate, and sort by size. Identify deals made this year and
last in each strata, and make an effort to see what other influences might
have impacted the rent (as noted above). The lowest pure real estate rent
in each strata is the market rent for that strata. The highest rent
achieved is market rent at the smallest tenant level.
We have developed a proportional rating for each rent
strata and we believe that it is sustainable under any professional
scrutiny. Our report deals with rent as a net rent figure with expense stop
/ expense recapture added. Note: Expense stops include reimbursement for
taxes so be sure to include the tax recapture portion at a level
commensurate with the state of the economy.
In most buildings there is additional income from sources
other than expense recapture. Parking income (for parking located on the same
tax account) should be included and any other regular, sustainable income
(itemizing by name on the report). We believe that antennae income may not
be tangible real estate income and generally do not include it. At full
market rents there is no additional income from expense recapture other
than a percentage of current actual expenses (generally without full
management fees).
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Balancing Rents,
Occupancy and Cap Rate
In a dynamic market with rents and occupancy moving quickly one direction
or the other, there can be a significant impact on value from the perceived
risk rate. Falling rents will increase occupancy and reduce risk when
applying the new lower rent in financial analysis, and vice versa. There
must be a corresponding and appropriate cap rate.
As note elsewhere herein, it is impractical and incorrect
to apply the lowest cap rate with the highest rents. In the peculiar
circumstance of the Houston CBD for 2004 with exceptionally low rates and
low occupancy, we believe that it may be necessary, in applying the market
rent, to accommodate that rent with higher than market occupancy and an
appropriately low cap rate.
The table hereon shows what we believe to be the
relationship between rents and cap rates for the Houston CBD for 2004. The
table on the succeeding page seeks to further analyze the entire strata or
rents by showing an anticipated narrowing of the range between lowest and
highest rents as rents fall.
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Houston CBD
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Cap Rate - Rental
Rate - Occupancy Balance Study
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As of January 1, 2004
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Highest Net Rent
Small Tenants
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Effective Gross
Rent
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Applicable Cap Rate
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Relative Market
Occupancy
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$10.00
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$17.00
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7.50%
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87.00%
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$11.00
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$17.71
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8.00%
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85.00%
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$12.00
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$18.43
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8.50%
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83.00%
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$13.00
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$19.13
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9.00%
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81.50%
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$14.00
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$19.81
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9.50%
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80.00%
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$15.00
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$20.46
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10.00%
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78.00%
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Influence and Importance of Sales,
Including Sale of the Subject
The process for measuring investment value
We believe that an analysis of sales of like-kind competitive
properties and, as well, of the subject property, can provide useful
information but not nearly to the extent than many Appraisal Districts
think.
Any sale, by the very nature of the real estate business,
is a leased fee sale (a sale in
consideration of leases in place at rents and terms achieved by unknown
influences). The most important thing a buyer considers is who is paying the rent – the credit in the
equation. An investment sale of an income producing property is,
essentially, an analysis of the credits, what their stability is, how well
they are doing in the subject property, and how the market has changed
since each individual tenant took possession. If, for example, market
standards for any one tenant have changed (like a grocery occupying a much
smaller space than newer leases), although the tenant may be strong credit
and apparently performing well, there is a good chance the tenant will
vacate at lease termination in order to move to more contemporary space.
To properly analyze the importance of a sale, one must:
I.
Measure
each and every lease for rate and terms.
a. Break the lease and rents down into
components of value for real estate and non-real estate influences.
b. Increase or decrease the rent of each
tenancy by Jan.1 market standards.
II.
Measure
the occupancy of the sale in terms of market standards.
III.
Estimate
the efficiency of selling management for controlling operating expense.
IV.
Determine
the source and cost of buyer’s funds and assess for market standards.
V.
Determine
the intentions of both seller and buyer to determine reasons for sale.
VI.
Determine
Buyer’s expectations for future growth of the market and usefulness
of the property for Buyer’s intentions.
VII.
Determine
the weight given to creditworthiness of tenants and eliminate all
consideration and value associated therewith.
VIII.
If
there is reasonable estimation of the property’s NOI whereby a cap
rate can be assigned to the transaction, determine the property’s
status relative to the subject by all the preceding measures to adjust for
an appropriate cap rate for the subject.
Example:
I.
A
shopping center that is 100% leased with a popular credit tenant occupying
90% of the space sells for an effective yield of 9%. 100,000 sf at $6.0
million - $60 psf. - $540,000 NOI.
II.
A
shopping center which is 50% vacant and has only a local Mexican Restaurant
and a bankrupt small department store sells at a yield of 1.5% - 100,000 sf
at $6.0 million - $90,000 NOI
III.
A
100,000 sf center, 100% leased with a 50,000 sf Bingo hall and 3 strip
joints sells for $6.0 million with a $1.0 million NOI – a 16 2/3%
yield.
What is the cap rate? 9%, 1.5% or 16 2/3%? Is the value of a 100,000 sf
center $60.00 psf?
What if Number 1 was bought by a REIT with 6% cost of
funds?
What if Number 1 was bought by a family with 10% cost of funds?
What if Number 1 was bought by the Seller of Number 3 who wanted to run
everybody out
so that he could expand his porn business?
How about if Number 2 was bought by the same party who was buying the
defunct business of the department store tenant?
Too many questions – too
little information. No decision on cap rate and value.
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Worksheet
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