chapter 22: valuation of distressed properties

Chapter 22:Valuation of Distressed Properties

IntroductionSeveral factors can result in a distressed

propertyOversupplied marketPoor designImproper location of improvementsInadequate maintenancePoor decisions made by owner or manager

IntroductionThese problems can result in:

Low occupancyHigher operating costsLow rent levels

The problems are sometimes curable and sometimes incurable

External obsolescenceLoss in property value resulting from negative

influence outside the property itselfAn element of accrued depreciationGenerally incurable

Two types of external obsolescence

1. Economic obsolescenceValue loss is caused by an occurrence or situation that

adversely affects the employment, quality of life or economics of an area

This problem may disappear over time2. Locational obsolescence

Value loss is caused by a negative influence outside the property because of its location, a health hazard close to the property or a change in property use close to the property

Generally considered incurable and may permanently impair property value

Occupancy obsolescenceLoss in the value of real estate improvements due to an

occupancy that is less than the stabilized occupancy that the property should achieve in the current market

It is generally the present value of income loss during the rentup of a property

It is generally curable; if not curable, it is locational obsolescence

Functional obsolescenceLoss in value due to functional inadequacies or

superadequacies due to poor design and/or change in market standards or requirements for building components

May be curable or incurable

Property Inspection and Analysis: Income ApproachThe feasibility rent must often be estimated:

Feasibility rent is the rent level needed to support the depreciated value of the property

Considers deductions for normal physical depreciation

Does not consider any adverse conditions such as external obsolescence, functional obsolescence, occupancy obsolescence, rehabilitation costs or conversion costs

Property Inspection and Analysis: Income ApproachThe difference between the value based on

feasibility rent and the value based on market rent is a measure of the loss in value due to the adverse condition such as external obsolescence

This loss in value may have to be used as an adjustment when using the sales comparison and cost approaches

Property Inspection and Analysis: Cost ApproachAppraiser must consider any loss in value due to

physical, functional, economic and occupancy obsolescence

The loss in value may have to be allocated between the land and the improvements

Two approaches to estimate loss in value:1. Loss in income2. Paired sales

Property Inspection and Analysis: Sales Comparison ApproachComparable sales may be scarceMust adjust for differences in age, condition,

quality, property rightsAlso adjust for differences in occupancy,

economic conditions and functionality of the properties

Example:Value Estimates with No Problem Summary of Value Indication

Income approach $2,142,209 Cost approach $2,146,996 Sales Comparison approach $2,160,000    Building Type - Office  Gross building area 24000 sqftNet leasable area 20000 sqftLand area 38000 sqftMarket rent estimate $15/sqftVacancy and credit allowance 6%Operating expense estimate $4.10/sqft

Functional obsolescence: Income approach

  Year 1 Year 2 Year 3 Year 4 Year 5 Year 6PGI $270,000 $280,800 $292,032 $303,713 $315,862 $328,496Vacancy $16,200 $16,848 $17,522 $18,223 $18,952 $19,710EGI $253,800 $263,952 $274,510 $285,490 $296,910 $308,786Management $12,690 $13,198 $13,726 $14,275 $14,845 $15,439Property tax $11,900 $11,900 $11,900 $15,000 $15,000 $15,000Insurance $4,000 $4,120 $4,244 $4,371 $4,502 $4,637Utilities $30,000 $31,500 $33,075 $34,729 $36,465 $38,288Janitorial $18,000 $18,720 $19,469 $20,248 $21,057 $21,899Maintenance $4,000 $4,120 $4,244 $4,371 $4,502 $4,637Total expenses $80,590 $83,558 $86,658 $92,994 $96,371 $99,900NOI $173,210 $180,394 $187,852 $192,496 $200,539 $208,886   Reversion @10% cap rate $2,088,862 Value Estimate @12%         $1,853,572  

Functional obsolescence: Income approach

Value - optimum ratio $2,142,209

Value - actual ratio $1,853,572

Functional obsolescence $288,637

Functional obsolescence: Cost approach

Unadjusted improvements value $1,861,993

Less functional obsolescence $288,637

Value of the improvements $1,573,356

Land value 285000

Total property value $1,858,356

Functional obsolescence: Sales comparison approach

Value indication - no obsolescence $2,160,000

Less functional obsolescence $288,637

Value of the improvements $1,871,363

Summary of functional obsolescence

Value Estimate  

Income approach $1,853,572

Cost approach $1,858,356

Sales comparison approach $1,871,363

Locational external obsolescence: Income approach

  Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

PGI$260,00

0$270,40

0$281,21

6$292,46

5 $304,163$316,33

0Vacancy $15,600 $16,224 $16,873 $17,548 $18,250 $18,980

EGI$244,40

0$254,17

6$264,34

3$274,91

7 $285,913$297,35

0Management $12,220 $12,709 $13,726 $13,217 $14,296 $14,867Property tax $11,900 $11,900 $11,900 $15,000 $15,000 $15,000Insurance $4,000 $4,120 $4,244 $4,371 $4,502 $4,637Utilities $30,000 $31,500 $33,075 $34,729 $36,465 $38,288Janitorial $18,000 $18,720 $19,469 $20,248 $21,057 $21,899Maintenance $4,000 $4,120 $4,244 $4,371 $4,502 $4,637Total expenses $80,120 $83,069 $86,658 $91,936 $95,822 $99,328

NOI$164,28

0$171,10

7$177,68

5$182,98

1 $190,091$198,02

2   Reversion @10% cap rate

$1,980,222 

Value Estimate @12%        $1,757,39

8  

Locational external obsolescence: Income approach

Value - optimum ratio $2,142,209

Value - actual ratio $1,757,398

Locational external obsolescence $384,811

Locational external obsolescence: Cost approach

Land value - no obsolescence $285,000

Land value - with obsolescence $200,000

Land value obsolescence $85,000

Unadjusted improvements value $1,861,993

Less allocated obsolescence $299,811

Value of improvements $1,562,182

Plus land value $200,000

Total property value $1,762,182

Locational external obsolescence: Sales comparison approach

Value indication - no obsolescence $2,160,000

Less locational external obsolescence $384,811

Value of the improvements $1,775,189

Summary of external locational obsolescence

Value Estimate  

Income approach $1,757,398

Cost approach $1,762,182

Sales comparison approach $1,775,189

Economic external obsolescence: Income approach

  Year 1 Year 2 Year 3 Year 4 Year 5 Year 6Market rent $13 $13.25 $14.50 $16.25 $17.55 $18.25

PGI$260,00

0$265,00

0$290,00

0$325,00

0 $350,958 $364,996Vacancy $15,600 $15,900 $17,400 $19,500 $21,057 $21,900Concessions $40,733 $41,517 $45,433 $0 $0 $0

EGI$203,66

7$207,58

3$227,16

7$305,50

0 $329,901 $343,096Management $10,183 $10,379 $11,358 $15,275 $16,495 $17,155Property tax $11,900 $11,900 $11,900 $15,000 $15,000 $15,000Insurance $4,000 $4,120 $4,244 $4,371 $4,502 $4,637Utilities $30,000 $31,500 $33,075 $34,729 $36,465 $38,288Janitorial $18,000 $18,720 $19,469 $20,248 $21,057 $21,899Maintenance $4,000 $4,120 $4,244 $4,371 $4,502 $4,637Total expenses $78,083 $80,739 $84,290 $93,994 $98,021 $101,616

NOI$125,58

4$126,84

4$142,87

7$211,50

6 $231,880 $241,480   Reversion @10% cap rate

$2,414,802 

Value Estimate @12%        $1,951,15

9  

Economic external obsolescence: Income approach

Value - optimum ratio $2,142,209

Value - actual ratio $1,951,159

Economic external obsolescence $191,050

Economic external obsolescence: Cost approach

Land value - no obsolescence $285,000 Land value - with obsolescence $200,000 Land value obsolescence $85,000 Unadjusted improvements value $1,861,993 Less allocated obsolescence $106,050 Value of improvements $1,755,943 Plus land value $200,000 Total property value $1,955,943

Economic external obsolescence: Sales comparison approach

Value indication - no obsolescence $2,160,000

Less economic external obsolescence $191,050

Value of the improvements $1,968,950

Summary of external economic obsolescence

Value Estimate  

Income approach $1,951,159

Cost approach $1,955,943

Sales comparison approach $1,968,950

Economic and occupancy external obsolescence: Income approach

  Year 1 Year 2 Year 3 Year 4 Year 5 Year 6Market rent $13 $13.25 $14.50 $16.25 $17.55 $18.25 PGI $260,000$265,000$290,000$325,000 $350,958 $364,996Vacancy $130,000 $79,500 $34,800 $19,500 $21,057 $21,900Concessions $21,667 $44,167 $42,533 $0 $0 $0EGI $108,333$141,333$212,667$305,500 $329,901 $343,096Management $5,417 $7,067 $10,633 $15,275 $16,495 $17,155Property tax $11,900 $11,900 $11,900 $15,000 $15,000 $15,000Insurance $4,000 $4,120 $4,244 $4,371 $4,502 $4,637Utilities $30,000 $31,500 $33,075 $34,729 $36,465 $38,288Janitorial $9,000 $13,104 $17,135 $20,248 $21,057 $21,899Maintenance $4,000 $4,120 $4,244 $4,371 $4,502 $4,637Total expenses $64,317 $71,811 $81,231 $93,994 $98,021 $101,616NOI $44,016 $69,522$131,436$211,506 $231,880 $241,480   Reversion @10% cap rate

$2,414,802 

Value Estimate @12%        $1,824,49

0  

Economic and occupancy external obsolescence: Income approach

Value - optimum ratio $2,142,209

Value - actual ratio $1,824,490

Economic and occupancy obsolescence $317,719

Economic and occupancy external obsolescence: Cost approach

Land value - no obsolescence $285,000 Land value - with obsolescence $200,000 Land value obsolescence $85,000 Unadjusted improvements value $1,861,993 Less allocated obsolescence $106,050 Less occupany obsolescence $126,669 Value of improvements $1,629,274 Plus land value $200,000 Total property value $1,829,274

Economic and occupancy external obsolescence: Sales comparison approach

Value indication - no obsolescence $2,160,000

Less economic obsolescence $191,050

Less occupancy obsolescence $126,669

Value of the improvements $1,842,281

Summary of occupancy and economic obsolescence

Value Estimate  

Income approach $1,824,490

Cost approach $1,829,274

Sales comparison approach $1,842,281