Solving (??) Current Valuation Mysteries (??)

For many, 2008 was a painful financial experience. As it relates to real estate, home

prices in most cases have eroded. Commercial properties are facing huge “maturity risk

exposure” (pending re-fi requirements). Lenders are trying to generate or keep cash….

and stay afloat.

 

One of the reasons cited for the ongoing distress in 2009 is the “valuation conundrum”.

More commonly, this is expressed as “No one knows where the bottom is” or “How do

we ‘price’ things now”?

 

Without question, current valuation is very difficult to accurately and precisely to gauge.

The primary valuation tools (comparable sales and income generation) are either

“frozen” (no sales) or “flawed” (who’s numbers can you believe?). Thus, how do we

“value” assets in this current environment?

 

Professional appraisers have always used a tool often overlooked in the marketplace.

Very simply, it is a cost analysis. Most times, this somewhat obscure method is not

given its due respect. Other times, such as now, it is the only method with any sort of

“semi-fixed” analytical base. Very simply, since site and building improvements have a

substantial “fixed cost”, it has a very useful basis in “stressful times” since a large

percentage of the components are “not stressed”, i.e., substantially “fixed”. For

improved properties, building values normally equate to 70-85% of overall asset value

(in a stable market). The key word here is “semi-fixed”.

 

By semi-fixed, I mean that most hard and soft costs are rarely discounted (substantially)

in the market. Even if discounted, they are much less likely to be materially impacted.

Even if difficult times, discounts of +-20% of hard and soft costs would be – draconian.

Most times today we hear construction costs are “down” about 5-10% from peak levels.

If land values can be reliably estimated, then a reasonable estimate of current value

(discount from par/cost) can be estimated via a simple “Band of Investment” analysis.

 

Table 1 illustrates the point. All figures can be readily adjusted to suit exact situations

(Class A-; B+; C-; land value erosion; etc). The results of a Cost Analysis (not

approach), even in a “stressful” market, can help firm value estimates. In the worst

case, such an analysis can also be tested against cap rates and/or yield requirements

from other methods (sales; income).

 

Insert Table 1

 

 

 

Thus, if an analyst is able to “isolate” the adverse market conditions for the major cost

factors (in this example, building costs), overall property value estimates will be much

more precise than attempting to value by non-existent sales comparisons or nebulous

income projections. Very simply, pro-rata component allocations for all aspects of a

property will then lead an analyst to a reasonable, defensible and bankable estimate of

value. Further, they will be based on more clearly defined factors such as actual

commodities for materials, construction time, and reasonably based fees.

 

Conclusion

Many real estate cycles have come and gone. This current “recession” at some point

will pass as well. Success in 2009 will accrue to those who understand all aspects of

current valuation. This includes the application of all value tools, current and detailed

understanding of site and submarket specific research, and application of solid analysis

and, oh yes, judgment. Those unable to produce solid market based opinions/estimates

are to be judged impostors, not analysts.

 

Dennis Duffy, MAI, Principal

RCDH & Co.

Article published in DCBIA, February 2009. Pipeline. Washington, DC: DCBIA.

 

Posted in Publications