Appraisal Matters

What can we do to make market research relevant and garner accurate market research conclusions?  Read on!

Get Your Kicks on Route 66

There have been many times where I did not accept the market and submarket boundaries presented in a market report.  When they were first delineated, they may have been 100 percent accurate, but just as time marches on, boundaries change too.  One determinant is what brokers think.  If they agree with the boundaries, great, but if they see no difference between two areas, the submarkets are often better served as merged.  Similarly, many times submarkets need to be created to understand the patterns that are present, otherwise the gold that you could data mine remains forever in the rock strata.

What I see as lacking so frequently in feasibility studies, market studies and commercial appraisals is the writer defining the submarkets based on actually driving around.  Sure, I understand there’s a financial aspect to this.  You can’t expect fabulous primary or secondary data if you don’t pay for it.  The Appraisal Institute even went so far as to classify the market research that a client can order by A, B, C and D, although I doubt many clients have even heard of it.  Still, when it’s presented in a report and it doesn’t cut the mustard, it is more of a liability than an asset to the reader.

Permit me to illustrate from a market research report I did for a shopping center in Orlando, Florida.  The following quote is from the report and it shows why delineating submarkets is important.

With over 118 shopping centers and 21 million square feet of shopping center space within 10 miles of the subject, excluding the substantial amount of freestanding retail space, competition is intense and there are many substitutes.

With 21 million square feet of shopping center space in the market, clearly to present anything of relevance I had to go to submarket analysis.  Unfortunately, there were no good reports from which to simplify the problem, so it was time to get into my rental car and take a ride.  No, I didn’t get a convertible.  Here is the result and the reasoning behind it:

The North Market is International Drive north of the Bee Line Highway.  Whereas five to ten years ago there was little demarcation of submarkets within the North Market, this has become far more pronounced.  Now, it is possible to divide the North Market up into seven different submarkets, which we have named, defined and described below.  They are listed sequentially below in a northerly direction on International Drive from Bee Line Highway.

• The Convention Zone – the expansion of the Orange County Convention Center spurred large, sprawling, upscale hotel development, trendy retail entertainment complexes and a small variety of homogeneously designed retail buildings.  The rail system provides easy access for attendees from the hotels on both sides of the Convention Zone directly to the convention center.  Pedestrian traffic is moderate.
• „The Dinner Restaurant Zone (Samoan Court to Jamaican Court) – the next northern subzone is characterized by a large number of national dinner restaurants such as Bennigan’s, TGI Fridays and others.  Pedestrian traffic is moderate during the evening hours.
• The Fast Food Restaurant Zone (just north of Jamaican Court to just past Sand Lake Road) – this subzone has a variety of major fast food franchises such as McDonald’s, Burger King, Pizzeria Uno, IHOP and others).  Pedestrian traffic is low, but traffic volume is very high due to the International Drive and Sand Lake Road intersection.
• „The Original Strip (just past Sand Lake Road to Howard Johnson’s, about seven lots north of Carrier Drive) – the older buildings that make up the Original Strip also contain the subject.  It is comprised of a wide variety of small freestanding buildings and older strip centers generally five units or less.  Relatively few national dinner chains or national franchises are present.  Relatively few theme entertainment or non-budget motels are present, although discount motels are in abundance.  Pedestrian traffic is low to moderate.
• Universal Studios (Howard Johnson and the City of Orlando boundary through the southern side of Kirkman Road) – This submarket contains Wet ‘N Wild and a back entrance into Universal Studios and the City of Orlando Convention Center.  A large number of hotels are present and national dinner chain restaurants once again make their appearance.  It has the highest amount of pedestrian traffic with two large theme oriented entertainment complexes in addition to the attractions above.
• The Fashion Outlet Zone (north of Kirkman Road to the end of International Drive) – this is the strangest subdistrict along International Drive.  There is a large, newer, several-anchor community shopping center that is almost full.  Yet several centers around it have high vacancy rates.  One large center is almost completely vacant.  Traveling north of this section are several large outlet centers with a diverse variety of national clothing stores present.  New development is underway in several sections, of which the only new development is along International Drive.  The Millennium Mall, a well anchored, upscale regional shopping center that opened in 2002 is also near the end of International Drive and development around the mall is underway in two areas.  Walking traffic is nonexistent.

What I’ve done is segment the market so the reader gets a mental picture of how comparable one submarket is to the other.  Equally important is the description of the subject’s submarket and the adjacent submarkets.  This provides two advantages:  it provides support for the selection of land sales, improved sales and rentals and it provides support for location adjustments.

But this is only the beginning.  In Part 3, we’ll peer through the magnifying glass to look at the submarket that contains the property and its competitors.

John Simpson MAI

There is no larger question mark in the marina industry than when marina lending will return.  Never since the great depression have we had such an example of what happens when the lending dollars stop flowing.  So, what are the signs that marina financing is coming back?

It seems that each recession is different, yet the answer to this question remains the same due to the nature of marinas.  There are some simple realities that marina borrowers just have to face.

• The major banks have been out of the marina financing business for many, many years and they’re not coming back until memories fade.  I don’t know why exactly but I suspect it has to do with problems that the big lenders had with with auditing.  Banks make more from bank fees than from commercial loans.  There are just too many fish in the sea to bother with the minnows, I suppose.
• When a lender makes a marina loan, they must hold the paper.  They must service it.  They can’t roll it over into more loans – the money is spent.  That’s because there is no secondary market for marina loans.  Not just now, but even during hot lending markets.  It’s not like you could get a billion dollars of marina loans and sell them to investors like residential mortgages are sold to Fannie Mae.  So what does that tell you?  That you just are not going to see banks holding a portfolio of marina loans.
• The marina industry just does not have the standards that other industries have.  There is no recent operating expense study like BOMA puts out for office buildings or Dollars and Cents in the shopping center industry.  Accounting is not standardized like you have in the hotel industry.  Bank underwriters and auditors have few tools to work with, so the major lenders have extra headaches when they make specialty loans.
• Marinas are a business even though the vast majority of value is vested in the real estate.  Many lenders do not want to loan on businesses due to problems with underwriting and, especially, auditing.

Let History Be Your Guide

I find it interesting that the answer to the marina lending question has been out there for years.  It’s simple history.

• Since banks must hold their own marina loan paper, they just aren’t going to hold much of it.  This essentially chops up the pie into so many little slices that finding banks that will lend on marinas will remain really hard.  Once they have their small fill of marina loans, the door is closed to everyone else.
• Since banks can’t securitize  the loans, they can’t roll the money over into multiple loans.  That means they can’t make points and other fees on multiple loans for the same amount of money.  Let’s say Bank A can take that $2 million and lend it on marinas.  They get one set of fees.  If they were to lend it on, say, shopping centers, they could securitize it by selling it to investors, get the $2 million back and lend it out again.  And again.  How many times can they do this in, say, the 5-year loan term of a typical marina loan?  That’s why securitization has been, and always will be, king.
• Back in August, I wrote a blog about marina marginal demand that can be equally well applied to marina lending.  Call it lending marginal demand.  In a  nutshell, bank lenders become interested in making marina loans when they can’t make enough loans via traditional property types.  Using the jargon of that blog article, first tier lenders (nationals) gobble up most of the major property type bank loans leaving little for the second tier (regionals) or third tier (local) lenders.  The second tier lender takes the rest and only when the third tier lender has no other options do they hop on the bandwagon.  Perhaps the lending environment becomes hot again so the second tier lenders move into making marina loans.  Still, their efforts will always be hampered by the lack of securitization for marina loans.
• So the economy starts to heat up again and manufacturers start generating cash.  What shall they do with it?  One avenue is the finance company.  At that point, some old favorites might reappear or new finance companies come on board.  It’s possible that we might see a rebirth of the marina finance company… or not.  Certainly when a couple or more finance companies come into the market, that’s a big sign that lenders are coming back.
• Speaking of finance companies, some of them make their money on float.  They borrower money at a certain interest rate and lend it at a higher rate.  The reason this type of finance company is no longer in the market is that their original financing source dried up.  If you can’t borrow, you can’t lend.  So when you start seeing finance companies springing up in other industries, you’ll know that, for the most part, someone is floor planning them so they can  loan it back out again.  Keep your eye out for new finance companies in other industries.  You’ll know money is starting to flow when you see new market entrants.
• Marinas are considered operating businesses by lenders and rightly so.  So when you start to see more financing sources for other operating real estate-based business like golf courses or motels, marinas should not be far behind.
• Anyone in the industry will tell you that boats rely on discretionary income and the ability to turn home equity into dollars.  When you start seeing specialty lending on RVs or other types of recreational property, you can bet the demand for boating will go up.  That signals that the financing noose is losening up.  Maybe it’s turning into a necktie.  It will take time to make it to real estate, but this is sure sign of a step in the right direction.

Here’s Your Bullseye

So, what kind of picture am I painting?  Marina lending is cyclical.  It depends on a trickle down effect from the first and second tier lenders.  But before that happens, you’ll see finance companies starting to spring up in other industries and lending on golf courses, motels and other operating businesses.  Maybe even in the marina industry too before the second and third tier lenders come along.  Even then, it seems that the deck is stacked and no one is going to be holding many chips (i.e. loans).  It’s kind of like an inverted funnel attached to a spigot.  When the water is flowing, you’ll get some out the other end but  less than what goes in.  And what goes in will take time to flow out.

‘Hard to believe I said all that without using my crystal ball.  I try to save it for my marina appraisals.

John Simpson, MAI

There is one area I haven’t touched on much within the volumes of Appraisal Matters.  It’s real estate market research.  Sure, I’ve shown my distaste with boilerplate market research.  I know for a stone-cold fact that reviewers just hate appraisal reports that have pages and pages of dry, static, outdated boilerplate that has no material relevance to the property being appraised.  Now that I’ve considered the problem properly identified, let’s try to find a solution.

The Foundation Before the House

A lot has been written on market research within various property-specific appraisal books and within the Appraisal Journal.  The same goes for other real estate disciplines that perform real estate research such as site selection.  I won’t so much as go into how to do real estate research but how to make it relevant.  Add to that timely and meaningful to the reader.

Many people believe that surveys done by large firms are the holy grail.  They have their uses but to completely rely on them for important financial decisions that you have to make is just a lazy way to go about it.  Let me give you a wonderful example courtesy of my wife.

I know of a small bank in Central New Jersey.  For decades, they have continually been one of the strongest Savings & Loans in the country.  Even during the Savings and Loan Crisis of the early 1990’s, they were virtually unscathed.  As I recall, they are something like always in the top 10.  The reason is simple – they do something no other bank I have ever seen does.  Their loan committee gets out in the car, drives to the property that is the subject of the loan request, inspects it and drives around the neighborhood.  Sure, they don’t have the coverage that Bank of America or Citibank has, but that’s not the point.  They don’t rely on general multiple listing statistics, CoStar publications or other “market reports”.  Anyone who is lending money could learn from this example

Primary and Secondary Data

In the above example, looking at the property is primary data…  the loan committee did it.  Similarly, relying on a market report is secondary data.  Ask any Olympian what the difference is between the gold and silver medal.

Now don’t get me wrong – I’m not against secondary data.  It’s just that you need to learn what it covers and what it does not before you make a judgment call.  I did this with investor surveys in a prior blog series.  It usually boils down to basic statistics.  Remember in Stat 101 where the professor spoke about populations and samples?  If what you have before you is a sample of a population, by relying on it, you are saying that your sample is reflective of the sample and that sample is reflective of the population.  In other words, you’re saying that your property is typical of that shown in the survey… but do you know if the the survey is reflective of the entire market or just a slice?  That’s why primary data always trumps secondary data.

Now that you understand the weaknesses of someone else’s work, in Part 2 I’ll get into what you can do to make your market research relevant.

John Simpson, MAI

As I am wont to do, I read the “morning news” over breakfast at my computer.   These are unprecedented times for the automobile industry, as this MSNBC.com article points out today.  Between Chrysler and GM, there are approximately 20,700 dealerships, but what is alarming is the following:

…GM and Chrysler could notify roughly 3,300 dealers this week that they will lose their franchises.

Feeling the Pain

My first job was in a mega car dealership (automobile leasing, to be exact).  I feel sorry for the people who work at those dealerships, but not for the dealers.  With very few exceptions, they’re all wealthy people and families, so no tears fall for them.  Few salespeople remain, so the job loss will be minimal for them; as an aside, I went into a Toyota dealership several months ago and with over a dozen sales desks, only one was occupied, so those that were paid on commission have long since left for, hopefully, greener pastures.  The administrative personnel will take the brunt of the job losses.

Of course, the law of probabilities says there are some unlucky dealers that have one or all of their dealerships targeted for downsizing.  In that respect, I feel sorry for the dealership owner and families.  Their family businesses will be liquidated.

Let the Battle Begin

I find it ironic that some dealers are mobilizing for a legal challenge to manufacturer.  If the manufacturer closes the plants that make a certain line of vehicles, it’s not like the dealer will be getting any more of them.  If they win a legal challenge and get to keep their franchise, what good is it when no cars roll onto the lot?  Are they going to challenge the manufacturers to keep the plants open and producing?  Sorry, I just can’t see that happening.  What they’re trying to do is buy time so that short term financial effects aren’t disasterous:

Under federal bankruptcy law, Chrysler can cancel contracts without having to pay dealers or repurchase their vehicles… They could be stuck with millions of dollars in inventory, potentially putting them at the mercy of creditors… Money owed to dealers by Chrysler for warranty work or rebates could just disappear.

Hmm… I’m not so sure some of this article’s quotes are true.  A dealer owns relatively few of the new cars on their lot.  They use floor plan financing whereby they pay the manufacturer a certain percentage of the invoice amount (the “tissue”, as they say) each month.  The agreements they have with the floor plan lender could be a sticky wicket because if the manufacturer doesn’t take back the cars, the floor plan lender is stuck in the middle.

Then there’s this counter-intuitive quote:

An advertising campaign in major publications like the Washington Post this week urge Obama… that “cutting dealers at this time would do absolutely nothing to make either GM or Chrysler more viable.”

Now that’s just plain spin.  First, the manufacturer can’t make that many cars and stay in business.  Second, when the brand is shut down, how viable is that?  In bankruptcy, the judge holds all the cards.

What That Means for Real Estate

In my seven part appraising automobile dealership posts, I discuss dark dealerships briefly and get into them more heavily in a later blog post.  What we are about to see is a bunch of bankruptcy filings by small dealerships and more real estate put onto the market.  It won’t be as bad as the numbers say, but it will still be significant.  Why?  Some megadealers will simply absorb the loss and use the buildings for collision centers or used car operations (and they have plenty of used cars in inventory right now). For instance, how many stand-alone Hummer dealerships have you seen?  They’re part of a large dealership chain, so expect them to be absorbed.  This is only one example, of course.

For the lenders, I doubt most of them have any worries.  The note behind the dark dealership is backed by the megadealership, so the dealer’s credit would go down the toilet if they simply walked away from the underlying mortgage.  Most of the mortgages are provided by the “big four” lenders and Capital Automotive REIT, so killing this goose means no more golden eggs in the future.  It’s the lender that backed the small dealer that has the problem or the small local bank that will lose sleep over this.

For most of the dark dealerships, adaptive reuse becomes highest and best use… but only when the market turns around financing because available.  For many of them, the value is land only.  Some will be sold by court order at liquidation prices, so there’s an opportunity for a savy cash purchaser to pick up a piece of large, prime real estate.  Best of all, they may get a building that has lots of high quality details.  Here’s a quote to that effect:

Many dealers are preparing to fight back, citing heavy investments backed by franchise agreements that in many cases date back decades.

‘Wish I could work with Italian marble tile underneath my feet.

John Simpson, MAI

I admit I left you hanging in Part 1.  Permit me to prove to you that I wasn’t teasing.

To recap from Part 1, if we have a market rent of $20 per square foot for retail space and we have a 150 foot bay length where the market demands half that space (or less), we know that the market rent for this space is not $20 per square foot.  It’s not $10 per square foot.  Let’s see what it really is.

It would be easy to partition the space into two units, one part usable by the market and the other… what?  I’ll get to that.  So if we want to determine the market rent for the space, we put up the partition and assign market rent to the front half of the space (whatever side gets the most “traffic”).  We’re half-way done.

The More Is Not Better Part

So what can we do with the empty space?  That depends on the market.

Could it be used and rented as office space?  Yes under the following circumstances:

• It has a door, preferably with a couple of windows to the “front”.
• It has a facade other than concrete block… something that would show the space as office.
• The Class C office vacancy is not so high that it wouldn’t be marketable.
• It would not interfere with the theme of the center (for example, medical space that needs lots of parking spaces that would be better used as parking for the adjacent restaurants)

Could it be used as a second retail bay sized correctly for the market?  Yes under the following circumstances:

• It has a door with retail windows
• It has a facade other than concrete block… something that would show the space as retail.
• It fronts along a reasonably visible location to retail traffic (i.e. it doesn’t face the back of the center where no one ever parks)
• There is sufficient demand for retail space that has lower visibility than the main retail space that fronts toward a road or in the case of a regional mall, fronts directly on the mall.

There won’t be many cases where you can say “yes” to the above.  If you can’t, then storage becomes the only option.  Ironically, the most demand may be for just this use.  Retail stores frequently have stock they need to store away when it’s out of season; what could be more convenient than storing it in the same mall?  In this case, you’d assign a nominal rent to the space.

The Trap Within the Trap

‘Bet you thought we were done.  ‘Sorry… I have more tricks up my sleeve.  Let’s say you assign $2 per square foot for storage to this functionally obsolete space.  How do you handle CAM?  If CAM is, say, $4 per square foot, you can bet that the storage tenant will not want to pay it because any other storage space would not incur this expense (which is double the rent and bluntly obvious to the storage tenant).  That means the owner absorbs the CAM.

What if it’s office space?  In a triple net Class C office market, you can get away with the tenant paying some expenses, but the landlord will still have to absorb something.  For a regional mall, that means the proportionate share of advertising and likely mall interior maintenance.  In a gross lease market the landlord will absorb everything except for utilities.

If the space is to be lower-tiered retail, advertising can get passed on through CAM.  Interior mall maintenance probably will not.

So what you have is a branching tree where you have to determine the highest and best use for the space, assign different rents and then assign different expenses to the tenant.  In all instances, it’s likely that the landlord will have to bear some additional expenses, but the amount depends on your highest and best conclusion.

Dealing from the Bottom

One more variable remains to be considered.  How will the market react to the space?  It might take forever to lease the space, good economy or not.  That’s the nature of functional obsolescence.  You might have to discount the rent, although you can’t really discount storage space rent without the landlord or manager deciding it isn’t worth the effort to lease out (if that were the case, the landlord would just leave it as is or perhaps store file boxes there rather than in a storage unit).  Maybe to entice someone the landlord would have to pick up all the expenses except for utilities.

Class Dismissed

The best thing of all is that this was an open book quiz, so having read this far, you get a gold star.  Class dismissed.  No homework.

John Simpson, MAI

Every now and then I run across a property that just doesn’t make sense.  I suppose someone thought it did (like the builder), but the market sure doesn’t.  The example of which I refer is the 150 foot long retail bay.

I Spy with My Little Eye…

I appraised a fashion center in Orlando, Florida and regional malls in New Jersey and Maryland that suffered from this problem.  What’s the big deal?  Well, in all these instances, retailers only needed no more than about half the space… if that.  It was more liability than asset because in all three cases, it took a whole lot longer to lease the space (even during good economic times).  This is analogous to my blog on the value loss of the parallelogram shaped office building in that both offer space to the market that it just does not want to pay for.

So let’s take a macro view of the problem.  Why does the market shy away from this space?

• Most obviously, retailers don’t want to lease what they can’t use.  Corporate has very specific space requirements and if it’s too far outside of what they’re looking for, it will just get passed on.
• Why pay electricity, heating and air conditioning on twice the space than you can use?  Given the utility rates of today, this is no small chunk of change.
• It’s twice the common area maintenance charge than what they can use.
• If you take the retail stock that a store will display and spread it over double the space, it kind of looks like they’re a temporary tenant, a soon to be going out of business or they just appear to the yet like they can’t stock enough to fill the store.  No matter how you package it, to the consumer it looks bad.
• If you have twice the space than you need, your sales per square foot will be half what it should be.  You can bet that Corporate will look at that store as a loser and it would be targeted for downsizing during the next economic downturn (which would have occurred by now, of course).  What good manager wants their compensation tied to sales per square foot in an overly large store?

The Trap

There is a trap that an analyst or appraiser can fall into.  Let’s call it thinking inside the box.  Let’s say you’ve got this vacant 150 foot retail bay space and you have comparables that say the market rent is $20 per square foot.  Time for a quiz… what’s the market rent for your vacant space?  Yeah, you can guess that it’s not $20 per square foot because you’ve read my many blogs and you know I wouldn’t give you such an easy question!  The $20 per square foot answer is thinking inside the box… and we can’t have that, can we?

So what’s your answer?  Did you say $10 per square foot?  Since I’ve mentioned that these spaces are about double the market size for a fully marketable retail bay, that would be a good guess… but not the answer.  Above you have five reasons why a retailer won’t lease that space, so why would they lease the whole thing for half the rent?  They’d still pay utilities and CAM based on the excess space.  They’d still have a sparsely populated store.  No, even for $10 per square foot, they’d still walk.

The answer to the question will be revealed in Part 2.

John Simpson, MAI

Can we talk?  About the income approach, that is.

Playing Hard to Get

The income approach has most of the same potential problems as the sales comparison approach.  Finding a lease for the land and a fast food building is almost impossible.  I’ve already talked about the sale-leaseback.  Since land leases are typically not that common, most of them are dated and therefore of minimal utility to your income approach.  As is typical of many markets, market participants buy a fast food franchise based on fee simple motivations, not leased fee.  Even when a lease is created, many times it is based on a fixed percentage of the fee simple value.  The most common numbers I’ve seen is a lease based on 10 percent of fee simple value.  It is an oxymoron to base a comparable property lease rate on a fee simple land value and use that in your analysis.  If all the properties in a market use a lease rate of 10 percent of fee simple value, you’d have to know fee simple value for your subject to use it.  That’s what we’re trying to solve for, isn’t it?

Another factor is that land leases are typically controlled by a small number of major companies.  Sometimes a small number of investors have done almost all of the land leases; this is common for markets where there are many shopping center pad sites.  How can you tell?  It’s pretty easy.  Call a few brokers who have signs on the highway.  If they say they can’t get it, you’ve got a zero percent chance of getting them.

Alone on a Desert Island

So… what do we do now?  I’m not saying that an income approach cannot be done, I’m just saying that in many major metropolitan markets, you won’t get enough data to do this approach.  Appraisers do not create the market – we report it.  If it’s not there, it’s not there and it’s time to move on.

One way around this is that your client might have information he/she is willing to share.  If you’re lucky, that is.  Even if they have it, they might not share it since it is confidential.  I’ve had clients that have all the information at their fingertips and not provide any of it for fear of influencing my thought processes.  That pretty much kills the ability to do the income approach given the discussions above.

There’s another very good reason for not doing the income approach.  If you do the sales comparison approach the way I suggest in Parts 5 and 6, you will have little or no time left over to search for hard-to-find land leases.  In my humble opinion, it’s better to put your time and effort into those areas that will produce results for your client than to chase data that is very hard to get.

I don’t have all the right answers… but is do have all the right questions!

John Simpson, MAI

So you want to play the sales comparison adjustment game, eh?  You can leave your dartboard behind.  I’ll get more accurate than that.  Don’t worry, I haven’t said you need to do paired sales, which is archaic appraisal theory that doesn’t fit into the real world.  No square-peg-in-round-hole whack a mole today.

The Overlap Problem

Remember our friend the site selector from Part 2?  He’s the one where you peeked over his shoulder and looked at the form he used in the field.  I hope you remember it, but fear not… I don’t give pop quizzes.

Some of the adjustment factors were site size, shape, traffic volume, traffic flow during peak periods, number of curb cuts and lot width.  Traffic volume and flow seem like partially duplicated adjustments.  Except for size, all the others seem too minor to bother with.  Combine all the adjustments except for size and it almost seems like you’re putting a lot of nebulous +5%, -10%, etc. adjustments in the mix.  There’s a better way.

The Rating Grid

Think like a site selector.  They’re not “+5″, “-10″ percent adjusting, are they?  No way.  What they have is a scoring sheet.  They’re assigning a scale to each item that they consider material (or should I say, material as defined by their firm) and at the end, they’re adding up the results.  The final number is how that property scores.  Do this for your subject and your comps and you can make the same adjustment that the site selector does.

Let’s take a simplified example.  Your subject rates a 5 on size, a 3 on traffic volume, a 4 on peak period traffic volume, a 2 on curb cuts and a 5 on lot width.  The total is 19.  Your comp rates a 4 on size, a 4 on traffic volume, a 5 on peak period traffic volume, a 2 on curb cuts and a 3 on lot width for a total of 18.  Now I ask you how easy it would be to do plus and minus adjustments using round numbers to come up with such a slight difference.  You’d probably be way off.  In this case, there is not enough of a difference to warrant an adjustment.  Actually, the better way to phrase it would be that they offset such that no net site physical characteristics adjustment is warranted.

At what level do you begin adjusting?   That’s your call.  One point wouldn’t be enough and maybe not two.  Three or more and I would begin.  But that’s just me.

In Part 7, we’ll get into the income approach.

John Simpson, MAI

The sales comparison approach is viewed by most appraisers as the primary indicator of value for fast food franchises.  The reason is simple – it has the most availability of data.  You’ve got a much better chance putting together 5 or 6 sale comps than you do 5 or 6 fast food rentals.  So let’s spend some extra time exploring this approach.

A New Spin on Our Old Problem

We’re back to the problem of whether or not the building contributes to value.  Your decisions here have a huge impact on the validity of the sales comparison approach.  How do you resolve this issue?  In your adjustment grid, show the price per square foot for the building and the land.  Take a look at the range.  I’ll bet you’ll find what I find most of the time:  the range is so much more narrow that is almost seems like price per square foot of land is begging to be used!

One reason for this is that price per square foot of building varies greatly with small changes in building size, as you would expect from the denominator of this ratio.  A second reason is what many market participants think:  that the value is all in the land.  As a result, the price reflects land value.  The third reason is that the overwhelming majority of value is in the land, so it should be the primary indicator of value.

One side benefit:  you can usually use shopping center pad site sales and pad rentals if you appraise it based on price per square foot of land.

Monkey Business!

Another issue you’ll face is how to handle sales of existing and established businesses that sold with the real estate.  That’s a little like what I blogged about in the automobile dealership series.  The technique I prefer for monkeying with the business value is to derive it from the participants to the sale; of course, if it’s a dark sale, there is no business and therefore no problem.  Another useful way to do it is illustrated in Convenience Stores and Retail Properties:  Essential Appraisal Issues by Robert Bainbridge, MAI, SRA, an the Appraisal Institute publication.   Pages 119 to 133 talk about calculating EBIDTA (earnings before interest, depreciation, taxes and amortization).  I won’t bore you with a long tirade about how it’s done except to say it’s done a lot like calculating a stabilized operating statement and capitalizing it, although you use business income and you can use techniques to separate personal property from the mix.  It’s hard enough getting cap rates, let alone cap rates where you have to extract business value and FF&E.

The only major problem with this approach is you need to have accurate numbers for the business.  That means you need the business profit and loss statements for your comparables… good luck with that.  You may get it for your subject, but it’s not like you have industry publications that you can compare them to.  In other words, you won’t be able to use a third-party study to determine if the business expenses are accurate.  So if you use numbers provided by your client without knowing whether they are at market, you’re essentially providing investment value, not market value.  That’s something to think about, right?

It’s Not Verified ‘Till It’s Verified

OK, so you know I’m a big proponent of verifying sales.  Maybe I do too much court work.  Nah!

There is one very good reason to verify fast food industry sales that you won’t find much of in other industries.  It’s called sale-leaseback.  There is plenty of it in this business because it’s essentially used as a financing vehicle.  Another problem is if you don’t ask this question, you might never learn that the cap rate from this sale reflects a motivation different from that of the market.  So not only do you compromise your sales comparison approach but you butcher your income approach as well by using sale-leaseback comps.  Now that’s what I call a powerful question to ask!

Guns and Butter Adjustments

So from Part 2, you might have guessed that the adjustments that need to be made to your comparable need to be specific to the fast food industry, not the appraisal industry.  In Part 6, I’ll present a novel way to handle adjustments similar to the way the fast food industry thinks.

John Simpson, MAI

Some appraisers always do a cost approach for a fast food franchise valuation, others only when data is scarce in the sales comparison and income approaches.  I view the cost approach in a similar manner as I do automobile dealerships and marinas:  it’s only useful as the approach of last resort.  When you can’t get that square peg into the round hole, it’s the cost approach to the rescue!

Paradoxically Speaking

So in the cost approach, you’re adding the depreciated cost of the improvements and entrepreneurial profit to the land value with site improvements.  From Part 3, can you see a big problem?  If in your opinion the market would not view the improvements as adding value, adding the depreciated cost of the improvements to land value would overstate your estimate!  Forget the age-life method for estimating depreciation.  In these situations, there should be no cost approach.  Don’t open Pandora’s Box if you don’t have to.

Reproduction or Replacement Cost New

Having said that I view the cost approach for fast food franchises in the same light as automobile dealerships and marinas, what’s my beef?  You may have a costing service in front of you and are ready to cost out the improvements, but there’s a good chance the reproduction or replacement cost new is not accurate.  Why?  Sample size, for one.  That’s why you can’t select a particular restaurant chain for costing from a cost service – you have to use a generic category.  I just don’t see McDonald’s or Chick-Fil-A handing out their construction costs.  Ask anyone of authority at the corporate real estate department level and you’ll see that they’re as tightly guarded as you can get.  Loose lips sink ships… or in this case, give this information away and it’s your job.

Functional Obsolescence

Like automobile dealerships, fast food restaurants can suffer a high degree of functional obsolescence.  Unlike automobile dealerships, the functional obsolescence is more gradual.  Just because the franchise designs change today doesn’t mean that a high degree of obsolescence is present tomorrow.  The pressure put on by the factory for an auto dealer to upgrade their facility is quite different from that of the fast food franchiser that provides no pressure to change.

When functional obsolescence is present, the real question is how much.  For the land-only market value scenario, it’s the entire remaining reproduction cost new less depreciation.  Although you could say that external obsolescence is also present when other same franchise buildings take market share away (as in the aforementioned Colorado appraisal assignment), it’s kind of splitting hairs.  The end result is the same – there is no remaining building contribution to the land.  In these situations, the cost of demolition actually makes land value lower by some nominal amount.

Entrepreneurial Profit

For the land-only market value, this is an oxymoron if ever there was one.  This, too, would be eliminated in a functional and/or external obsolescence adjustment.  The whole theory that someone would build a building that is contrary to what the market would build and make a profit in doing so is just plain silly.

In Part 5, I’ll get to the primary indicator of value used by appraisers – the sales comparison approach.  If you’ve read this far, you’ll want to check it out for sure.

John Simpson, MAI