Appraisal Matters

Over the years, I have found one property type that seems plagued by a riddle.  Not the riddle of the sphinx, but one almost as difficult to solve.  The riddle applies to industrial properties and it goes like this:  When does real estate become business?  The answer is when many of its components are so specific that they have no other use.  I’ve got two examples.

I once appraised a computer add-on board manufacturer’s facility.  It was large, beautifully designed and as technologically specialized as you could find.  It’s market, like most of the industrial market in the state, was depressed at the time.  There was too much speculative industrial construction.  The economy had little to do with it - it was all about worldwide computer industry demand.

The quandary was it had anti-static floors, advanced air circulating and balancing equipment and lots of fixtures that were specific to only this use.  As I was able to confirm with multiple real estate brokers, a manager of a similar type of plant and the regional economic development officer, all these real estate fixtures and components had no value to the next user.  Not 50 percent off, not 75 percent - no value whatsoever.  Essentially, these specialized and super-adequate systems were 100 percent functionally obsolete.  The market recognized this, but when you consider the sheer dollar cost of these items, it’s hard to image such a market value write-down.  The real estate components were considered by all to be part of the business.

We recently ran into another example:  high-ceiling, bulk cold storage warehouses.  Almost all of these uses are in the food service industry.  This market is separate and unique from dry warehouses.  Unlike the example above, when it comes time to sell one of these buildings, the owners typically spend a fair amount of money to bring them back to being a “plain vanilla shell” for the sole purpose of making them more marketable to a wider range of users.  The market is controlled by a small number of tightly held companies and the union of the distribution channel and customers are long-term.  Barriers to entry are too high for new entrants.  Finding arm’s-length transactions is very difficult and getting arm’s-length leases are just as hard.  Like the above, the expensive freezing and circulatory systems are 100 percent functionally obsolete to the next user.

There are three key points from the above:

1. It is hard for some owners and managers of these facilities to realize that the huge amount of money they spent on these “real estate components” has no contributory value.  It is very easy to take a cost approach and value the building with these components and not consider that on day one, they’re worth nothing in the real estate market.  Not even the car you drive off the lot depreciates that quickly!
2. Appraisers need to separate the market for these components from that of the building itself.  Market participants consider them business components, not real estate.  They need to make the tough call of making a high functional obsolescence adjustment.  For the HVAC system, I can see taking partial adjustment because it can be used “as is”.  For the expensive electrostatic floors, it’s the difference between standard, market floors and the electrostatic floors.  For the freezing units, it can all be considered functional obsolescence.
3. The cost approach is typically used as the sole valuation method for highly specialized properties.  When you have an industrial building with extra business components, it’s really easy just to do one.  It is only applicable when you can make the tough call of applying various functional obsolescence adjustments to different components, otherwise the value indication is substantially overstated.

There may be other property types where the same argument can be made.  I’d love to hear about any examples you know in a comment.

John Simpson, MAI