Cultural Differences – Know Who is Across the Table

Reading that there are nearly two dozen German companies in the area (https://www.timesfreepress.com/news/business/aroundregion/story/2019/jul/29/german-connection-chattanooga/500019/) reminded me that there are cultural differences in the way people from different countries approach real estate. While we have a very strong system set up to support real estate ownership and transactions it’s not the same around the world and when engaging with other cultures it can be critical to understand the idiosyncrasies they have in order to be successful.

For instance the majority of Germans do not own their own homes. They are one of the largest leasing oriented countries with something like 80% or more not being owners. This will have obvious effects that we can see but also not so obvious ones like the limited number of potential buyers and a system that is not as efficient in transactions.

Another example are Middle Eastern countries. Their system of laws around real estate and their understanding of contracts is vastly different than ours. Where we have a simple underlying belief that if I sign a contract with you today we are in a ‘Contractual Relationship’ and we will follow its course to the end many Middle Eastern countries do not have the same adherence or even basic belief in such rigid structure. You can sign a contract today and find yourself tomorrow completely renegotiating it or worse find that there is a second contract they have entered into. They see nothing wrong with this and consider that if you wanted the property you would have bought it, without consideration for any due diligence. There is also a distinct bartering mentality which will drive you insane if you’re not prepared for it. Middle Eastern cultures will retrade and renegotiate endlessly – even at the closing table – in order to get even just one more dollar. This is not viewed as wrong or disrespectful but actually as good business. As fighting for every last possible bit of value. It’s just much more fluid than we’re used to.

On the opposite end of the spectrum would be Asian societies where structure and a rigid adherence to a way of doing business can seem almost stifling and if you don’t do your homework you can lose a deal before you even have it presented.

In short, as with all deals do your homework on who the other party is, their style and motivations. You don’t want to lose out on a deal because you decided not to join the Japanese for Sake and karaoke after a long day of negotiations. Sake and karaoke is not optional.

What’s It Worth – Let’s Talk Valuation

So you’re looking at a building and trying to figure out what it’s worth. How do you sort out a value?

Well, that depends (everyone loves that answer I know). It depends on where you are standing naturally. Are you the owner? Are you a lender? Are you an insurance company? Are you a buyer? Each of these (and many others) will come up with a different valuation of a property based on their unique perspective.

An extreme example of the variability of valuation occurs when we look specifically at appraisals. Whomever orders the appraisal will dictate the bend of that valuation. When a bank or lender orders one it will be different that when a buyer or seller orders one directly. This can be extremely confusing as we like to think that there is just one price for something. However, appraisals can vary substantially based upon their purpose and it’s not generally viewed as manipulation.

Value changes based upon where you are looking at a property from.

Let’s put the esoteric discussion on hold for a bit and discuss the basic fundamentals of valuation and then we can come back to how they are ‘nudged’ depending upon who is directing the valuation.

In appraisals there are three standard methods for determining value: Income Approach; Cost Approach; and Sales Comparison.

In general appraisers will use two of the three methods to ‘derive’ a valuation for the property. Typically the Cost Approach valuation is the one that is dropped as it is furthest from what is considered a ‘market value’.

Income Approach:

At its most basic the Income Approach is determined by subtracting the expenses from the income.

So the math looks like this: Income – Expenses = Cash Flow

Pretty simple but now we need a way to easily compare it to another property. We need Net Operating Income or NOI which is the income that is left after subtracting vacancies, losses and expenses. The NOI can then be used to calculate what is called the Capitalization Rate (cap rate) or the estimated rate of return from the property assuming you bought it without leverage (loan).

So, the math looks like:

Income – Credit Losses & Vacancies – Expenses = Net Operating Income (NOI)

NOI / Sales Price = Capitalization Rate (Cap Rate)

So, if you have $100,000 in income; $30,000 in Credit Losses, Vacancies, Expenses and a sales price of $1,000,000 your Cap Rate is 7%.

$100,000 – $30,000 = $70,000 (NOI)

$70,000 / $1,000,000 = 7% cap rate

Cost Approach

The most straightforward and often disregarded method of valuation in commercial is the Cost Approach method. This is simply what would it cost, in today’s dollars, to acquire the land and build the same building you are looking at. In most markets market pricing is well above replacement, however, it is always good to be aware of and consider. If you can buy land and build exactly the same building next door to the one you are looking at for less its value is undercut.

Sales Comparison:

Most people who have bought and sold a residential property have seen the Sales Comparison (comp) method as it is the primary technique utilized by residential appraisers. There are many more houses than there are commercial properties so the Sales Comparison method will usually provide a good indicator of where the market is. When dealing with commercial sales it can become much trickier since there are not as many similar properties to compare.

In using Sales Comparison the goal is to find like properties sold within the prior two years to provide a guide in valuing. For instance if you are trying to value a 50,000sf shopping center you may have to look at a wider geographical area to find something to compare to and you may actually have to look at different sized properties and then compare on a per square foot basis in order to get to a valuation.

In finding similar sales you will again need a good way to translate the value of the sold comparable property back to your target shopping center. Traditionally a Price Per Square Foot is used as it helps to deal with variation in property sizes. So, if you look up the recent sales and find a 40,000sf shopping center nearby that sold for $5,400,000 you can quickly determine that it sold for $135 per square foot (psf) and use that to estimate your valuation.

$5,400,000 / 40,000sf = $135psf

Difficulties can arise if the property you are trying to compare is in a town of say 100,000 people and there are only a handful of similar centers. It may be necessary to expand the scope and include any strip retail in order to actually find a comparable. Though a dialed in broker will have a good sense of where the market is for a particular product type it’s hard to build a serious valuation on a brokers ‘feel’ for a product.

You can quickly see that with a limited pool of comparable sales to use it can be quite difficult to come up with a strong valuation consensus using the Comparable Sales method alone. Which is why it is typically used in tandem with the Cash Flow method to help inform the valuation and not as a stand alone.

Now you understand the fundamentals so let’s get into the interesting stuff! First you need to know that there are two written and formal ways of setting a market valuation for a property: first is the Broker’s Opinion of Value. This is the less used, quicker, easier and less accurate form of gauging the market value of a property. Each state is different in how they outline the process for a broker to provide a valuation so it’s not worth getting into the specifics but suffice to say these are typically based upon a market survey of similar properties and current sales. Essentially a listing and sales comparable approach. Many brokers will not provide these as it can be a significant liability if the person they provide it do disagrees with their assessment.

Second is the more traditional appraisal completed by a professional appraiser whose only job is the valuation of properties and who is bonded and insured to provide valuations. Appraisers are the default arbiters of value and are relied upon in the market for valuations.

A bit About Appraisers:

As I said in the beginning valuations will vary depending upon who is ordering the appraisal. This can be most obvious in residential. Following the downturn in 2008 the residential appraisal industry took a lot of heat and the way appraisals were carried out changed dramatically. Before the change appraisers were local and went to each house they appraised rendering their value and being very well informed of the local valuations. Following the change they were able to do appraisals remotely and the person doing your appraisal now may never set foot in your town. It’s all data. This change was in large part to shield appraisers from influence. Prior to the change it was not unheard of to have brokers; bankers and even property owners ‘helping’ appraisers to get to a specific number that was needed to close a deal.

Thankfully in commercial this kind of nonsense is far less likely. Mostly because the commercial appraisal takes much much longer, costs more and in most cities there may only be two or three people qualified to perform commercial appraisals. Typically commercial appraisers have a substantial and rigorous training period in residential before they’re even allowed to look at a commercial property. Commercial appraisals can take months to complete and are huge. Some can run to more than 100 pages. Residential appraisals take less than a day.

We can just say that in commercial there are a lot more zeros involved and this makes it much more complex and less susceptible to funny business.

Where it Gets Muddy:

Who is ordering the appraisal and what’s the purpose? These are the questions you will be asked when you call up and order one. If it’s for a purchase and is being ordered by the lender they will want it to be very close to the contract price. If it’s not – and in commercial this does happen – then the buyer likely will have to come up with additional capital to cover the difference as the lender will follow the appraisal.

However, if the owner of a building orders an appraisal because they want to know what their building is worth you can bet it will be different than if there was a contract. That is not to say that there is anything wrong with the process. It’s called anchoring and without an anchor that is provided the appraiser will use only the market indicators to derive the value.

If you are a buyer and you order an appraisal for yourself it will be different – lower – than if the seller ordered the same appraisal on the same building. Perspective makes a difference.

Again – and to stress – there is nothing nefarious here. These are the vagaries of valuation. How much something is worth depends a lot upon who is valuing it. We could go down the economics rabbit hole here but let’s not because I can see a lot of you dozing off already.

And So:

You need to be aware when reviewing an appraisal where it came from and under what circumstances it was ordered. There is a day coming when appraisals will be fully automated, it really is all just data, but until then we need to be able to understand the nuance of how value is derived.

New Condo Building Downtown

The integration of automated parking into projects is making its way to downtown and with it some new condos that I suspect will find a market ready for them. Given the recent taste for building for lease multifamily rather than condos I would bet there is some latent demand for condos downtown. This will be an interesting project to watch both for the sales but also for the developers willingness to shoehorn residential into buildings where most cannot imagine it. This is how innovation happens.

https://www.timesfreepress.com/news/business/aroundregion/story/2019/jul/11/24-condos-stacked-parking-system-planned-down/498638/

Apartments to Hotels – How to Pivot

Quick thinking developers and building owners seeing the glut of rooms on the apartment rental market have begun to pivot to hotels. A wise move and one that can be quite lucrative. Though now we have the concern about having too many hotel rooms but hey it’s always something isn’t it.

Keep an eye on these projects and see how downtown absorbs and builds around them. Those that get left on islands where there is little else will have a hard time in the long run.

https://www.timesfreepress.com/news/business/aroundregion/story/2019/jul/11/laquinta/498569/

And the Cycle Continues – Multifamily DOWNtown

John Wise says it well: “…I’m afraid the party is over and there are going to be some tough times for some developers.”

In every real estate cycle there is the BOTTOM, the UP, the TOP and the DOWN. Calling the BOTTOM and TOP is hard to do but seeing the UP and DOWN is much easier. We are now seeing the long called for DOWN with discounts, desperate marketing efforts and other tricks starting to come out. In time we may see the next phase of a down: sales. Discount sales as lenders and investors pull the plug on projects they’re just going to write off as a loss. Those are usually a good indication that the BOTTOM is close by.

How long any of this actually takes to happen is a guess and is dependent on lenders staying power and devotion to the market. A local lender / investor with long ties to the market may stay with a project and work with the developer / owner to restructure the debt or delay payments in order to weather the downturn. Most national lenders and equity players have a much shorter fuse and when things look like they’re going to take a while to rebound many will cut bait. Take their lumps and move on.

This can be a great deal for tenants with lowered rents and all manner of incentives. It can also be great for those looking for an opportunity to buy into the market as some of the projects may trade at a discount. With a new lower basis it will be easier to ride out the market downturn and then make even better money in the following UP cycle.

https://www.timesfreepress.com/news/business/aroundregion/story/2019/jul/01/chattanoogrental-rates-rise-so-do-discounts-n/497882/