Breaking News

Transactions-Based Index (TBI):
2008 Q2 Update

August 5, 2008

Results for the 2nd quarter of 2008 show a 2.7% decline in the capital return for the properties sold in the NCREIF database. The demand-side index continued to fall, by 2.7 percent and the supply side of the market also decreased its reservation prices by 2.8 percent in the second quarter.

Click here for press release.

Moodys/REAL Commercial Property Index (CPPI): July Update

July 29, 2008

The latest results of the Moodys/REAL CPPI show a decrease of 3.5% in May for the all properties national index. Click here for Press Release on MIT-RCA inde

I’m not sure I can add anything to this other than this is what we see in the field.

Eileen Simpson

It occurred to me while I was replying to a comment on my “Marina Unit of Measure Fallacy” blog that price per slip is even more potentially misleading than the items I itemize. When does the price per slip not apply?

When the purchaser wants to use the site differently (condo development or new boat dealership), the price per slip becomes skewed. When there’s too much land, it becomes skewed. When there are lots of buildings and on-site amenities, it becomes skewed. When the marina is purchased by a “first-time” marina investor, it becomes skewed. If there are few slips but major boat repairs or sales going on, it becomes skewed. If it is a truly “investment grade” marina, it can become skewed. Whew!

The commonality and bottom line in the above is that marinas fit into a large number of categories that are mostly discrete. A typical market participant in one category will often have absolutely no interest in another category. Why? The answer is simple: the degree of specialization and knowledge of the marina owners varies so much.

Let’s take some real world examples. The boat dealer has knowledge of boat repairs, but do they know how to run a lodging business (hotel, motel or bed and breakfast)? I think not. The opposite holds true too. Does the basic marina operator, who has never owned a boat dealership, understand the boat sales business? How about the repair business? And so it goes.

If the participants differ, clearly the definition of “comparability” should also. Comparing marinas from one tier to another and using price per slip is like comparing price per tire of a Ford to a Mercedes. The buyers are different in both cases. So are the market tiers. It’s an apples-to-oranges comparison. That’s why most marina sales comparison approaches should be only used as a “rough” check on the income approach.

John Simpson, MAI

During the past few years of explosive growth, the highest and best use for marinas very often was NOT as a marina.  Many traditional marinas changed to mixed use or condominium developments, especially in the southeast.  Now that that the real estate bubble has burst, development is often not the highest and best use of the land anymore.

Value-in-Use is the net present value (NPV) of a cash flow or other benefits that an asset generates for a specific owner under a specific use.  In the U.S., Value-in-Use is generally estimated at a use which is less than highest-and-best use, and therefore value-in-use is generally lower than Market Value.  Every person that calls wants to know what the market value of their marina is, but of more importance may be the value-in-use.  For marinas with no development potential or expansion ability, both market value and value-in-use may be the same.

Why Value-in-Use is Important to Lenders

During the easy lending times, lenders loaned on the highest and best use market value of the marina.  There is nothing generally wrong with that, but it is risky.  Every downturn in the market has hit marinas hard and fast.  Often lenders will ask us to calculate fee simple and leased fee value on traditional properties and provide them with the lower number to lend on.  Underwriters should think about doing the same with marinas, only asking for the lower number between market value and value in use.

Lending is tight right now for marinas, but what if underwriters used value-in-use?  Wouldn’t funds become more available and help alleviate the credit crunch for marina owners?  These loans would be stable and well supported by the current income streams.  Lenders should not be afraid of asking for something other than market value.  We also find that cap rates for marina sales are based upon the value-in-use income stream, NOT highest and best use.

Why Value-in Use is Important to Marina Owners and Potential Investors

Yes, we know that when going for a loan, you are looking for the highest value, but should you?  Limiting lending to a number that can be supported by your income stream is smart in the long run.  Some of you are out there have crushing debt based upon development potential.  At the time it might have seemed like a good idea.  Does it now?

How about that tax bill this year?  In most jurisdictions marinas are assessed at their highest and best use.  Almost without exception the taxes for this year are based upon sales that were very high and had sold for development.  Assessors use highest and best use and now the tax bills are crushing many marinas.  With high operating ratios already on the books, these increases in taxes are causing a crisis in the industry.  Of course assessors must follow their local rules which tell them to value at the highest and best use.

Thinking of buying a marina?  Unless you KNOW you can redevelop, purchase on value-in-use.

Why Using Value-in Use is Important to Communities

The heart and soul of waterfront communities is their marinas and fisheries.  What will happen to the local economies if they go away?  That is a distinct possibility if something is not done to protect marinas from economic ruin.  I know that governments are strapped by the downturn in the economy and any mention of tax relief is not popular.   Think of the alternative.  We live in the Chesapeake Bay Region.  I talk to owners daily about their inability to survive based upon tax assessments that consider redevelopment, rather than their current use.  If the economy had not changed, how many owners would have been forced to sell for development?  Where would our soul and traditions have gone?

Agricultural assessments came along to protect the farmer.  I think it is time to start protecting our marinas in a similar way or we will have no boat services left.  Marinas are a special use that are important to local economies.  Farm land was worth saving… so are marinas.

There have been some efforts throughout the Country to change how marinas are valued for tax purposes, but they have not been widespread.  We had an aborted try in Maryland this session with the original bill being corrective, but it was vetoed by the Governor.  A watered-down bill was passed that only helped a very small subset of users.   In Florida some communities have moved toward using value-in-use to save their waterfronts.  It is time to open this dialog across the Country.

The Environmental Movement and Value-in-Use

Things are changing.  Waterfront development is not popular and many areas put great restrictions on this development.  As appraisers, determining the highest and best use of a property is extremely difficult.  To do so properly, very expensive studies are needed.  How many marina owners have a current wetland study in place?  How many have soil studies?  We are asked all the time if a waterfront property can be developed.  The bottom line is without very expensive engineering studies, it is impossible for us to know.  The chances for development become less and less as the environmental movement continues to gain momentum.  Value-in-Use can be easily found.  Highest and Best use without these studies? It is not so easy!

The marina industry needs relief and help.  It needs access to funds and tax relief.  Using value-in-use would help on both fronts protecting lenders from risky loans, and preserving marinas for waterfront communities.

Eileen Simpson

When functional obsolescence is present at a marina, it is usually one of two types:  Those that affect the marketability and value of the marina (which I call supply-side obsolescence) and those that are recognized by boaters (demand-side obsolescence; again my term).

From marina surveys I’ve recently performed, there is a clear and almost universal pattern in demand-side obsolescence.  The following items of demand-side functional obsolescence reflect affect occupancy and rental rates:

• Single amp electrical power - the vast majority of boaters want dual amp configurations.  Each power post is shared between two boats, so what the market demands is two receptacles on each side (four per post).  Why?  One receptacle is used for plugging in air conditioning units when the boat is docked.  The other is used for everything else, of which the most pressing need is for recharging on-board batteries.  Marinas with single-receptacle only configurations have higher vacancy rates.
• 30 versus 50 amp electrical power - 30 amps is fine for most medium sized cruisers and sailboats.  However, 50 amp is demanded for larger boats (the size of which varies by region, but in general is 50 feet plus).  There are just more electronics to run.  30 amp-only marinas loose the larger boat market.
• Sewer pump-out - if you don’t have it, expect a large hit in occupancy.
• Slip location on the dock - There are two principal areas on many marina docks that are really hard to rent.  An interior corner location, such as you might find in a “T”-shaped dock configuration, is the most difficult.  You can find two of those in the “T” configuration, on both sides of the intersection of the horizontal and vertical lines that make up the letter T.  The second location is at along side some marina fairways (i.e. boat waterway entrance/exit points to the marina).  For instance, let’s say we have two “T” configurations next to each other (T T).  The space between the two T’s is the fairway.  Docking boats across from each other at the end of the T’s (the right end of the left T and the left end of the right T) are difficult to rent.  On a windy or stormy day, few boats want their boat to be docked at these locations for fear of a boat collision with boats entering or exiting the marina via this fairway.  Expect significant rental discounts and much higher vacancy rates at these locations.
• Water depth and draft - as you might expect, boats require a sufficient draft to not run aground.  Drafts are not universal by boat size, so I can’t give any firm guidelines here.  When silt builds up, boaters recognize low draft and will not rent at slips they might otherwise if there was sufficient depth.  This results in undersized boats being docked in overly large slips if the rental rates are based on price per lineal foot of boat.  If they’re based on the maximum boat size that can be accommodated at the slip, this is a big problem because smaller boats will not pay higher rent for larger slip sizes (i.e. a 32 foot boat will not be docked in a 40 foot slip because the owner will not want to pay the higher rate differential when silt prevents 40 foot boats from using the slip).
• Amenity inadequacies - this is a difficult topic to quantify because marinas vary so much in the amenities they offer.  By amenities, I am referring to services offered in buildings, not services at the dock or services offered under the banner of “repair”.  Boaters want clean, air conditioned restrooms and showers.  Pools are in demand too.  Wet bars and snack bars (perhaps restaurants in some locations) are also in demand.  Overnight accommodations in some areas are demand.  A lack of one and especially more than one of these items negatively affects occupancy, although the degree depends on what is missing and how much boaters in that market demand it.
• Wavy and warped docks and bulkheads - I’ve experienced this first-hand and can say the boaters that rent from marinas with such noticeable problems tend to be those with the smallest boats.  Most of the mid- and large-size boats just go elsewhere.
• Combination’s of the above - this double whammy is generally so expensive to fix that the marina suffers permanent functional obsolescence as a result.

In real estate, everyone talks about location, location, location.  Even the best location cannot overcome the demand-side problems above.  ‘Been there and done that.

John Simpson, MAI

The Fed’s Beige Book has some dismal information.  In our back yard (VA,DC,MD) things were stable, but we are starting to see a slip again since no one is loaning on new projects.  This is stagnating the commercial real estate market.

An excerpt on our home region:

5th District: Maryland, Virginia, North Carolina, South Carolina, southern West Virginia, District of Columbia. The economy weakened. Retailers reported slowing sales, increasing layoffs and flat wages. Manufacturers said orders slowed, and were worried about higher prices for raw materials and transportation. Exports grew.

Residential real estate was slow, and commercial real estate weakened. No major construction has been announced recently, and builders were having difficulty financing new projects.

Eileen Simpson

Many marinas are feeling some effects from the current “recession”.  Third-tier marinas, those in rural locations (defined as not within walking or biking distance of a town or city with a variety of things for boaters to do) are affected the most… by far.  Here are some trends I’m seeing from our marina surveys:

• Vacancy rates have increased slightly in most marinas.
• Service revenue is holding steady in well developed and well positioned marinas, but way down in the rural facilities.
• Moorings typically have the highest vacancy rates due to their lack of water and electric service and they have increased noticeably in second and third tier marinas; for many marinas, mooring vacancy has increased.
• The larger boat slips (50 feet plus) are full and the vacancy is primarily in the 28 to 40 foot boat range.
• Many marinas did not raise their rates for the 2008 season to help maintain occupancy.
• The number and length of boat trips is way down.  A higher percentage of owner-repairs are happening or being postponed in second and third tier markets, decreasing marina boat repair revenues.
• First tier marinas, those with the best locations, the widest range of services and generally the highest percentage of 50 foot+ boats, do not seem to be affected much.
• Sailboat supported marinas have higher occupancies.  This is because the cost of fuel has made many powerboat users keep their boats out of the water, or sell them.

Across the board, conservatism and belt-tightening are happening in the industry.  It’s no different with all of us.

John Simpson, MAI

In my continuing obsession with appraisal/lending issues given the bank shakeouts that will occur over the next 12-18 months, here’s an email conversation with IndyMac on an appraisal assignment occurred in late May with my appraisal firm Miller Samuel.

The report was ordered with a specific inspection date needed. Up until then, our turn time was consistently 7-10 days, usually inspecting the property within a day or 2 after the order depending on the contact info accuracy and customer cooperation. Granted, 7-10 days is not stellar, but we are very busy, ours clients know this in advance and our competitors (that I would consider competent) have the same turn times as well.

You can see one of our employees frustrations toward the end because we had gone through great effort to accommodate the bank to inspect the property on the day they needed it done and they did not indicate early on that there was any “rush” plus they basically told us we were not needed, after a warm and fuzzy relationship that preceded this conversation. Very odd.

I guess what annoyed me in seeing this email later on, was the comment about their 0 default rate and yet the lender collapsed 2 1/2 months later. I am sure this person was responding to their own branch’s experience but it’s weird they brought up such a reference in the dialog, inferring (to me, anyway) that it was a big problem looming at the bank).

Incidentally, 300 banks are projected to fail in the next 3 years.
May 28, 2008 email dialog

IndyMac Please provide status on this report - thanks

Miller Samuel [address omitted] will be inspected tomorrow, May 28th.

IndyMac And how soon thereafter can we expect the completed report? Thanks

Miller Samuel All appraisal turnaround time is currently 7-10 business days starting from the time of inspection.

IndyMac We are going to have to cancel this order- sorry but your turn around time is just too long.

Miller Samuel [name omitted] we have worked an entire schedule around this appt. When do u need the hard copy and we will deliver it.

IndyMac We have appraisers that give us reports back within 2 days of the inspection. This is still not going to work. If you can get us the reports back in that time frame we will have a lot of business for you. I am sorry

Miller Samuel Yikes! That’s called bang it out, hit the number appraising. No that’s not something we participate in. That’s how subprime occurred and why the housing market continues to fall. Conditions for mortgage fraud remain in tact with many lenders because of a lack of concern for quality. 48 hr Speed = Bad appraisals and ultimately bad loans. We can do 5-7 business days. I really hope you guys don’t end up like countrywide and all the rest. But with 2 day turn time its inevitable.

IndyMac I understand your position and would never ask you to do something you are not comfortable doing. This branch does AAA business with typically low ltv’s, high credit, etc. Our default ratio is nearly 0 pct and we pride ourselves on efficiency and effectiveness. I think going forward we should help you gain access earlier in the transaction so you can adequately do your job. If there is something we can do on our end please let us know.

July 11, 2008

IndyMac collapses

July 17, 2008

FBI fraud inquiry after IndyMac collapse

IndyMac Collapse Fuels Fears About WaMu

My definition of an expert in any field is a person who knows enough about what’s really going on to be scared.
- PJ Plauger

Eileen Simpson

You’ve got to read this article.  http://www.financialweek.com/apps/pbcs.dll/article?AID=/20080714/REG/436047405

Eileen Simpson

True??? For appraisers it would be great for business but I hope this does not happen for the Country.  Should we be surprised?  Appraisers saw this coming at least 18 months ago, if not longer

The ability to verify data is becoming harder and harder.  As appraisers, we must verify sale, capitalization rates and comparable rentals with one of the market participants.  This is becoming harder every day for many reasons:

• Since many transactions are represented by Realtors, we rely upon them for data.  Many who were in the business have now left.  This puts their sales/rental file in limbo.  When we call into a company, they now have a skeleton staff who are so stretched and stressed they are unable to help us.
• The Realtor Companies are cutting back on their advertisements in Loopnet and Costar leaving many of the transactions a mystery.
• Many of the buyers no longer wish to cooperate because their properties are now losing value and they are embarrassed.
• More and more transactions are now private.  These have always been the hardest to follow up with and often finding the phone number of a participant is impossible.
• The number of transactions is very low.  It is difficult to get a handle on a market with such a small pool of data.

We’re finding after years of being spoiled by TOO much data, we now have to expand on our research to find meaningful comparable data.  This trend is worse in the small commercial market than the larger investment grade market.

Eileen Simpson

Most people believe that the days of “cheap gas” are over.  Some of the reasons include demand from China and other developing nations, the perception that the oil reserves in the Middle East are running out and an increasing dependence on foreign oil, to name just a few.

High fuel prices are causing difficulties for some types of marinas, whereas others are virtually unaffected.  Sailboat-only marinas are virtually unaffected by high fuel prices, as are yacht and super-yacht marinas.  Powerboat-dependent marinas, however, are feeling the effects of high fuel prices in the following ways:

• New and used powerboat sales demand declines with high fuel prices.
• Trip lengths decrease and fewer trips are taken, thereby shrinking the “trade radius” of powerboat-dependent marinas.
• Another spin-off effect of decreased trip length and number is that there is a lower demand for boat repairs, which can increase parts inventory and make it more “expensive” to keep qualified labor on-staff.  There is more pressure put on outsourcing, although since skilled tradesmen are hard to find, this may not translate into much outsourcing.
• Yet another spin-off effect is that transient demand may be adversely affected.  Boats that are stored off-site may not even make it into the water, thereby decreasing transient demand.  Perhaps they may be stay shrink-wrapped during the prime boating months and miss the season entirely.
• Powerboat users spend more time at the docks and less time cruising.
• High fuel prices tend to increase in Spring/Summer due to greater vacationing demand.  Unfortunately, this coincides with most of the peak season for marina slip demand.
• Curiously, there may be more demand for certain amenities and businesses at at marina as a result of power-boaters spending more time at the dock.  This may be offset by loss in slip and other business income from vacant powerboat slips, however.

Already, this is affecting slip occupancy.  Many of the powerboat and partial powerboat marinas I have visited have seen a slight decline in occupancy as a result.  If this becomes a prolonged multi-year phenomenon, powerboat marinas will likely try to lure sailboat slip renters away from sailboat marinas, thereby putting more pressure on slip rental rates.  Time always tells.

John Simpson, MAI

Eileen and I have been extracting cap rates and operating expense ratios from sales for almost a decade and a half together.  During that time, I’ve reviewed an untold number of marina appraisals and have spoken with dozens and dozens of lenders and appraisers about the same thing - the operating expense ratio.  It’s time I set the record straight.

Let’s take yesterday.  An appraiser called and said something like “the operating expense ratio of 61 percent seems high”.  Or even worse, the report will go out to a decision maker with an operating expense ratio that’s similar to industrial buildings, apartments, or other common property types and the decision maker  will rely on it.  What they don’t know is that marinas always have a materially higher operating expense ratio than common property types.

Here’s why.

1. Payroll - do industrial buildings and triple-net lease real estate have it?  Apartments sometimes do, and sometimes don’t depending on the size.  Marinas need personnel in the office to lease slips, rent transient (daily) slips, etc.  They need at least one or two dock hands to help customers with one request or another at the docks.  A dockmaster and maintenance person (if they are not the same) is necessary to keep the facility in shape.  If you’ve got boat repairs, boat sales, motels, hotels, golf courses, bed and breakfasts, whatever in place, add more people to the payroll line item.
2. Insurance - do industrial buildings and office buildings have the potential to be damaged or destroyed with each major storm that comes around?  Bulkheads and docks are very expensive to fix.
3. Repairs and maintenance - marina docks are subject to wave damage from storms.  The buildings are located in flood zones.  The salt air corrodes and wood borers can chew up piles.  Docks planking needs to be kept in good shape.  The list goes on.  Comparing a marina’s repairs and maintenance expense to an industrial building or apartment project does not consider any of this.
4. Utilities - this expense is not passed on to the boater like it is with a tenant.  And we all know what’s happened to fuel prices, but don’t forget that water and electrical bills are increasing at a greater pace than ever before.
5. Reserves - marina owners rarely allocate anything to this (see my prior post, Owner’s Don’t Reserve - They Refinance.  Considering that every item on or under the docks is subject to weathering and most types of bulk-heading will deteriorate too, a line item for reserve should be present.  A two percent of effective gross income reserve just does not cut it for a marina.  Some banks I know are requiring 4 percent of effective gross income to be set aside in their bank account for a reserve, but depending on how well depreciated the marina is, even that may not be enough.

That’s why we call marinas a special purpose property.  They are a labor of love and a lifestyle.  They DO make money, but expenses are higher and your return on you equity is lower than other real estate investments.

Want the lifestyle?  Want to invest?  Do it wisely and with the advise of experts.

John Simpson, MAI

I’ve worked with John for 13 years and although I am an appraiser, for marinas I am a data gatherer and general muse for him.  I’m also the one that begs and pleads for data in a market that is very closed to providing income information.

Over the years we’ve come across tons of marinas that have excess land that they cannot develop due to wetlands, local laws, flood plains, or general lack of a market for the land.  Our backyard (The Chesapeake Bay) has extreme limitations on waterfront development.  As a result, so many marinas are paying taxes on “worthless” land (of course the wildlife finds it very valuable).

Marina owners seem to want to hold onto these excess acres in the hope of future development.  Tax assessors love this extra land because they most often assume that it can be developed and tax the land at a high rate.  Here are some things to consider:

1.  Can you store boats and is there a demand?

2.  Is dry stack storage possible and is there demand?  Do government restrictions prevent you from getting a launch ramp (i.e. without it, you can’t put dry stack storage)?

3.  Do you need more parking?

4.  Is it wetlands?  Does the Tax Assessor know this?

5.  Are you in a rural area?  If so, how many years will it be before any demand would be feasible?

6.  Check with your local Planning Department.  How many waterfront developments have been approved?  How long did it take?  If you consider the time-value of money would it be worth developing?

7.  Do various government regulations so substantially limit the buildable area of the site that you only have a “postage stamp” you can build on (i.e. building setbacks, inability to obtain driveway access on a highway, contribution toward municipal tree funds for land clearing, flood zone building restrictions, high water and sewer hookup fees, etc.?

Paying high taxes for years on land that is not providing a return on investment is a waste of time and money.  Many jurisdictions love to have donations for wetlands preservation and parkland.  Many private groups are also interested in preserving this land.

If you have 30 acres, use 10, and the rest are wetlands and woods you can’t cut; why would you keep them?  Donate and take the write-off and reduce your liability and taxes.  It’s also great for the environment preserving valuable tidal and wetlands.

So many people look at waterfront land as extremely valuable and it CAN be.  Over the years the laws have changed.  That is why so many residential waterfront homes have new ones built around the original structure.  During the last boom some investors succeeded in convincing governments to allow waterfront development.  The process took so long that they missed the market and many are now failing or have stopped their processes.  Grandfathered properties with improvements hold their value.  Vacant waterfront can be problematic in many areas.  Take a hard look at your land usage.  You may get more return by donating the land.  Keep what you need and get rid of the rest.

Eileen Simpson

Over the past month, we’ve gotten a huge number of bid requests for marina appraisals all over the country.  I inspected a marina yesterday that typifies the problem.

Marinas are facing top-down and bottom-up pressure that’s squeezing profitability.  From the top-down perspective, the reduction in slip demand is causing higher vacancies in many marinas.  Many marina owners are faced with lowering their yearly slip rate increases just to maintain the occupancy near the same level as last year.  This affects motorboat marinas more than sailboat marinas because the cost of fuel has reduced the number of boater trips and this negatively impacts boat store sales, motel, hotel and bed and breakfast occupancies when present at the marina, and other on-site businesses.  Of course, we all know boat sales volumes have declined and with fewer boat trips, repair businesses may also suffer.

From the bottom-up view, fixed costs are just that.  There’s little a marina can do to lower its insurance rates, for example.  Variable costs such as personnel can be reduced to a point, but this is partially offset by increases in contractor expenses to do the same job.  Repairs are being put off as much as possible and in some cases, dredging is being postponed (it is frequently a multiple year process for getting all the permits for dredging and to get a place to store the spoils, so if the process is started, it’s typically not halted).  Upgrades to utilities are not being done much either.  An extreme example is that some owners we know have optioned to refurbish the guts of boat slip utility posts rather than replacing them with all new posts that have modern electrical loads and solid electrical distribution (i.e. no load drop-offs).  These are only just some of the changes from the bottom-up perspective.

The one factor no one seems to be addressing is the balloon payment.  If a note is coming due within the next two years or so, it’s going to be difficult to refinance given lower revenue increases and higher expenses, squeezing profitability.  Cap rates are also not as aggressive, on a whole.  A marina may not be worth today or next year what it was at the height of the market when lending criteria was much more flexible.  Since marina owners rarely reserve and frequently refinance major repairs, the balloon note payment plus repairs can be materially higher than current market value under today’s weaker market conditions.  This is a recipe for insolvency.  Lenders and Marina Owners need to start talking NOW.

John Simpson, MAI

The effect of the recession has highlighted how much retail owners and purchasers have relied upon steady or annually improving rents, cash flows and projections. Perhaps it’s not possible to completely prepare for a change in future market conditions, but not adapting to them when making financial decisions can crush cash flow. This two-part blog article will discuss dangerous assumptions involved with retail acquisitions in a recessionary environment.

Triple Net Investment Grade Leases

One of the most unpleasant retail surprise has been with triple net investment-grade long-term leases (henceforth investment-grade leases). Many tenants that everyone expected to remain financially sound and last forever have downsized, renegotiated their leases or gone out of business. When demand declined and an oversupply situation arose, the value of investment-grade leases declined for two reasons. First, market rent declined, leaving many leases with contract rent greater than market rent. Investment-grade lease tenants, whether stand-alone or an anchor in a shopping center, are savvy enough to know they’re in the much better negotiation position. Every lease can be broken and they know it. The result has been what the banking industry refers to as a “cram down”, – for retail tenants, landlords needed to drop their contract rents closer to market or else the tenant walks.

Many landlords also feel the financial pressure from the recession and litigating a long-term lease against a usually publicly traded national tenant is more expensive than renegotiating the lease rate. If the anchor is part of a shopping center, having one or more dark anchors usually results in lost in-line bay tenants, in-line bay tenant renegotiation, the owner absorbing the common area maintenance charges of the anchor(s) and a better negotiating position for the remaining anchor(s). Owners know this and so do their anchor tenants. The results are many reasons to renegotiate the investment-grade lease.

Valuing Investment-Grade Leases

In addition to the drop in market rent, the increase in the vacancy and collection loss for large retail properties throughout the country has resulted in a decline in the market value of investment-grade leases. Even if contract rent is not renegotiated, higher market vacancy and collection losses are required for many investment-grade leases, which lowers net operating income and therefore value.

More importantly, the capitalization rate (the fraction that gets divided into net operating income to produce a value estimate) goes up, usually by a considerable amount. Why? First, the probability that the lease rate will be renegotiated lower is much greater in a recession. Second, there’s the possibility that the investment-grade lease tenant will file bankruptcy. If that happens, it’s notoriously easy for the court to cancel a lease. Third, in most markets, retail hubs have shifted to other areas as the result of large super-regional mall construction or retail sub-markets that were created in the last ten years, pulling tenants to those newer, larger markets (a basic application of the retail attraction theory) and away from older markets. All these factors result in higher capitalization rates and therefore lower investment-grade lease values.

Modernization

Many shopping centers are in need of modernization; however, the recession has siphoned funds to do so from many owners. The whole purpose of renovating a shopping center is to make it more competitive and to increase rental rates. When few or no competitors are renovating, there is little need to renovate to become more so. More importantly, rental rates will not increase as long as the recession continues to plague the cash flow of retail tenants. Basing a purchase decision on an expensive shopping center renovation is not a wise investment decision, especially when the debt service from renovating will be added to the debt service from the acquisition.

Although a prudent purchaser or owner would calculate the return on investment (ROI) of renovating a shopping center, seldom do they calculate the return on the renovation or all the costs associated with their expectations. Basic expected value theory is a useful technique to use to calculate the ROI. By taking the income from the tenants to be brought to the center due to the renovation, multiplying each income stream by the probability of attracting the tenant and adding them, the expected rental income is derived. Applying the same technique to the additional common area maintenance reimbursements, increases in rental rates for existing tenants (likely none, as discussed below) and all incomes, the result is the expected income the center will receive. The same can be done for the expenses of obtaining these tenants (leasing commissions, tenant improvements if any, etc.). Some costs will be incurred regardless of how many new tenants will be added as a result of the renovation: an example is additional regional or national advertising. These costs do not get a probability multiplied by them.

Adding all the incomes and expenses above results in an expected net operating income from the renovation.   Of course, renovating the shopping center might also help maintain rent levels and tenants; if an estimate can be made as to what the rent loss would be to renegotiate, that too can be included in the income calculation above. It then becomes easy to calculate the ROI for the renovation. We have done this many times and it is rare that it results in a sufficient return to justify the cost to do so. Most shopping center owners do mental variant on the above and know that it is not financially feasible to renovate a center during a difficult recession.

New Management and Filling Large Amounts of Vacant Space

Lofty expectations for attracting new tenants to a shopping center are a recipe for disaster. The market dynamics that affect a center remain the same, so the effect of changing management and filling vacancies is limited. Most times the expectations for new tenants are based on attracting national tenants, but there are two problems with this. Frequently many of the expected national tenants were already located at the center and left or they already considered it and dismissed it altogether. Unless the dynamics of the retail market change substantially for the better, they won’t relocate there now or in the future. Also, national tenants have sophisticated methods for evaluating a center and a market, so if the dynamics are not within their parameters they will not be interested. If they’re not already there and the market is still the same, expecting to get them is myopic.

Increasing Rents and Tenant Talk

Expecting to simply acquire a center and raise rents is another disaster waiting to happen. When a center has materially lower rates than its direct competitors, it’s easy to compare the two and assume that rents can be increased. This overlooks the fundamental weaknesses in the market or the property. There’s a reason the center is renting for less and unless the owner or purchaser of the center understands this, no amount of rent raises will be accepted by the tenants. This has been tried too often without success. All it does is alienate tenants, creating a hostile environment.

Tenants in a mall tend to talk to one another and lease rates are a favorite topic. When a center takes on temporary tenants, long-term lease tenants frequently find out how low the rates are from them and their knowledge is power. Raising rents when there are temporary tenants in a shopping center is a strategy doomed to failure.

Conclusion

Many prospective purchasers of malls have expectations that do not coincide with market realities. Financial analyses are performed based on lofty expectations for change and although the ROI might appear attractive, the probability of them happening can be a very different matter entirely. Most of the time the realities are brought to the forefront when a third-party is hired to perform a market study, such as an appraiser. By then, a lot of money and time has been invested and unfortunately wasted. This can be avoided by having a market study or reposition study performed before tens of thousands of dollars are spent on non-refundable deposits, renovation plans, title investigations, Phase 1 environmental site assessments and the many other due diligence requirements to make transactions happen.

John Simpson, MAI

My friends and family are constantly amazed by the interesting things I see in the field.  Now, most of the time, inspections go off well and nothing unusual happens.  The following is a list of some of my most memorable inspections.  Many I cannot print.

1. Dead body found in the basement of an apartment building;
2. An alleged crack dealer cooking alleged crack in an apartment with his 90-year-old  Grandmother in the room;
3. A “hair salon” with 20 girls and 20 rooms and no hairdresser on staff;
4. A Dentist who has not drilled teeth in 20 years, but has rooms and rooms of gas;
5. A hole in a basement that was so deep I could count to 10 before I heard the coin drop;
6. A vacant building that the owner kept swearing had tenants.  Not even toilet paper in the whole building, but he insisted that it was 100% occupied;
7. A row building that the entire rear area was gone and only the front was being held up by the adjacent buildings; and
8. Many, many with dead vermin.

There are others but I’ll save them for another time.  My husband has some great pictures which will follow soon too.  Just when it starts to get boring, something interesting happens.

Eileen Simpson

“Past performance may not be indicative of future results. Then why is it OK for an appraiser to assume as much?  And if every appraisal used this declining market logic in determining value, how would our market or any market reverse course”

This whole sentence indicates why there is a problem right now.  Some otherwise fine people are complaining that an appraiser had the audacity to market “declining market.”  Well, it IS declining.  It is not the role of the appraiser to help turn around the market.  It is the role of BUYERS to decide that.  We measure what buyers are doing.  Our job is not to stop the bleeding.  Please read you post again.  It is a scary one.  Don’t kill the messenger!

Original post: Beware The Appraisal

Eileen

This post makes me wonder about the whole “Dummies” Series that I have used to learn new things all the time.  I can’t believe they put this in writing!  Below is the post from a wonderful blog called the Soapbox.  The direct link is: http://soapbox.millersamuel.com/?p=398

Eileen

Commercial Grade is a post by John Cicero, MAI who provides commentary on issues affecting real estate appraisers, with specific focus on commercial valuation.  John is a partner of mine in our commercial real estate valuation concern Miller Cicero, LLC and he is, depending on what day of the week it is, one of the smartest guys I know. …Jonathan Miller

I think that I finally understand what the problem is.

We just need to go back to basics and make sure that the real estate lenders are being property educated. I recently came across a textbook written for lenders: The Complete Guide to Financing Real Estate Developments (Hardcover) by Ira Nachem ( 2007, McGraw-Hill, New York), List price $79.96. Seemed like a respectable enough book, which is why my jaw dropped and I had to read the following section three times to make sure that I wasn’t imagining things…

A section in Chapter 5 with the heading “Influencing the Appraisal”,

Since appraisers want to continue to receive assignments, they generally have a desire to satisfy you, their client. You sometimes can play on that desire and get the appraiser to produce a report with values a bit higher (or lower) than he otherwise would report….If you want to make sure that the appraiser is not undervaluing the property, you should tactfully indicate your concern up front…

Do you believe this stuff?!

As I was reading this I kept on waiting for Alan Funt to jump out and tell me that the whole thing was a joke. He didn’t. (I guess he couldn’t since he died in 1999.)

It gets better…

A third reason to go against a conservative valuation involves market conditions and competition among lending institutions. When more lenders are in the market, competition for business increases…To be more competitive, loan officers who receive higher appraised values can make larger loans…

Over the years I’ve spoken to numerous loan officers that truly don’t have a clue as to how the appraisal function is supposed to fit into the underwriting process. Unfortunately books like this do little to educate them.

I look forward to reading future books in this series: “Shmearing the Building Inspector” and “Tax Evasion for Dummies”.

I have to admit that the whole mess on the residential side has been interesting to me, but has not impacted our firm because we no longer do residential appraisals.  The problem with appraiser independence is still a problem on our side too.

Our best mortgage clients are ones where we have NO contact with the loan officer.  If your entire income was based upon closing loans, could you really 100% not try to influence appraisers to help you close loans?  Human nature wins out every time.  Also, what happens when the appraiser receives a significant amount of work from a client only to be told that income will be taken away if a loan does not close.

Creating a “Chinese Wall” is the best way to protect the process.  Cuomo’s proposal tries to do this, but since law makers are not appraisers, he missed the mark.  Creating a bunch of management companies is not the answer.  The secondary market has the power to tell lenders they will not purchase loans without a separation between sales and appraisers.  Laws won’t do it, but controlling the purse-strings will.  Investors for mortgage backed instruments need to demand that their money is protected by creating a wall between commissioned employees and appraisers.  The secondary market is now crying fowl, but they knew what was going on and turned a blind eye.  Everyone thought values would go up forever.  They never do!

Here is the link to the orginial article: Cuomo’s Appraisal Rules Irk Lenders

Eileen

Conclusion

There are many decisions that need to be made for a successful tax appeal. The tax savings can be substantial. Conversely, the opportunity cost of a tax appeal that is lost due to one or more of the pitfalls outlined in this paper can be just as dramatic. When multiplied by a portfolio of properties in multiple jurisdictions, tax savings can easily run into the millions of dollars and the situation becomes even more magnified. No one likes to pay more than they legally have to. The right team and the right decisions make all the difference.

Key 9 – The Presentation

When it comes time to argue a case, you will often be faced with a time limit. Other tax appeals are scheduled for that day and if you run over, you may not be permitted to continue. You want to have the key points stressed and presented in an organized manner. Keep in mind that the appraiser can speak about his report, but it is up to the other members of your team (especially the attorney) to pitch the merits of the case.

Another factor to consider is that “pictures speak louder than words”. Tables, charts, graphics, pictures and other visual aids can make even a complex concept easy to understand. Usually, all participants to the case will know the general direction of the market, so limit this discussion or perhaps do not discuss it at all. Stress trends that affect rental rates, capitalization rates, land sale prices and improved sales prices as appropriate. Also, stress physical features that result in functional obsolescence, decreased rent, and increased expenses or extended marketing times.

Assessors frequently do not consider items of functional obsolescence in their valuations. When replacement cost is used in the cost approach, most forms of functional obsolescence are not factored into the reproduction cost new estimate of the building. More importantly, items of functional obsolescence help paint a picture that the property is not as valuable or desirable as the Assessor may depict it.

Example: We were involved in a tax appeal case of an office building that suffered from seven forms of function obsolescence, such as a poor air conditioning system, a low voltage electrical system that blew out computers, roof problems, insufficient elevator capacity, etc. Although the building was Class C, the appropriate comparable data was at the absolute low-end of the spectrum. The Assessor considered Class C buildings at the upper end along with some Class B buildings. After “painting a picture” of all the things that were wrong and expensive cost to retrofit the building, the board ruled in our client’s favor that its value was reflec