Is that thing a “fixer upper” or a “tear down”?

Today a friend asked me how real estate appraisers value properties that are in “below average” condition.  He wanted to know if we valued them in their “as is” condition, and whether or not repair costs were factored in.

In essence, how do you know if a property is a “fixer upper” or a “tear down”?

In a nutshell:

  1. If a property is in poor condition, an appraiser considers whether or not the value of the real estate, in its “as is” condition, exceeds the value of the underlying land.
  2. An appraiser determines this by analyzing the cost to repair the building to typical/average condition, and comparing the net value against the value of the underlying land, less demolition costs.

In detail:

It’s a relatively simple process, the appraisal buzzwords associated with this valuation method are “highest and best use” and “cost to cure”.

To demonstrate the analysis, I went on the Honolulu MLS and found a commercial property built in 1959, the same year Hawaii became a State.

Here, in all of its glory, is the poor condition (according to MLS)  office / retail property known as “1339 North School Street”:

1339 North School Street

1339 North School Street, Honolulu, Hawaii

A bunch of appraiser math/mumbo-jumbo below, skip to the chart at the end to see the answer.

For our purposes, the asking price is irrelevant, especially because the listing includes additional land parcels.  The figures used below are part of a simplistic appraisal demonstration only.

Let’s assume an appraiser determines that vacant land in the subject neighborhood is worth $100 per square foot.  Similarly, let’s assume average/typical commercial buildings are selling for $300 per square foot of building area.  The values would compare as shown below.

HYPOTHETICAL APPRAISED VALUES – 1339 N. School St.
Item Area in Square Feet Value Per Square Foot Total Value
Vacant Land 20,000 $100 $2,000,000
Less: Demolition Costs     -$100,000
Equals: Property Value   $1,900,000
       
Average Condition Building 7,500 $300 $2,250,000
    Difference $350,000

Since the value of an average condition building “as improved” is worth more than the property “assuming demolition”, we proceed to the next step: determining the value of the building in poor condition (its “as is” condition).

HYPOTHETICAL APPRAISED PROPERTY VALUE – COST TO CURE
Item Building Area
in Square Feet
Building Value
Per Square Foot
Total Value
Average Condition Building 7,500 $300 $2,250,000
Less: Cost to repair to average condition   -$500,000
Equals: Poor Condition Property Value   $1,750,000

Let’s assume a reputable contractor estimated the construction/repair cost necessary to renovate the subject building to “average” condition to be $500,000.  This amount is deducted from the “if in average condition” building value to arrive at the value of the overall property in poor condition of $1.75 million.

So, where are we at?

How does land value (assuming demolition) compare to property value (assuming renovation)?

HYPOTHETICAL APPRAISED VALUES – HIGHEST AND BEST USE
Item Total Value
Land Value Assuming Demolition $1,900,000
   
Poor Condition Property Value $1,750,000
Yep, it's a tear down.

Yep, it’s a tear down.

In this hypothetical scenario, the value of the underlying land, even after deducting demolition costs, exceeds the value of the poor condition property “as is”.  Therefore, the highest and best use of the property is demolition of the built-in-1959 (54 year old) improvements to make way for new development.

Questions, comments?  Please leave them in the comment box, I would be happy to clarify and/or expand.

Aloha, Chris

Land Value via the Income Approach – A Quick Primer

If you’re generally familiar with real estate appraisal, you are no doubt aware that the sales comparison approach is the preferred method of valuing land in most situations.

That said, there are other techniques that can be developed: Market Extraction, Allocation, Land Residual, Ground Rent Capitalization, and Discounted Cash Flow Analysis.

The last three procedures in that list are income capitalization techniques–they are the focus of this article.

Ewa SubdivisionSubdivisions are often valued via the income approach.

Ground Rent Capitalization

Due to the large amount of leasehold land in Hawaii, local appraisers frequently employ this technique to convert ground lease rents into land values.

In appraisal school, one of the first formulas taught is: Income / Rate = Value ( I / R = V )

Here is an example of how it works:

IRV Land Example

As shown, a property’s annual income can be converted to a land value if a capitalization rate, or “rate of return” as it is commonly called in Hawaii, can be derived from the market.  In this example, if an eight percent (8.0%) rate of return was applied to a ground rent of $50,000 per year, the indicated land value would be $625,000.

Land Residual

Similar to the Ground Rent Capitalization technique described above, this method converts the allocated portion of a property’s income that is attributable to the land, and again divides it by a land capitalization rate that is market derived.  Most often, this method is employed when testing the feasibility of alternative uses in highest and best use analyses.

The key difference between this technique and the one above is that income for an improved property is typically the starting point, and it must be segmented (with market support) into the income attributable to land (IL) and income attributable to the building (IB).

The following chart is an example of the Land Residual technique used for Highest and Best Use testing purposes:

H&BU - Land Residual

(Note: In my experience in Hawaii, this method is used so infrequently for market value purposes that the term “Land Residual” is most often meant by appraisers to describe Yield Capitalization/DCF/Subdivision/Development Analyses–described below)

 Discounted Cash Flow Analysis / Subdivision Development Analysis

Yield Capitalization can also be used to value land, it is sometimes referred to as one of the following techniques:

  • Discounted Cash Flow Analysis
  • Subdivision Analysis
  • Development Analysis
  • Subdivision Development Analysis
  • Yield Capitalization
  • Land Residual (Hawaii)

In this technique, gross sale prices are estimated and costs (such as construction, management, or developer’s profit) are deducted to arrive at net income.  This net income is then discounted to a present value estimate for the underlying land.

An example of a Subdivision Development Analysis is shown below:

DCF Example - Subdivision

Comments and/or Questions?  Please leave them in the comments section below–I’d be happy to clarify or expand.

Aloha, Chris