Anyone who has tried to value distressed properties over the past few years knows the stress and difficulty in the process. After a fair amount of effort and frustration, you may have felt that the value you came up with was just a shot in the dark. What approaches work well and what do they entail? Let's look at some traditional approaches to valuing real estate, including some concerns and benefits of each.
A natural first step in valuing a property is to look at comparable sales in the marketplace. The principle of substitution seems like a reasonable thought, but transaction volumes have fallen drastically in recent years. While deal activity may have picked up recently in some markets, a dearth of actual sales has been the norm. Plus, some would argue that the few sales that do occur are, by nature, distressed sales.
In any case, without any actual sales, or, at least, not enough good ones, many appraisers choose to consider listings. Listings provide another reference point for the appraiser, but what does the listing price represent? Is it the likely sales price? While it's true that in some overheated markets, properties may actually sell for more than their listing prices, the reality is that many properties sell for below that, especially in a distressed situation. So how much of a listing discount is reasonable? Lest we forget that real estate is a local business, it is important to talk to local professionals. Get as specific as you can about the market and the property. There is oft en a story, and when there is, it probably is not published on the listing page, so have those conversations. Once one understands the market, one can measure the bid/ask spread.
Then, there's the cost approach, which represents the ceiling among the valuation approaches, the idea being that an investor would pay no more for a property than the cost to build a replacement (although one rarely identifies all forms of depreciation). One general concern with the cost approach is that, since we rely on industry averages, and not the actual replacement or construction cost of that specific property, it may just be a reference point. With a lack of transaction data in the marketplace, more reference points are generally a good thing.
In a distressed market, some appraisers are simply applying a percentage discount to replacement cost, where the discount represents external obsolescence. That obsolescence can be hard to measure, especially in the absence of actual sales or a solid income approach, but it is still included. Even in a boom market, the appraiser is challenged in estimating entrepreneurial profit. And don't forget, when building up your cost approach, you will need to perform the sales comparison on the land, so the issues mentioned earlier come into play.
Finally, since we are talking about income-producing properties, we would expect that the income approach would be the most reliable approach. But is it being applied properly? There are two methods to the income approach: the direct cap (applying an overall capitalization rate to a single year's net operating income) and the discounted cash flow (calculating the present value of a stream of expected cash flows). Both have issues and benefits.
While the direct cap method is quick and easy, there are a few concerns in applying it. Obviously if the property is not stabilized, then this is not the most reliable method. But even a "stabilized" property may have a down year because of the market. And what single year of income should be capitalized the prior year? The next year? These days, we have found that many use the prior year's income as the base for capitalization; less speculation is involved.
All things considered, the discounted cash flow is probably a better solution in distress situations. Of course, when building a DCF you still have your own set of issues, one of the biggest being simply the number of assumptions that go into the analysis. Many of these assumptions are market-based, such as the rental growth rate or the discount rate. For example, it is not uncommon to forecast rent spikes after a few years of decreasing or fl at rents. Without sufficient transaction volume, those assumptions can be difficult to determine. One interesting debate centers around terminal cap rates: should these be based on current cap rates, a more normalized cap rate or something else? Valuing a property in a distressed market does not have to be a source of stress. Yes, it might mean a little more work, but with some diligence and an understanding of the data points that are available, you can begin to triangulate around a value that makes sense.
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