Small-Market Valuations

Appraisers dig for data to determine value.

The demand for high-quality commercial real estate in primary and many secondary markets has been gaining strength during the past 12 to 18 months. As the availability of good product in primary markets has diminished, some potential buyers are considering alternatives in smaller secondary and even some tertiary markets. While major investors will not consider these areas, there are outside investors that want higher returns and understand the risks of buying in these smaller markets.

Valuing real estate becomes more difficult in secondary and tertiary markets where the lack of recent, arm’s-length comparable data is a major hurdle. Other concerns in small markets are population, job, and income growth over the holding period. The lack of barriers to entry is often an issue based on the availability and relatively low cost of land. Finally, the sophistication and motivations of buyers and owners in small secondary and tertiary markets can lead to varying sales prices.

As a result of these factors, valuing complex properties in primary or large secondary markets is often easier than valuing simple properties in smaller markets, mainly because of the availability of market data, which includes more-consistent sales and rent comparables and investor expectations.

Yet there are a number of ways that a resourceful appraiser can gather the required data and attain a market value for a property in a small market. Let’s look at some of the differences between primary markets and secondary markets and several ways to value properties in secondary and tertiary markets.

Secondary Markets Move Up

Over the past decade, the lines between primary and secondary markets have blurred. Real Capital Analytics defines secondary markets as Atlanta; Austin, Texas; Charlotte, N.C.; Dallas; Denver; Minneapolis; metro Philadelphia; Phoenix; Pittsburgh; Portland, Ore.; Raleigh/Durham, N.C.; Salt Lake City; San Diego; and Seattle; among others.

While considered secondary, many of these markets have seen increased demand for real estate, which has resulted in more leasing activity and sales transactions and thus more market information, benefiting the valuation process.

Small secondary and tertiary markets have fewer properties that are attractive to outside investors. While outside investors are showing increased interest in small secondary markets, the majority of the transactions involve local or regional investors.

But size is not always a deciding factor for real estate investors. Tertiary markets in North Carolina, for example, generally have a countywide population of less than 150,000, with many having fewer than 100,000 residents. While these markets are small, they generally have some attractive retail, industrial, and office uses.

When comparing market transactions, however, the difference in overall capitalization rates between properties in larger markets and tertiary markets may be minimal or nonexistent. For instance, a community shopping center in a North Carolina tertiary market sold in fourth quarter 2012 at an 8.35 percent overall cap rate to an out-of-market buyer. According to the PwC survey at the time, the institutional nationwide average cap rate was 7.06 percent, a spread of 129 basis points.

A similar property in a larger North Carolina market sold at the same time for a similar overall cap rate. The main reason for the similar valuations is the tertiary market property is considered a class A location, while the larger market sale is in a class B location.

Valuation Techniques

To fairly appraise properties in secondary and tertiary markets, appraisers generally need to dig to uncover data that will help them arrive at a market value for the subject. Here are three major techniques they use.

Identify comparables. Scarce local data can result in the perception of a less-reliable valuation in the opinion of a lender or purchaser. Appraisers can overcome this issue by making the client or user of the valuation aware of the effort undertaken to find local data. When out-of-market data is used, the appraisal must clearly show how it is credible in the valuation. While there is often adequate data for smaller properties, the larger investment properties often require comparative sales data from outside the market.

For example, we valued a new, single-tenant office building containing approximately 90,000 square feet, leased to a credit tenant for 10 years in a tertiary market. The subject property was under contract at the time of our valuation. Based on the lack of local, comparable data, we used comparables in other small markets as well as a comparable in a larger market.

The larger-market comparable was also leased to a credit tenant for at least 10 years. The comparable was similar in quality, but slightly superior in age. The subject’s net operating income on a per unit basis was slightly less than the comparable, the result of lower land costs and the older age of the improvements. The subject’s contract price was based on a 7.50 percent overall cap rate compared to 6.72 percent for the comparable. The 78-bps spread is in line with survey information and broker opinions when comparing properties in larger markets to those in smaller markets.

Gather local data from area experts. In small secondary and tertiary markets, it’s crucial to interview brokers, owners, and even the tenants when possible. We recently valued a U.S. post office in a tertiary market with five years remaining on its original lease term with some remaining renewal options. Our research found few recent rural post office comparables with similar remaining lease terms.

Brokers interviewed during our research stated that based on the size of the property and the rent level at the subject, a suitable alternative investment would be small net-leased properties, similar to Dollar General or Family Dollar, with a similar remaining lease term.

At the property inspection, we interviewed the facilities manager, who said that this U.S. post office was favored as it was located in the central business district and across from the county government offices. The property had more parking than the surrounding post offices, a higher percentage of leased mail boxes, additional sorting and routing capacity available, and had recently benefited from the consolidation and closing of another U.S. post office in the county.

In this case we were able to overcome the lack of identical sales by considering appropriate alternatives as supported by our discussions with brokers as well as the tenant. Other good sources in small secondary and tertiary markets are representatives of the local economic development committees, the local Chamber of Commerce, and reporters.

The EDC and the chamber are good sources for new businesses in an area and even for information on businesses that are closing or relocating. EDCs often track land sales in business and industrial parks and will have knowledge of property sales and rents. In tertiary markets they are generally the most knowledgeable in the local industrial market.

News reporters are an overlooked source, especially in tertiary markets. Discussions with reporters have uncovered zoning or council meeting minutes discussing planned competition, road projects, major employment changes, and other issues impacting value.

Use interviews to sort out inconsistent data. While secondary markets attract out-of-market investors, tertiary markets mainly attract local buyers. Generally, the result is a less sophisticated market and buyer pool, which often causes pricing irregularities. For example, in late 2012, we valued a grocery-anchored center in a tertiary market that was under contract using a 9.25 percent overall cap rate based on in-place income and expenses. The same center sold in mid-2011 on an 11.0 percent overall cap rate.

Both transactions were arm’s length and met the definition of market value. The decline in the overall cap rate resulted in a 20 percent value increase over a year-and-a-half period. For comparison purposes, two national surveys had overall cap rate declines of 2.0 percent to 4.0 percent during the same time period. Factors considered in our valuation included the following.

• The population of the county (under 50,000) declined from 2000 to 2012 and was projected to decline over the next five years.

• County unemployment was 19.2 percent, up from 11.5 percent in 2007.

• Occupancy was minimally better in 2013 than in 2011.

• The anchor had less than 10 years remaining on its original lease term at both sales.

• The center was constructed in 1999 with one small shop bay having never been leased.

• The adjacent center was vacant with the exception of seasonal use and storage.

• The subject’s anchor spent money in 2009 to renovate and update the store.

• Anchor store sales were average for the market and have remained flat over the past four years.

• Comparable shopping center properties had overall cap rates in the 9.75 percent to 11.0 percent range.

The above factors painted an inconsistent picture of the market and the subject, which is not too uncommon in tertiary markets. For clarification on the market and how potential purchasers would interpret it, we relied on broker interviews.

Interviews conducted included local brokers for the local market knowledge and regional brokers to gauge the depth of the buyer pool. In this case, according to both sets of brokers, the only real buyer was a local buyer.

The buyer for the subject was local, owned a similar grocery-anchored center within 20 miles of the subject, and wanted to purchase another center. The subject was the only available center in the county, and based on the market data available, the buyer was paying an above-market price for the center.

Knowledgeable brokers, many with the CCIM designation, are important in the valuation process. In addition to verifying comparables, they are crucial to understanding the market and trends within the market. The relationship between brokers and appraisers can be mutually beneficial and brokers should consider appraisers as a good source of local and regional market information, comparable data, and potential leads.

Valuations in small secondary and tertiary markets have become easier as more sources of data are found online, but to truly gain market perspective, the appraiser must speak with local brokers, market participants, and even tenants. As the real estate market continues to improve, the smaller markets should see the benefits of the recovery with more transactions, which in turn will make valuations in secondary and tertiary markets more reliable.

John Scott Jr., MAI, MRICS, is managing director of Integra Realty Resources’ Charlotte, N.C., office. Contact him at