Not since the passage of Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) in 1989 has the valuation of real estate come under such scrutiny and disruptive change as it has in 2022. For much of the past 30-plus years, commercial real estate valuations were credible, even during the COVID-19 pandemic. But commercial real estate valuation has become more complex due to the introduction of three factors:
- A blurring of real estate and business enterprise value.
- Environmental, social, and governance (ESG) and diversity, equity, and inclusion (DEI) constraints along with a new set of proposed appraisal guidelines and credentialing that may replace the Uniform Standards of Professional Appraisal Practice (USPAP).
- Practical Applications of Real Estate Appraisal (PAREA), which is the probable replacement criteria/methodology to overhaul current USPAP and appraisal guidelines.
More than three decades ago, the motivating force in the appraisal industry was a lack of public trust in appraisals resulting from a deregulated savings and loan industry that led to egregious overvaluations and eventually a collapse in the ability to properly analyze asset value. The savings and loan crisis lasted a decade and led to the creation of the Resolution Trust Corporation and USPAP, which were needed to restore the structure of the real estate valuation industry.
Is your valuation knowledge up to date with these three factors?
Complexity from a blurring of the business value (going concern elements of valuation) to the pure real estate fee-simple property rights of value. Today, this blurring of property and business values extends to all property types and industry sectors, including hotels and hospitality variations (including timeshares and Airbnb/VRBO), self-storage, manufactured housing and for-rent subdivision communities, REITs with NNN-lease structures for big-box retail stores, e-commerce warehouses, and mixed-use adaptive reuse projects.
Brokers, investment advisers, and appraisers are quickly realizing an ESG score may become more impactful on valuation than the selection of a cap rate.
ESG/DEI as a valuation element to address climate risk and diversity impacting every aspect of the CRE industry and today’s economy. ESG is no longer an acronym that operates as a substitute for climate change. And along with DEI, the two concepts are now mainstream policies that influence capital allocation and valuations at the property level for both investment advisers and individual CRE professionals. How so? ESG scoring criteria and capital allocation implications based on these scores are transaction determinants. A less-than-favorable ESG or DEI score can derail a REIT merger or debt/equity capital allocation to a property. Brokers, investment advisers, and appraisers are quickly realizing an ESG score may become more impactful on valuation than the selection of a cap rate.
PAREA providing an alternate pathway for aspiring appraisers to fulfill experience requirements. The Appraiser Qualifications Board (AQB) created PAREA with the objective to “create an alternative to the traditional appraiser supervisor/trainee model for gaining appraisal experience.” PAREA was influenced by a 2020-2021 U.S. Department of Housing and Urban Development investigation by The Appraisal Foundation, an entity created by the 1989 FIRREA legislation.
The AQB adopted the criteria and guide note for PAREA in 2020, with both going into effect Jan. 1, 2021. PAREA, related to new appraisal credentialing, are guidelines currently under development by the AQB with aim for release and public comment in late 2022.
A sales comparison approach to value that uses cap rates from comparable transactions without adjusting for going concern would be like comparing apples and oranges.
My perspective as a 35-plus year appraisal veteran — and speaking independently from my role on the board of trustees for The Appraisal Foundation — is that PAREA advocates for a less-demanding path for the credentialing of state-licensed appraisers. With the goal of boosting diversity so “the appraisal profession [reflects] the population of the United States,” PAREA will significantly modify mentoring, supervision, and apprenticeship programs. Currently, USPAP 2020-2021 has been extended through 2022 and will likely be further extended to a fourth year in 2023. As PAREA is finalized in 2024, The Appraisal Foundation will determine the future of USPAP, which may become “USPAP Light” or, effectively, “USPAP Goodnight.” Any fundamental change in appraiser credentialing could be a déjà vu moment that potentially results in another appraisal crisis.
Few commercial real estate property types escaped significant changes in the COVID-19 era. These changes impact not just the use and operation of the physical commercial real property, they impact the understanding of market value by blurring the physical “sticks-and-bricks” fee-simple market value with going concern or business value. The going concern represents the value of the total assets of the business including tangible (the real estate — land, sticks, and bricks), intangible, and financial assets. This blurring of value comes into focus through the graphic in the most recent publication of “The Appraisal of Real Estate, 15th Edition,” by The Appraisal Institute, along with case studies involving timeshares, manufactured homes, and self-storage property types.
Timeshare Industry and Property. The timeshare industry has been moving from the traditional weeks-based system to a points-based system. While the new system allows flexibility for individual owners, it also creates operational and going concern complexity. The weeks-based system gives an owner the right to a unit in a specific resort during a specific week each year. However, in the points-based system, the owner’s rights to a specific resort show as points that can be exchanged for use at a different time during the year or at other resorts in a company’s network. This gives the points-based owner more use options — options that also translate into value. There is increased value in having this flexibility, especially amid COVID-19. Appraisers and brokers should consider precisely how the change from this traditional week-based system to one based on points accrues to the business value of the timeshare property — not the real estate market value. Weeks versus points is a change that blurs the market value of real estate with the going concern of a timeshare property. The physical property may look the same, but the revenue and operational costs of such a change are quite material.
UMH Properties’ Sebring Square in Florida shows Class A manufactured homes that are a step up from traditional trailer parks.
Manufactured Housing. Manufactured housing communities have evolved tremendously since their inception and subsequent 1976 regulation. The early years in this industry sought to address the nation’s housing shortage after World War II. Today, they are positioned to play a key role in addressing today’s ever-increasing shortfall. The dated neighborhoods that were initially the norm, leaving negative connotations aside, are not comparable to the manufactured housing of the last two decades. They are no longer referred to as trailer parks, and these new communities share more with traditional single-family neighborhoods in both layout and home design. They offer amenities such as fitness centers, dog parks, pools, pavilions, pickleball and shuffleboard courts, storage facilities, community centers, gated entrances, and increased management services. Many of these changes are due to the consolidation of ownership, largely from institutional investors or REITs, because larger institutional owners have more resources to improve these assets.
Self-Storage. The self-storage industry is another example of a property type that has undergone considerable change. Like manufactured housing, the influx of institutional capital (REITs) — along with the evolution of design, services, and operations — has made this property type more of a business than an assemblage of storage lockers on a tertiary piece of land with limited highest and best use. The self-storage market of today is far removed from the mom-and-pop-owned sites with design features like single-story elevation, non-climate-controlled units, unappealing steel buildings with drive-up exterior access with limited or no security, and no on-site resident management.
Modern Class A self-storage properties are vastly improved from the stereotypical barebones assets.
The facilities are now more typically acquired and owned by institutional capital and professionally managed, with facilities featuring climate-controlled units, interior secure access, elevators, and drive-thru access. They also offer more services that accrue to the intangible assets of the going concern or business — services such as extensive security systems, and online lease and bill pay — plus, on-site management that operates a moving store offering supplies and rental trucks for use. In essence, these properties house a going concern that has all the characteristics and operating costs of a hotel. Institutional capital has transformed this property type so much so that self-storage as a CRE asset category experienced the highest value appreciation in 2021 over the past 12 months from before COVID-19, jumping 28 percent, according to Green Street.
The evolution of the self-storage facility is leading to bifurcation of the classification of these facilities between institutionally owned, Class A properties, and the remaining 70 percent of inventory owned and managed by mom-and-pop entities. Self-storage facilities are generally categorized into Class A, B, or C properties, which correspond to the facility’s age, condition, location, quality, amenities, and level of management. According to the 2020 Self-Storage Almanac, six public companies control 31.2 percent of the nation’s self-storage supply, and the 100 Top Operators (including these six public companies) represent 47.7 percent of the nation’s 2020 self-storage supply.
Class A self-storage facilities attract a particular group of owners who are institutional in nature (REITs) and are investing in both the business enterprise and the going concern versus solely the real estate. As a result, transactions of these type of self-storage facilities represent sale of a going concern and not just the real estate. Such transactions are typically based on a price-earnings multiple. The inferred cap rate applies to the going concern business sale and not the real estate. The real estate (land and building) are just one of the three types of assets contributing to the value of a going concern, and care needs to be taken not to ascribe personal property, intangible assets, or financial assets to the real estate. A sales comparison approach to value that uses cap rates from comparable transactions without adjusting for going concern would be like comparing apples and oranges.
The emphasis on class type for self-storage properties parallels that associated with flagged hotel properties, franchised restaurants, etc., in that all are professionally managed businesses operating within a real estate asset that have elements of going concern.
Pulling It All Together
The complexity of going concern and business enterprise is embedded in more CRE property types than just hotels and restaurants.
When determining the market value of commercial properties, care needs to be taken to ensure that the calculated valuation reflects asset components specific to the real estate itself and not the elevated value of the going concern. The following are some recommended adjustments to separate real estate market value from the going concern. It’s not just a legacy hotel or restaurant with business enterprise value to consider in 2022. The breadth of property types with going concern value has expanded and some adjustments are required, including:
- Extract Non-Realty from Sales Transaction Comparables. When determining the real estate market value, non-realty components — such as the cost of moving trucks or fixtures constructed for specific uses — must be adjusted for or extracted from the total transaction sale price.
- Market Rent and Occupancy. The objective in a market value determination is to estimate the average market rent and occupancy versus a specific property’s operating rent and occupancy that could be influenced by other factors, like “weeks versus points” pricing in timeshares or inferior or superior amenities and services as in the case of climate- versus non-climate-controlled self-storage.
- Management Fees Don’t Capture All the Going Concern. Consider the revenue contribution and expense-side accruing to going concern value from any additional off-site services (advertising, IT and tech support, accounting, security monitoring, etc.) that may be above what is generally seen in the market. A general 3, 5, or even 10 percent overall management fee often doesn’t cover the expenses for the business services not related to the typical 3 to 5 percent property level management for physical maintenance and on-site management.
- Distinguish the Going Concern Cap Rate in a Transaction. Selecting a cap rate requires judgment and a breakdown between the asset classes (tangible real estate, intangibles, and financial assets). Of significant note on this point is Chapter 37 in “The Appraisal of Real Estate, 15th Edition.” REIT and portfolio transactions often utilize a purchase price allocation (PPA) to segregate the non-realty, property-by-property market value for the real estate and use these transaction price allocations for SEC and GAAP accounting reporting. Be sure to inquire about the PPA with the buyer so as not to misrepresent a pro rata of the portfolio sale with non-realty attributed to an individual property in the aggregate transaction.
- Don’t Overlook the Cost Approach. The cost approach is integral to the principle of substitution and is a reliable method to value just the real estate assets. Note the following from “The Appraisal of Real Estate, 15th Edition”:
In situations where the cost approach can be developed reliably, it can be useful in determining the appropriate allocation of value to the different asset classes. A common strategy is to use the cost approach to value only the tangible asset classes (land, sticks, and bricks). The value indication from the cost approach can then be compared to value indications from the sales comparison and income capitalization approaches to highlight the inclusion of non-realty and intangibles to the going concerns.
ESG/DEI as a Valuation Element to Address Climate Risk and Diversity
As mentioned earlier, ESG and DEI initiatives are now critical CRE factors. ESG scores by proxy advisers such as Glass Lewis and ISS — as well as CRE debt monitoring companies like Trepp — can make or break a transaction. Several top-10 banks with CRE concentrations now incorporate a level of ESG underwriting to the commercial real estate credit approval process. A credit request based on a less-than-favorable ESG score influenced by a single tenant (such as a firearms maker or fossil fuel company) or a property ownership structure that lacks diversity can result in a negative credit approval decision.
Brokers, CRE investment advisers, and appraisers collectively need to understand how ESG scoring is going to impact all aspects of the CRE transaction process.
The nationally recognized CRE debt-monitoring company Trepp has published extensively on ESG scoring and developed its own modeling that translates down to the individual property level. Trepp has also partnered with RMS, a Moody’s Analytics Company, to create a new composite environmental risk score based on the integration of RMS’s climate catastrophe risk models with Trepp’s CMBS and CRE products. This partnership will provide both a physical risk score and a business interpretation to properties listed in Trepp’s database. In the future, the partners plan to bring new scores and metrics focusing on enhanced risk measurement and add more granularity to facilitate analysis.
Brokers, CRE investment advisers, and appraisers collectively need to understand how ESG scoring is going to impact all aspects of the CRE transaction process from underwriting to capital allocation to market value. The ESG score may become more impactful on value than the selection of a cap rate.
From the embedding of going concern and business value within more property types to the evolution of PAREA that could potentially replace the USPAP, a lot is changing in how commercial real estate value is determined. Whether you are a broker, appraiser, or investment adviser, how commercial real estate value is determined is more in focus in 2022 than at any point dating back to 1989 and the passage of the FIRREA legislation.
Don’t get caught off guard. Start getting prepared today for how CRE valuation will be conducted tomorrow.
K.C. Conway, CCIM, MAI, CRE
K.C. Conway, CCIM, MAI, CRE, is The CCIM Institute's Chief Economist.