Newcastle is a real estate advisory, investment and development firm.

Heartland Real Estate Business - Published October 2006

By Kevin Jeselnik

Appraising the Situation

In some cases, an appraisal may not be the best way to determine a property’s value.

When one wants to establish the value of a property, an appraisal is the standard means by which a property owner can find its worth. Appraisals, guided by the Appraisal Institute standards, can be implemented in three ways: the sales comparison approach, which compares three to five similar properties sold to the subject property under appraisal; the cost approach, in which an appraiser estimates the value of any improvements that have been made, subtracts the amount of depreciation of the improvements, and adds an estimate of value of the site itself; and the income capitalization approach, which is derived by dividing a property’s net operating income by the desired rate of return.

The other major use of an appraisal is to find a property’s highest and best use. The four criteria to establish highest and best use are whether the use is physically possible; legally permissible; financially feasible; and creates maximum profitability.

While an appraisal is a good way to establish a basic value of a development site or existing property, sometimes the limitations of its methodology constrain its ability to obtain the best value.

“At the end of the day, an appraisal is an opinion of value,” says Peter Tortorello, vice president and partner at Chicago-based Newcastle Limited, a commercial real estate advisory and development firm. “Regardless of the type of appraisal, it needs to conform to the uniform methodology established by the Appraisal Institute.”

“An appraiser cannot work outside the three established approaches to value and still consider its assessment an appraisal,” explains Michael Haney, president of Newcastle Limited. “We have considered some instances we have run across where appraisals didn’t apply the best value.”

Condemnation
If a property owner is facing the possible condemnation of its property, it might not be in its best interest to have an appraisal on file, says Haney. “Appraisals are what the courts or an attorney consider ‘discoverable,’ the condemning body could obtain any appraisal that may have been completed on the property” he explains. “If an appraisal is written from an approach that is not in your best interest, it may start to establish a value that is less than what a property owner would get through a condemnation if they handled it as a more typical condemnation negotiation.”

If facing condemnation, Haney advises that instead of calling an appraiser the condemned property’s owner speak with a real estate advisor or condemnation attorney to establish a strategy for responding to the condemning party. “While it is important to have appraisers on your side if it’s necessary in a condemnation, you do not want to go out and just order an appraisal; that can work against you,” Haney says.

Redevelopment/Rezoning
Another situation where an appraisal may not be the best manner by which one can valuate a property is when a property is likely to be redeveloped or rezoned. “With unimproved or redeveloped land, the sales comparison approach has to be used,” Tortorello explains. “When you get into urban areas, and zoning and adjacent land uses come into play, it is really difficult to compare a property to another property that is perhaps eight blocks away, when zoning issues and such can change drastically within that distance.”

Using the sales comparison approach, an appraiser can compare two 15,000-square foot properties under different zoning on different streets and complete a sensitivity analysis by making a percentage adjustment based on one of the property’s superior location or inferior frontage. “However, it becomes very difficult to value a property that is to be redeveloped or rezoned simply on a per square foot basis,” Tortorello says. “You need to take a look at the property on a floor area ratio basis, which is the total square footage that can be developed on the site.”

An appraisal may value the land based on its location and size, but not include the value added by what can be developed on the land. “One needs to be careful in a situation in which a property is being redeveloped to look at what the development potential is,” Haney says. “It needs to be valuated on that potential development, not on the value of the land on an as-is basis. Often in a redevelopment/rezoning situation, appraisers will under-value a property because they are not really allowed under the [appraisal] methodology to get into a property’s potential.”

To determine the true value of such a property, it must be evaluated from the point of view of a developer, for its potential worth in its future state rather than as it stands at the time. Using the residual analysis to calculate land value of a development is one way to evaluate its worth, which essentially deduces how much a developer would be willing to pay for the land measured against the prospective investment return a particular project might draw from the site. What a developer can afford to pay may be substantially different than the appraised value of the existing building.

Community/Political Issues
When a development site or existing facility is the subject of community or political scrutiny, appraisals can sometimes over-value a property. “Especially in large cities such as Chicago, even if a property is zoned for an intensive use, community groups can influence political forces and limit what a development can be,” Haney explains. “Sometimes, looking at a property’s potential based on current zoning can actually result in someone overestimating what could realistically be achieved on that property.”

Many owners might say that having one’s property over-value is not a bad thing, but if someone is trying to decide whether to sell a property or not it could be. An owner needs to have as accurate an estimation of its property’s value as possible; it may not be as valuable as it seems after it has been run through the political machine. “It’s difficult within the context of the Appraisal Institute standards for an appraiser to really take into account political influences that might affect a property’s value,” Haney says.

In this situation, a residual analysis will help determine value, but the interested parties must dig deeper to understand the political and community back-story. “It’s a very circumstance-specific issue,” Haney notes. “Sometimes a group is against a certain tenant, sometimes the worry revolves around building height or shadows, or there might be concern about the need for more affordable housing or additional landscaping.”

Physical Barriers and Technical Challenges
When a property possible has physical or geotechnical problems, an appraisal may not take these issues into account. It is not required that any in-depth site work or due diligence is performed when an appraiser valuates a property. This means that the presence of wetlands, potential environmental contamination, or other problems such as the distance between the property and certain utilities may be overlooked and not reflected in the established value.

“These kinds of factors can have a significant impact on value, but because an appraiser is not required to do an in-depth analysis, this type of information is not brought to bear on the value on which an appraiser settles,” Haney says. Having a third-party consultant evaluate the property for potential environmental challenges is important in order to establish an accurate price.

Impact of Ongoing Business
“If the property is developed for a special use, or if the value of the property is derived from the income stream, it may be difficult to establish value through appraisals,” Tortorello says.

Haney has an example that illustrates how projects developed for a specific use are hard to valuate. Newcastle is developing a school for children with autism in Chicago with Easter Seals Metropolitan Chicago. “It’s a not-for-profit, so you can’t take an income capitalization approach to valuate it because it is not generating a profit,” Haney explains. “The sales comparison approach doesn’t make sense because schools do not trade often and it would certainly be hard to find comparable schools nearby. And the cost methodology doesn’t work well either, because a school for autism has to be specially designed and has a lot of unique and expensive interior finishes.” It would be very difficult to explain to a bank or investor why a project like this cost so much – the special needs of the kids – through an appraisal.

As these examples show, there are several unique cases wherein an appraisal would not be the most accurate method to valuate a property. In each case, it is advisable to contact a real estate consultant and find ways to evaluate the property to best establish its worth. – K.J.

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