The Expensive Omission

I laugh when I seen a marina income approach with . . . → Read More: How to Tell a Bad Marina Appraisal – Part 6 of 7]]> The income approach always needs to be included in a marina appraisal.  It’s how the market works and thinks.  It’s not an owner occupied property like a single family residence… it’s an investment in a business, so the report isn’t exactly civilized if it’s excluded.

The Expensive Omission

I laugh when I seen a marina income approach with only four, five or six expense line items.  Can the expenses of any business be completly shown in so few line items?  It’s not possible, yet I’ve seen this in many marina appraisals I’ve reviewed.  This isn’t investment grade real estate where the tenant pays most of the expenses.  It’s not vacant land where you only have “caretaker” expenses like a management fee and real estate taxes.  You should see between one and three dozen expense line items… if not, it’s a bad marina appraisal.  Don’t blame me… it’s just the nature of the business (note the operative word business here).

The Understated Operating Expense Ratio

Remember in Part 1 when I said I’d be saving a few tricks for my litigation bag?  This is one of them.  However, what I will say is that a 35 or 40 percent operating expense ratio does not reflect the fact that marinas are operating businesses.  That’s the operating expense ratio range I’d expect to see for new apartment construction; not even older apartments have a ratio this low, as any perusal of an IREM income/expense report will show.  The payroll line item alone should tell you that you won’t be in that range (if it’s included at all in the appraiser’s projections).  That’s as far as I’ll go on the topic.  The rest stays in my bag.

The Crap Rate

Oh… sorry… perhaps I should have said cap rate.  Then again, maybe I was right the first time.

Most of the cap rates you’ll see in marina appraisals are done based on the band of investment or mortgage equity techniques.  When there’s no marina financing, using them is just plain misleading.  The results are equally so.  Put that bad appraisal in the shredder.

As I indicated, I like to get cap rates by surveying those in the market.  I’ve surveyed hundreds of marina owners and professionals and received upwards of a hundred responses.  Sometimes the listings will give me support, though the range in asking prices tends to be too high in a recession and the asking cap rates too low.  You can tell by how long the marina has been listed in many cases.  When everyone is telling me a tight cap rate range, I’ve got support from the market participants who are the market.  In a recession when sales don’t exist, what’s more relevant and market supported than that?

Time Management 101

Another tip for telling a bad marina appraisal is the length of the income approach.  Three, four or five pages just doesn’t cut it.  Marinas are too complex to explain in so few pages.  Rather than doing a cost approach or sales comparison approach when there aren’t any sales, time management dictates that the appraiser should spend most of his/her time on the income approach.  After all, that’s how the market thinks and reacts.  It’s better to have one really good and relevant approach than diluting the result by chasing two or three approaches when there’s only one reliable approach… and everyone in that market knows it.  When it comes to the income approach, bigger is usually better.

In Part 7, I’ll summarize all the things you should look for to determine if an appraisal is bad or not.

John Simpson, MAI

The Biggest Problem with Using the Cost Approach for a Marina

When you find that there is no sales comparison approach but there is an income approach and a cost approach, that will tell you you’ve got a bad appraisal.  That may seem harsh, . . . → Read More: How to Tell a Bad Marina Appraisal – Part 5 of 7]]> It’s time for the approach to value I love to hate:  the Cost Approach.

The Biggest Problem with Using the Cost Approach for a Marina

When you find that there is no sales comparison approach but there is an income approach and a cost approach, that will tell you you’ve got a bad appraisal.  That may seem harsh, but it’s true… and the truth is an absolute defense, as they say on the crime dramas.  Since the land value represents a large portion, if not most, of the value of a marina, the appraiser just has to get this part right.  ’No two ways around it.

The problem is that if there aren’t any marina sales, there really aren’t any marina land sales.  What the appraiser used were land sales that weren’t approved for a marina… and as anyone in the marina industry knows, if it doesn’t have all the approvals you need for development, you don”t have a marina.  Those that really know this lesson only too well lost their assets in this Great Recession.

It may be waterfront land, but it’s not marina waterfront land in most cases.  Even if it is zoned for a marina, in most states, it takes years to get all the approvals, so since your marina has approvals because it has slips, the comparables all need to be approved, not just waterfront land.  Since financing came to a scretching halt for existing marinas, you can bet it really died for marina land development, so I don’t see how the appraiser could even come up with three land sales in the same market.  Appraisers just don’t win the lottery.

The Second Biggest Problem with Using the Cost Approach on a Marina

Regardless of whether it’s a recession or not, the fundamental problem with a cost approach is that the cost estimating services just don’t get marina construction costs right.  There just isn’t enough of a pool of data in the U.S., let alone locally, from which to draw reliable numbers.  Another problem is that marinas vary so much based on their market tier that a small sample just won’t produce reliable results. 

The other issue is how to handle the length of time and cost of obtaining approvals for your comparables when they’re not in place.  Well, good luck with that.  Most appraisers just ignore it.  ’Sorry… you just can’t do that.  Unapproved waterfront land does not equal approved marina development land.  It’s like I said earlier in this blog series… it’s a different market with different market participants.  Not only that, in this case, the market participants probably view the highest and best use of their sites as anything but a marina.

In Part 6, I’ll dive into the best and most reliable approach to value:  the income approach.  ’Stay tuned.

John Simpson, MAI

When the market is lukewarm or hot (remember those days?), your appraiser will have enough sales data to work with.  Or at least, he/she should.  You’ll see three, four, five, or more sales in the report.  Even though the appraiser considers them “comparable” sales, in most cases, they really aren’t. . . . → Read More: How to Tell a Bad Marina Appraisal – Part 4 of 7]]> Selling the Sales in an Up Market

When the market is lukewarm or hot (remember those days?), your appraiser will have enough sales data to work with.  Or at least, he/she should.  You’ll see three, four, five, or more sales in the report.  Even though the appraiser considers them “comparable” sales, in most cases, they really aren’t.  ’Sorry to be the bearer of bad news.

Market Tiers

Granted that virtually no two marinas are alike, this isn’t an excuse for data that isn’t comparable.  The biggest problem is with market tiers.  If your marina is a plain marina (i.e. a “warehousing” marina), that’s a very different market from the boat dealership marina or the boat yard marina.  If your marina is 100 slips, that’s a different market from the 300 or 400 slip marina because the sale price difference will attract different buyers between the two.  If your marina is in Downtown Annapolis, that’s a different market than the Eastern Shore or Northern Anne Arundel County (the same thing applies to Boston Harbor versus the outlying, mostly suburban areas and many other cities).  If you’re a yacht marina, you’re in a different market from the cruiser marina.  I’ve yet to meet a marina owner who would consider a 100 slip and a 40o slip marina substitutes.  If your marina is a lake marina, it’s probably not comparable to a blue water marina, so mix and match doesn’t work.  I could continue, but I’m sure you get the point.

Have you figured out the common theme here?  To have a reliable sales comparison approach, the sales have to be comparable (it’s called the  sales “comparison” approach for a reason).  Comparability shouldn’t be determined by the appraiser but by the market, or shall I say market participants.  As part of the verification process, I’ve had many an occasion to ask a simple question of the buyer that determines comparability.  If, say, my subject were 100 slips and I was verifying a sale of a marina with 300 slips, all I have to add to the conversation is a simple question:  ”Did you or would you have considered a 100 slip marina?”  That’s all it takes.  Nine times out of ten, the answer is “no” and in most cases, I even get an explanation why not.  It then becomes easy to say I considered other sales like this one but the owners did not consider them substitutable with the subject, so they aren’t comparable (hence their exclusion from the sales comparison approach).  Simple… clean… but it does take time and effort to get this information.

Other Sales Comparison Clues

Other clues include the number and amount of the adjustments as well as whether there is anything in the sales write-up that indicates it’s verified.  Let me just go on the record to say that there are a lot of sales that are not arm’s-length in the marina business and if the data isn’t verified, it’s a lead, not a sale.  Sales that have a line item that says “Verified With” and then “buyer”, “seller”, etc. and no further information that indicates the appraiser actually spoke to someone at the marina are probably not truly verified.

Let me give you an example.  A marina sale that has 15 acres of land but a very low building density probably has wetlands, poor soils, flood plane issues, etc.  If the sale says verified with the seller and there’s no discussion of the excess land, either the appraiser isn’t asking the right questions or he/she hasn’t really verified it.  This sort of information an appraiser needs to know to get the adjustment right.  Another example is the appraiser says the site has approvals for additional slips or buildings but doesn’t mention them.  Wouldn’t you expect the appraiser to ask that question as part of the verification?  That’s the kind of thing you need to help make an excess land adjustments.  A final example is a verified sale that has no financial information (i.e. cap rate or gross income multiplier) and no mention of whether this disclosure was refused or eve that the appraiser asked the question. 

In Part 5, I’ll explore using the Cost Approach in lieu of the Sales Comparison Approach and why any reliance on it will result in a bad appraisal.

John Simpson, MAI

OK, I’ll admit marina sales are almost impossible to get.  It’s been a completely barren market for arm’s-length transactions in such states as Maryland and New Jersey.  So in this Great Recession, it’s easy to say there haven’t been any sales and move on to the income approach.  Does the . . . → Read More: How to Tell a Bad Marina Appraisal – Part 3 of 7]]> Selling the Sales in a Down Market

OK, I’ll admit marina sales are almost impossible to get.  It’s been a completely barren market for arm’s-length transactions in such states as Maryland and New Jersey.  So in this Great Recession, it’s easy to say there haven’t been any sales and move on to the income approach.  Does the report even say that?  Too many don’t mention it or, as I have seen in great abundance, they just tell you so in a sentence or two and that’s it.  Well, I’m sorry to say that’s not it.

Is there any discussion of listings?  Believe it or not, getting marina listings is a difficult and time consuming thing to do.  The reason is that most marinas are not really listed for sale.  Marina owners will give brokers a “one-day” listing if they bring a buyer to see the marina.  Most feel a real estate broker doesn’t know didly about a marina, which as I’ve said is a special purpose property.  That aside, there are sources such as CoStar and LoopNet that have listing information available for easy viewing or at a nominal fee.  If the appraiser doesn’t even mention them, it’s a lazy report.

Of course, the listing prices are usually too high compared to what the marinas are really worth.  The appraiser may not find a range that’s reasonable from which to work.  If that’s the case, I’d like to see it mentioned.  Listings provide the only market evidence for cap rates when there aren’t sales, so they’re useful for the income approach (as you can tell, my opinion of the band of investment or mortgage equity techniques when there is zero marina financing is that they’re misleading and produce misleading results).

The alternative to not using marina listings for cap rates is doing an investor survey.  That’s one of the many tools I have in my little goody bag:)  I do those surveys in different geographic reasons and I know what cap rates and return on equity the players in the market are willing to accept.  But, of course, as I discussed in Part 1, you won’t see any survey for a $2,500 or $3,500 fee because the fee doesn’t warrant the effort.

In Part 4, I’ll sell the sales in an up market.  In other words, what to look for in a sales comparison that shows the appraiser isn’t getting accurate results.

John Simpson, MAI

Fluffy is Nice… But Not When It’s My Appraisal

Back in the day, it was the conventional wisdom that the thicker the report, the better it was.  That lead to some rather humongous addendas.  As far as marinas are concerned, the market description is where the fluff . . . → Read More: How to Tell a Bad Marina Appraisal – Part 2 of 7]]> So we’ve learned that the price is not always right.  Why?

Fluffy is Nice… But Not When It’s My Appraisal

Back in the day, it was the conventional wisdom that the thicker the report, the better it was.  That lead to some rather humongous addendas.  As far as marinas are concerned, the market description is where the fluff is.  It’s not uncommon to see 20, 30 or even 40 page market sections that talk about all kinds of things other than what’s relevant.  For instance, the office market, population growth, household incomes, etc.  It’s not that this couldn’t be of some use to some person out there, it’s just that it has such an indirect effect on any one marina as to be useless, so it should be regarded as irrelevant.

Now here’s my second tip.  Add up the number of pages in the market section.  Now add up the number of pages in the valuation section.  Are they similar?  I’ll bet they aren’t because it’s uncommon to find a valuation that is even 50 percent of the length of the market section.  Yes, I’ve seen 40 page market sections with 5 pages of valuation.  There are only three possibilities here:

1. There’s too much fluff in the market section
2. There’s too little analysis and discussion in the valuation section
3. Both of the above

You be the judge.

In Part 3, I’ll delve into typical marina valuation techniques and how they can be abused to provide you with a sloppy appraisal report.

John Simpson, MAI

I promised a real-world example.  So be it.  About a dozen years ago or so, I called and spoke to one of the designers of the Urban Land Institute’s Dollars and Cents study.  I don’t have access to the reports I did at that time (it was under someone else’s employ), but in 2002, . . . → Read More: Caveats to Industry Standard Operating Expense Studies – Part 3 of 3]]> “But You Promised…”

I promised a real-world example.  So be it.  About a dozen years ago or so, I called and spoke to one of the designers of the Urban Land Institute’s Dollars and Cents study.  I don’t have access to the reports I did at that time (it was under someone else’s employ), but in 2002, I had a difficult shopping center to appraise.  So I called and spoke to a project manager for their industry standard study.  The names have been omitted to protect the innocent.  Here is the actual text from my appraisal report (minus the name of the interviewee)

The numbers in the columns of Dollars and Cents intentionally do not add up.  For instance, Total Rent is comprised of Minimum Rental Income and Overage Rental Income, yet adding these two sub items together does not equal what is shown as Total Rent.  This can be said of virtually all the items in their Operating Results tables.

According to Urban Land Institute (ULI) , they do not add up because “each line item is calculated based on the total of its own category.”  This has significant impact on the results. To best understand the difference, we’ve presented a numerical example below.

Table 4-2 of their 2002 edition (page 87) has a “Property taxes and insurance” amount of $1.71 per square foot.  Yet underneath it is a “Property taxes” amount of $1.91 per square foot and an “Insurance” amount of $0.10.  Clearly, adding the two sub items does not even come close to the “Property taxes and insurance” item above; in fact, the sum is $0.30 per square foot greater than the total!  The reason for this is that, say, 25 centers replied to ULI’s survey with a line item for “Property taxes and insurance”, yet only 15 of them had a separate line item for property taxes and another for insurance.  Taking the average from 15 survey responses and adding them up would not likely equal the 25 responses for the the two components that were not delineated separately.  This explains why very few of the Dollars and Cents totals add up to the sum of their individual components (i.e. they are not based/calculated on the same number and is based on different sample sizes).

Having said the above, which numbers do we choose?  According to ULI, that depends on the line item we are using as a basis of comparison.  To use the example above, if we wanted to compare the subject’s Property and insurance line item [note the singular], we would need to choose the same category from Dollars and Cents, not add up the individual components and use that for comparison.  That leads us the natural question, which of the two is accurate? ULI answered that question with “it depends”.

Although technically correct, this answer leaves us with having to choose which of their numbers truly reflects the results of a particular category and since each item and its total are based on different sample sizes, there is simply no way to know.

Dollars and Cents of Shopping Centers is the accepted authority for deriving industry based numbers, so disregarding it would not be proper.  Given the faults discussed, it is our opinion that using the largest income and expense categories would produce the best comparison.  The largest categories would have the greatest number of survey samples (being the most reliable), differences in the reporting of their smaller line items would average out, and a typical market participant would give particular credence to these categories over the smaller line items that may or not be reported in a center’s operating statements.  The largest categories would be Total Operating Receipts, Total Operating Expenses and Net Operating Balance; only these three categories will be compared to the subject.

So there you have it.  Try calling them or other designers of the industry standard studies and ask them about any confusion they have. You paid for the study… you’ve got the right to know.

John Simpson, MAI

Another factor not considered in the blanket acceptance of industry standard operating expense studies is the size of the sample.  As discussed in Part 1 of this post, Dollars & Cents appears to have a threshold where a certain number of responses for an expense category are necessary for it to be reported.  Fortunately, most . . . → Read More: Caveats to Industry Standard Operating Expense Studies – Part 2 of 3]]> Sample Size

Another factor not considered in the blanket acceptance of industry standard operating expense studies is the size of the sample.  As discussed in Part 1 of this post, Dollars & Cents appears to have a threshold where a certain number of responses for an expense category are necessary for it to be reported.  Fortunately, most studies of this type report the number of properties that have been used to provide that information, so we have an ability to judge whether the data is sufficient to be statistically significant.  Strangely, few people seem to notice this stat.

Same goes for IREM’s Income/Expense analysis.  Selecting another random page, each grouped set of columns has a “Buildings” column that appears to report the number of buildings where respondents provided that line item on their financial statements.  This example has 92 buildings as part of the the sample… a really good number!  The individual income and expense line items range from 1 to 90, but about 90 percent of them show 70 observations or more, so we can see that the sample is good enough to be credible and statistically significant.  I can’t say there’s much gray between the black and white of the printed word and page for this study… which is a good thing.  Same goes for BOMA’s Experience Exchange reports.

Let’s take an example.  The IMI Financial Operational Benchmark Study for Marina Operators is an indispensable source for marina operating data, but the number of marinas used as part of the sample are much lower than that reported by similar studies by ULI, BOMA and IREM.  Their 2000 study had 13 respondents from Region III (13 Midwest states) and 13 from Region IV (13 West Coast states). With California in Region IV, do you think that 13 marinas are statistically significant enough to be reliable?  Would you accept the Region III results with only 13 marinas reported from 13 states or an average of 1 per state?  I’d say the odds are against them even being a reliable and reflective sample of the population, as they say in statistics speak.  I’m not trying to bash the study… I’m simply pointing out that you need to know how well it represents what it is supposed to represent to rely on it.  When there aren’t many “observations” in a sample, don’t treat it like the gospel.

Do the Math

Getting back to our example from Part 1, it looks like our Sherlock Holmes sleuthing is paying off.  Let’s say we select the Average column as best reflective of the property we’re comparing it to.  Have you tried to see how well the numbers add up?  Going back to my random page selection from Dollars & Cents, Total Advertising and Promotion is $0.98 per square foot of GLA (gross leasable area) on average.  Underneath that and indented are components of Advertising and Promotion.  Advertising is $0.39, Promotion & Special Events are $0.21, Christmas Decor/Events are $0.09 and Marketing Administration is $0.17.  Doing the math, that’s $0.86, not $0.98 per square foot.

That leads me to two thoughts.  First, almost all of the “Total” columns suffer from the same problem.  Second, Merchants Association was blank, which was part of Total Advertising and Promotion.  You’ll find lots of these situations… but don’t conclude the difference is Merchants Association!  You’ll see why in Part 3 when I go over a real example and the response of one of the industry study designers to my questions.

“Totally…”

I can’t help but read this title using Crush’s voice from Finding Nemo.  I’m sure he’d read the paragraph above and say “Like… Dude… when do I use Total?”  Well, Crush, Total isn’t really a total.  I’m sure you just as confused as poor Crush.  You see, the Total columns is based on the the number that is reported from the sample respondents.  It is not the sum of the line items that comprise it, which is somewhat misleading given that they are presented in the Dollars & Cents study as indented below the total they would logically represent.  What this means is that if you want to use total advertising and promotion to compare to your subject’s total advertising and promotion line item, that’s the way to compare it.  You don’t add the sub-items up because you’d find in most cases that they add up to a different total.

So let’s take this a step further.  You’ve got a financial statement in front of you with advertising, promotion, Christmas Decor/Events and Marketing Administration, or their equivalents.  Should you compare these to the individual line items or add them up and compare them to the Total advertising and promotion expense?  Your guess is as good as mine.  It’s not explained well at all in the industry standard studies.

The Operating Expense Ratio

Given the issues discussed above and those presented in Part 1, you might want to fall back on the operating expense ratio (net operating income divided by effective gross income) as the most reliable line item.  Now that’re you’ve studied and are ready for the final example, do you think the operating expense ratio is stand-alone, is based on the sum of the total columns or the sum of the individual subitems for each total column?  If you find out the answer, let me know.  It has to be calculated somewhere because it is the ratio of two numbers, but whether it is calculated from each sample financial statement submitted or is calculated from column items is anyone’s guess.

Stuffing Santa’s Stocking

So maybe I’ve made you a big fan of using the average in an industry standard operating expense study.  Before you start getting cocky, ask what the average is an average of.  Studies like BOMA’s Experience Exchange Report are great because they give you tabular statistical data on what comprises the average.  You can see the average square footage per office user in a particular category, the occupancy rate and lots of other details.  That’s very useful for pinpointing how well the property you wish to compare to the study reflects the properties that are reported.  If your number is significantly different, maybe consider one of the other categories like high, low, Upper Decile, Lower Decile, or whatever is used in the study.  ‘Food for thought.

Conclusions

To base important financial decisions on industry standard operating expense studies is a little like being spun around and having to play darts blindfolded.  If you understand the caveats of each study, you’ll at least be pointed in the direction of the dartboard.  You may find that to score a bulls eye, you’ll have to contact the designer of the study and have them answer your questions and give you advise on how best to interpret their numbers.  That’s what I did and you’ll see the result in Part 3.

John Simpson, MAI

How I Would Handle the Value Range Problem

Using our $15,000 to $70,000 per acre sale range example, what I would do is create a ranking table for the subject and the sales.  I’d rank each feature on a 1 to 5 scale.  . . . → Read More: Secrets of Appraising Vacant Land – Part 4 of 4]]> So up to know I’ve explained the what, but not the how.  Let’s fix that.

How I Would Handle the Value Range Problem

Using our $15,000 to $70,000 per acre sale range example, what I would do is create a ranking table for the subject and the sales.  I’d rank each feature on a 1 to 5 scale.  The total would give me some idea of how each sale compares to the subject and every other sale.  But that’s just a start.

One key thing is missing from the above.  All of the characteristics have the same weight using a simple scaling grid, but that’s not the way market participants think.  One purchaser might view soil with a greater weight than another and so on.  In your verification, try to get that type of information.  What characteristics did they consider to be more important than others?  When you’ve verified all your sales and gotten this type of information, you might see some market tendencies.

Another question you can ask is whether the purchaser found out something after the fact that would have changed their purchase price.  “If you were to buy the property back then knowing what you now know about it, would you have paid the same price?”  That’s a key question to ask.  If the answer is “yes”, you’ve found support for an adjustment.  You’ve found support for a ranking weight adjustment.  You’ve also explained why there may be some outlier sale price per acre and how to handle it.

A Check and Balance

There is a little technique that you can use to provide a check and balance on your final value conclusion.  I call it the the land to gross sellout ratio.  It’s really just a builder’s rule of thumb.

If you find out the sale prices of the homes a developer intends to build on a site (or better yet, the prices for what they actually built), add them up.  You can also take an average.  That’s the denominator.  The numerator is the sale price.  Then just do the math on your comparables and look at the range.

Let’s do an example.  You see that a developer bought a property for $100,000 and expected to build five homes that will sell for $200,000 each.  That’s $1 million in revenue.  Taking $100,000 and dividing it by $1 million is 10 percent.  You’re saying that raw land is worth 10 percent of what the income will be.  Let’s say we have four other sales with ranges between 7 and 15 percent.  Now that’s a range you can work with!  If you conclude a market value that would have a land to gross sellout ratio of 11 percent, you could simply put together a quick table that shows the ratios for your sales and where your subject fits into the matrix.  Maybe 11 percent falls in the second position of the five sales if you ranked their ratios from low to high, for example.  You’re in the range and you’ve supported your conclusion.

I use this technique whenever I appraise residential subdivisions.  I explore it in depth in my upcoming Subdivision Analysis online seminar I’m developing for appraisal education provider McKissock (a shameless plug, I’ll admit:)  Still… the point is that you can reconcile a huge range in sale prices by proper due diligence, considering intangible sale factors and using these two techniques.  Appraising vacant land doesn’t have to be that risky, even though land development is.

John Simpson, MAI

Risky Business

Even children know that anything that takes years to come to . . . → Read More: Secrets of Appraising Vacant Land – Part 3 of 4]]> Let’s take a look at the land from its futuristic orientation.  By that I mean that the property will have to receive approvals, site improvements, building improvements and find users (tenants and/or owners) that span a substantial amount of time into the future, usually years.

Risky Business

Even children know that anything that takes years to come to fruition is a lot riskier than something that exists today.  A bird in the hand is worth two in the bush, as they say.  The word “future” is synonymous with risk.  The longer you have to wait, the more variables can get in the way to change your chosen path.

Many aspects about development risk you already know quite well.  Every one of us knows that the economy can change, sometimes for the worse and sometimes for the better.  Let’s add a change in supply to the list, not as in land supply but as in home or end-user building.  While you’re in the process of obtaining approvals for development, some major national builder may decide to start building in the same town.  Maybe they’ll start building next door or across the street.  National residential home builders prefer to buy lots from subdividers (developers who buy raw land, obtain the approvals, install site improvements and then sell the whole project to home builders), so if there’s something already in the pipeline, it doesn’t mean the developer who is trying to obtain those approvals will developer their own homes.  So, surprise… XYZ national builders is going to open up and turn your lovely project from profit to loss.

Another risk factor is the unknown of the approval process.  Maybe you’re the lucky one who is trying to obtain approvals for a subdivision that houses a roosting area of endangered birds.  Maybe you didn’t know the land had an environmental problem; you did pay for a Phase 1 environmental site assessment before you bought it, right?  Perhaps you didn’t know the water table was so high.  What if your conceptual use doesn’t fit into the new Master Plan that just came out and was voted into law?  Maybe you need financing and the lenders just aren’t lending (we’re now all experts in that).  Could a natural disaster happen that changes the way governments view new development?  This is only the “short” list… I didn’t want to strain my fingers.

How Developers View Risk

For developers, it’s really quite simple.  The higher the risk, the higher the profit they need to make the time, effort and cost worthwhile.  That’s why entrepreneurial profit is included as a line item in any cash flow projection.  Still, there’s a relationship between the discount rate used in the subdivision development method (which is a risk rate) and entrepreneurial profit (the return for taking that risk), so there’s a trade-off.  Raising the discount rate and lowering the entrepreneurial profit has the same basic effect as lowering the discount rate and raising entrepreneurial profit.  Of course, the amounts are important, too, but I just wanted to put that fact out there for thought.

Back to Appraisal Theory

So getting back to the appraisal arena, future risk means the following:

• A higher discount rate if you perform the subdivision development method
• A strong tendency to use historical sales data to avoid the nebulous nature of the future
• Dismissing listings that are available today but may not be in a year or two
• Higher allocation for entrepreneurial profit

This all sounds good, but when you are faced with, say, five land sales that range between $15,000 and $70,000 per acre and you can’t see a physical difference between them, how does the above help?  Well, owners view risk differently.  They have different levels of expectations for how their dreams will turn out for the property; as a result, entrepreneurial profit expectations vary.  They view locations differently too.  In other words, there are many subjective elements that explain differences in land values between comparable sales that y0u never see in improved property transactions.  Even though we appraisers have to assume “competent” and “knowledgeable” buyers as part of the definition of market value, this is frequently not the case when it comes to land purchasers. This is where verifying the sale comes into play.

This argument is the single most important aspect that is typically left out of an appraiser’s report.  Why were these particular sales presented?  What sales were excluded?  Why?  How would the market and market participants view this property?  How did they view the sales?

By not answering these questions, the appraiser can wind up selecting a market value in the aforementioned example range of $15,000 to $70,000 per acre that could be way off.  That’s why land valuations are inherently harder than improved property valuations and why the appraiser’s business risk is so much higher.  There’s just a lot of variables for the appraiser to deal with.

In Part 4, I’ll explain how I would handle all these variables… assuming I got paid well enough to do so.

John Simpson, MAI