Commercial Investment Real Estate September/October 2019 | Page 21

• If the prices paid for properties leased to credit tenants command a premium associated with credit tenants, are the prices for these properties likely overstated as an indication of value for ad valorem tax purposes? While this point is highly debated, an argument can be made that the answer is an irrefutable and resounding yes. Many contend that, for example, if the fee-simple interest of a Lowe’s is being valued, an appropriate comparable might be a physically similar home improvement store — even if it was leased to Lowe’s at the time of sale. While most well-intentioned appraisers would agree that a premium to reflect a credit tenant is inappropriate when valuing a fee-simple interest, many would then unintentionally capture such a benefit in their valuation by using comparables of leased properties with these premiums embedded within their sale prices. What further makes this practice improper is that a sale of a property is comparable only if it’s a competitive alternative for the property being valued. If the property being valued is available for occupancy, most prospective purchasers would not consider a property encumbered by a long-term lease as an alternative. A better indication of value for the fee-simple interest in a Lowe’s store would be a freestanding retail property — one not encum- bered by a lease with a credit tenant, even if it didn’t share the Lowe’s design, and even if it were vacant. One of the best ways to examine the market is to review inves- tor surveys, which consistently show that investors have a lower rate-of-return requirement for institutional properties than for non- institutional properties, with the disparity apparently attributable to the security of the income stream associated with credit tenants. Another way to evaluate the market is to analyze transaction activity, including sales of owner-occupant (or fee simple) sales and investor (or leased fee) sales. Benton Advisory Group com- piled information regarding 106 sales of big-box retail properties where a fee-simple interest was conveyed, along with 39 sales of big-box retail properties that reflected a leased-fee interest. The sales that conveyed a fee-simple interest had a median sales price of $28.30 psf, while leased properties had a median sales price of $77.66 psf — an astounding difference of 174 percent. Additionally, investor sales consistently sell at higher prices than large retail properties purchased by owner-users. The research also supports that pricing is different for these asset types — and by an even wider margin than expected. Let’s look at actual tax assessment practices. An early step in any valuation is to research comparable sales, the basis being evaluating highest and best use. This concept involves develop- ing a profile of the most likely buyer. Sales of leased fee proper- ties are plentiful, and professional valuers often err by using them as the basis of fee-simple valuations. In the Lowe’s example, the tax assessor’s valuation of more than $10.4 million was so much higher because it was based on comparable sales that were meaningful in every regard — except the properties were leased to financially strong tenants and purchased by investors seeking those secure income streams. CIREMAGAZINE.COM Investor & Owner Occupant Sales Retail Properties in the U.S. > _ 100,000 sf Investor Sales (Price psf) Owner Occupant Sales (Price psf) $180 160 140 120 100 80 60 40 20 0 Q1 Q2 Q3 2016 Q4 Q1 Q2 2017 Q3 Q4 Q1 Q2 Q3 Q4 2018 Source: The CoStar Group The appraiser’s $3.9 million valuation appropriately used sales of properties that reflected fee-simple transfers (i.e., owner-occu- pied or vacant). They argued that their much lower appraisal was a pure real property valuation, not influenced by an income stream that would not be generated by an owner-occupied prop- erty and would not be part of an owner-occupant’s purchase decision. They eventually settled on $5.5 million — 47 percent less than the original valuation. This methodology, that the value of a fee-simple interest is best estimated by analyzing sales that conveyed a fee-simple interest, is accepted by numerous courts. Two prime examples are Target Corporation v. Sedgwick County, Kansas and Lowe’s Home Ctrs., Inc. v. Twp. of Marquette. Once the buyer profile is established, a thorough demographic analysis is critical, including trade area population, median household income, per capita income, percentage of shoppers age 15 to 35, and number of households. Average daily traffic count, competition within the trade area, and the balance of retail supply/demand are also important. In summary, establish an appropriate buyer profile, and, if the purpose of the valuation is for ad valorem tax purposes, and the value sought is that of the property unencumbered by leases, then the data relied upon should reflect that. Two Costco stores, for example, that look identical to shoppers can look very different to buyers if one is encumbered by a highly desirable lease with Costco, and the other property offers nothing but real estate. The comparables appropriate for valuing a fee-simple interest are sales that conveyed a fee-simple interest — which would typically involve properties that were vacant or occupied by their owner. Alvin O. Benton Jr., CRE, MAI, is the president of Benton Advisory Group in Marietta, Ga. Contact him at [email protected]. Bradley Carter, CCIM, CRE, MAI, is a principal and appraiser for Greystone Valuation Services in Atlanta. Contact him at [email protected]. September | October 2019 19