Real Property Appraisals/Cost Approach
QUESTION: Hi John
I am a commercial broker in TN. I contacted a property owner of a hospice facility who said they do not want to sell but if someone offered the right price they would consider it. President of the hospice would not let me pin her down on a price; ďwe will consider any reasonable offer.Ē This is a currently operating facility, owner user. 50,000 sf, one-story, 3.5 acres.
This is a great site for apartments and I have a buyer who is wanting to purchase it. Obviously there is no Income Approach to the appraisal, and I assume the Comparable Approach would look at similar facilities of comparable acreage and square feet; but Buyerís contention is that an appraisal for the Cost Approach would NOT take into consideration the cost of the improvements PLUS the cost of the land. The land comps for this site would be $27/sf; and Iím guessing building costs in TN would be around $80/sf for the shell and around $40/sf for the buildout, or $120/sf.
So buyer is saying the site would either be worth the land cost of say $4.1MM or the cost to rebuild, $6,000,000, based on the Cost Approach.
My question is: would the Cost Approach value be BOTH the land cost and the improvement cost, or would you only consider the cost of improvements?
Not asking for any specific cost or comp numbers, only asking how to calculate the Cost Approach for this type situation.
Thanks so much, John
Exercising the Cost Approach does include land value. The basic technique is as follows:
1. Calculate the Replacement Cost for all of the improvements
2. Add entrepreneurial profit if appropriate
3. then subtract physical, functional and external obsolescence
4. then add in the land value.
The result is the value by the Cost Approach.
Now, having stated the above, there are cases in which you would only use the Replacement Cost of the improvements, such as if you were going to compare the cost of the subject property improvements to the cost of a comparable properties improvements, excluding land value for both properties.
Be VERY careful if you only consider the cost of improvements because real estate is so location specific. In our example in the paragraph above, Land Value where the Subject property is may be more or less than land value where the comparable property noted above is. In the case where land value in the subject property is located is less than where the comparable is located, it is going to cost you more to buy land and build where the comparable is located.
I'm concerned with your analysis from two standpoints. First, you state that "there is no Income Approach to the appraisal" and second, you are only considering the cost approach. The favorite saying about the cost approach is: "Cost..does...not...equal...value".
I've only appraised two hospice properties in my career & they are like medical office buildings as they contain a lot of medical improvements. I doubt that this operating facility could be recast as an apartment because all of the medical equipment would have to be removed.
If a buyer is going to consider an apartment use, the Income Approach would be a CRITICAL analysis. You would have to conduct what we call a Highest and Best Use Analysis wherein you would have to forecast the potential income and expenses of an apartment vs. the income and expenses of a hospice to see which use yields the highest value.
You also shouldn't omit the Direct Comparison Approach. Listings and sales of hospice use properties would have to be contrasted against listings and sales of apartment properties to see which use yields the highest value.
The correlation of the analysis of the Income and Direct Comparison Approaches will show you if economic obsolescence is present in the Cost Approach. If the Cost Approach yields a value of, say, $10 million and both the Income and Direct Comparison Approaches indicate around $8 million, it costs more in this area to build this use that you could sell it.
The Principal of Substitution states that a buyer will not pay more for a property than the buyer could pay for a reasonable substitute property. If it costs $2 million more to buy the land and then build a hospice, no one is going to build in this area until it is financially feasible to build one. In this case, it is more reasonable to buy an existing project.
I hope that this has given you some ideas for additional analysis. Good luck!
John C. Carlson
CA Certified General Real Estate Appraiser
Victorville and Diamond Bar, CA
---------- FOLLOW-UP ----------
This is fantastic; Thanks so much for that excellent explanation; very, very helpful.
I did leave out a couple things in the interest of trying not to waste your time by being too long-winded. The hospice facility would be razed if apartments are built; in this case the site is already zoned for apartments, the Land Use Plan would allow apts, there is no max density, the floor area ratio is among the highest in Nashville(5.0), building height allowable is 150 feet, it has frontage on two major streets, access to two corner traffic lights, no floodplain and level topo. Yea, I know; its like an apartment site dream-come-true.
Direct Comparison would be ideal; unfortunately I cannot find any other sales.
What I meant to say is no Income Approach from the standpoint that there is no income stream to derive a cap rate, since the facility is owner user. Thanks for that explanation for Highest & Best; I did not know that. With the actual density for apts being in the 900 unit range (assuming 900 sf avg unit), H&B should easily be apartments; not that this particular area could actually absorb 900 units, but thatís a different issue.
Yea, the principle of Substitution, or an aspect of it if I understand it correctly, is likely to kill this thing. Iím thinking the owner will want more than my guys can afford to pay to make the numbers work; Iíve told my guys they should come up with a preliminary pro forma (these guys are apt developers for 20 years) and back into the land cost based on whatever return they need. That way they know what they can pay per unit, and thatís their offer for the hospice site (generally speaking); that way it is not a question of too high or too lowÖ.itís all they can afford to pay for that specific return. So the owner either accepts it or they donít. But they want to throw a number against the wall to see if it sticks. A waste of everyoneís time in my opinion, because I cannot believe the hospice owner will even consider or counter the $4.6 million LOI my guys are working on.
Thanks so much, John,
I'm sure that we both have seen sellers who need a reality check. I just verified a listing of a good quality auto repair center. List price was $1.675 million, listing agent received an all cash offer with 15-day Escrow at $1.6 million. Unbelievably, the seller decided the price was too low, blew out the offer & raised the list price. The Agent wants to scream.
I would like to ask a favor. Since I seem to have provided some useful information, I would like to ask if you would send me a short "Testimonial"? I'm assembling these for use on my Website.
Good luck to you again. Maybe the seller will come to his senses.
John C. Carlson
CA Certified General Real Estate Appraiser
Victorville & Diamond Bar, CA