USC Marshall School of Business FBE 591 – Guest Lecture Valuation Methodology in Appraisal PracticeFebruary 24th, 2016Lloyd F. Hussey USC MBA/MRED 2010

What are we going to cover?Part I. Who hires appraisers and why? Part II. What “interest” or legal rights do they appraise? Part III. Live model illustrating three approaches with reference to some supporting market data

Part I. Who Hires Appraisers and Why?Four Common Appraisal Engagements:

1. Lender Appraisal for Loan Underwriting2. Purchase Accounting - GAAP / ASC 8053. Fair Value Reporting - GAAP / ASC 8204. Litigation Support

1. Lender Appraisal for Loan Underwriting –sample language:

• Lenders order appraisals as part of their loan underwriting process. • They will not lend more than a certain percentage of the collateral’s value, typically around 65% for senior debt providers.• For example if the property is appraised at $10,000,000 and the borrower gets a $6,500,000 senior loan at 65% LTV, the bank can take comfort knowing that if values decline 35% and the borrower defaults, they can foreclose and may recover the full amount of their outstanding loan. • This provides a safety margin for banks which are highly regulated and risk averse.

Lender Appraisal for Loan Underwriting

2. Purchase Accounting – “PPAs”• A Purchase Price Allocation (“PPA”) estimates the Fair Value of certain tangible and intangible assets acquired in accordance with Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 805, Business Combinations and Topic 820, Fair Value Measurement. • GAAP reporting companies are required to fair value all the underlying components of value when they acquire a “business” which could be a multi-$B operating company like Safeway, or a single multi-tenant office building. • What are the typical underlying components of value?

• Land • Building Improvements• Site Improvements• Leasehold Assets• Leasehold Liabilities

Land BuildingSite Lease Intangibles

PPA continued…• Why break out the purchase of an office building into several different balance sheet items? • Because…

they are each treated differently from an accounting perspective:Land: Held at historical cost on the balance sheet, never depreciates.Building Improvements: Depreciated over 27.5-39.0 yearsSite Improvements: Depreciated over 5-15 years typicallyLeasehold intangibles: Amortized over remaining term of the lease. Can be assets or liabilities.

PPA continued…Sears 10K Example

Note the line items for Land, Building, Depreciation…Land/Building allocation determined in the PPA valuation directly impacts the depreciation expense that flows through to the Income Statement and so reduces and taxable earnings…thus, influencing managers. $1B in EBITDA/$100MM in depreciation expense/40% corporate tax rate = $360MM tax bill. If $200MM in depreciation expense, tax bill is $320MM, a delta of $40MM. Assuming 100MM shares O/S = $.40 EPS impact.

A Sidebar on Unlocking Real Estate Value on the Balance SheetActivist investors may pressure the boards of operating companies that have a lot of value locked up in real estate to spin off real estate into a separate company or do Sale-Lease Backs. This cash can be used for much higher growth activities like R&D, Acquisitions, Etc. $4.4B NBV does not reflect FMV

PPA continued…•How are PPAs performed in an appraisal context?• Land is valued using the sales comparison approach most commonly. • Building and Site Improvements in Purchase Accounting are valued under the Cost Approach – this is really the only time when the Cost Approach is used in actual practice. • We will walk through an actual PPA model in Excel…exciting!

3. Fair Value Reporting – ASC 820• Investors in real estate investment funds want to know what their positions are worth periodically. This is called “marking to market”. • These funds are not freely traded and many have 7-10 year lives without redemption rights. The most useful information for users of investment company financial statements is the fair value of their investments.• Fair value of investments is considered when analyzing performance of investments and making investment decisions by fiduciaries. • Therefore, an investment company (as defined by GAAP) must ensure that substantially all of its investments are fair valued periodically….either by internal investment professionals or by a third party appraiser.

• Note: Internally prepared appraisals are often just excel DCF models and require a lot more work to audit. • Example: Large manager of pension fund real estate assets prepared a DCF valuation of waterfront lifestyle center which was ground-leased from the Port of San Diego…was missing ground rent payments in the cash flow model, overstated the fair value by $20MM. • Take-away: never take an Excel valuation model for granted, they are built by humans and can and do contain math errors.

4. Litigation over Disputed ValuationDevise

• DEFINTION:• A testamentary disposition of land or realty; a gift of real property by the last will and testament of the donor. • Slightly disguised example from real case:

• 3 siblings inherit approximately $300MM portfolio of Los Angeles Industrial Properties• Executor of the estate divides the properties among the siblings.• Sister believes that the two Brothers have colluded with the Executor and unfairly influenced the process. • She sues her brothers claiming her allocation of the portfolio is not equitable. • The law firms from both sides hires a neutral top tier appraisal firm to value each property.

Part II. What is being valued?

Common types of real property interests:1. Fee Simple2. Leased Fee 3. Leasehold 4. Ground leasehold

Fee Simple• Don’t be confused by the use of the word “FEE”…this is a term from feudal England, has nothing to do with fees or the method of payment. A fee simple interest is the complete “bundle” of rights associated with owning or leasing real property. • The bundle of rights includes the right to use, to sell, to mortgage, to lease, to enter, and to give away, or the right to refuse to exercise any of these rights. • Trick question: does USC have a fee simple interest in:• Tutor Center?• University Gateway?• How is fee simple interest valued?

• If purchased as an income property and not and owner-user property, the income approach can be very useful if DCF developed to account for vacancy absorption period. • Direct Capitalization not used because no income to capitalize.

• Sales comparison approach is useful. For example, when you buy a house the bank’s appraiser will rely exclusively on the sales comparison approach to compare your house to others in your neighborhood that have sold recently. • Cost approach only used in an accounting context.

Leased Fee Interest• A leased fee interest is essentially a property that you own (the fee interest) which you have leased to a third party, which now has a leasehold interest in your property. You thus have a form of partial interest…you own the property but don’t have the right of use. • For example, Freebird Burrito is owned by USC, by the University has given away the right to use and occupy the space for a term of years. • How is leased fee interest valued?

• Most relevant method is Income Approach because it is an income producing asset. • Sales comparable can be useful. i.e. Downtown Santa Monica office buildings trade between $750-$1250 PSF. • Cost Approach only used in Accounting Context.

Building Leasehold Interest• The valuation of a leasehold is equal to the present value of the difference between the current market rental rates and the contract rents in accordance with the lease terms over the holding period.• Example:

• Restaurant with contract rent of $75,000 per year today, escalating at 3% annually per the terms of the lease through expiration in seven years. • Market rent today for that restaurant is $100,000 per year, and is estimated to inflate at 5% per annum for next seven years. • What is the value of the lease?

Building Leasehold InterestInflation Year 1 2 3 4 5 6 7

3%Contract Rent $ 75,000 $ 77,250 $ 79,568 $ 81,955 $ 84,413 $ 86,946 $ 89,554 5%Market Rent $ 100,000 $ 103,000 $ 106,090 $ 109,273 $ 112,551 $ 115,927 $ 119,405

Above/Below $ 25,000 $ 25,750 $ 26,523 $ 27,318 $ 28,138 $ 28,982 $ 29,851 Discount rate PV $ 25,000 $ 21,281 $ 19,927 $ 18,659 $ 17,471 $ 16,359 $ 15,318 10%PV of lease $ 134,016

Ground Leasehold Interest• The same methodology as building leaseholds• Calculating market rent for land most commonly requires estimating it’s fee simple value and then applying a market based land rent yield. • For example: • Land value conclusion: $100,000• Market rate land rent: 8%• Market ground rent: $8000

Ground rent in the news…Frank McCourt retained 50% ownership of all of the parking lots at Dodger Stadium after selling the team and ground leased them back to Guggenheim for 99 years. Assuming a $200MM land value * 9% market rate land rent yield = $18MM market rent. Asset or liability for the Dodgers?

Part III. Walk through of three approaches in case study1. Cost Approach2. Sales Comparison Approach3. Income Approach – DCF/Direct Cap4. Reconciling the 3 value indicators to conclude a value.

1. Cost Approach How is building cost in the valuation context calculated? • First we need to determine the construction costs for the building, as new. • The appraisal/valuation profession use a reference guide called Marshall Valuation Service (MVS). Fight On! • MVS publishes costs per square foot for a wide variety of buildings and provides input on regional cost adjustments and other construction cost refinements. • Let’s look at some MVS data…

Step 1 – First figure out what type of structure you are valuing!

What is it made of…• Steel • Wood Frame• Masonry/Concrete • Metal• Popovich is probably a Class C structure

Step 2 – Next, what kind of property type are you valuing? OfficeIndustrialRetailApartment

Step 3 – Once you have determined the BASE COST, it goes through a series of adjustments….we will walk through these in the model!

EXAMPLES• Square Foot Refinements:

• Fire Sprinklers? ADD: $2-$3 PSF• Height and Size Refinements:

• Number of Stories: Add 1/2 % for every story above 3. For example, a 5 story bldg. has a Number of Stories Multiplier of 1.01• Local Cost Multiplier:

• Takes the indicated base cost for your building and modifies up or down it to reflect the cost of construction in your location. Typically ranges from .75 to 1.4• Current Cost Multiplier:

• The base costs are only updated once in a while in the MVS guide so they issue periodic current cost tables which bring the stale cost data up to date

Current Cost Multiplier• Current Multiplier: The base costs are only updated once in a while in the MVS guide so they issue periodic current cost tables which bring the stale cost data up to date

Local Multiplier

Local Cost Multiplier: takes the indicated base cost for your building and modifies it up or down to reflect the cost of construction in your location.

Step 4 – Now you have a final square foot cost and can add in the contractor profit and “soft costs” to arrive at the REPLACEMENT COST NEW

• Contractor Profit Margin: • Ranges from 10% - 30% in most cases in the appraisal setting• Completely subjective input, can be used to goal seekSoft Costs: • Soft costs include things like city permits, engineering studies, environmental reports, architectural services, etc. which are not baked into the base cost• Typically range from 5% to 15% in an appraisal setting• Completely subjective input, can be used to goal seek

Step 5 – Now we know what the building cost new, but what’s it worth today?

• What comes next once we arrive at RCN? • The building is unlikely to be new or else the appraiser would use the actual cost of construction.• RCN must be discounted by depreciation and obsolescence to reflect the passage of time and physical, functional, economic decay. • Obsolescence is not commonly applied unless there is large divergence between the cost approach and the market based methods (sales or income)• Physical depreciation is commonly calculated using the age/life method.

• i.e. Effective Age/Economic Life of the Asset• Effective age is somewhat subjective as it is loosely based on actual chronological age, can be manipulated by appraiser to goal seek

Cost Approach…Pulling it all together to get a value for the whole property

BASE COST +SF REFINEMENTS*MULTIPLIERS*PROFIT MARGIN*SOFT COSTS=RCNLESS DEPRECIATION=Depreciated COST OF THE BLDG

+ Site Improvement Depreciated Cost

+ Land Value = Cost Approach Overall Value

Let’s go to the model

2. Sales Comparison Approach Some commercial properties are similar to each other but they are all very unique in terms of their:• Lot sizes• Square footage• Zoning • Logistical linkages (freeway access, rail spurs, airport proximity)• Deferred Maintenance• Date of sale• Etc. Etc.

2. Sales Comparison Approach The Sales Comparison Approach attempts to compare “similar” properties which have sold for a know price to the subject property by making adjustments to each of the comps that equalizes the differences so that we have something closer to an apples to apples comparison…• Subject Property is a distribution warehouse with a dedicated rail spur.• Comp 1 has the same freeway access but no rail spur

• The Subject has an attribute that is superior to the comp so…• How would we make the adjustment for “Access” to the comp price?• + or - ??

Let’s go to the model

3. Income Approach – Direct Capitalization• A quick/short cut way to estimate the value of a stabilized, income producing property. • In it’s simplest form, only requires 2 numbers: NOI and Capitalization Rate.• You apply this method by establishing a market yield (also known as the capitalization rate) for your property. • Yields reflect the perceived riskiness of the asset’s cash flows and the relative attractiveness of other yield bearing assets. • The 10 year Treasury Note is a key benchmark yield that acts as the risk free rate of return...all others assets trade at a spread to this or similar index rate based on their relative risk.

3. Income Approach – Direct Capitalization• The 10 Year T-Note is hovering around 2.0%• Class A Office in Prime Locations is trading at approximately 4.0% because the credit worthiness of the tenants paying rent there is great, but not as good as the US Government.• Trick question:

• If the Fed raises rates 25 Basis points for 8 consecutive quarters and the 10 year is trading at 4%, would you still accept a 4% yield on a Class A office building?

3. Income Approach – Direct CapitalizationThe SIMPLE MATH• Let’s say the market yield for an investment in Santa Monica office buildings is 5%. • If I am shown a Santa Monica office building a yield of $5,000,000 in annual net operating income (NOI), what is the building worth to most market participants? • Investors solve for this by dividing the NOI by the required yield. $5MM/.05= $100MM

3. Income Approach – Direct CapitalizationWhere do capitalization rates come from in the appraisal setting?• Published transaction data

• CoStar• Real Capital Analytics• REIS• RERC

• Brokerage research/survey data• CBRE• Colliers• Cushman Wakefield

3. Income Approach – Direct Capitalization

Co-Star Comps• Santa Monica Office Building traded at a 5% cap• NOI=$1,182,500• $1,182,500/.05= $23.65 MM

3. Income Approach – Direct CapitalizationCBRE 1H2015 Cap Rate Survey

3. Income Approach – Direct CapitalizationProject Javelin Exhibit XXXDirect Capitalization Model

Total SFMarket Rent Conclusion $/SF/Yr. (NNN) $/Year Sources:

128,700 $ 12.00 $ 1,544,400 Co-Star, Loopnet, Market participantsPotential Gross Income $ 1,544,400 Other Income $ -Less: Stabilized Vacancy and Collection Allowance 10%Colliers Dallas Market ReportEffective Gross Income (NNN) $ 1,389,960 Operating Expenses @ $0.00 PSF NNN $ -Management Fee @ 3.0% $ 41,699 PwC 1Q2014Reserves @ $.25 PSF/Yr. $ 32,175 PwC 1Q2014Net Operating Income $ 1,316,086

Overall Capitalization Rate 8.00%PwC 1Q2014, Realtyrates.com, RERCCapitalized Value $ 16,451,078 Rounded $ 16,500,000

3. Income Approach – Discounted Cash Flow (DCF)The Income-DCF approach is the most versatile and widely used valuation approach. Why?• Unlike the Direct Cap which relies on the assumption of a stabilized, constant growth income stream from a property….with a DCF model infinite scenarios can be modeled allowing modeler great flexibility:

• Non-constant growth rate• Long periods of vacancy• Large cap ex requirements• Operating losses• Varied market leasing assumption• Redevelopment during the hold period

Let’s go to the model

3. Income Approach – Discounted Cash Flow (DCF)In professional practice, DCF models are created with Excel or ArgusExcel • Multifamily• Single tenant or relatively small tenant roll

Argus• Primary institutional DCF modeling tool• Powerful, industry standard, expensive• Allowing you to enter many leases and lease specific terms in a way that would require an extremely complex Excel model.

3. Income Approach – Discounted Cash Flow (DCF)Argus makes it much easier to model widely varied contract rent cash flows and dictates how the space is leased up at market rent after that tenant vacates. •

4. Reconciling the 3 approaches together • Which approach is most relevant to the appraisal assignment?

• If the Subject Property is located in a market with little to no recent transaction volume, you will not have reliable indication of value.• Income Approach DCF is almost always a very useful methodology because it takes into account lumpy future cash flows, non-constant growth assumptions, redevelopment during the hold period, etc. • Cost approach is almost only ever seen in a valuation performed for purchase price allocation. Other appraisal users only care about the overall value in most cases. • If the cost approach value indication is significantly higher than the sales comps and income approach are indicating, appraisers tend to use obsolescence as the plug.

• Sales Comparison Value: $3,000,000• Income Value: $3,250,000• Cost Value: $5,000,000

• If buyers are paying below cost, there must be something “wrong” with the building or the health of the industry the building was designed for…this is where obsolescence comes in. • What would you pay for a typewriter factory or a casino in state that just outlawed gaming? • You would be unlikely to pay the depreciated replacement cost! Probably close to land value only.

Thank You!