Valuation Issues for Industrial Sites Income Approach Issues

Transcription

1 ABA/IPT Advanced Tax Seminars Advanced Property Tax Seminar Thursday, March 17, 2005 Valuation Issues for Industrial Sites Robert F. Reilly Chicago, Illinois (773) San Francisco, California Portland, Oregon Chicago, Illinois New York, New York Washington, D.C. Atlanta, Georgia

2 Discussion Outline Income approach to to property valuation Generally accepted income approach methods Application limitations regarding industrial facilities Alternative income approach valuation methods Income capitalization/residual value method Profit split method Residual income method Rental income method Discount rate/capitalization rate rate methods Examples of of alternative income approach methods Application limitations to to income approach methods 2

3 Application of the Income Approach to Property Valuation The The income approach is: is: best suited to to value a fee fee simple interest in in income-producing property well suited to to value real real estate (RE) and and tangible personal property (TPP) that that generate discrete rental income most applicable to to rental property with defined lessor/lessee interests applicable when there is is a defined measure of of economic rent: potential gross income (PGI) effective gross income (EGI) net net operating income (NOI) 3

4 Application of the Income Approach to Property Valuation (cont.) The The income approach is: is: applicable when the the appraiser can can extract a market-derived cap cap rate: overall direct capitalization rate rate (R) (R) overall yield capitalization rate rate (Y) (Y) commonly used to to value tenant-occupied commercial or or residential RE: multi-family apartment buildings office buildings retail shopping malls multi-tenant warehouse buildings used to to value leased industrial or or commercial TPP: commercial aircraft railroad locomotives and and cars mainframe computers 4

5 Generally Accepted Income Approach Methods Direct capitalization: where: V = value of of rental property RE RE or or TPP I I = lessor NOI from rental of of RE RE or or TPP R = overall capitalization rate, typically based on on band of of investment/mortgage and and equity components Yield capitalization: 1 CF V = + 1+ Y CF V = 2 V = value of of rental property RE RE or or TPP CF CF = lessor cash flow from rental of of RE RE or or TPP CFn = property terminal or or resale value Y = overall yield rate, typically based on on band of of investment/mortgage and and equity yield components + I R CF CF 2 3 ( 1+ Y) ( 1+ Y) ( 1+ Y) n n 5

6 Generally Accepted Income Approach Methods (cont.) Income approach conclusion applicable: To To value discrete RE RE or or TPP TPP only only Based on on lessor s rental income from from RE RE or or TPP TPP only only Based on on income earned on on tenant occupied rental property Capitalized income generated by by subject assets (RE (RE and and TPP) TPP) only not by by diverse bundle of of assets Cap Cap rates rates based on: on: secured creditor s mortgage rate rate lessor s required return on on property investment mortgagor/lessor mix mix of of debt debt and and equity Cap rates not not based on on business enterprise debt and and equity rates Income measure (RE and and TPP rental income) and and cap cap rate rate (property cap cap rate) calculated on on consistent basis 6

7 Application Limitations Regarding Industrial Facilities Most industrial facilities are are owner-occupied, not not tenant-occupied Most industrial facilities are are not not rental properties Many industrial facilities are are special purpose not suitable for for alternative tenants/users Difficult to to extract any any measure of of economic rent PGI, EGI, or or NOI Difficult to to extract lessor/investor expected rates of of return either direct cap cap or or yield cap cap rates. 7

8 Application Limitations Regarding Industrial Facilities (cont.) Income generated at at facility is is business enterprise (BE) income not property rental income Income generated at at facility is is due due to to integrated bundle of of assets, including: net net working capital (NWC) RE RE TPP intangible assets (IA) Facility owner s cost of of capital is is based on on (1) (1) unsecured debt, (2) (2) BE BE equity, and and (3) (3) BE BE debt/equity mix When BE BE income used, income approach estimates value of of BE, BE, where: BE BE = NWC + RE RE + TPP + IA IA Income approach estimates unit value of of all all BE BE assets, not not summation value of of RE RE and and TPP. 8

9 Alternative Income Approach Valuation Methods Income Capitalization/Residual Value Value Method Applications procedures Use Use yield yield capitalization or or direct direct cap cap Use Use BE BE NOI NOI or or CF CF Use Use BE BE yield/direct cap cap rate rate Conclude value value of of BE BE operating at at facility Application limitations Requires estimate of of BE BE valuation variables Requires estimate of of BE BE yield/direct cap cap rate rate Requires valuation of of NWC NWC Requires identification and and valuation of of each each IA IA Intellectual property, including software Customer/supplier relationships Contracts, permits, licenses Assembled workforce Goodwill and and going going concern value value Final Final adjustment Concludes total total value value of of RE RE and and TPP TPP Must Must subtract TPP TPP from from total total to to estimate RE RE Requires TPP TPP value value (typically cost cost approach) 9

10 Alternative Income Approach Valuation Methods Income Capitalization/Residual Value Value Method (cont.) Simplified illustrative example BE BE = Next Next period period CF CF WACC WACC g where where WACC WACC is is weighted average average cost cost of of capital capital and and g is is expected growth growth rate rate = $1,000,000 10% 10% $10,000, , ,000-1,000, ,000-1,000, ,000 $6,000,000-2,000,000 = 4,000,000 BE value NWC value Patent value Trademark value Software value Customer contracts Assembled workforce RE and TPP value TPP (based on RCNLD) RE value 10

11 Alternative Income Approach Valuation Methods Profit Split Split Method Application procedures Use Use BE BE NOI NOI or or CF CF Perform functional analysis of of relative contribution of of NWC, RE, RE, TPP, TPP, and and IA IA Estimate economic rent rent for for each each asset asset class, as as percent of of BE BE profit Functional analysis based on on qualitative assessment of of how how fungible/unique each each asset asset is is Conclude profit split split percentage for for RE RE and and TPP TPP Profit split split income = total total BE BE income x profit split split % Value of of RE RE and and TPP TPP = profit split split income cap cap rate rate 11

12 Alternative Income Approach Valuation Methods Profit Split Split Method (cont.) Application limitations Involves subjective functional analysis, based on on qualitative factors and and relative contribution to to profit Different profit split split % results in in different values Requires BE BE yield/direct cap cap rate rate Final Final adjustment Requires final final split split of of RE RE and and TPP based on on profit split% between RE RE and and TPP TPP 12

13 Alternative Income Approach Valuation Methods Profit Profit Split Split Method Method (cont.) (cont.) Simplified illustrative example: Profit Profit to to be be split split $1,000,000 = BE BE CF CF Profit Profit split split analysis analysis 5% 5% to to NWC NWC 35% 35% to to IA IA 60% 60% to to RE RE and and TPP TPP 100% 100% total total income income Profit Profit split split to to RE RE and and TPP TPP $1,000,000 x 60% 60% $600, Capitalization of of profit profit split split income income $600,000 10% 10% = $6,000,000 = RE RE and and TPP TPP value value 13

14 Alternative Income Approach Valuation Methods Residual Income Method Application procedures Start Start with with BE BE NOI NOI or or CF CF Conclude value value of of NWC NWC and and each each IA IA Estimate fair fair rate rate of of return return on on NWC NWC and and IA IA Calculate fair fair return return (FR) (FR) on on NWC NWC and and IA IA Subtract FR FR on on NWC NWC and and IA IA from from BE BE income Conclude residual income to to RE RE and and TPP TPP Use Use BE BE yield/direct cap cap rate rate Capitalize residual income by by cap cap rate rate Application limitations Requires values values for for NWC NWC and and each each IA IA Requires fair fair rate rate of of return return on on NWC NWC and and IA IA Requires BE BE yield/direct cap cap rate rate Final Final adjustment Concludes total total value value for for RE RE and and TPP TPP Need Need value value for for TPP TPP (typically cost cost approach) Need Need FR FR on on TPP TPP Subtract FR FR on on TPP TPP from from BE BE income Capitalize residual income to to RE RE 14

15 Alternative Income Approach Valuation Methods Residual Income Method (cont.) Simplified illustrative example: Total Total BE BE income $1,000,000 BE BE CF CF FR FR on on NWC NWC and and IA IA $500,000 NWC NWC value value x 6% 6% FR FR $30,000 FR FR on on NWC NWC $3,500,000 IA IA value value x 12% 12% FR FR $420,000 FR FR on on IA IA Residual income $1,000,000 BE BE NCF NCF -- 30,000 FR FR on on NWC NWC ,000 FR FR on on IA IA $550,000 residual income Capitalization of of residual income $ 550,000 residual income 10% 10% BE BE cap cap rate rate $5,500,000 RE RE and and TPP TPP value value 15

16 Alternative Income Approach Valuation Methods Rental Income Method Application procedures Locate comparable rental rental property Rent Rent expressed on on PSF PSF or or % of of revenue basis basis e.g., e.g., sale/leaseback of of industrial/commercial plant, plant, lease lease of of electric utility utility generation plant plant Adjust comparable rental rental rates rates for for size, size, location, age, age, condition, etc. etc. Conclude rental rental rate rate for for subject facility Express rental rental rate rate based based on on common metric e.g., e.g., % of of revenue Capitalize rental rental income by by overall cap cap rate rate Application limitations Finding comparable rental rental properties Finding comparable rental rental rates rates Adjusting comparable properties to to subject Requires property yield/direct cap cap rate rate Final Final adjustment Depending on on comparable properties, may may conclude value value for for RE RE and and TPP TPP or or RE RE only only 16

17 Alternative Income Approach Valuation Methods Rental Rental Income Income Method Method (cont.) (cont.) Simplified illustrative example: Identify Identify comparable rental rental properties located located 4 comparable properties obtained rent rent formula formula adjusted adjusted comparable rents rents to to subject subject concluded market market rent rent for for subject subject is is 4.5% 4.5% of of revenue revenue subject subject facility facility BE BE revenue revenue $12,000,000 Estimate subject subject potential rental rental income income $12,000,000 BE BE revenue revenue x 4.5% 4.5% market market rental rental rate rate $540,000 potential rental rental income income Estimate overall overall property cap cap rate based on on band band of of investment method method Capitalize rental rental income income $ 540, ,000 rental rental income income x 9% 9% direct direct cap cap rate rate $6,000,000 RE RE and and TPP TPP value value 17

18 Discount Rate/Capitalization Rate Methods For For residual value, profit split, and and residual income methods: Capitalized income is is BE BE income Use Use BE BE discount rate/direct cap cap rate rate Typical discount rate rate is is WACC for for BE BE Typical direct cap cap rate rate is is WACC expected growth rate rate For For rental income method: Capitalized income is is property income Use Use property yield cap/direct cap cap rate rate Typical direct cap cap rate rate is is band of of investment mortgage and and equity components method Typical yield cap cap rate rate is is direct cap cap rate rate (based on on band of of investment) plus expected growth rate rate 18

19 Application Limitations to Income Approach Methods Based on on BE BE income and and BE BE value methods Application of of income approach to to industrial facility values BE BE operating at at facility Need to to estimate BV BV discount rates/direct cap cap rates rates Need to to estimate value of of non-re and and TPP TPP assets Need to to estimate income from from non-re and and TPP TPP assets Need to to allocate BE BE value at at facility to to RE RE and and TPP TPP Objective is is to to isolate economic rent rent income related to to RE RE and and TPP TPP Taxing authorities typically will will use use BE BE income in in standard income approach methods Taxing authorities and and courts not not familiar with with income approach adjustments Taxing authorities and and courts do do not not make adjustments for for most most income producing rental properties 19

20 Summary and Conclusion Income approach applicable to: to: income producing rental property apartment complexes, office buildings, retail retail malls lessor/lessee properties property where rental income comes from from RE RE and and TPP TPP Income approach methods must must be be adjusted when: owner occupied property special purpose property property produces BE BE income, not not rental income property where RE, RE, TPP, TPP, NWC, and and IA IA function as as an an integrated unit unit property produces income but not not rental income Alternative income approach valuation methods: all all have have application limitations all all based on on allocation of of BE BE income to to RE RE and and TPP TPP rental income all all applicable when income approach required by by statute, administrative rule, rule, etc. etc. 20