September 1995 Revised January 2007 In a number of marketplaces across the country, condominium or strata title (the terms are synonymous) subdivided developments are becoming commonplace. These projects are marketed on the basis that businesses can own the space within which they operate, as well as to individual investors on the basis that this ownership interest can be acquired in commercial or industrial properties at price levels below those possible in conventionally subdivided freestanding investment properties. One also sees bareland strata subdivisions develop from time to time, wherein individual lot owners acquire an interest in common property, like an improvement, lying outside their lot boundaries. Bareland strata provides a fee simple ownership mechanism, yet offers substantial advantages over the alternative non-fee simple mechanisms to retain control of these offsite improvements, such as cooperative or corporate share arrangements. Much as on-going exposure to residential condominium properties has led to a significant body of knowledge within the appraisal community for the valuation of these assets, the passage of time has brought about a greater awareness of the pitfalls inherent in non-residential strata properties, some of which entail potential litigation risk for appraisers. Strata title commercial/industrial properties offer the advantages of ownership in smaller properties than could be achieved for stand-alone buildings; maybe the only way to secure tenure in a specific location, and offer reduced management burden for such things as building and grounds maintenance. However, individual unit owners have less control over both day-to-day operations, and eventual re-development. Because a strata project is usually managed by the strata council, property management and maintenance standards could be lower than for a rental project owned and operated by a sophisticated investor. Absentee ownership of a significant number of units can create problems for owner-occupants in the same project due to differences in philosophy about maintenance, management and marketing. In cases of developer failure before a project is complete, the strata owner can end up in a project that lacks the synergy of a completed development, or on which maintenance is neglected. FLOOR SPACE MEASUREMENTS
The applicable Condominium or Strata Title Act specifies how the boundaries of individual condominium units have been identified. In British Columbia, for example, the boundaries are established as the centre of the floors, walls or ceilings, as the case may be. However, discretion is left to the Registrar Land Titles for defining the limits of garages, parking space, storage areas, and areas and spaces not enclosed by floors, walls or ceilings. In general, it is preferable to define the condominium by reference to the walls of the building. Any outside areas that are for the private use of the owner of a condominium may be regulated and defined under exclusive use agreements. These agreements can provide for exclusive use of a part of the common property by one condominium owner, and are the most appropriate way for dealing with such areas as balconies, mezzanine, storage space and parking stalls. In some instances, real estate boards have adopted policies on how commercial or industrial condominium sizes are to be set out; in most cases, an appraisal on this type of property can utilize these local policies. Confusion can arise when identifying the floor area of a condominium property, due to the various ways that may be used for expressing floor areas. Strata lot size must be measured according to requirements specified within the applicable legislation. However, such may not equal rentable or usable floor area. Also, creative marketing can swell the size of a strata unit by including the balcony, mezzanine and even the parking area. For industrial property, direct comparison is complicated by difficulties in ascertaining precisely the floor space of a unit. Typically, an industrial unit will involve a certain main floor area with mezzanine development common over at least a portion of the main floor. This mezzanine development could involve low-grade light storage floors to higher capacity light manufacturing space, to office space ranging from minimal quality to high cost office finishes. The appraiser needs to use standard techniques in measuring these spaces or direct comparison will become, at the least, a frustrating experience and, more than likely, fraught with error. A suggested technique is to evaluate the property based on the areas specified on the strata plan, with separate identification and analysis of finished areas and quality for mezzanine and main floor finished areas. LOCATIONAL ADJUSTMENTS Significant variations in rent levels often exist within a commercial development, depending on such things as exposure and unit size. Particularly in commercial property, where the units are being traded within the investment community, these differentials in rent can be expected to lead to dramatic differences in market value per square foot of strata lot. Although one of the touchstones of appraising residential condominiums involves ensuring comparables are from the same project, the additional requirement of analyzing rental variations within the property must be considered when valuing commercial strata projects. 2
LAND USE ZONING Particularly for strata industrial projects, municipal and regional policies regarding land use controls must be carefully considered. Individual occupants may well fit up a space to levels not permitted by the zoning bylaw or sublease a portion of the space for a use which is contrary to occupancy permit requirements. This caveat is of greater concern in a strata title sector, where many property owners are less sophisticated than those controlling larger holdings. Ideally, this situation is best addressed in the valuation process through comparison with properties bearing a similar nonconforming feature. REPLACEMENT RESERVES Strata corporations periodically need to spend large sums of money on roof replacement and similar capital irregular maintenance items. While provincial legislation may require the funding of replacement reserves, the level of contribution is commonly much less than what could be needed. It is possible for one strata project to have a substantial replacement reserve fund because its council has been diligent in building one, and a similar project next door to have insufficient or no funds in reserve. When one considers that the cost of roof replacement on even a modest project could cost $50,000, the significance of the presence or absence of reserve funding becomes apparent. As an appraiser, you aren t expected to investigate funding for reserves, but those reading your reports will find it useful if you state in your report that the level of reserves ought to be investigated if the project appears to need major work. STRATA FEES/ASSESSMENTS Common area maintenance and insurance expenses are typically covered in the strata fees assessed to each owner. The quantum of fees is determined by the developer or owners association, and will vary according to reserve levels, maintenance standards, the likelihood of winter storms necessitating substantial snow removal expenditures, amenities, upgrading requirements, and so forth. Investigations into strata corporation bylaws or assessment of its financial status is clearly beyond the responsibility of an appraiser. Where unusually high or low fees are evident, they ought to be noted. Use caution in making adjustments for the level of strata fees. High fees could reflect more amenities that enhances the value of the units, or a special assessment that will shortly expire. STRATA CORPORATION BYLAWS Appraisers seldom read the bylaws of the corporation governing a unit they are appraising, and this is neither necessary or practical to minimize liability. However, unusual situations can arise from time to time for things like leased land tenure. Many strata corporations pass bylaws limiting 3
activity in strata units to certain uses (only clothing manufacturer s outlets might be permitted in an outlet centre, for example), to restrict a kind of use (like restaurant) to only one of the strata lots or to forbid undesirable activities. These clauses serve the same function as the restrictive covenants in many standard form commercial leases. Rental could be forbidden in some projects. PROPERTY DISCLOSURE STATEMENTS Real Estate Boards in general, and the commercial brokerages in particular, are becoming more insistent about vendor disclosure statements. These serve as a marketing tool and help limit the realtor s liability. If available, they can be usefully attached to your report, along with any other pertinent documents that may be available. Obviously, an appraiser needs to ensure his report responds to any issues identified in the disclosure or listing documents. MARKETING INCENTIVES These incentives can include favourable interest rates or a tenant improvement package. Where tenant improvement packages are concerned, it is probably less important to adjust sales to a bare shell basis than it is to ensure all comparisons rely on the same basis, particularly if the fit-up package is common throughout the project. Another common marketing incentive is a guarantee of a minimum rental rate or rate of return. Typically, these guarantees have an expiry date. Particularly where the vendor is marketing to unsophisticated purchases, these guarantees may exceed market rental rates. Even when rented with leases in place, caution is needed to understand the extent to which the contract rent was achieved through inducements. The offers to lease could provide more insight here than the actual leasing document. The appraiser s professional responsibilities are set out in CUSPAP Appraisal Standards Rules, 6.2.22 and Comments, 7.23.1. INCOME V.S. DIRECT COMPARISON Some strata properties will trade primarily on direct comparison, while others will trade almost exclusively on the income approach. Careful evaluation of available sales evidence and market analysis are two techniques available to discern the most applicable approach. Generally, one may find the investment criteria of more significance in the commercial sector, while industrial properties may tend to trade more on a direct comparison basis. However, there is ample evidence of exceptions to these observations. INCOME APPROACH Selection of capitalization rates from sales of strata title properties is desirable. Particularly for property acquired with at least a partial eye to investment characteristics, strata title ownership represents a distinct impediment, in that redevelopment cannot proceed until most, if not all, the strata title units are held under common control. Some analysis suggest that this lack of 4
independence ought to adversely affect the rate of return that strata title properties achieve, a theory that is borne out by some, and contradicted by other, market evidence. As strata title developments continue to age, legislative vehicles will no doubt be developed that facilitate the redevelopment process. Legislative changes in this area will warrant careful examination for their effect on the rate of return investors require. Appraisers often consider the overall value of a property when evaluating an appropriate capitalization rate. For strata title properties, this consideration is best applied to the value of the size of the investment as it would typically be marketed. DIRECT COMPARISON APPROACH Strata properties tend to attract different types of investors than freestanding properties do. Units often have a stronger owner-occupier appeal. Where the appeal is significantly towards owneroccupiers, the direct comparison could warrant greater weight in the final conclusion of value consideration. The common unit of physical comparison is price per square foot of strata lot, with price per square foot of rentable or usable area also offering insight. Consider the nature and extent of mezzanine buildout, as well as nature of parking, type/cost of heating system, view, and in-project location. COST APPROACH The Cost Approach is not an appropriate valuation technique for strata title properties because of the issues of common land and shared building facilities. The Cost Approach should be avoided as a valuation technique for market value appraisals, i.e., for mortgage or value-in-exchange purposes. Appraisers are routinely asked, particularly by lenders, to complete all three approaches when preparing an appraisal for commercial or industrial properties, including strata titled offices, warehouses and retail units. The solution to this problem lies in educating the client of the strengths and weaknesses of the Cost Approach, and on the research and analysis necessary to complete a meaningful valuation. Appraisals in which the Cost Approach is completed ought to make clear the limited weight that can be placed on the results. Valuing a condominium by the Cost Approach would require appraisal of the site as if vacant and available, costing of all structures, landscaping and site improvements, estimation of soft costs, marketing and holding costs, the estimation of a likely absorption period, developer s fees and entrepreneurial profit, and the determination of depreciation from all sources. Once the depreciated value of the entire project is known, it can theoretically be allocated to the individual unit. The results can be invalid at least, and downright misleading at worst. 5
BARELAND STRATA Bareland strata developments provide a useful mechanism to construct and maintain roads that the municipality is not willing or capable of undertaking, and have been used to provide utility servicing or other amenities, like private sewage systems in areas where no public or community system is available. In some exclusive developments, designation of things like roads as common property keeps them out of the public realm, and thus makes them unavailable for use by nonresidents. Owners of bareland strata property are subject to additional controls arising from the strata corporation policy, and may need approval to undertake construction or other activities. The bareland strata corporations could, for example, require approval of all exterior modifications and forbid the placing of certain kinds of materials in the sewer, where a private sewage system exists. As with all strata corporations, a levy is imposed on strata lot owners for roads and services maintenance and such items as liability insurance. These costs can be significant and are not typically faced by owners of fee simple property. The best technique for valuation of bareland strata properties is prudent selection and analysis of comparable data, preferably from within the subject or other bare land strata subdivisions. For further information, a variety of other considerations exist for the valuation of strata title property, and these are summarized as well in the Claims Prevention Bulletin CP-9, Appraising the Individual Condominium Housing Unit. CUSPAP REFERENCE Legal Attributes Practice Notes 12.28.1 Members must be aware of the duty to investigate the legal attributes of certain property types. Condominium values, for example, can be affected by specific condominium bylaws that apply in some projects. The status of the reserve fund, special assessments for units in the complex and restrictions on common property can also influence values. While selecting sales from within the same complex can mitigate some of these concerns, particular care should be taken when it becomes necessary to rely on sales from outside of the complex. Reserve Fund Study Practice Notes 12.48.1 Since Reserve Fund Studies are completed to provide financial planning advice, the consulting service should consider the stated policies in the condominium corporation defining 6
those components to be covered by the study and incorporate a comprehensive benchmark analysis including life cycle analysis, current and future replacement costs and future reserve fund accumulations. The Study should provide comments on any apparent deficiency in the reserve fund account or in future reserve fund accumulation, along with a cash flow model covering an appropriate time frame. Note: As with all professional practice bulletins, this publication is not intended to set out all professional/ethical responsibilities or regulatory requirements, nor to identify all valuation or theoretical aspects of the subject matter. The purpose is simply to raise areas of potential liability exposure in ordinary day-to-day practice to the attention of members, and to suggest professional practices that can help avoid liability insurance claims. Members are encouraged to suggest topics and/or writers for future bulletins by contacting the AIC offices at info@aicanada.ca. 7