René Nelson with Pacwest Commercial Real Estate asks the expert Zoe York, MIA Appraiser Duncan & Brown, about collecting data and applying market standards to generate a full analysis for a multifamily or commercial property in Eugene.
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Rene Nelson: Let’s talk about the process. From my perspective as a broker, whether I’m listing a property or I’m representing a buyer, I pretty much go through the same process. For multifamily, the first thing I do is get a rent-roll, and I get the last three years of operating statements and seller’s tax returns. Then I start to analyze those.
Rene Nelson: What I’m looking for are trends. How have the expenses been? Have they been pretty consistent across the board or have we seen maybe a big spike one year or two, especially for repairs and maintenance? Can that be explained? Were there capital improvements included in there, like a roof or a paint job?
Rene Nelson: But if I see either really low factors for maintenance and repair, I instantly become skeptical. I’m kind of wondering, “All right, has this property been managed on kind of a band-aid effect—where they’re not really putting in the true maintenance and repair that they should be?”
Rene Nelson: I look at that from a listing broker situation because I know that most likely a buyer is going to have to obtain a loan and then there’s going to have to be a price that my seller and I agree upon, and that has to be defendable when an appraiser comes out. Or if I’m representing a buyer, we don’t want to overpay for a property if then they get into it and there are a whole bunch of issues down the road with deferred maintenance or different things, so that maybe the operating expenses change once my client takes possession of the property.
Rene Nelson: So, walk me through what you do when you analyze a property from your appraisal process.
Market Standards in the Appraisal Process for Investment Real Estate Eugene
Zoe York: It’s a very similar process as what you do. I collect all the historic data, because I really need to understand what’s been going on in the past and understand the full picture of what’s going on with the property. I also like to ask for three years of profit and loss statements. I ask for a current rent-roll. And a lot of times I’ll interview the property manager or the owner and ask them when their last rent increases were and how frequent their turnover is.
Zoe York: That’s something that’s also really important to ask, because if you have very, very long-term tenants, then there’s a good follow-up question: “Okay, how are your unit interiors? How often are you updating? If you have several 10-year tenants, are the finishes the same that they were when they moved in?” Because a lot of times you’ll have lower rents but also those rents will be associated with a inferior condition of the unit. So I ask those questions to just get a picture of exactly what’s been happening historically in this property.
Zoe York: But from my perspective, because I’m doing these appraisals day-in and day-out, I have a very large database in my head, also in my files, of expenses of similar properties, so I have what we call an appraisal of market standards.
Zoe York: Market standards are basically again this collective database of what other property owners are paying for expenses, not just what this property owner is paying. For example, if a property owner is doing their own maintenance, they might have a very, very low maintenance expense. But when it comes time to do an appraisal, everything I project is market standards. A lot of times, if it’s a property that’s been professional managed and has very consistent expenses, market standards will be exactly what their historic operations have been.
Zoe York: Categories where I don’t see market standards match up very often is repairs and maintenance. A lot of times you’ll see huge variations in repairs and maintenance, and that doesn’t always correlate to the property owner not doing their scheduled maintenance or doing too much. A lot of times what that will be is they’ll do a bunch one year and nothing the next year. And then if I’m only able to look at three years of operating history, I’m not really able to get a very good idea of what an ongoing average expense would be. So then I’ll use market standards because I’m going to say, “This is how much per unit I’m seeing across the board over expenses that I’ve analyzed over decades.”
Zoe York: That’s an important thing to understand from the listing broker versus the appraisal perspective: You’re also trying to look at market standards, but you’re really trying to get a feel for what’s been happening historically and what they might expect to spend moving forward. But when it comes to the appraisal process, I might completely throw out their history if I feel it’s not relative to market standards and only use what the market is expecting.
Zoe York: Again like you said, when you’re dealing with a property listing, you also have to consider that because the appraisal is going to go off market standards. So if maintenance is projected too low and your expenses are too low, that isn’t going to correlate when it comes time for me to do the appraisal because I’m going to project that higher expense.
Zoe York: Another thing that I like to talk about is vacancy. A property owner might have a zero percent vacancy ongoing vacancy for a property that has very low turnover, long-term tenants. They might have even had a 2 percent vacancy over 10 years.
Zoe York: But almost always we’re using a 5 percent vacancy factor in apartments moving forward when I’m doing the appraisals. The reason for that is even though the cap rate, the performer in an income approach, is a one-year snapshot, what it’s meant to do is reflect the property over a holding period. Typically, we consider a holding period to be about 10 years. So that vacancy factor is not only the vacancy; it’s vacancy and credit loss during that time period. But it’s not just what the vacancy in the market is today. For example, in Eugene, Springfield, it’s about 3 percent today. It’s not just what the vacancy is today, but what your expectation as an investor would be—what your vacancy over that 10-year holding period would be.
Zoe York: In the recession, for example, our vacancy was 6 or 7 percent. Even in this best time it’s at about 3 percent and it could go a little bit lower than that. But if I’m projecting over a 10-year holding period, we see 5 percent to be about the market norm. That’s an important thing for property owners to understand, that when they see an appraisal, when I project a 5 percent vacancy, that doesn’t mean that there is 5 percent now or there has been 5 percent in the past. What it means is that any investor looking to purchase the property would reasonably expect 5 percent vacancy and credit loss over the holding period of the property.
Rising Flood Insurance Rates
Rene Nelson: An expense that I’m also starting to see factored in is insurance cost. It seems like insurance premiums are starting to go up for many owners. Are you seeing that also?
Zoe York: I am seeing that. I’m also seeing flood insurance as a huge factor. It’s something that I have to ask about constantly. If I see a property that’s in the floodplain and they’re going to need flood insurance, then I have to ask the property owner for their most recent premium for this current year because the past premiums don’t necessarily reflect what their ongoing expense is going to be.
Zoe York: This is something that needs to be shopped around when you go to buy a property. It’s also something that I see huge variations in because if an investor owns a portfolio of properties, they’re going to get a lower insurance rate on that one property because they own so many properties. Whereas if you just buy your one apartment complex, you’re going to pay more because you don’t have this whole portfolio of properties insured under the same company.
Zoe York: This is another one of those market standard things. When I project forward, if I see that an investor, who I know owns a very large portfolio of properties, has a very low insurance expense, I will project market standards for that insurance, not what that investor has historically paid.
Rene Nelson: Yes, obviously this increase in the expense of flood insurance makes a direct impact on the bottom line for net operating income.
Zoe York: This is kind of a new thing, and it isn’t something that I have seen frequently impacting rents. But I do wonder how it’s going to impact triple net rents for offices and retail, moving forward.
Rene Nelson: Well, it seems like FEMA just repositioned their map in the last 12 to 24 months, so owners are just now getting those notices of either, “Your premium’s going up,” or, “Now you are in the flood zone.”
Zoe York: For brokers, appraisers, and property owners, this will be a very important thing moving forward because there’s always an adjustment period in the market where people realize this expense and then how that gets translated into the market as value or rent or risk. It will be an important thing for us all to watch moving forward over the next 12 to 24 months as to how that impacts property values and net operating income.
For more information about investing in commercial real estate in Eugene, call me today: René Nelson, CCIM, (541) 912-6583 / firstname.lastname@example.org / www.eugene-commercial.com