Contributed by Sabina Miroshnikov of Richey May & Co.
Our recent white paper, titled “Welcome to the Land of OZ – Tax Benefits of Investing in a Qualified Opportunity Zone Fund,” explored new opportunities resulting from the 2017 tax reform bill to cash out unrealized gains and put them to work within certain low-income areas (called Opportunity Zones) while deferring taxes until December 31, 2026. This follow up white paper provides an overview of techniques for measuring the fair value of these real estate assets under U.S. GAAP.
First and foremost, real estate assets can include the following:
- Undeveloped land;
- Single-family residential buildings;
- Multifamily residential buildings, such as apartment buildings, condominiums, or townhomes;
- Retail buildings, such as shopping malls or strip shopping centers;
- Office buildings;
- Industrial buildings, such as warehouse or manufacturing facilities; and
FAIR VALUE VS MARKET VALUE
In the real estate industry, the terms “fair value” and “market value, although similar, do have slightly different meanings. Fair value, an accounting term, is defined by FASB ASC 820 “as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” Fair value is considered only from the perspective of the party that holds the property and considers that the property will be sold in the most advantageous market for that party. Market value, a real estate appraisal term, assumes the property has been previously exposed for sale and the closing takes place on the appraisal date. Market value considers both the buyer’s and the seller’s best interests, but does not consider special or creative financing deals.
The following are steps of the real estate appraisal process:
- Identifying the asset to be appraised, the type of value to be established and the effective date of the appraisal;
- Listing assumptions and limiting conditions;
- Collecting and analyzing market data;
- Estimating highest and best use of the property;
- Estimating the value of the property and
- Concluding on the value of the property
APPROACHES TO FAIR VALUE
COMPARABLE SALES APPROACH
There are several approaches to estimating the fair value of a real estate asset, the first and the most well-known of which is the comparable sales approach. This process involves analyzing market data and comparing the property to be valued at the most recent sales of other similar properties. A typical unit of comparison selected for these calculations is dollars per square foot. The appraisers then make adjustments factoring considerations such as the timing of comparable sales, the physical differences between the properties, the location differences, etc. This market data collection is something that typically goes hand in hand with other approaches as it relates to estimating property values.
The cost approach is another method of estimating fair value and is the most straight forward. The common formula is the following:
Cost of reproduction of the property – Depreciation of the property + Value of the land on which the property sits (as if it was vacant) = Fair value
However, the cost approach is limited in determining the fair value due to many subjective depreciation factors, such as wear and tear, functional obsolescence, and external factors, such as a deteriorating neighborhood.
DIRECT CAPITALIZATION AND DISCOUNTED CASH FLOW APPROACH
For more complex fair value appraisals, specifically in cases with commercial real estate that brings revenue, the direct capitalization (DC) and discounted cash flow (DCF) approaches are used. Both methodologies are based on the net operating income (NOI) of the subject property. In both approaches, calculations of fair value are based on the property’s actual earnings or earnings potential.
First, the NOI is calculated according to the following formula:
Total potential income based on actual leases – Vacancy allowance, operating expenses, and the allowance for replacement of short-lived assets = NOI
NOI ÷ Rate of return (known as “the capitalization rate,” which is used to translate operating income into a property’s value) = Estimated market value
The capitalization rate is set by the market, and since appraisers and commercial real estate agents can look at comparable sales for properties recently sold in similar areas, they can get the NOI’s for those properties and then calculate the overall capitalization rate for that market.
The final formula is then followed in the DC approach:
Capitalization rate x NOI of the property being appraised = Fair value of that investment property
It is important to note that as the value of the property increases, the NOI must also increase for the capitalization rate to stay the same, and for the real estate investment to stay profitable.
The DC approach, however, is not the most accurate valuation if a property’s income stream is complex with variations in cash flow. In cases involving unstable and fluctuating NOI levels, a DCF analysis will yield a more reliable property valuation.
The DCF approach, unlike the DC approach, accounts for the stabilization of a new real estate investment opportunity, which can take years to stabilize. With the increased risks of predicting the future NOI for an investment, the capitalization rate that goes into the equation is normally higher than it would be in the DC approach. Calculating the DCF also assumes a sale of the property at the end of a given period. These types of investment opportunities yield gains in the future but might be bringing a negative NOI for the first few years, so appraisers use the concept of time value of money to calculate the weighted average cost of capital for the investment. In simple terms, it means how much money would have to be invested currently, at a given rate of return, to yield the cash flow in future. The total discounted cash flow of an investment is also referred to as the net present value, in which “net” means the sum of all positive and negative cash flows, and “present value” means discounted back to the time of investment.
DCF is calculated as follows:
Cash flow ÷ Discount rate of each year + future sales price (net sales gains) (net gains from the future sale of the property) = Fair value
From an investor standpoint, if the DCF analysis results in a value that is greater than the current cost of the investment, the opportunity may be a good one.
Investors often base their purchase decisions on the capitalization rate, as they use them to quickly compare similar investment opportunities. However, other factors can be just as important to consider, such as a need for renovation, vacancy rates, location, and the underlying economic fundamentals of the region for an investment property, which are all added risks. When comparing similar investment properties with similar prices, which have different capitalization rates, it is up to the investor to decide whether the extra yield on their investment is worth the additional risks inherent in that property.
If you have questions about fair value measurements of real estate assets, or questions about Opportunity Zones or Qualified Opportunity Funds, Richey May’s professionals are available to help. Please contact Stephen Vlasak for any questions regarding this white paper, or regarding the public accounting services Richey May provides to the Alternative Investments industry.