What is your dealership real estate worth today? That is a very good question, and not one that is easily answered. Most dealers and their lenders order an MIA appraisal to determine real estate value.
Unfortunately, during the recent real estate bubble and subsequent crash, appraisals have often proven unreliable in determining what your real estate is worth.
By way of example, I know a dealer whose real estate appraised for $6million in 2002. The same property appraised for nearly $12 million at the peak of the real estate bubble in 2006, doubling in just 4 years. Since then, according to three different appraisals, the property’s value has plummeted. It was valued at $8 million last year, $6 million in April and $5 million in May, below its 2002 value.
How can the same property have so many different values in such a short period? We all know that the frothy credit markets are primarily to blame for the boom and bust in commercial real estate. However, part of the blame can also be placed on the way in which real estate is appraised.
Appraisers typically deploy three methods when valuing real estate. They are as follows:
- The cost approach: The cost approach is based on the idea that a buyer would not pay more for a property than the cost to construct a substitute property. In this approach, appraisers collect data from comparable land sales to determine the cost of land and then calculate the current cost of constructing the improvements. As part of the process, the appraiser also applies discounts to the building costs to take into account depreciation and market dynamics.
- The sales comparison approach: The sales comparison approach is similar to the cost approach, in that it relies on comparable sales to determine value. In this method, a property is valued by comparing the subject property to similar properties that have sold in the surrounding areas. The appraiser then applies the comparable pricing metrics to determine value.
- The income capitalization approach: The income capitalization approach is based on a multiplier between the property’s net operating income and its value. Not unlike blue sky multiples, capitalization rates are derived from expected risk adjusted returns on real estate investments. These return expectations are then applied to a property’s net operating income to determine the property’s value.
In today’s market, all of these approaches have flaws, particularly when valuing owner-user real estate. The first challenge is that since the Great Recession, we have had few comparable transactions upon which to calculate substitute pricing. Instead, the available comparables are often recent distressed sales of abandoned dealerships. In search of non-distressed sales, appraisers must often look far outside a subject property’s region, even to another state. Given this situation, the cost and sales comparison approaches vary widely depending on the appraiser. Neither method is dependable as a barometer for value today.
Alternatively, appraisers could depend more heavily on the income capitalization approach. However, this approach is rarely considered. Appraisers reason that because most dealership real estate is owner-occupied, the rental income may not be market and is therefore not a good determiner of value. While accurate, this assumption is unfortunate because the income method is the only one that takes into account what a dealership may be able to support in rent.
In the end, the biggest challenge with all of these valuation methods is that none actually looks at the dealership’s financial performance. The appraiser never considers whether the dealership can/will support the value being placed on the property. This is particularly problematic in a market where over 13% of all dealerships have closed in the last two years.
To accurately value dealership real estate that is owner-occupied, an appraiser MUST understand how much the underlying business can support in rent payments. This means (i) reviewing the dealership’s current and projected financials, (ii) applying traditional metrics to determine the appropriate rent level (usually about 1.5% of sales and 10% of gross) and (iii) researching available mortgage financing terms. Numerous dealership brokers now deploy this method, in lieu of relying on an appraisal. An example of the application of this method can be seen in the box below.
Based on 2009 NADA figures, the average dealership paid about $30,000 per month in rent, before insurance and taxes. At that level, assuming a 7.3% fixed mortgage interest rate (400 bases points over the 10-Year U.S. Treasury on 6/2/10) and a 20-year amortization, the average dealership could support a $4 million mortgage. Assuming banks and captives are lending 80% loan-to-value, the average dealership’s real estate is worth $5 million.
Example of alternative real estate valuation methodolgy
If dealership sellers and buyers valued real estate in this fashion, more transactions might close. Charles Oglesby, CEO of Asbury Automotive, recently commented to Automotive News that, “The seller still believes the real estate to have the values that existed in the past.” Today, sellers need to accept lower real estate values, while buyers need to do their own analysis to determine how much real estate a dealership can afford. Neither sellers nor buyer should rely on real estate appraisals (new or old) that do not take into account the dealership’s current and future financial performance.
In closing, property appraisal has become much more of an art than a science. Let’s return to the science and leave the art to the artists. When it comes to owner-occupied, single-purpose real estate, appraisers need to look through the real estate to the underlying business when determining value. If the business cannot support the appraised value, guess what? The value is probably wrong.