- Replacement Cost. This is a tricky one. Why? Because in order to determine the value of improved income-producing real estate, the value of the underlying land must be determined before application of any cost estimate to replace the improvements. Just valuation of the land alone requires a firm understanding of applicable zoning rules and regulations, the environmental condition of the soil, the underlying geologic conditions, its topography, and its encumbrances such as easements and encroachments. For investors, this process is nearly impossible to digest in a timely manner with any degree of confidence, especially in dense areas where comparable vacant land may not exist.
- Market. This one would appear to be the most accurate. It is not. Market valuation is generally determined through examination of comparable past sale transactions within a subject market. Looking at the past to determine current value is helpful. However, the accuracy of past transaction information that is not verified by any third party is unreliable. Real estate sales transaction information is published by a variety of different services that scour public records for data. With a touch of the buttons on a computer keyboard or cell phone – presto, a plethora of information is presented. While a great deal of data is publicly available, many transaction details are private. Without third party verification and certification and detailed analysis of each relatively comparable transaction, reliance on published data may be the road to perdition, particularly in our current world, where the present and future may not resemble the past.
- Income. This method seems simple enough. Application of a market rate of return (capitalization rate) to an income stream is not brain surgery. But, the quality of the income stream, accuracy of the reported income, and the likelihood that the income stream will continue are key factors of paramount importance that are often overlooked.
Investment real estate is purchased and sold at agreed-upon prices based on many factors, which are known exclusively by the parties involved. By way of example, does the $400M price paid by Steve Ballmer for the Los Angeles Forum property represent the true value of the property, somehow based on the value of the underlying land, the income produced, or comparable sales? The answer is NO. It represents the price that Mr. Ballmer paid to settle a turf war that now enables him to proceed with his new Los Angeles Clippers arena project. So now you know the truth. Traditional methods of real estate valuation are limited. Discerning real value is an art not a science.
Disciplined focus in the market we know well (the Westside region of Los Angeles), where we are continuously operating with our ears to the ground and our eyes wide open, provides us with the unique ability to know true value. That’s the art of valuation. It’s all about the details…and my nose.
Lawrence N. Taylor