1. USC Marshall School of Business
FBE 591 – Guest Lecture
Valuation Methodology in Appraisal Practice
February 24th, 2016
Lloyd F. Hussey USC MBA/MRED 2010

2. What are we going to cover?
Part I. Who hires appraisers and why?
Part II. What “interest” or legal rights do they
appraise?
Part III. Live model illustrating three approaches
with reference to some supporting market data

3. Part I. Who Hires Appraisers and
Why?
Four Common Appraisal Engagements:
1. Lender Appraisal for Loan Underwriting
2. Purchase Accounting - GAAP / ASC 805
3. Fair Value Reporting - GAAP / ASC 820
4. Litigation Support

4. 1. Lender Appraisal for Loan Underwriting –
sample language:

5. • Lenders order appraisals as part of their loan
underwriting process.
• They will not lend more than a certain percentage
of the collateral’s value, typically around 65% for
senior debt providers.
• For example if the property is appraised at
$10,000,000 and the borrower gets a $6,500,000
senior loan at 65% LTV, the bank can take
comfort knowing that if values decline 35% and
the borrower defaults, they can foreclose and may
recover the full amount of their outstanding loan.
• This provides a safety margin for banks which are
highly regulated and risk averse.
Lender Appraisal for Loan Underwriting

6. 2. Purchase Accounting – “PPAs”
• A Purchase Price Allocation (“PPA”) estimates the Fair Value of certain tangible
and intangible assets acquired in accordance with Financial Accounting
Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 805,
Business Combinations and Topic 820, Fair Value Measurement.
• GAAP reporting companies are required to fair value all the underlying
components of value when they acquire a “business” which could be a multi-$B
operating company like Safeway, or a single multi-tenant office building.
• What are the typical underlying components of value?
• Land
• Building Improvements
• Site Improvements
• Leasehold Assets
• Leasehold Liabilities
Land Building
Site Lease Intangibles

7. PPA continued…
• Why break out the purchase of an office building into several different balance
sheet items?
• Because…
they are each treated differently from an accounting perspective:
Land: Held at historical cost on the balance sheet, never depreciates.
Building Improvements: Depreciated over 27.5-39.0 years
Site Improvements: Depreciated over 5-15 years typically
Leasehold intangibles: Amortized over remaining term of the lease. Can be assets or liabilities.

8. PPA continued…
Sears 10K Example
Note the line items for Land, Building,
Depreciation…
Land/Building allocation determined in
the PPA valuation directly impacts the
depreciation expense that flows through
to the Income Statement and so reduces
and taxable earnings…thus, influencing
managers.
$1B in EBITDA/$100MM in
depreciation expense/40% corporate tax
rate = $360MM tax bill. If $200MM in
depreciation expense, tax bill is
$320MM, a delta of $40MM. Assuming
100MM shares O/S = $.40 EPS impact.

9. A Sidebar on Unlocking Real Estate Value on the
Balance Sheet
Activist investors may pressure the
boards of operating companies that
have a lot of value locked up in real
estate to spin off real estate into a
separate company or do Sale-Lease
Backs. This cash can be used for
much higher growth activities like
R&D, Acquisitions, Etc.
$4.4B NBV does not reflect FMV

10. PPA continued…
•How are PPAs performed in an appraisal
context?
• Land is valued using the sales comparison approach most
commonly.
• Building and Site Improvements in Purchase Accounting are
valued under the Cost Approach – this is really the only time
when the Cost Approach is used in actual practice.
• We will walk through an actual PPA model in
Excel…exciting!

11. 3. Fair Value Reporting – ASC 820
• Investors in real estate investment funds want to know what their positions are worth
periodically. This is called “marking to market”.
• These funds are not freely traded and many have 7-10 year lives without redemption
rights. The most useful information for users of investment company financial
statements is the fair value of their investments.
• Fair value of investments is considered when analyzing performance of investments and
making investment decisions by fiduciaries.
• Therefore, an investment company (as defined by GAAP) must ensure that substantially
all of its investments are fair valued periodically….either by internal investment
professionals or by a third party appraiser.
• Note: Internally prepared appraisals are often just excel DCF models and require a lot more
work to audit.
• Example: Large manager of pension fund real estate assets prepared a DCF valuation of
waterfront lifestyle center which was ground-leased from the Port of San Diego…was missing
ground rent payments in the cash flow model, overstated the fair value by $20MM.
• Take-away: never take an Excel valuation model for granted, they are built by humans and can
and do contain math errors.

12. 4. Litigation over Disputed Valuation
Devise
• DEFINTION:
• A testamentary disposition of land or realty; a gift of real property by the last will
and testament of the donor.
• Slightly disguised example from real case:
• 3 siblings inherit approximately $300MM portfolio of Los Angeles Industrial Properties
• Executor of the estate divides the properties among the siblings.
• Sister believes that the two Brothers have colluded with the Executor and unfairly
influenced the process.
• She sues her brothers claiming her allocation of the portfolio is not equitable.
• The law firms from both sides hires a neutral top tier appraisal firm to value each
property.

13. Part II. What is being valued?
Common types of real property interests:
1. Fee Simple
2. Leased Fee
3. Leasehold
4. Ground leasehold

14. Fee Simple
• Don’t be confused by the use of the word “FEE”…this is a term from feudal England,
has nothing to do with fees or the method of payment. A fee simple interest is the
complete “bundle” of rights associated with owning or leasing real property.
• The bundle of rights includes the right to use, to sell, to mortgage, to lease, to enter,
and to give away, or the right to refuse to exercise any of these rights.
• Trick question: does USC have a fee simple interest in:
• Tutor Center?
• University Gateway?
• How is fee simple interest valued?
• If purchased as an income property and not and owner-user property, the income approach can be very useful if DCF
developed to account for vacancy absorption period.
• Direct Capitalization not used because no income to capitalize.
• Sales comparison approach is useful. For example, when you buy a house the bank’s appraiser will rely exclusively on
the sales comparison approach to compare your house to others in your neighborhood that have sold recently.
• Cost approach only used in an accounting context.

15. Leased Fee Interest
• A leased fee interest is essentially a property that you own (the fee
interest) which you have leased to a third party, which now has a
leasehold interest in your property. You thus have a form of partial
interest…you own the property but don’t have the right of use.
• For example, Freebird Burrito is owned by USC, by the University has
given away the right to use and occupy the space for a term of years.
• How is leased fee interest valued?
• Most relevant method is Income Approach because it is an income producing
asset.
• Sales comparable can be useful. i.e. Downtown Santa Monica office
buildings trade between $750-$1250 PSF.
• Cost Approach only used in Accounting Context.

16. Building Leasehold Interest
• The valuation of a leasehold is equal to the present value of the difference
between the current market rental rates and the contract rents in
accordance with the lease terms over the holding period.
• Example:
• Restaurant with contract rent of $75,000 per year today, escalating at 3%
annually per the terms of the lease through expiration in seven years.
• Market rent today for that restaurant is $100,000 per year, and is estimated to
inflate at 5% per annum for next seven years.
• What is the value of the lease?

17. Building Leasehold Interest
Inflation Year 1 2 3 4 5 6 7
3%Contract Rent $ 75,000 $ 77,250 $ 79,568 $ 81,955 $ 84,413 $ 86,946 $ 89,554
5%Market Rent $ 100,000 $ 103,000 $ 106,090 $ 109,273 $ 112,551 $ 115,927 $ 119,405
Above/Below $ 25,000 $ 25,750 $ 26,523 $ 27,318 $ 28,138 $ 28,982 $ 29,851
Discount
rate PV $ 25,000 $ 21,281 $ 19,927 $ 18,659 $ 17,471 $ 16,359 $ 15,318
10%PV of lease $ 134,016

18. Ground Leasehold Interest
• The same methodology as building leaseholds
• Calculating market rent for land most commonly
requires estimating it’s fee simple value and then
applying a market based land rent yield.
• For example:
• Land value conclusion: $100,000
• Market rate land rent: 8%
• Market ground rent: $8000

19. Ground rent in the news…
Frank McCourt retained 50%
ownership of all of the parking
lots at Dodger Stadium after
selling the team and ground
leased them back to
Guggenheim for 99 years.
Assuming a $200MM land
value * 9% market rate land
rent yield = $18MM market
rent.
Asset or liability for the
Dodgers?

20. Part III. Walk through of three approaches
in case study
1. Cost Approach
2. Sales Comparison Approach
3. Income Approach – DCF/Direct Cap
4. Reconciling the 3 value indicators to conclude a value.

21. 1. Cost Approach
How is building cost in the valuation context calculated?
• First we need to determine the construction costs for the building,
as new.
• The appraisal/valuation profession use a reference guide called
Marshall Valuation Service (MVS). Fight On!
• MVS publishes costs per square foot for a wide variety of buildings
and provides input on regional cost adjustments and other
construction cost refinements.
• Let’s look at some MVS data…

22. Step 1 – First figure out what type of structure you are valuing!
What is it made of…
• Steel
• Wood Frame
• Masonry/Concrete
• Metal
• Popovich is
probably a Class C
structure

23. Step 2 – Next, what kind of property type are you valuing?
Office
Industrial
Retail
Apartment

24. Step 3 – Once you have determined the BASE COST, it goes through a series of
adjustments….we will walk through these in the model!
EXAMPLES
• Square Foot Refinements:
• Fire Sprinklers? ADD: $2-$3 PSF
• Height and Size Refinements:
• Number of Stories: Add 1/2 % for every story above 3. For example, a 5 story bldg. has a
Number of Stories Multiplier of 1.01
• Local Cost Multiplier:
• Takes the indicated base cost for your building and modifies up or down it to reflect the
cost of construction in your location. Typically ranges from .75 to 1.4
• Current Cost Multiplier:
• The base costs are only updated once in a while in the MVS guide so they issue periodic
current cost tables which bring the stale cost data up to date

25. Current Cost Multiplier
• Current
Multiplier: The
base costs are only
updated once in a
while in the MVS
guide so they issue
periodic current
cost tables which
bring the stale cost
data up to date

26. Local Multiplier
Local Cost Multiplier:
takes the indicated base
cost for your building
and modifies it up or
down to reflect the cost
of construction in your
location.

27. Step 4 – Now you have a final square foot cost and can add in the contractor profit and
“soft costs” to arrive at the REPLACEMENT COST NEW
• Contractor Profit Margin:
• Ranges from 10% - 30% in most cases in the appraisal setting
• Completely subjective input, can be used to goal seek
Soft Costs:
• Soft costs include things like city permits, engineering studies, environmental reports,
architectural services, etc. which are not baked into the base cost
• Typically range from 5% to 15% in an appraisal setting
• Completely subjective input, can be used to goal seek

28. Step 5 – Now we know what the building cost new, but what’s it worth today?
• What comes next once we arrive at RCN?
• The building is unlikely to be new or else the appraiser would use the actual cost of
construction.
• RCN must be discounted by depreciation and obsolescence to reflect the passage of time and
physical, functional, economic decay.
• Obsolescence is not commonly applied unless there is large divergence between the cost
approach and the market based methods (sales or income)
• Physical depreciation is commonly calculated using the age/life method.
• i.e. Effective Age/Economic Life of the Asset
• Effective age is somewhat subjective as it is loosely based on actual chronological age, can be
manipulated by appraiser to goal seek

29. Cost Approach…Pulling it all together to get a value for the whole property
BASE COST
+SF REFINEMENTS
*MULTIPLIERS
*PROFIT MARGIN
*SOFT COSTS
=RCN
LESS DEPRECIATION
=Depreciated COST OF THE BLDG
+ Site
Improvement
Depreciated
Cost
+ Land
Value
= Cost Approach
Overall Value
Let’s go to the
model

30. 2. Sales Comparison Approach
Some commercial properties are similar to each other but they are
all very unique in terms of their:
• Lot sizes
• Square footage
• Zoning
• Logistical linkages (freeway access, rail spurs, airport proximity)
• Deferred Maintenance
• Date of sale
• Etc. Etc.

31. 2. Sales Comparison Approach
The Sales Comparison Approach attempts to compare “similar”
properties which have sold for a know price to the subject property
by making adjustments to each of the comps that equalizes the
differences so that we have something closer to an apples to apples
comparison…
• Subject Property is a distribution warehouse with a dedicated rail
spur.
• Comp 1 has the same freeway access but no rail spur
• The Subject has an attribute that is superior to the comp so…
• How would we make the adjustment for “Access” to the comp price?
• + or - ??
Let’s go to the
model

32. 3. Income Approach – Direct Capitalization
• A quick/short cut way to estimate the
value of a stabilized, income producing
property.
• In it’s simplest form, only requires 2
numbers: NOI and Capitalization Rate.
• You apply this method by establishing a
market yield (also known as the
capitalization rate) for your property.
• Yields reflect the perceived riskiness of
the asset’s cash flows and the relative
attractiveness of other yield bearing
assets.
• The 10 year Treasury Note is a key
benchmark yield that acts as the risk free
rate of return...all others assets trade at a
spread to this or similar index rate based
on their relative risk.

33. 3. Income Approach – Direct Capitalization
• The 10 Year T-Note is hovering
around 2.0%
• Class A Office in Prime
Locations is trading at
approximately 4.0% because the
credit worthiness of the tenants
paying rent there is great, but
not as good as the US
Government.
• Trick question:
• If the Fed raises rates 25
Basis points for 8
consecutive quarters and
the 10 year is trading at
4%, would you still accept a
4% yield on a Class A office
building?

34. 3. Income Approach – Direct Capitalization
The SIMPLE MATH
• Let’s say the market yield for an investment in Santa Monica office buildings is 5%.
• If I am shown a Santa Monica office building a yield of $5,000,000 in annual net
operating income (NOI), what is the building worth to most market participants?
• Investors solve for this by dividing the NOI by the required yield. $5MM/.05=
$100MM

35. 3. Income Approach – Direct Capitalization
Where do capitalization rates come from in the appraisal setting?
• Published transaction data
• CoStar
• Real Capital Analytics
• REIS
• RERC
• Brokerage research/survey data
• CBRE
• Colliers
• Cushman Wakefield

36. 3. Income Approach – Direct Capitalization
Co-Star Comps
• Santa Monica Office
Building traded at a
5% cap
• NOI=$1,182,500
• $1,182,500/.05=
$23.65 MM

37. 3. Income Approach – Direct Capitalization
CBRE 1H2015 Cap Rate Survey

38. 3. Income Approach – Direct Capitalization
Project Javelin Exhibit XXX
Direct Capitalization Model
Total SF
Market Rent
Conclusion $/SF/Yr.
(NNN) $/Year Sources:
128,700 $ 12.00 $ 1,544,400
Co-Star, Loopnet, Market
participants
Potential Gross Income $ 1,544,400
Other Income $ -
Less: Stabilized Vacancy and Collection
Allowance 10%Colliers Dallas Market Report
Effective Gross Income (NNN) $ 1,389,960
Operating Expenses @ $0.00 PSF NNN $ -
Management Fee @ 3.0% $ 41,699 PwC 1Q2014
Reserves @ $.25 PSF/Yr. $ 32,175 PwC 1Q2014
Net Operating Income $ 1,316,086
Overall Capitalization Rate 8.00%
PwC 1Q2014, Realtyrates.com,
RERC
Capitalized Value $ 16,451,078
Rounded $ 16,500,000

39. 3. Income Approach – Discounted Cash Flow (DCF)
The Income-DCF approach is the most versatile and widely used valuation
approach. Why?
• Unlike the Direct Cap which relies on the assumption of a stabilized, constant
growth income stream from a property….with a DCF model infinite scenarios
can be modeled allowing modeler great flexibility:
• Non-constant growth rate
• Long periods of vacancy
• Large cap ex requirements
• Operating losses
• Varied market leasing assumption
• Redevelopment during the hold period
Let’s go to the
model

40. 3. Income Approach – Discounted Cash Flow (DCF)
In professional practice, DCF models are created with Excel or Argus
Excel
• Multifamily
• Single tenant or relatively small tenant roll
Argus
• Primary institutional DCF modeling tool
• Powerful, industry standard, expensive
• Allowing you to enter many leases and lease specific terms in a way that would
require an extremely complex Excel model.

41. 3. Income Approach – Discounted Cash Flow (DCF)
Argus makes it much easier to model widely varied contract rent cash flows and
dictates how the space is leased up at market rent after that tenant vacates.
•

42. 4. Reconciling the 3 approaches together
• Which approach is most relevant to the appraisal assignment?
• If the Subject Property is located in a market with little to no recent transaction volume,
you will not have reliable indication of value.
• Income Approach DCF is almost always a very useful methodology because it takes into
account lumpy future cash flows, non-constant growth assumptions, redevelopment during
the hold period, etc.
• Cost approach is almost only ever seen in a valuation performed for purchase price
allocation. Other appraisal users only care about the overall value in most cases.
• If the cost approach value indication is significantly higher than the sales comps and
income approach are indicating, appraisers tend to use obsolescence as the plug.
• Sales Comparison Value: $3,000,000
• Income Value: $3,250,000
• Cost Value: $5,000,000
• If buyers are paying below cost, there must be something “wrong” with the building or the health of the industry
the building was designed for…this is where obsolescence comes in.
• What would you pay for a typewriter factory or a casino in state that just outlawed gaming?
• You would be unlikely to pay the depreciated replacement cost! Probably close to land value only.

43. Thank You!