When Is ‘Ugly' a Negative Influence On Value of Commercial Real Estate?

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In this article, Michael Allen of Ryan, LLC, discusses whether “eye-searingly awful” building designs can, or must, negatively impact appraisals for purposes of property taxation. Allen offers best practices for girding against such potential fluctuations.

Michael Allen

By Michael Allen

Michael Allen is a principal and NE Region CRE leader at Ryan LLC.

When proportion, balance, form, and function come together in delicate harmony, the architecture of commercial real estate (CRE) can be nothing short of an art form. But when, on occasion, those principles clash, the results can be CRE that is eye-searingly awful. But do these CRE architectural misses ever rise to the level of an adverse condition or obsolescence that requires a negative adjustment in valuing the affected property either for a sale or ad valorem property taxation? Some experts believe that they can.

How Do You Know If Your Building Is ‘Ugly'?

U.S. Supreme Court Justice Potter Stewart once commented that even if he could not define pornography that he knew it when he saw it. Are “ugly” buildings analogous, and can they bear a similar commercial stigma? If, as Plato asserts, beauty is in the eye of the beholder and therefore inherently subjective, how can there ever be an objective and market-supported adjustment for the opposite characteristic affecting a commercial building?

One clue as to whether your building is objectively considered to be commercially blighted by its aesthetic would be if it has been added to one of the many “ugliest buildings” lists that populate the Internet. These lists, which can be local, regional, and even national in scope, are of course very subjective and biased, as well as often spiteful. But if your building appears on such a list, that is a sure clue that you may have some stigma that affects the value of your property.

Furthermore, if your property has also earned a widely accepted and perhaps pejorative “nickname” from the local CRE brokerage community and your peers, that is never a good sign and an even better indication of blight because it will probably impact and taint the next buyer's view of the property because it is so ominously known. The so called “Darth Vader” office building in Washington, D.C. comes to mind as such an example.

But, the question remains—should this type of aesthetic criticism have an impact on the next buyer's valuation of the property or its current property tax assessment?

When Does ‘Ugly' HaveNegative Impact on CommercialReal Estate (CRE) Value?

Recently, a distinguished commercial real estate appraiser commented to me that:

“If a building can have a premium because it is architecturally outstanding then an ugly building can require a negative adjustment. But remember that beauty is in the eye of the beholder. Look at the results of the ugliest dog competition.” Hal Horstman MAI

To me that insight underlines the core issue in this debate, which is that in order to be credible and persuasive, there must always be an objective basis for identifying and establishing the negative financial impact associated with specific “ugliness” in a building. Namely, if you can prove economic blight, you should adjust for it.

What Are Investors BuyingWhen They Buy ‘Ugly' CRE?

Money is fungible, and buyers of CRE are typically buying an anticipated, future, stabilized, annual income stream discounted to a present value. This is usually derived from their own particular point of view as to how they can resell the property at a profit, as mitigated by their estimation of the likely cost/risk to do so at the end of their investment hold period. This process explains why so many underwritings for the same property in a “hot” CRE can vary so widely.

Investors rarely underwrite their acquisitions by ascribing any separate value to the aesthetics or beauty of a building. In the final analysis, CRE buyers are buying future revenue not bricks and mortar. Almost all commercial income-producing properties in the U.S. and Canada are underwritten for acquisition and property tax purposes, using one of several techniques that discount the anticipated future revenue into a present value (with adjustments thereto for current cost to cure adverse conditions and/or future lease up costs if tenancies are likely to churn in the short term).

This is true if direct capitalization under the income approach to value is used as the primary valuation methodology, where a single year's stabilized future net operating income (NOI) estimated is converted into a value estimate by applying a market extracted and supported capitalization rate (cap rate) to the selected NOI. It is also true in the context of yield capitalization (aka discounted cash flow analysis or DCF), where the estimated annual NOIs for each year of the entire holding period are discounted to a present value and then added together with the putative net sales price at the end of the holding period, to estimate the current fair market value of the subject property.

Both of these methods also require “below the line” adjustments for identified items that could materially impact the anticipated future NOI and thereby retroactively discount the underwritten and anticipated future income returns. But do you have to make such an adjustment for just being “ugly”?

If all cash is fungible, meaning that if you have cash to invest you do not have to invest in CRE because you actually have a vast array of other investment vehicles to consider that all compete directly with CRE. The difference in choosing one investment vehicle over another is a combination of risk and required yield. A balanced portfolio is probably the key for most modern investors, particularly non-U.S. investors, who may have a currency play by buying U.S. assets with foreign currencies that are declining against the U.S. dollar. Consider the recent history of the euro for instance. If you had bought US CRE when the euro was trading at 1.60+ against the USD and then resold at the recent lows of 1.04+/-, you would have made a nice return on that investment without any asset appreciation or cash flow during the entire investment period.

These international buyers, who have been very active since the end of the 2008-12 recession, typically see US CRE as being a defensive play and a capital preservation move. Accordingly, their yield expectations are often to only cover core inflation. The benefit they seek is primarily principal preservation, currency gain on the liquidation of the investment, as well as having a portion of their entire assets in the “safe haven” that the U.S. is considered to be both politically and financially.

There is always going to be less empirical data to support such a discount for ugly in a hot CRE market; however, when the current bubble bursts (as it must, given the likely hood of rising interest rates, failure to meet future rent projections, and maturing mortgages, etc.), will ugly become a differentiator and an impactful obsolescence on resale? Should assessors not be taking that into account in their current, proposed assessments until the bubble bursts?

How Does Ugly Affect Value?Principle of Substitution

The Principle of Substitution states that when several similar or commensurate commodities, goods, or services are available, the one with the lowest price attracts the greatest demand and widest distribution. In the CRE world that means that a reasonable, typical, knowledgeable, and prudent buyer will not pay more for one property than for another that is equally desirable and fulfilling of his/her ROI requirements. Otherwise expressed, if you can buy a similar property and cash flow, why buy the one from the ugly building?

The determinative factor for choosing one CRE property over another is usually driven by the anticipated future NOI and the discount rates that should be applied to convert those assumptions to a market value. Aesthetics are usually trumped by the quality and quantity of the anticipated cash flow.

Of course, all of the definitions of fair market value, fair value, and market value, etc. share certain basic underlying principles. They are all focused on determining a prospective value based on the most probable price that the next purchaser would pay for specific real estate, as of a particular date, in an arm's-length transaction and after full exposure to the market, etc. It is the need to mirror the next purchaser's underwriting and willingness to buy a particular property where the ugly issue can arise. If the ugliness of a particular building eliminates it from the pool of properties that a typical, CRE investor in that type of property would otherwise consider in a particular market, then that is a clear indication that a negative adjustment is warranted for the valuation of that property for acquisition and/or assessment purposes.

What Are Objective Signs That Ugly Is Having Negative Impact on Value Based on Current Operations?

When considering a negative adjustment to the value of potentially “ugly” buildings, you have to start by identifying and analyzing the operation of that building's competitive set (“comp set”) of competitor properties.

The current management of an ugly building, if competent, will know with whom they are competing, particularly in the case of a multi-tenant office building, apartment complex, or hotel where competitive data is widely available. By using one of the many databases like CoStarTM, one can ascertain the asking rents and proposed terms of the comp set, and then compare them to the subject ugly building.

Assuming that the selected comp set truly represents where your current and future tenants would also look if they rejected your ugly building then this data should indicate if any negative adjustment(s) to the ugly building's value is needed. Consider the following two illustrations of a pro forma comp set analysis:

In Example 1, the subject ugly building is clearly performing in the middle of the pack compared to its comp set (i.e., $26.50 psf as compared to the comp set range of $21.75 to $30.00 psf). There would not appear to be any particular aesthetic stigma to adjust for because its net effective rent (NER) psf anticipation and vacancy rate are both in the line with the competition. Accordingly, it is far more likely that differences in building age, lease terms, and amenities are influencing market demand and therefore value more than any perception of ugliness.

However, in Example 2, the comp set analysis tells a different story entirely. Here, the ugly building is way outside of the range set by its comp set, thereby indicating that something else is negatively impacting its operations and therefore its value. Absent any other identified factor, it may be appropriate to assume that the aesthetics of the building are having a market impact, and that the increased vacancy rate and reduced net effective rent psf anticipation is due to that impact. In which case, you need a negative value adjustment.

How Do You Calculate,Make the Adjustment for Ugly?

The way you adjust value for ugly should depend on whether it is curable or not. As a general rule, once you build an “ugly” building, the original and all subsequent owners are stuck with the result, for better or worse.

If that means that you have a reduced tenant appeal, generate lesser rents than your comp set, and therefore have a negatively impacted value and/or you turn off potential buyers, all of that indicates that some kind of negative adjustment is required. If not established, the impact of ugly gets relegated to being a matter of taste not commerce.

If Curable?

If the physical attributes that create the ugly obsolescence are reasonably easy to fix, at a reasonable cost, and the overall financial impact to the operation of the building is not overly impacted, the problem can be deemed “curable.” But it has to make economic sense to fix, and there has to be a real likelihood that future vacancy will drop to market levels and that anticipated NER will increase as a result.

When curable, you calculate this adjustment by estimating the present value of the total cost to cure the ugly components needed to make the subject resemble the comp set and get the same NER psf. Then, you deduct that lump sum amount from your income approach value estimate. It is relatively easy to do, and the adjustment is more or less objective because it is based on the estimated costs to cure. Even if it will take a long time to do the corrective work, a discounted version of those costs to represent their present value can be used. That would only be needed if inflation is rising, which might push up remedial costs substantially during the cure period.

If NOT Curable?

It may be that the market indicated ugly obsolescence is incurable because it's located outside of the subject property, or it may just not make sense economically to spend the money to fix it. In either case, you may be left with an economically blighted building that is just never going to compete as well with its comp set. How do you address for that impact on value?

The best way to do so is by adding a risk rate to the going in cap rate used in your income approach to value. This can be tricky to do because selecting the appropriate risk rate is very subjective and hard to extract accurately from the market.

One technique to use would be a modified matched pair approach. To do so, you would identify and select as many similar recent leases in the subject property and your comp set as possible. You would try to find similar tenants, with comparable credit risk, space requirements, and location within the buildings. The idea is to isolate the decision factors made by the lessee in choosing one building over the other. The fewer identified differences the better.

Of course, if the tenant(s) who is interviewed for this analysis also indicates that he/she did not lease because the subject building is too ugly, then that helps. Interviewing local leasing brokers as to how they would present the subject property and if they believe a discount should be offered because of its aesthetics would be corroboration for the need to make an adjustment, particularly if their opinions were consistent, and they formed a large sample of opinion.

Consider the following simplified example of such a matched pair analysis:

Conclusions

1. Ugly can be a building attribute that produces a negative impact on value.

2. Adjusting for that stigma must be done objectively and by reference to the market.

3. Even if an ugly building is operating currently at a level comparable to its comp set that does not mean that the next buyer will not discount its market value. If all other factors are equivalent, there will always be the most demand for the least ugly alternative.

4. It may be hard to distinguish an over-performing ugly commercial property from an average performing attractive one.

5. If the ugliness is curable, deduct the present value of the aggregate cost to cure from the income approach value estimate.

6. If not curable, add a market derived risk rate to the going in cap rate being used under the income approach to value.

7. This issue is one that should be raised routinely with assessors if empirical data can be developed to support the argument for a reduction in assessment.

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