Sunday, June 29, 2014

Appraisal of a proposed resort project near the Canadian Rockies

 
Curiously dead ground vegetation for a proposed vacation resort

These were 130 acres in a town west of the Canadian Rockies popular with snowmobile enthusiasts. Local leaders want to make their town the “Next Canmore”, an expensive vacation community about one hour's driving distance west of Calgary and the first town east of Banff, Alberta's most famous ski destination. This town, though, was 300 miles west of Edmonton.

The local authorities, eager for economic development, had granted entitlements to a developer to build 183 condos and 70,000 square feet of commercial space. To impress how much political support she had for this project, she invited the mayor to have lunch with us. I ordered a “moose burger”, but I was also informed by the two that the restaurant didn’t really serve moose meat.

No feasibility study had been done, but I was told that there was a waiting list of 250 for the condos, and substantial "verbal interest" for the commercial space (meaning no leases or letters of intent). It turned out that the waiting list for the condos was just as real as the mooseburgers. It was just a collection of names and addresses of people who had responded to ads in snowmobile magazines, and there had been no discussion of prices, nor had there been any contracts signed.

The condos were priced quite steeply, from $430 to $455 psf Canadian, with prices ranging from $350,000 to $680,000, in one high density building. The town itself, though, had 21st century homes on their own lots for sale for less than $270,000. Per Landcor, the data service I use in BC, the highest priced home sale in the last year had been at a price of just $225,000, a new log home of 1068 square feet on a conventional-sized city lot.

124 of the 130 acres were a former rail yard previously used by the Canadian National Railway. Railyards are often heavily contaminated through years of washing out tank cars. Rail ties, too, were treated with arsenic to resist rot before being set in place. The photo demonstrates a mostly grey area of dead ground cover, punctuated by young pine trees, a tell-tale sign of contamination.

The properties had been acquired at the peak of the market in 2007, and in my previous valuation assignment in BC, I noticed that the sale of vacation properties began to considerably diminish after 2007. Yet, in this situation, the developer had appraisals done by Canadian appraisers estimating land value several times as high as the acquisition price in 2007. It gives me the impression that the Canadian appraiser profession is less effectively regulated and policed than in the U.S.

Tuesday, June 17, 2014

Another appraisal assignment in Nayarit, Mexico raises red flags of possible fraud




This was the appraisal of nearly 1000 hectares (over 2000 acres) of beachfront land, my third appraisal in Nayarit. There were many red flags to cause me to be suspicious:

1. The borrowing entity was a company in Cyprus, a country known as a hotbed of offshore shell companies (2267 identified so far by ICIJ). Shell companies are notorious for straw officers and directors and untraceability. Think of Cyprus as another Cayman Islands.

2. The borrowing entity had no history and no web site.

3. The borrowing entity did not own the land but had a JVA (joint venture agreement) with the landowner, a Mexican national.

4. The principal of the Cypriot company consistently misspelled his own name throughout the JVA.

5. All the bank account information of the Cypriot company had the company name misspelled.

6. As with Mexican land scams I’ve uncovered, the borrower’s representatives extolled the development possibilities for the land, but their credentials were not as real estate developers, but as marketing or public relations consultants.

7. No credible development plan was presented, but I was told that there was an agreement with the “Canadian Retirement Association” to build thousands of vacation homes for Canadian retirees. I have been unsuccessful in verifying the existence of the Canadian Retirement Association.

8. The Toronto phone number I was given for the Canadian Retirement Association connected me to a man who seemed to be more fluent in Spanish than in English and who bragged about his 75 “advertising awards”. This is not the talk of someone who would be trusted to manage a Canadian pension fund.

9. Similar to the Mexican land scams I’ve seen, I never got to meet the actual property owner, but I was given a document that assigned the right to mortgage his land to one of the borrower’s representatives. As I learned today at the ACFE Fraud Conference in San Antonio, identity fraud is a growing problem in Mexico as it is here in the USA, so I have to be careful.

10. As with Mexican land scams I’ve seen, my request for a current predial (property tax bill) instead yielded a predial from 2008, raising the possibility that the property has diminished in value since then or even the possibility that there was no affiliation with present owner such that a current predial could be provided.

Having been collecting listing data on this part of Nayarit for the last two and a half years, I noticed that asking prices on beach land in this area have declined up to 60%. Regardless of the suspicions I had about the loan request, the appraised value fell short of what was needed, any way.

Land loans are an ideal conduit for fraud in Mexico, by the way, because the value is so hard to determine, accurate information is so hard to come by, and it is easy to hire a Mexican appraiser to appraise the land for $100 million.

 

Tuesday, May 13, 2014

Another appraisal in the Bakken area of North Dakota/Canada


Bakken is a subsurface shale formation underneath North Dakota, Montana, South Dakota, Saskatchewan and Manitoba and has become the biggest oil find in North America in the last 40 years (not since Alaska). North Dakota has the most favorable location over the Bakken foundation and has undergone boomtown economic conditions similar to the Alberta Oil Sands near Fort McMurray, Alberta.


In my latest appraisal assignment, I appraised a massive RV (Recreational Vehicle) Park which provides temporary housing for hundreds of new workers in the oil and oil service industries as well as a motel with fully occupied RV spaces behind it.

Being a boomtown economy, there is an extreme shortage of housing for incoming workers. This is a real worry for oil firms and oil service firms desperately in need of manpower; in the last measurement of unemployment in Williams County, home to the largest Bakken-area city of Williston, the last measured unemployment rate was 0.9%, and other Bakken-area counties were at around 1.5%.

RV Parks have been the quickest solution in providing new housing, and the 765 space RV Park I appraised was actually in the business of wholesaling its spaces to housing contractors who then erected temporary housing, either in the form of manufactured housing (as seen in left of above photo) or else recreational vehicles themselves (as seen on right of above photo).

In this case of such an enormous RV park, the gross income multiplier seemed to be the most reliable method of valuing, as the collected rent per pad was much lower than for much smaller RV parks in which the landlord needed no intermediaries to lease RV pads.  Using “price per pad” established by much smaller parks would have overvalued the subject park.

The motel averaged occupancy of about 90% last year, while for the first third of this year it has been close to 100% and is budgeted to average 93.5% for the year.  Despite the high occupancy, room revenue multipliers in this region were not found to be higher than motels in other states; only the incomes were high.

Numerous motels are also being erected and designed to be extended stay lodging.  At the new Telluride Lodge where I was staying, which advertises itself as "executive housing" to distinguish itself from the other more blue collar housing choices available, I checked in to find no soap or shampoo in the bathroom.  In my trip to the front office to explain these missing items, the incredulous front desk clerk offered me a bottle of dishwashing liquid instead.
"Executive housing" offered at Telluride Lodge south of Watford City

Room revenue multipliers at motels listed for sale started at a remarkably low 2 x revenues.

What accounts for the pessimism of investors?  Perhaps the most obvious reason is the slowdown in employment growth, which was close to 50% per year prior to 2012 but only 6.5% in the last year, which is still good, but is temporary housing and lodging being built too fast to cope with a coming slowdown?

The most labor intensive phase of an oil boom is the exploratory phase.  Extraction requires less personnel and is also a declining number.  Based on these realities the North Dakota state government's Oil and Gas Division and North Dakota State University are both predicting that Bakken-area employment will begin to decline starting in 2020. Maybe this why so many investors want their returns upfront in the form of current returns.  As the need for exploration personnel lessens, too, will the need for temporary housing lessen.



Friday, April 4, 2014

Another Appraisal at Playa Novillero, Mexico


This assignment called for the appraisal of 91 hectares of beachfront land at Playa Novillero very near some land I previously appraised in 2012. Playa Novillero is Mexico's longest beach at 82 kilometers, but is isolated and lacking in visitors. Despite being zoned for tourist development, land uses at the beach reveal abandonment rather than new development.

The beach is ideal for families, having about 50 meters of sand extending inland and shallow depths for a long distance out, but the beach is busy only week per year during a Mexican holiday week.

There are no close international airports. Last time I was here it took 2 hours to get here from the Mazatlan airport, and this time it took me 4 hours to travel from Guadalajara. Decent roads end at the town of Tecuala, which is 22 km inland from the beach, and arriving at the small village (population 249) at the south end of the beach, one has to drive up the beach to access the beach properties. This time our GMC got stuck in the sand and I had to get down on my chest several times to clear the soft sand from around the tires.

Most of the beach homes are abandoned.




As in the last Mexican appraisal assignment, the loan applicants were pledging as collateral a property that they did not own yet, although they did possess a 4-year-old purchase contract and a document conveying "Special Irrevocable Power" for 5 years, with less than a year from the end of the contract. They said they were taking their time executing the purchase contract, but there was no plan to close on the purchase at the time of loan funding, leaving the lender with the prospect of having no collateral for the loan.

Just as in the other beach property assignments, the most consistent indicator of value in this case was the price per lineal meter of beach front.

Sunday, February 16, 2014

An Appraisal in Nigeria, Land of Inconvenient Factoids

Ikoyi neighborhood in Lagos

A factoid is defined by Wikipedia as “a questionable or spurious (unverified, false, or fabricated) statement presented as a fact, but without supporting evidence.” A good appraiser learns how to distinguish between facts and factoids. A bad appraiser does not care.  In my latest assignment in Nigeria, I found the nation to be as rich in factoids as it is in oil.

I was initially given 2 weeks’ time to submit a valuation report on an 11-unit luxury apartment building in the prestigious Ikoyi neighborhood of Lagos, Nigeria’s largest city. In contacting the borrower, I stipulated that tenants had to be notified in advance that I would be entering their apartments during my property inspection. The borrower then informed me that this could not be done, because Nigerian Law required that an attorney be hired to provide 21 days’ advance notice to each tenant. Was this law real, or just a factoid? These apartments were labeled as “corporate serviced apartments”, which suggested to me that they received regular maid service of some kind, and how often do maids need a legal writ to clean a room?

The importance of seeing inside the apartments was mainly to verify occupancy, as the subject neighborhood of Ikoyi in Lagos has become seriously oversupplied with new, luxury 3 bedroom 3 bathroom apartments.

Several years ago, prior to the Global Financial Crisis, Ikoyi was known as the most expensive neighborhood on the African continent. Flats were selling for more than a million dollars and renting for $5000 to $7000 per month. The last canvassing of vacant apartments in Ikoyi in late 2012, however, indicated a vacancy rate of 42%.

The subject property was represented as fully leased at individual unit rents of $58,000 to $60,000 per year, or about $5000 per month. Was this real or just a factoid?

Arrival at Lagos Airport

The Nigerian embassy in Washington had provided my visa and told me that no immunization certificates were needed for entry into Nigeria when traveling from USA or northern Europe. When I was exiting customs at Lagos Airport, however, a customs agent asked for my proof of Yellow Fever immunization (which I had left at home). I told her what the embassy had told me, but she told me that all persons entering the country had to show the card. Was this the truth or just a factoid?

Without my Yellow Fever card, she said that I would be sent back home [having wasted more than $10,000 on a plane ticket]….unless….I could pay a fine. “How much is the fine?” I asked. “How much can you pay me?” she responded. “$50,” I said. She said “No, $100.” When I tried to hand her the $100, though, she cautioned me to not display the money, instead instructing me to go to the men’s room and then place the $100 in my passport, which she took out of my folded passport as I exited Customs. As this was the first of other attempted extortions to come, I learned one useful thing – Nigerian civil servants do not like to be witnessed taking bribes.

Back home from Nigeria, I read the current issue of The Economist, which had an article entitled "Big Country, Thin Skin", stating that Nigerian "corruption is so endemic that many visitors pay their first bribe before they have even left the airport."

Research in Ikoyi

Since the crisis, demand for luxury apartments has weakened, and some major oil companies such as Shell, Exxon and Schlumberger have constructed their own employee housing. Meanwhile, construction of new luxury 3 bedroom apartments continues unabated.

In driving through Ikoyi at 9 pm, it was eerie to see so many dark, empty residential towers. I wanted to see the subject property at night (one way to estimate occupancy), but the borrower told me that he had no permission to enter the subject’s gated Parkview Estate community during the night.

He couldn’t get permission to visit his company’s property? Either this was another factoid or neither he nor his company really owned the building. Neither he nor his company was named on the Certificate of Occupancy, the Nigerian version of title.

The inspection

I was actually shown only one apartment the following day, and the functionality of the building was not impressive, with long narrow apartments, no elevators, minimal fenestration, and no power on during my inspection, despite the presence of two back-up generators.
Center hallway inside unit
Typical bedroom
Kitchen
In the U.S., when an appraiser inspects a building represented as fully occupied and finds the power turned off, this is an instant red flag, but there are many power blackouts per day in Lagos, which has one of the world's least reliable electrical infrastructures. That is why many buildings there have back-up electrical generators, and the subject property had two of them to guarantee 24 hours-a-day electrical service.

Most new apartments in the U.S. have separate electrical meters for each apartment, so I asked to see the meters just in case only one meter was turned off. There was only one meter for this whole property, though, and I noticed that common area electricity was turned off, too. For the period of time I was at the property, about 45 minutes, the power was off the whole time, which would be a situation unacceptable to real occupants as food perishes in dark refrigerators and freezers, and fussy executives don’t want to come home to walk up three flights of stairs in the tropical heat to a warm apartment.

There were no signs of other tenants during my 11 am weekday inspection, although there is the possibility that all tenants would be at work. Nevertheless, there were no personal effects or plants in windows or on balconies to indicate that anyone lived there. The two cars in the parking lot belonged to staff only.

On that basis I had to conclude that the property was vacant. I don’t give loan applicants “benefit of the doubt” in face of evidence to the contrary. Moreover, an examination of documents further made their claims of rent and occupancy to be absurd.

The documents

Despite repeatedly requesting operating statements for 2012 and 2013 prepared by a property manager or accountant, I instead received an Excel spreadsheet for 2013 indicating that 12 units out of 11 had been occupied at rents of $58,000 to $60,000 per unit per year (representing 109% occupancy) at rents well above asking rents in the neighborhood, with relatively few expense items listed, all in very round numbers (not typical of an accountant’s report or professional management report), and not including usual line items such as building insurance, water, sewer or property management. The report appeared to have been hastily prepared and not consistent with standard worldwide real estate accounting procedures.

I did find 10 of the subject property’s apartments listed as available for rent on the Internet for the dollar equivalent of $36,810 per year each, or about 40% less than what the borrower had represented as being rented for at the time, which was November 2012.

On that basis I dismissed the operating statement and rent roll as factoids and not facts.

Leaving Lagos

The passenger screeners were greedy. I normally travel with both a laptop and an I-Pad, but did not take the I-Pad out of my luggage. The first passenger screener informed me that failing to take out the I-Pad was a violation and I would need to pay a fine. I asked “How much?” and she said “Just drop it into the luggage tray” without specifying an amount. I took out Nigerian currency from my wallet and hurriedly dropped a 100 naira note into the luggage tray, failing to compute that my bribe amounted to the equivalent of only 60 U.S. cents. She just looked at it, irritated, and said “Take it back”.

I stuffed my remaining Nigerian currency into my right pocket and was then greeted by a personal screener (frisker). He detected the wad of cash in my pocket and asked to see it. He then asked how much I could give him, and I just responded with a loud “How much do you want?” That seemed to embarrass him and he hurriedly let me pass.






Thursday, January 30, 2014

Discounted Cash Flow Analysis throughout the world – Who does it right and who does it wrong?



I entered the appraisal profession at an opportune time – in the mid-1980s, when discounted cash flow (DCF) analysis had come into vogue in the real estate industry.  The crowning moment for DCF’s new place in real estate investment analysis became apparent in the purchase of the Pan Am building (now the Met Life building) in New York in early 1981.  The price paid shocked many, as it reflected a “going-in” capitalization rate of just 4% for an 18-year-old building in a time of high inflation. 

Manhattan was just awakening, though, from a 1970s stagflation-induced real estate coma of no new construction, and the rapid expansion of the financial industry brought the Manhattan office market to full occupancy, with rents increasing 50% from early 1979 to the end of 1980.  The buyers of the Pan Am Building relied on a DCF model based on cash flow projections for years into the future, anticipating the ability to re-lease space at much higher rental rates.  In this context, the purchase price was justified.

I was recruited out of graduate school by Jones Lang Wootton, where I was promptly put to work creating DCF models for regional malls and high-rise office buildings owned by their institutional clients.  My work wasn’t questioned because my superiors had never been taught DCF analysis and did not understand how it worked.  Many of my business school peers also landed into cozy positions not previously available to new graduates, all because they could perform DCF analyses.

In hindsight, all of the DCF models of the 1980s were toxic, rosy fantasies which failed to consider the possibilities of overbuilding and recession.  Hundreds of billions of dollars were lost based on DCF models – and will continue to be lost, as I am about to explain.

Between 1988 and 1998 I worked as a bank review appraiser and chief appraiser and reviewed a lot of commercial real estate appraisal reports, noticing that when appraisers used both a DCF model and a direct capitalization method in their reports, the DCF model usually produced higher estimates of value.  One reason why was because they projected income growth equal to or exceeding expense growth, contrary to the documented operating histories of most income properties.

In examining the long-term operating histories of income properties, expenses increase faster than revenues over the life of the building. This is why expense ratios are higher for older buildings, as is graphically demonstrated by a typical subset of BOMA data in Figure 1, and is equally supported by IREM data.  Notice how the line representing the operating expense ratio for each age subcategory increases in slope relative to gross income.  The numerator, Expenses, is increasing faster than the denominator, Gross Income.  This is a graphical proof of expenses increasing faster than income for income properties.

                              

                                                           FIGURE 1

Data from BOMA (Building Owners and Managers Association)


There is a logical reason for this. As a building ages, it becomes less competitive in its marketplace and the rate of rental increase slows, while the aging of the property requires increasing maintenance and capital improvements expenditures. This is the reality of physical and functional obsolescence.

The natural end of the economic life of a building is when expenses finally exceed collectible income. If expenses typically grew no faster than income, on the other hand, no building would become obsolete. That would be nice for building owners, but the real world does not operate in this manner.

DCF models which forecast expense growth to be the same rate as consumer price inflation are therefore fundamentally wrong.

Since it is so hard for some appraisers and valuers and even the Appraisal Institute to accept this, let me present an analogy – your car.

What are your likely operating expenses for your car in its first year of operation? Perhaps $100 to $200 for oil changes. With consumer price inflation currently at about 2%, would you predict the car to cost you $102 to $204 in its second year of operation? $104.04 to $208.08 in the third year? What about the 10th year? Would you expect operating expenses in the range of only $119.51 to $232.02? No, because the car is a deteriorating asset, and many parts will need replacement.

A building is a deteriorating asset, too. There are two forces governing expense growth – price inflation and increasing maintenance and capital improvement needs. This places the rate of expense growth higher than price inflation alone.

The above graph, indicating the typical pattern of expenses increasing faster than income for income properties, was originally part of my book (see sidebar) for the Appraisal Institute, but was not allowed by the editors, as the Appraisal Institute maintains that income and expenses increase at the same rate. This is also reflected in the 13th Edition of The Appraisal of Real Estate, published by the Appraisal Institute in 2008, in which DCF models indicate decreasing operating expense ratios as buildings age. This is a mysterious retrogression for the Institute, who published my uncensored article on DCF analysis in The Appraisal Journal in 1990. To deny now what I wrote then makes me wonder if they’ve been hijacked by the Flat Earth Society.  It also suggests that a generation of MAIs has been taught to overvalue properties using DCF analysis.

The Appraisal Institute may be a formidable opponent for me to challenge, but fortunately, I have rules of arithmetic on my side.

Why is this matter so important? Most DCF models project 11 years of cash flows, and the underestimation of expense growth gets compounded, resulting in serious overvaluation.

One of my fellow Appraisal Institute authors, Howard Gelbtuch, assembled and edited an enlightening book entitled Real Estate Valuation in Global Markets, in which highly decorated appraisers and valuers from many nations explain how real estate valuation is done in their countries. Once again, most who presented DCF models had final year operating expense ratios lower than beginning expense ratios. Many of the violators were Western nations that are considered financially sophisticated. Other nations getting it wrong were:

Belgium, Canada, Czech Republic, Denmark, France, Germany, Hong Kong, Italy, New Zealand, Poland, Portugal, Saudi Arabia, Spain, Sweden, Taiwan and Turkey.

Which nations got it right? Nations less likely to be considered part of the supposedly sophisticated Western herdthink:

Argentina, Bulgaria, Chile, Indonesia, Japan, Romania, South Korea, and the Turks and Caicos Islands.

Getting beaten by the likes of Argentina and Bulgaria in DCF analysis should shame appraisers and valuers from the most affluent Western nations into "stepping up their game".

Next stop:  Lagos, Nigeria

Tuesday, January 21, 2014

HUA ZHU HOTELS GROUP AND CHINA’S MIDSCALE HOTEL MARKET



Beijing's Wangfujing Night Market, a popular tourist spot.  One of the closest stalls in the photo sells barbecued scorpions.

In traveling throughout China, I have been constantly surprised to find most hotels to be independently owned and managed and unaffiliated with known franchises. The higher end hotels (such as Peninsula, Swissotel, Raffles, Hyatt) are an exception, as they are particularly suited to serving Western travelers, but at this stage in China’s march towards prosperity, with its burgeoning middle class, the time seems ripe for major hotel companies to consolidate the remainder of the Chinese lodging industry, just as was done during the 1960s and 1970s in American history, when hotel names such as Hilton and Holiday Inn became commonplace.

China has now reached a threshold in which leisure travel is taking off, presenting opportunities for mid-priced and economy hotel chains to gain market share. Meanwhile, the new Chinese leader, Xi Jinping, has spent the last year cracking down on wasteful spending by government workers, such as stays at 5-star hotels, and local governments have enacted similar restrictions, so far as to cause 56 5-star hotels to request that they be re-labeled as 4-star hotels. This should redirect much government and business travel into midscale hotels.

Entrepreneurial forces have already been put to work to consolidate the midscale hotel market, as several Chinese companies have been building midscale hotel chains (in the 2 to 4 star range), achieving economies of scale, brand awareness and customer loyalty. These hotel chains are relatively new; none existed as a franchise before year 2003. The creation of a strong hotel brand adds great value to each such branded hotel because of central reservation systems and guest loyalty rewards programs (although the Internet has slightly eroded this value).

The most noticeable Chinese franchises are 7 Days Inns, a limited service chain similar to Super 8 (which is also common in China), Jinjiang Inns, a state-owned hotel company that covers the higher end of “midscale”, and Hua Zhu Hotels Group, an assemblage of several different brands such as Starway, Hi Inn and Hanting.


Hanting Beijing Wangfujing Hotel, with nightly rates starting at $46

Hua Zhu has particularly attracted attention recently because of its very rapid growth, surpassing Jinjiang Inns before 2010 to become China’s largest hotel chain. Hua Zhu Hotels Group had its IPO on NASDAQ in 2010 (as China Lodging Group) and has expanded its reach from 413 hotels at the time of its IPO to 1425 hotels today, with 152,879 rooms in all. China Lodging Group stock (symbol HTHT) opened on NASDAQ in 2010 at $13.50 per share and is now trading at $26.60 per share. There have been two days this month in which HTHT was listed on Yahoo Finance’s top 5 stocks “gaining on unusual volume”.

Hua Zhu Hotels Group has existed since 2005, and its revenues expanded 60-fold in 6 years, as follows:

Year Revenues (RMB) Earnings (RMB)           # of hotels
2006 54,031,000
2007 235,306.000        -111,623,000
2008 764,249,000        -136,162,000                 167
2009 1,260,191,000        42,545,000                 236
2010 1,738,493,000      215,751,000                 438
2011 2,249,597,000      114,832,000                 639
2012 3,224,527,000      174,887,000               1035
2013* 4,153,000,000*    221,000,000 **           1425
*projected
**first 3 quarters

As of the 3rd quarter of 2013, average daily occupancy was 94%, average daily rate was 186 RMB ($30.74) and REVPAR (revenue per available room) was 175 RMB ($28.93). While these numbers are lower than those of 2010, Hua Zhu explains it is because they are shifting towards lower-tier cities in their expansion. Meanwhile, their frequent guest program is reported to have more than 13 million members, constituting 80% of room nights sold.

Because the Hua Zhu brand is now so well established, Hua Zhu can now move from a business model in which most of their hotels were once leased and operated to a business model emphasizing managing and franchising, enabling Hua Zhu to expand its reach with much less capital and operations risk, much like the other most successful hotel franchises. 60% of their hotels are now managed and franchised vs. owned as leasehold.

The recent dip in share price to $26.60 would indicate a price/earnings ratio of 28 for the trailing 12 months, but the first two quarters reported minimal earnings (mainly due to depreciation expense) despite strongly positive cash flows from operations, whereas the last two quarters had respective earnings of 39 cents per share and 50 cents per share, suggesting a much lower PE ratio based on forward earnings. The recent dip in price seems to be caused by a general overreaction to the most recently reported  dip in PMI (from 50.5 to 49.6) in China.  Even the Chinese internet stocks such as QIHU (down 10% after the report) and YY (down 7.4%) are behaving in similar fashion despite being unrelated to the manufacturing sector.

Disclosure: I own this stock.


Shanghai's Xujiahui District and Starway Xujiahui Royal Garden Hotel, with rack rates starting at $76

Monday, January 20, 2014

Commercial Real Estate Values Rising Due to Cap Rate Compression

My previous posts have discussed this situation in Hong Kong and Singapore, but the same phenomenon is at work in the U.S., too. http://www.internationalappraiser.com/2010/12/asian-growth-story.html
http://www.internationalappraiser.com/2012/12/hong-kong-revisited-risks-presented-by.html

Many are trumpeting the return of rising commercial real estate values in the U.S., but how much of this rise is organically grown rather than the effect of artificially low interest rates?  By “organically grown” I mean growth based on improving net operating incomes at the properties being measured.
Buying properties just because the market is going up due to cap rate compression would be just as illogical as buying stocks because their price/earnings ratios are going up.  Such an investor would just be paying more for the same amount of income.

Last fall I appraised a portfolio of southern California industrial and retail properties for a divorce, requiring me to estimate market values as of year 2013 and year 2002.  All but one property had increased in value in those 11 years and the average increase was 51%, yet the majority of properties were earning less net operating income (NOI) than 11 years previously.

Examining just those properties that suffered declining net income, the average NOI was 17% below 11 years ago, but the average value was 28% higher than 11 years ago.

What made these declining properties worth more?  The most obvious answer is the compression of capitalization rates in response to artificially low interest rates resulting from the Federal Reserve Bank’s doses of “quantitative easing”.  The range of cap rates in 2002 was 7.5 to 9%.  The range of cap rates in 2013 was 5.5 to 6.1%.  NOI divided by .055 is going to yield a much higher value than NOI divided by .09.

One could argue that today’s low cap rates are a vote of confidence in the future of these properties and a rebounding economy, but how can one be confident about properties that have been declining in economic performance for the past 11 years?    

It requires a leap of faith to value these properties as if their NOIs will start rising again, particularly since these were mostly older properties, built before 1980.  Yet, I’ve seen this happen once before, in the early 1980s, when the lack of commercial real estate construction after 1974 resulted in a serious shortage of commercial space by the end of the 1970s.  Nevertheless, I don’t see a nationwide shortage of commercial space today, only some small pockets which have supply constraints.

The concern I have here is that when the Fed tapers its “quantitative easing”, the consequent rise in interest rates will quickly reverse the gains in commercial real estate value.  In a matter of months we have already seen the US 10-year bond rate rise from 1.6% to 2.82%.  Is this a portent of rising interest rates to come?

For instance, what if cap rates returned to the levels of 2002?  The subset of properties that fell 17% in NOI but rose 28% in value would consequently see a 35% reduction in value from today’s values. 

“Quantitative easing”, of course, is just a euphemism for “money printing”.  My economics courses at the University of Chicago taught that the consequence of rampant money printing was inflation, which is indeed what happened in the 1970s in the U.S.  Inflation can manifest itself in consumer prices, or also, more recently, in asset price inflation, as the extra money now somehow finds its way into the coffers of the upper class, enabling them to bid up equities and art prices to record levels.  It’s getting so hard to buy a decent Picasso for less than $20 million nowadays.

The natural consequence of inflation is an increase in interest rates, as investors want to be compensated for the erosion of purchasing power over time.  Real estate capitalization rates are correlated with interest rates, so one can expect the commercial real estate market to face some major headwinds in the future.

Similar consequences may happen overseas, too, as all of the major central banks, even China, which did it again today, have been printing money to recover from the Global Financial Crisis 5 years ago.

Soundly run nations, such as Switzerland, are also adversely affected by the declining level of confidence in other currencies.  When investors lost confidence in the Euro, for instance, they traded Euros for Swiss Francs, temporarily elevating the value of the Swiss Franc before the Swiss government stepped in to devalue its own currency in order to preserve its export markets.

In my previous travels in Asia, I’ve seen commercial properties sold at ultra-low capitalization rates, in the 2 to 3% range, in places such as Hong Kong, Singapore, and Shanghai.  Residential cap rates are even lower.  With cap rates this low, there is little margin for interest rate increases before the streets become flooded with red ink and real estate values are pushed downwards.















Singapore skyline.  Top photo: Hong Kong Central

 

Monday, December 23, 2013

An Appraisal in the Bakken area near the U.S.-Canadian border


A “man-camp” erected to house incoming oil workers, 99% of whom are male. At this man-camp, each worker gets an 8’ by 10’ room including a lavatory and window. Beyond the front door is a security guard who frisks residents for alcohol and drugs. Also note the security perimeter fence. If it resembles a prison, it is only to keep oil workers sober enough to safely operate heavy machinery.

The Bakken Formation, an entirely subsurface shale formation underneath North Dakota, Montana, South Dakota, Saskatchewan and Manitoba, has become the biggest oil find in North America in the last half century, and is bringing boomtown conditions to western North Dakota towns and cross-border Canadian towns.

The U.S. Geological Survey estimates up to 503 billion barrels of oil in the U.S. portion of the Bakken formation, of which 7.4 billion barrels are recoverable using today’s horizontal drilling and hydraulic fracturing (“fracking”) technology. This shale also holds an estimated 6.7 trillion cubic feet of natural gas, too. North Dakota oil production alone is now up to 871,000 barrels per day, estimated to exceed 1 million barrels per day in 2014. 25% of the Bakken formation is on the Canadian side of the border, though.

Most of the major oil and oil service companies are scrambling to build space up here, which is why I was evaluating a business park on the North Dakota side of the border and receiving a glimpse into the distortions in real estate markets caused by sudden economic booms. Within the business park alone, for instance, all lot sales had been at full list price, a phenomenon I had not seen in a few years.

Typical industrial park

The first distortion in boomtowns, of course, is the extreme shortage of housing for incoming workers. This is a real worry for oil firms and oil service firms desperately in need of manpower. The most common solution has been the erection of employee “man-camps” such as in the photos above and below. Sometimes, employee housing is installed in available space within industrial buildings, including truck garages.
Each mobile home houses up to 5 men

Newcomers often arrive to find hotel rooms sold out at high rates, such as $250 for a weekday night at the Holiday Inn Express or $197 for the Microtel in Williston, 70 miles south of Canada and one of the worst affected North Dakota towns. Apartments are full and nonworking apartment residents have had to leave the community after seeing their rents quadruple. Some newcomers resort to living in their cars at first. Then comes winter. The morning temperature on the day of my arrival on the last day of fall was minus nine degrees Fahrenheit, and temperatures have been known to go below minus 20 in the winter.

Retailers and restaurants cannot find enough workers when the oil industry pays much better. McDonalds is paying employees up to $17 per hour, but some fast food restaurants, such as Carl's Junior, have now closed their dining areas and serve customers only through drive-through. There is not enough manpower to clean and maintain interiors. The local unemployment rate is 1.8%.

The Manitoban towns of Virden (population 3114 and known as “the oil capital of Manitoba”) and Waskada (population 225) are also experiencing boomtown conditions such as a severe shortage of housing and hotel rooms, with real estate developers turning empty buildings into employee lodging.

Hotel rooms are also in short supply in southeastern Saskatchewan, and the oil town of Estevan, population 13,000, now has housing prices that match those of Calgary, another city made rich by oil, and the local Best Western charges starting rates of $160 for a weekday night. Meanwhile, in the town of Killdeer, ND, where I was working, asking prices on wood-framed mid-century houses start at around $300,000.

PS: The loan on the business park was funded by Kennedy Funding Financial out of Englewood Cliffs, New Jersey.

 

Tuesday, December 3, 2013

Declining golf course values in Asia parallel U.S. golf industry decline


The recently closed Kajang Hills Golf Club in a southern suburb of Kuala Lumpur

Revenues per golf course in the United States have been declining for more than a decade now, even when the main economy was improving. Revenues have been declining not just since the last recession but since the previous recession which coincided with the NASDAQ crash of 2000.

This is due to the twin problems of static or declining golf course usage and overbuilding of new golf courses by residential subdivision developers recognizing that golf courses increase the values of surrounding residential lots. For the subdivision developer, a golf course is often conceived of as a loss leader to enhance the value of the remaining development.

Private golf courses (“country clubs”) depend upon the sale of high-priced memberships, and these courses are even more adversely affected by current circumstances because:

1. Private clubs have traditionally had higher expense ratios (estimated at 84% in 2003, probably > 100% now) and lower profit margins than semiprivate or public golf courses in order to preserve their prestige and exclusivity, and

2. Private club memberships were sometimes bought by members not just for golfing use, but also because of their perceived investment value. These buyers have now departed from the market, making it difficult for country clubs to increase revenues as current members die off or else fail to pay their dues.

Every golf course I have appraised in the last decade has had negative operating income, as were the comparable golf course sales analyzed, but this property type still gets appraised by other appraisers as if new ownership is all that is needed to turn around an unprofitable golf course and that the industry will suddenly turn back to profitability. They often estimate value by using discounted cash flow models based on projections of improving cash flows and return to profitability. Many golf course appraisal specialists are also beholden to golf course owners and developers and produce inflated estimates of value for them.

The golf course valuation textbook most often referred to by appraisers is Analysis and Valuation of Golf Courses and Country Clubs, by Arthur Gimmy and Buddie Johnson, which was published in 2003. This excellent book offers much useful knowledge on golf course valuations, but was not written for the times we are currently in. At that time, the decline in golf course revenues was thought to be the result of a brief recession and that revenues would once again increase after the recession ended. Instead, revenues continued to decline.

Being an American appraisal textbook, there is ample discussion of the Three Approaches to Value (Cost Approach, Sales Comparison Approach and Income Approach), with most emphasis on the Income Approach, and rightfully so for any investment property. But their presentation of the Income Approach requires direct capitalization or yield capitalization of a positive net operating income, either at present or else in the rosy future, and this steers appraisers towards the use of unrealistic discounted cash flow models in which the 13-year declining trend suddenly reverses course.

Gimmy and Johnson also offer some other useful valuation techniques which are more appropriate to today’s circumstances (positive revenues, negative net operating income), such as the use of “total revenue multipliers”, “golf revenue multipliers” and “greens fee multipliers”, which I use instead when I appraise golf courses which are losing money and showing a pattern of increasing losses. They classify these methods, though, as “sales comparison approach” methods rather than “income approach” methods, while I contend that these methods are the new income approach for golf course valuations in light of the extreme shortage of profitable golf courses. Their classification of these multiplier methods as only allowable in a sales comparison approach only confuses appraisers who are required to perform an income approach in the valuation of a golf course.

These methods are difficult to apply to private clubs, however, in which most of the revenues come in the form of membership fees. Luckily, the private clubs I have appraised so far were already moving towards semiprivate status – allowing non-members to pay daily fees – and this data can be used to impute certain revenue multipliers corresponding to what would be received as a public (non-membership) golf course.

Some of the golf course buyers I have met are inexperienced in golf course management, but think that their success as bankers or lawyers will assure their success in this difficult business. Many golf course purchases seem to be vanity purchases, too, motivated more by social climbing than by economic fundamentals, as it can be a boost to the ego to have the town’s most important people playing golf on your golf course.

Asian golfing industry

I have heretofore considered the decline in golf course values as a phenomenon confined to the USA and the destinations dependent upon American tourists, such as the Caribbean.

In my recent tour of Asia I was surprised to find declines in the golfing industry in Japan, Korea and Malaysia, three countries which had growing golf industries until recent years.

Malaysia

It had been difficult to find collated data on the Malaysian golf and country club industry until the Inland Revenue Board (the Malaysian IRS) started enforcing full taxation last year on the advance fees collected from new members, which are typically 80% of the full membership fees. In the country clubs’ accounting statements, these revenues are prorated over the term of the membership, but IRB wants to tax the revenues at the time of collection, which adversely affects the finances of this industry. So far, it has identified 180 private golf clubs, almost 90% of the golf courses in this country, with about 500,000 golf club members, and has assessed a total tax bill of more than 600 million Malaysian Ringgit (about $200 million) for these clubs, or an average of about $1 million per club.

Prior to this sudden tax bill, a Malaysian blogger had reported that most of the country clubs were already running at a loss and that golf club membership fees had already declined by more than half. Just as in the U.S., buyers of memberships who previously bought in expectations of capital appreciation in the value of their memberships have now departed the market. Deflation in golf club membership fees is a self-fulfilling prophecy, because it encourages potential new members to wait until there are further price reductions. Such private clubs often end up as semi-private -- having to allow in non-members who can pay daily fees for use of the golf course, but this in turn demotes the exclusivity of the club.

South Korea

South Korea is facing a similar situation. The Korea Golf Course Business Association has been monitoring golfing numbers for 30 years now and has reported steadily increasing numbers in rounds played, which were about 18 million last year. They count 248 golf courses, of which 20 have now registered for court receivership.

Noticing the increasing financial strains at private clubs, existing members have been suing the clubs for the return of their initiation fees, which they had also initially considered as appreciating investments. This is no trivial matter. The Korean Herald reports that there has been an average of 100 new lawsuits per month, and the total amount requested in these lawsuits is 7 trillion Korean Won (about $7 billion). Somehow, this number doesn’t seem right, because if it was true, these lawsuits would bankrupt the Korean golf industry.

Japan

Japan ranks second worldwide to the U.S. in golf demand, and third in supply (2350 golf courses) but half of Japan’s country clubs have gone bankrupt since the Japanese economic bubble burst around 1990. In Japan’s case, golf demand peaked earlier than in the U.S. and Korea, and as of 2010 (KPMG Benchmark Survey) the number of golfers in Japan had declined by one sixth, from 10.2 million to 8.5 million since 1992, the peak year, but rapid golf course development in the 1990s led to oversupply.

When demand exceeded supply in the 1980s, the Japanese golf industry also evolved towards a private club membership system which collected “deposits” from new members, which were refundable at any time without any adjustment for interest. As the Japanese economic malaise continued for a second decade, many members started requesting deposit refunds, forcing many golf clubs into bankruptcy due to the lack of cash to make refunds.

Conclusion


The private golf club industry have been adversely affected in the U.S. and Asia for the same fundamental reason, that such memberships were previously bought as investments with potential for capital appreciation. Now that such memberships have been depreciating in value, with many clubs facing bankruptcy, golfer-investors who purchase private club memberships as investments have left the market, leaving only those who purchase golf club memberships for nonfinancial reasons, such as playing golf. New golf courses were also developed in expectations of continuing growth in membership, while the number of golfers in these aforementioned countries has either remained flat or has declined, thus leading to oversupply of golf courses in general.