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.

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.

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.

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

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

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