Many real estate changes are now taking place, simultaneously, that might, singly or together, represent potential, major “game changers” (agents of change) to the future of real estate and thus real estate appraisal. The agents of change include, without being limited to: increasing homelessness, material decline in demand for “brick & mortar retail properties, globalization of real estate ownership, changes in the environment for office space and globalization of real estate ownership, to identify some major items. Despite these observable phenomena there does not seem to have been much major discussion as to how the appraisal profession may need to analyze and address these changes. Suffice it to say that, in over 50 years the study of real estate valuation has focused on improving methodology and professional standards. The integration of computers and innovative, interactive programs have facilitated material forward progress and the development of detailed, mandatory uniform standards have provided greatly enhanced credibility for the work product. However, there has been a complete absence of any new valuation theory discussion. The profession is still working with the three approaches to value (Cost, Comparable Sales and Income) although the methodology has changed significantly and for the better. The changes taking place may or may not suggest that an academic critique of present theory and methodology needs to take place to make sure that, moving into the future, the theories and methods in use are the right ones and provide a measurable level of reliability and relevance
The purpose of this paper is to examine the changes (causes and effects) taking place with the objective of stimulating the kind of thinking and research necessary to develop enhanced appraisal models, methods and theory needed to sustain the future of real estate valuation as a profession. For the active, practicing appraiser this paper probably doesn’t have much in it that they haven’t thought about, but thinking about and raising issues are two different things. As a biproduct an attempt will be made to examine some possible solutions to some problems.
HOMELESSNESS: In the last few years most people have become aware of the growing homeless problem but there is a lack of understanding as to the underlying reasons for the problem. There are multiple related and/or unrelated causes. First, not all homeless people are victims of the same cause.
LACK OF HOUSING ALTERNATIVES: Many counted as homeless are in that state because they can’t find any affordable housing. In many jurisdictions this observed problem seems to be caused by a lack of enough building of new housing supplies. A shortage of supply faced with rising demand leads to increasing rents and housing prices. At some point the potential renter or buyer is priced out of the market and living on the street becomes the housing alternative.
MENTAL HEALTH PROBLEMS: Mentally ill people without support, resources or available treatment alternatives add to the homeless increase because there is no other alternative and they often require specialty housing in facilities that are different from conventional housing.
DRUG ADDICTION: Part of the homeless population are substance abusers who may need specialized intervention and living facilities.
The same causes of being homeless do not apply to all of the homeless population.
CAUSES: The common cause of homelessness is a lack of housing supply. For the renter without enough money to consume a rental unit, a mentally ill person or a substance abuser it is the same cause albeit the mentally ill and substance abusers require different types of housing alternatives.
Inadequate housing supply, in many jurisdictions, is the result of flawed land use and zoning policies. In San Francisco, for example, the City down zoned properties in the late 1970’s resulting in a 50% reduction of previously allowable densities This was at a time when builders were eager to build and the change effectively discouraged development. In addition, the codes became more restrictive with the addition of requirements (like providing a percentage of affordable housing) that were unrelated to health and safety. The net result was a curtailment of potential, new supply. So, in effect, the leaders of the time reacted to citizen anti high-rise pressures instead of understanding the negative result on the future of what they were creating. Then, San Francisco, in 1978 created a strict residential rent control ordinance that effectively created two classes of renter. One class were the renters that were living in what became controlled rental units protecting the current occupant. The other class were renters without protection such as those who occupied units built after the date of the ordinance. Finally, the City instituted a cumbersome, lengthy and very difficult permit process adding significant costs to project development. Despite what turned out to be the misguided belief of the Planners that the developer absorbed these costs the developer merely passed all of these added costs on to the consumer.
SOLUTIONS: The only obvious solution, as things now stand, would seem to be for effected localities to induce, over time, a massive increase in supply. Accomplishing this would necessitate a revision of land use and zoning policies designed to substantially increase height limits (wherever practical) and allowable densities. Modernize all codes to spell out what limits are permitted. At the same time all requirements having nothing to do with health or safety need to be reviewed with a removal of those requirements adding cost to the project but not enhancing the housing experience. Finally, remove all public hearings in the approval process unless a material variance from code is sought. The permit process needs to be expedited and taken out of politics. An example of the housing problem is the fact that many communities have experienced runaway price increases for single family housing. The result is that the price of a home has become so high that potential buyers can’t afford to buy yet the neighborhoods remain zoned for single family use. In terms of the future, the zoning must be changed to allow higher densities. There appears to be only one major City studying that solution at the present time.
These steps might take years to resolve the supply problem but increasing supply is the only obvious solution.
FUTURE: If the housing problem is not addressed aggressively the result may well be an extinction of the cities as we know them. Cities require an available of army of service workers, at every employment level and reasonable commute distances to the workplace. When workers can no longer find housing and commute problems become unacceptable cities will begin to die. Signs of this are beginning to be evident in the hotel and restaurant sector where the availability of lower service level employees is forcing operating cost problems. The solution for hotels might be to devote some of their rooms to workweek housing for those employees. Restaurants don’t have that option readily available and can only compete for employees through wages and the economic impact of that option may negatively impact economic viability.
In order to solve these problems expert study roups should be appointed with the charge of providing detailed analysis of the observed problems along with developing a roadmap for solutions. Solutions will be long term involving a two year or longer development time so the appointed group might also be charged with developing interim solutions, in six months or less, designed to immediately induce major short term additions to the housing supply. Failure to take this step now could inevitably lead to the death of a City as those necessary service workers will no longer be able to live in or near the City and provide all their services. What then? How will future appraisers deal with these problems?
RETAIL: The retail revolution now taking place didn’t just happen. The probable precursor may have been the emergence of “big box” stores consisting of huge, warehouse stores like Costco Walmart and single purpose retailers like Best Buy. These retailers not only changed the way business was done but also adopted the on-line sales strategies to increase their sales. The advent of widespread, on-line shopping has allowed consumers worldwide to shop any brand or product without leaving home. Retailers can quickly expose their products to consumers via well developed websites, print media and television advertising without needing a global network of brick and mortar stores. The game probably began to change with the national and international expansion of retail brands either directly or via franchising. This change caused the diminution of the viability of small, local retailers. Today there are few, small, independent retailers or family owned department stores remaining as most have been absorbed by major chains, gone out of business or bankrupt. The incursion of on-line shopping changed the dynamics of major department stores to the point that some are now struggling financially. Department stores and large “big box” retailers have been exiting business faster than new stores are opening with the most recent being the Sears announcement of store closures and Barneys going out of business. Bankruptcy of a major retailer was a very infrequent occurrence but is now not unusual. This problem is negatively impacting both stores located in Central Business Districts as well as neighborhoods. In many parts of the country retail vacancies are pervasive and present problems for their communities. The bottom line is that demand for retail store space has declined and continues to decline. These factors operate to change the risks of retail property ownership due to increased vacancy risk as well as the impact of this problem on capitalization rates.
CHANGES: Some of the changes have caused the creation of new models. It had been observed that young people like to “hang out” at the Mall and that adults like to “go out”. The result of this is that specialty shopping centers focusing on the entertainment sector (like motion picture theaters) are enjoying success while other types of shopping centers are not. As available as movies are on TV, there is no substitute for the large screen. And there is no question that “eating out” is an increasing phenomenon with both fine dining, fast food and everything in between being popular. Specialty centers with multi-screen motion picture facilities coupled with many restaurants have, so far, been successful in attracting tenants as well as customers.
Not all store types found in shopping centers can benefit from internet sales. Supermarkets, liquor stores, barbers, beauticians including a range of types like nail salons, spas, shoe repair etc. will still need brick and mortar space. In other words, if something is needed in less than 24 hours a store may be the best answer.
In many parts of the Country shopping centers may have been overbuilt with no infill tenants available to occupy vacancies. In shopping centers, the “in-line” stores depend on the “anchor” (most often a department store or big box store) and when the anchor vacates the in-line stores lose their customer draw. Some centers have leases where the in-line shops can opt for early lease termination if the anchor tenant vacates.
On-line shopping giants like Amazon create a new set of problems as their increasing sales lead to traffic and congestion problems resulting from the massive number of package deliveries. Whether this problem can be solved by an increase in drone deliveries (in place of surface street deliveries) or not remains to be seen. However, the increase of on-line shopping may increase the demand for expansion of distribution centers, either new or use for vacancy in-fill tenants, but proximity to transportation hubs may be a criterion.
It has been common for retailers to have clauses in their leases making the contract rent just a minimum to be moved higher by percentage rents if sales exceed the stated minimum level. Given the current retail environment one possible change could be the disappearance of percentage rents across the board. Retailers with internet sales do not need the store to generate more sales.
In the past, shopping centers and other retail in general were ranked based on tenant quality with those having the best balance sheets classified as a “credit tenant”. Years ago, major retail bankruptcy was unusual. However, with the use of financial tools like “leveraged buyouts” and financed internal expansion few, if any, are free from bankruptcy risk. The reduction in credit ratings might be expected to impact capitalization rates.
CAUSES OF RETAIL PROBLEMS: Some Cities, like San Francisco, caused problems by flawed land use or zoning policies. San Francisco adopted measures intended to protect the small retailer such as tightly controlling the issuance of permits for chain stores in neighborhood commercial districts. Retailers with 11 or more stores nationwide were ineligible for permits. While perhaps, arguably rational as a protection for “mom and pop” stores this type of solution eliminated an entire spectrum of demand for brick and mortar retail space. Similarly, when banks, title companies and restaurants were driving space demand, rules were adopted that precluded their expansion. The Planners completely overlooked a study of the viability of “mom and pop” stores. Retail stores depend on supply chains, employees and operating capital as well as business operating acumen most of which the “mom and pop” operators lacked. This was the attraction of owning a franchise where the franchisor provided the operator with a business model that had everything except the operating capital. However, ruling out chain stores eliminated franchise operations from the demand group. A global change in buying habits and patterns away from brick and mortar stores to shopping on the internet may be the greatest cause of problems affecting retail real estate.
DID THE LAND USE AND ZONING RESTRICTIONS SOLVE THE IDENTIFIED CONCERNS? Absolutely not In many communities across the Country retail vacancies are a major problem with no viable solution in sight. San Francisco, for example, is studying the idea of taxing vacancy under the misguided assumption that landlords are greedy and refusing to rent their vacant space unless they get the rent they want. Any experienced retail leasing agent will confirm that the rent a landlord can command is market driven and only mentally deficient landlords hold out for unrealistic numbers after reasonable exposure of the space to the market. Taxing vacancy will not induce a landlord to rent the space if there is no demand. Problematic vacancy is a sign of a shortage of demand.
SOLUTIONS: The obvious solution is to figure out how to increase demand. Developing a comprehensive list of neighborhood serving retail uses that do not need to be in shopping centers as well as those retailers that can compete in the existing competitive retail environment (businesses that are not impacted by on-line sales) might be a worthwhile exercise. One result of this type of study might be a refocusing of options in terms of identifying potential tenants. A solution to that problem may be to revisit the zoning ordinances and land use policies with a goal of eliminating or revising all that impede demand. In other words, stimulate demand through increasing permissible uses. The urgency of this is forcefully demonstrated by a San Francisco case that was publicized as this paper was being completed: Trader Joes, a well-known and respected food market chain applied for a permit to open a store in a neighborhood that was not serviced by any food stores within close proximity. The Board of Supervisors had to override the prohibition of chain (formula) stores to allow the application to move forward. Despite this, the application is expected to consume an inordinate amount of time before final approval. A potential competing market tenant had reportedly abandoned its plans because of the difficulty in obtaining a permit. In a forward-looking planning environment this permit application should have received a rapid approval. Instead, the tenant is penalized by having to spend unnecessary money because of a very flawed zoning rule.
A Planning Department is not equipped to micro-manage uses or to interfere in any way with the law of supply and demand. The market must be the arbiter. The process of granting permits needs to be streamlined and expedited to eliminate the costly delays in permit issuance so that a potential merchant does not need to squander capital pursuing a lengthy permit process. Finally, where neighborhood commercial zoning may not permit upper floor residential uses the zoning should be changed to permit them as a means of expanding the surrounding customer base as well as housing supplies. These problems deserve extensive study with a goal of alleviating the problem long term.
OFFICE BUILDINGS Office properties have enjoyed an unprecedented rising rent trend to the point where only the largest and most secure firms financially can compete for space. Small tenants and startup ups with limited capital are essentially priced out of the market.
The cause of this problem can, in San Francisco, be traced by the adoption of rules limiting the issuance of new permits to 950,000 square feet annually and many barriers to entry into the development market. The permit limitation had what, certainly was an unintended consequence, of providing a windfall in rental profits to existing building owners. It wasn’t always so good. During the “dot-com bust” and 2007-8 real estate recessions there was an office vacancy problem. However today the potential problems facing office building are quite different.
TECHNOLOGY: The rapid rise of technological advances plus housing shortages combine to induce working from a home office instead of a central office. An escalation of this trend must be expected. Also, business firms are recognizing the impact of office space rental on their annual budgets. Some firms are experimenting with the use of shared offices as opposed to assigned private offices. This model was tried many years ago by major accounting firms who found that much of their staff was, daily, working outside of the central office. The technical ability to remotely “tap” into all needed files greatly reduces the need to be present in the central office in order to work and the use of video conferences, via the internet and dial in meetings, substantially reduces the need for face meetings in office conference rooms. This change should be expected to accelerate as many types of office jobs may be adaptable to this model much in the same manner that firms have outsourced office functions to overseas contractors.
ACCESS: The commute distances of today consume valuable travel time and workers who “tele-commute” tend to be more productive. The advantage of working in the central office seems to be more a matter of employee supervision than necessity in many instances. Technology is changing that.
FUTURE PROBLEMS: It is possible that the advances in technology may, in the not too far distant future, reduce the role of office buildings as the workplace in favor of technology dominated models. When that takes place the office building may need to be re-invented.
SOLUTION: Future office building design may need to provide an exit path if office uses are no longer viable. Such would include an original design that anticipates a probable conversion from office use to hotel or multi-family residential uses which, in turn, would necessitate zoning that anticipates that solution.
GLOBALIZATION: The major investments in real estate are now coming from all over the world. The market for “investment grade” real estate is now international (global). Real Estate, for the most part should be divided into two categories (investment grade and locally owned). Smaller properties tend to be owned by local investors and location tends to dominate value. Homes priced for the average market are also locally owned. However, super luxury homes tend to be, often, marketable in the international market. Utilizing locally generated capitalization rates for globally marketable properties tends to be a short sighted exercise. Rather, the search should be more global than local and include investor surveys that are nationally or internationally published.
The search for supporting data may need to be expanded to a national or international scope where that is the market for the property. The definition of a comparable sale may need to change.
CHANGES TO STUDY: Office buildings or shopping centers that are investment grade properties most probably can’t be valued based on the use of a sales comparison approach mainly for the lack of an adequately sized sample of sales of contemporary, comparable properties from which to draw the appropriate capitalization rate. Rather, the capitalization rate needs to reflective of the market in which the property would sell.
Appraisals may have to be much more informative. While market value is a value at a specific moment in time, appraisals in the future may need to provide the client with information that will permit judging whether the concluded value will most probably be durable or subject to downward adjustment in the near future. There is a saying that “perception is 90% of value” and the one perception that may be universal is that most humans, when taking financial risk, hate uncertainty. In the future, developing research that provides insight into “uncertainty” may help in reading markets. Fortunately, the advance of technology has all manner of economic data available and it is now more a matter of selecting the best data than developing that data de novo. This means that appraisers may expect to have the availability of excellent sources of reliable data.
For professionals who regularly utilize DCF (Discount Cash Flow) models a daunting task will probably be deciding how, when and if the observed changes might impact the host of assumptions that go into the DCF study. For example, many practitioners have used the inflation rate as the rate of change in rent. That may be supportable except when there are major changes taking place or projecting lease renewal probability may not find good support when demand is not reasonably predictable. The result of DCF studies may not be reliable when any material assumptions are not realistic or supported. This area most likely needs careful examination and revision of methodology where indicated.
CONCLUSION: All observed problems suggest many things. First, land use policies and zoning must not be etched in stone and will need regular review to make changes that are needed to reflect what the market is telling the observer about the future. A jurist commented (in a case whose name is unimportant) something to the effect that “Planning and zoning are tools for use in planning for the future and should not be used to deny the future.” Planners should recognize that developers are not the enemy and promote “can do” attitudes instead of “can’t do”. Planners need to recognize the economic cost of protracted permitting processes and make sure that the process is defined to be expeditious instead of cumbersome and costly. Planners have to consider that their plans can not control or change the laws of supply and demand as much as that may be desired. If there were a way to limit each family to one child (as China did) they would not need to struggle with the problems of growth. However, that would not be realistic. Lastly, Planners and the political establishment behind them just can’t legislate design. Great design requires great architects and a bureaucratic attempt to control design will fail. Planners must begin with a visit to Cities like Hong Kong, Singapore, Shanghai, Dubai and Abu Dhabi to figure out what is necessary to induce the development of cutting edge and innovative architecture in our markets. Finally, appraisers may wish to be pro-active in planning for perceived changes rather than risking being consumed by them.