In This Issue...

Insurance Appraisal (or Replacement Cost Estimates)

A replacement cost estimate is defined as, "the cost to replace an entire building with one of equal quality and utility”. These estimates are typically required on an annual basis for insurance purposes. One important issue regarding these reports is the level of detail required in the estimating process.

Jonathan Bloomfield addresses this issue in his article entitled "Why Do I Need a Detailed Replacement Cost Estimate? Just A Ball Park Estimate Will Do."

Real Estate Due Diligence – Understanding your Investment Risks

“Look Before you Leap”, “Leave No Stone Unturned”, “An ounce of prevention is worth a pound of cure”. These well known sayings describe the essence of "Due Diligence", which, on a real estate transaction, involves a complete investigation of an income producing property from top to bottom, inside and out. Ignorance may be bliss, but the wrong move could cost you.

David Eger summarizes some of the key Due Diligence issues and provides some useful tips, in his article entitled "Six Points That An Investor Should Consider When Buying Income Producing Properties"

It could be said that asking for a “ballpark” estimate is like asking for an estimate that you know will not be accurate before you receive it.

The Altus Cost Guide is a useful tool for calculating a ballpark estimate however you wouldn’t want to base your building insurance on it. For example, the 2007 guide gives a figure for an office building of 10-20 storeys in Vancouver at $200-280 per square foot of gross leasable area which is interesting as a guideline but not really of any practical use to an owner. At 150,000 square feet, that’s somewhere between $30M and $42M.

The problem, of course, is that there is no such thing as an ‘average office building’. For arguments sake however let’s assume that what many people would picture as an average office building in Vancouver consists of the following:

  •   150,000 square foot gross floor area
  •   15 storeys
  •   concrete frame
  •   glazed curtain wall cladding
  •   rectangular plan building shape
  •   some retail at ground level
  •   11 foot floor to ceiling heights
  •   3 levels of underground parking totalling 30,000 square feet,
  •   4 elevators
  •   full zoned HVAC system, fully sprinklered with fire alarm system
  •   good quality interior finish to common areas

For this hypothetical building a ‘ballpark estimate’ could indeed be produced. A figure of approximately $265 a square foot of GFA (total $39.75M) would be reasonable. This fits into the higher end of the Cost Guide’s range – which itself is based on ‘average buildings’.

The most crucial part of the estimate is to truly understand what is included or excluded in this figure. If the person asking the question is making different assumptions and these are not clarified then there is plenty of scope for a potentially costly misunderstanding.

For example: “Oh I thought that your figure was based on leasable area and that tenant improvements, demolition and landscaping were automatically included” ………..so straight away there’s another say $50 a square foot (or $7.5M) that could have been missed.

The problem with the ‘average model’ is that very few office buildings actually fit into the above noted description of average. Any deviation from the above example could have a profound effect on the cost.

A prime example of this is the effect of differing plan shapes – a building with an irregular plan could have twice as much external skin as a building with the same GFA built to a rectangular plan shape. This is particularly crucial as the external envelope can be one of the most costly elements in the construction.

To add yet another dimension to the discussion, we have only considered office buildings. Offices and warehouses are probably the type of building that least varies from a predictable format but others such as hotels and civic buildings vary enormously.

So what is the solution if you are considering replacement costs for your property? The following advice will hopefully be useful.

1. Do not rely on anything resembling a ballpark estimate. Have a ‘building specific’ estimate performed. If the building is quite ‘standard’ it may be possible to use the Marshall & Swift commercial estimator software. Altus selectively uses this in combination with comparison data from our in-house database of costs. Many clients find that this offers as high a level of detail they require for insurance purposes for an affordable fee.

2. Make sure that the estimate outlines exactly what the estimator has observed during their site inspection and what assumptions were made. This is something that Altus does as a matter of course and avoids any miscommunication. It also demonstrates, without doubt, that the estimator has thoroughly considered the construction of your building. Our ‘checklist of information required’ covers the minimum information needed to obtained for an estimate.

3. Consider how far your building varies from the ‘perceived norm’ for the type of occupancy. Identify the cost driving elements and if you think that you have a building with non-standard attributes, consider an Elemental Estimate, which entails a high level measured take-off which is then priced on an individual elemental basis. This provides a higher level of accuracy although are generally more time consuming.

4. Do not rely on an outdated replacement cost estimate, particularly in the current period of construction cost escalation. A 2 year old estimate may leave you inadequately insured.

5. Do not be complacent about the inherent risks to your building, particularly in a seismically active area such as British Columbia. Remember the reasons why you spend money insuring your building in the first place and then consider the implications of insuring it for too low a value. The money invested in a good replacement cost estimate is a tiny fraction of the cost of the operating and management costs but is an essential part of the annual routine of diligent property management.

Jonathan Bloomfield
Senior Cost Consultant
jonathan.bloomfield@altusgroup.com
Direct Line: 778-329-9262

The commercial real estate due diligence process can be an onerous task, but, an extremely important one. I have summarized below a number of points worth considering during the property acquisition process.

1) Paying too much for a property. In other words, making an offer which is greater than market value.

Prudent purchasers of commercial properties should generally make their offer to purchase subject to an appraisal. An appraisal is a supportable or defensible estimate or opinion of value. It is an impartial, expert and reasoned conclusion, formed by a trained professional based on an analysis of all relevant evidence. It represents the appraiser’s perception of the most likely and most probable dollar value of the appraised interest(s), subject to the qualifying conditions imposed. The opinion is the appraisers opinion based on perceptions of the market as shown by the data in the report. (Note that it is stressed that appraisers estimate value, they do not determine it. Courts determine value in case of a dispute.). A professional real estate appraiser specializes in providing opinions of value of various types of property. They charge a fee based on the type of the property, complexity of the property, and purpose of the appraisal assignment. This fee is not based upon a predetermined value estimate and therefore an appraiser can provide an objective, independent estimate of value. All members of the Appraisal Institute of Canada are required to conform to the Canadian Uniform Standards of Professional Appraisal Practice.

2) Buying a property without obtaining advice from a qualified building inspector and/or an engineer.

Prudent purchasers of commercial properties should generally make their offer to purchase subject to a ‘Physical and Environmental Due Diligence’. It is stressed that an appraisal and a building inspection should not be confused as serving the same function. An appraisal is an opinion of a property's market value. While the physical condition of the property is critical, the appraiser also has to consider subjective issues such as location, design/function, and supply and demand, all of which have a significant influence on marketability and value. A physical and environmental due diligence is a thorough examination of the physical condition of the structure and its components. A building inspector or engineer should at the very least provide an opinion of:

a) The structural soundness of the improvements and the services to the improvements.

b) The condition of the roof and electrical and mechanical facilities, including air quality.

c) The presence of any environmentally hazardous substances (such as asbestos).

d) The presence of any insect and rodent infestation.

e) The presence of any soils contamination (examples of this could include seepage from an adjacent gas station or an old dry cleaning operation).

f) The overall type and condition of the soils, and their overall stability with regard to the existing improvements and any future development.

g) Any potential of flooding.

The report provided should provide realistic costs and time lines for repair, replacement, and remediation of any of the above items.

3) Buying a property without conducting a detailed financial review.

The price paid for most income producing properties is directly related to their current and expected income flow. Verifying the current income flow and estimating the future income flow is a time consuming but important process. Typically, for larger properties, an estimate of cash flow over a 10 year period should be conducted. Some of the important elements of a ‘Financial Due Diligence’ include:

a) A review of all leases to identify not only their financial terms but also any important lease clauses, such as; options to terminate, options to expand or downsize, options to renew the lease at a fixed rent, options to ‘go dark’, future free rent periods, and any outstanding tenant improvement allowances payable by the landlord.

b) An analysis of the tenant profile. Personal tenant interview are a good idea as well as some research into the overall strength of each tenants covenant. The strength of the covenant of a tenant is determined by its financial stability and general reputation in the business world.

c) An analysis of the historical operating statements (which should be audited), the year to date performance, and the current budget. Any budgets provided should be reviewed to determine if they are reasonable as well as to identify any possible mistakes.

d) An analysis of accounts receivable and accountants payable as well as any contractual agreements (such as with cleaning, elevator maintenance, and security companies).

e) An analysis of recovery revenue. The majority of leases which are typically struck for office and industrial buildings are on an a ‘net basis’, whereby the tenant pays basic minimum rent as stipulated in the lease, as well as its proportionate share of operating costs and taxes. The tenant therefore assumes the risk for potential increases in operating expenses and taxes. A gross lease is a lease in which the landlord receives a stipulated rent and the landlord is obligated to pay all or most of the operating expenses and real estate taxes. For most retail properties, some tenants pay less that the ‘full recovery rate’. It is therefore vital that the recovery or ‘additional rent’ section of the lease agreement for each tenant in a property be reviewed and fully understood in order to accurately estimate both the current and future income earning potential of a property.

f) A review of property tax statements in order to determine if there are any arrears in unpaid taxes and utilities.

g) A review of the properties tax assessment. Is it over or under assessed, properly classified, and will the assessment increase upon the purchase/sale of the property?

4) Buying a property without a full understanding of the market in which the property is located.

A typical market analysis will include the following:

a) An Economic Overview. A brief review of the main economic indicators, both historical and projected, is required in order to determine if the future outlook of the local market and surrounding areas is positive or negative.

b) A Competition and Leasing Market Overview. In order to estimate the future earnings potential of a property, an analysis of any competing properties and the rental rates which are being achieved in these properties is required. In addition, a review of new and any proposed developments in the area should be conducted.

c) Investment Market Overview. An analysis of investment demand, investor preferences, and a survey of current valuation parameters will assist in determining not only the price to be paid but will also give an idea of the properties ‘liquidity rating’. In other words, ‘how difficult will it be to re-sell the property in the future if required to do so’.

5) Buying a property without a ‘legal due diligence’.

A typical legal due diligence will include the following

a) A title search and a summary of all charges registered on title.

b) An opinion of any impact on value with respect to the charges which are registered on title.

c) A review of the heritage site registry. A ‘Protected Property’ or a property which is on the heritage list could affect the properties future development potential.

d) A review of the properties specific zoning and official community plan designation, and any other municipal regulations, is required in order to determine if the property conforms to current municipal requirements as well as to assist in identifying the future development potential of the property.

e) A review of the business licenses to determine if the building operations on the property are in good standing.

f) A review of the most recent Fire Marshall and Health Department inspections to determine if there are any outstanding orders.

6) Buying a property without a review of the site survey and building survey.

Are the building areas and site areas stated correctly? The only way to determine this is through either reviewing or obtaining a site survey as well as a copy of the building plans and certified floor plans.

David Eger
Senior Director
david.eger@altusgroup.com
Direct Line: 778-329-9251