Appraising small shopping centers and retail properties can be complicated, although the process is usually pretty straightforward. Appraisers are often called on to work with small shopping centers, since they are popular with high-net-worth investors who are looking for steady income, and because the availability of debt for the sale is often a variable. An accurate appraisal of a small shopping center requires knowledge of the market, and of the retail tenants, as well as the comps.
Most common types of small shopping centers
The three most common types of small shopping centers in the United States are (1) the unanchored strip center of 15,000 to 25,000 square feet, such as are commonly seen along secondary highways; (2) small power centers anchored by a chain such as Office Depot or T.J. Maxx; and (3) the neighborhood center, anchored by a grocery store. All three basic approaches to appraisal—sales comparison, cost, and income—can come into play in valuing these properties.
Lee Holliday, VAS national retail practice leader for CBRE (a New York City–based real estate services firm), explains that the principal difference between appraising a shopping center and apartment building is that in the latter, you’re usually looking at 300 similar leases, and the churn is predictable. A shopping center might contain 10 retail tenants, with no two leases alike. The appraiser must examine those leases and get an idea of how likely the tenant is to renew—not to mention the tenant’s long-term ability to pay.
“Consumers create demand for retail,” he notes, “and different channels of retailing are emerging. The Internet impacts some retailers more than others. Neighborhood centers with grocery store anchors are somewhat affected, but because people like to go food shopping, less so. Smaller, well-located and -leased strip centers with service tenants like nail salons continue to do fine. The big box concept has been affected by the Internet, which is why power centers are being developed less frequently and are getting smaller.”
Shopping center success is consumer-driven, Holliday notes, and in today’s active market, it’s usually easy to find supportable comps for these properties. However, larger power centers offer fewer comps because of fewer transactions. In today’s market for power centers, the credit of the individual tenants is especially important.
“An appraiser needs a good understanding of the tenants’ credit,” he cautions. “Retail has its own metrics, and these need to be understood too, but the process is straightforward.”
Holliday adds that small shopping centers are popular with investors, but product is scarce, with not many new centers being built. Moreover, while an owner might want to sell, the question “If I sell, what will I buy?” can be daunting.
Considering net leases when appraising small shopping centers
Net leases often come into play when appraising retail properties. Jaime Patteson, research analyst for Tulsa, Oklahoma–based Stan Johnson Co., specializes in appraisals of net-leased retail, especially single-tenant properties such as drugstores or banks. She notes that the primary difference between any commercial property and residential property is the income production value of the former versus the traditional real estate value of the latter.
“Residential real estate is typically appraised on actual real property value criteria (land, improvements, etc.),” she says. “Commercial property valuation takes into consideration cash flow analysis, tenant creditworthiness, rate of return, and other criteria that determine the long-term value of the property, in addition to traditional real property value. When comparing retail properties to other commercial property types, tenant quality is key.”
Patteson urges appraisers to examine the tenants’ credit ratings (although some tenants might be local/regional merchants with no credit footprint, but reliable nevertheless), as well as the leases’ length, expense structures, time remaining, and landlord responsibility. The appraiser must also consider the tenants and lease terms of the comps. Rent zones—varying rental rates based on tenant size and placement—also require consideration; so do rent escalations and extended lease options.
“You have to make apples-to-apples comparisons; you need to understand lease structures such as triple-net and absolute net, and how they impact value,” she says. “You need to value the asset based on type of ownership—fee simple versus ground lease or leased fee—and how those variations impact cap rates. Factor in retailer sales and performance within a market and evaluate the strength of the market demographically.
Vacancy and other factors when appraising small shopping centers
David Glauber, president of American Appraisers Corp., Louisville, Kentucky, says shopping centers can be challenging to appraise if they have persistent vacancy—although a little vacancy is normal.
“Do you give the vacant space value or not?” he asks. “You have to look forward. If we’re at the end of a downturn and things are looking up, we might treat a vacancy differently; we might use a different vacancy rate, or we might do a discounted cash flow and determine how much rent you’ll lose over the next few months. Some centers have had significant vacancy ever since they were built, 20 years ago, and in that case, you just don’t give that space value. You appraise the center as though that space were not there. Or does that vacant space add value in some way?”
The property’s age, condition, location, and accessibility are all factors, but the income is a reflector of all of those, Glauber points out, and income is always the motivation for buying a small shopping center.
“When you’re looking at comps, the net income is the only difference you care about,” he says. “You could have a comp that’s two states away, but if you know the markets, it can still be a good comp. The hardest retail properties to appraise are the little neighborhood centers off the beaten path, with persistent vacancy.”
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Article by Joseph Dobrian. Joseph Dobrian has been writing about commercial and residential real estate, and real estate-related finance, for more than 30 years. His by-line has appeared in The Wall Street Journal, The New York Times, The New Yorker, Real Estate Forum, Journal of Property Management, and many other publications. He is also a noted novelist, essayist, and translator. His website is www.josephdobrian.com, and he can be contacted at [email protected].