The purpose of this article is to analyze valuation methodology for several atypical types of apartments. Various circumstances and situations can cause an apartment complex to have above-or below-market rental rates, occupancy rates and operating expenses. This analysis examines the following two situations:
- low-income subsidized apartments, which receive above-market rental rates from HUD or another government agency, and
- projects that are part of the Low Income Housing Tax Credit (LIHTC) program.
The LIHTC program was established by the U.S. Congress to encourage development of affordable housing in economically disadvantaged areas. Project developers receive a tax credit for following the guidelines established by the program. They typically sell these credits to Fortune 500 corporations for 45 percent to 60 percent of the total project cost, excluding land.
The first step in the valuation process is analyzing market value definitions. The following is the definition from the Texas Property Tax Code, Section 1.04 (7): market value means the price at which a property would transfer for cash or its equivalent under prevailing market conditions if:
- exposed for sale in the open market with a reasonable time for the seller to find a purchaser,
- both the seller and the purchaser know of all the uses and purposes to which the property is adapted and for which it is capable of being used and of the enforceable restrictions to its use, and
- both the seller and the purchaser seek to maximize their gains and neither is in a position to take advantage of the exigencies of the other.
Section (b) of the Texas Property Tax Code further requires: the market value of property shall be determined by the application of generally accepted appraisal techniques, and the same or similar appraisal techniques shall be used in appraising the same or similar kinds of property. However, each property shall be appraised based upon the individual characteristics that affect the property’s market value.
The definition of market value, according to the 10th edition of The Appraisal of Real Estate published in 1992 by the Appraisal Institute, is: market value is the most probable price, as of a specified date, in cash, or in terms equivalent to cash, or in other precisely revealed terms for which the specified property rights should sell after reasonable exposure in a competitive market under all conditions requisite to a fair sale, with the buyer and seller each acting prudently, knowledgeably, and for self-interest, and assuming that neither is under undue duress.
The term which requires further review in the above definition is “knowledgeably.” Is the purchaser knowledgeable regarding the effort required to comply with subsidized housing program requirements and tenants? Does he consider the effort to be rent for real estate or compensation for services? Does the purchaser of an LIHTC project understand that maximum rents are now established for at least 15 years based on deed restrictions? (LIHTC deed restrictions are now required for 30 years in Texas and most other states.)
Fee simple estate is defined in the third edition of the Dictionary of Real Estate Appraisal published by the Appraisal Institute as: absolute ownership unencumbered by any other interest or estate, subject only to the limitations imposed by the governmental powers of taxation, eminent domain, police power and escheat.
The practice in Texas is to base the assessed value on the value of the fee simple estate as opposed to the leased fee estate. This analysis is based on valuation of the fee simple estate instead of the leased fee estate.
The definition of leased fee estate in the third edition of the Dictionary of Real Estate Appraisal is: an ownership interest held by a landlord with the rights of use and occupancy conveyed by lease to others. The rights of the lessor (the leased fee owner) and the lessee are specified by contract terms contained within the lease.
The primary difference between the fee simple estate and the leased fee estate is that the tenant and landlord are each bound by commitments to pay rent and allow use of the property for a term. The contract rent agreed to between landlord and tenant may or may not be equal to market rent. For example, if a landlord entered into a 30-year lease for rent of $5 per square foot 15 years ago (when market rent was $5 per square foot) and the current market rent is $10 per square foot, the tenant has a substantial advantage. The tenant has a leasehold estate which may or may not have value depending on the term of the lease, the contract rent and market rent.
The Dictionary of Real Estate Appraisal defines leasehold estate as the interest held by the lessee (the tenant or renter) through a lease conveying the rights of use and occupancy for a stated term under certain conditions.
Conversely, if the tenant agreed to a rental rate of $15 per square foot in a strong market 10 years ago, and is committed to pay that rent for another 10 years, there is a substantial advantage to the landlord, and the tenant has a leasehold estate with a negative value. Practice in Texas is to establish the assessed value based on the fee simple estate instead of the leased fee estate. Therefore, the relevant criteria for determining market value includes market rent, market expenses, market occupancy and market derived capitalization rates. If a taxpayer made a poor business decision 10 years ago and has substantially below-market rent, it is inequitable for the taxing entities to reduce their ad valorem tax due to the bad business decision of the property owner. Conversely, if a property owner made a fortuitous or wise business decision and entered into an above-market lease, it is not appropriate to collect an above-average level of ad valorem tax from him because of his luck or prudence.
Market rent is defined by the third edition of the Dictionary of Real Estate Appraisal as: the rental income that a property would most probably command in the open market; indicated by current rents paid and asked for comparable space as of the date of appraisal.
Market rent is the compensation paid for the use of the real estate. It should not include compensation paid for factors other than the use of the real estate such as additional services which are not typically provided.
The next step in this process is to analyze valuation of properties which participate in subsidized programs which receive above-market rental rates. The final section will address valuation of projects in the LIHTC program.
Valuation of Subsidized Housing
This analysis will consider both the income and the sales comparison approaches to value. The cost approach is not utilized since it would provide similar results after calculating external obsolescence due to differences in rental rates.
Apartment owners who participate in subsidized housing programs may or may not receive above-market rental rates. For many years, HUD offered above-market rental rates as an inducement to property owners to participate in the program. There are two reasons for HUD paying an above-market rental rate:
- to compensate for the inconvenience of dealing with a bureaucratic government program which mandates detailed inspections not typically required in the private market; and
- to compensate for working with residents who tend to be at the lowest socioeconomic level in our society.
It has not been unusual for HUD to pay contract rent of $0.70 to $0.80 per square foot per month for subsidized housing projects, even though the market rent for competing projects might only be $0.45 to $ 0.50 per square foot per month. The rent and sales comparables used in this analysis are located in a neighborhood characterized by income levels in the bottom quartile of the Houston area, minimal new construction of residential or commercial buildings for 25 years and heterogeneous levels of quality and appeal. Some sections, such as Riverside, have experienced gentrification, but other areas are marked by poorly maintained properties. Both the market rent projects and the subsidized rent projects are located in the area south of downtown Houston, bound by 288 to the west, Interstate-45 to the east, and Almeda-Genoa to the south. Consider the following tables which list rental rates for projects which do not participate in a subsidy program (market rent projects) and projects which do participate in a subsidized rent program:
|Property||1 Bedroom/ 1 Bath||2 Bedroom/ 1 Bath|
|St. John Apartments||$355||$0.43||$455||$0.43|
|Property||1 Bedroom/ 1 Bath||2 Bedroom/ 1 Bath|
|Royal Palms East||$443||$0.70||$537||$0.64|
The average rental rate for the market rent complexes is $0.45 to $0.50 per square foot per month and $311 to $391 per unit per month versus $0.70 to $0.87 per square foot per month and $458 to $538 unit per month for the subsidized rent projects.
Sources at the Houston HUD office indicate that expiring contracts for subsidized properties are being reviewed – if the owner so desires – for only one year. After that term, it is uncertain which course the plan will take. Indications that are subsidized programs are changing from the current contract rent method to a resident voucher program. The voucher method would involve issuing certificates to individuals who may then use the voucher at any participating property. The voucher amount would be based on individual’s income. In addition to the plan to phase out above-market subsidized rents, another reason not to use contract rent when valuing subsidized housing is it is inconsistent with national public policy to penalize apartment operators participating in this program since the difference between market rent and contract rent is compensation for participating in the program and working with the low-income residents. It would also be inconsistent with practice in Texas to use contract rent instead of market rent when performing the income approach to value. The three reasons contract rent should not be used in valuation are:
- it may include compensation for participation in the program and may not be equal to market rent,
- current plans are to eliminate the program and,
- it is inconsistent with national public policy
Another factor to consider when performing the income approach is the market occupancy. Since tenants at the subsidized housing projects do not pay their rent or pay very minimal rent, the occupancy tends to be at above-market level. Consider the following tables which list the occupancy rates for both market rent projects and subsidized rent projects:
|St. John Apartments||80%|
|Anna Dupree Terrace||100%|
|Royal Palms East||98%|
Note that the average occupancy rate for market rent projects in only 73 percent compared to 97 percent for subsidized rent projects.
Sample income approaches to value for a market rent project and a subsidized rent project are shown below. Both approaches assume a 200-unit apartment complex with 160,000 net rentable square feet.
|Gross potential income @ $0.50/SF||$960,000|
|Less vacancy @ 10%||$96,000|
|Effective gross income||$864,000|
|Opr. Exp @ $3.50/SF||$560,000|
|Cap Rate @ 15%|
|Indicated value by income approach||$2,026,667|
|Value per unit||$10,133|
|Gross potential income @ $0.70/SF||$1,344,000|
|Less vacancy @ 5%||$67,200|
|Effective gross income||$1,276,800|
|Opr. Exp @ $3.75/SF||$600,000|
|Cap Rate @ 15%|
|Indicated value by income approach||$4,512,667|
|Value per unit||$22,563|
The example above uses rent of $0.50 per square foot per month for the market rent project and $0.70 per square foot per month for the subsidized rent project. The vacancy rate is 10% for the market rent project versus only 5% for the subsidized rent project. The operating expenses are estimated to be $3.50 per square foot for the market rent project – which is within the range typically used for low-income multifamily housing in the Houston area. The level has been increased slightly for the subsidized rent project to account for the cost of communications with the government and compliance with their special requests. The capitalization rates for both these cases has been estimated to be 15%, which is low as will be demonstrated by the sales price per unit in the sales comparison approach. Note that the value indicated using market rent is $2,026,667 versus $4,512,000 based on using the subsidized rent. The higher contract rent and lower vacancy for the subsidized rent project results in a value via the income approach that is 23% higher than the value indicated by the market rent project.
Sales Comparison Approach:
The sales comparison approach analysis further demonstrates the typical market values in this submarket. We have utilized information on comparable sales both from our internal database and from the Harris County Appraisal District database. Most sales within the submarket are listed:
|KMC||Sale Date||Address||Sales Price||# Units||Price/United|
|534K||01/03/95||5610 Royal Palms||$450,000||88||$5,114|
|574J||11/14/90||12100 Martin Luther King||$300,000||545||$550|
|574J||12/03/92||5203 Park Village||$200,000||203||$985|
|574J||05/08/90||11911 Martin Luther King||$1,990,000||611||$3,257|
|533G||11/02/95||5800 Bayou Bend Court||$810,000||108||$7,500|
The comparable sales within the subject submarket ranged in value from $550 per unit to $7,995 per unit, with an average of $4,119 per unit. The median sales price was $5,018 per unit, and the midpoint was $4,252 per unit. Note that most of the sales are in the range of $5,000 to $8,000 per unit. Investors apparently believe a cap rate higher than 15 percent is appropriate since most of the sales are below the level indicated by using market occupancy and market rent.
The income approach to value indicates a value of $5,000 to $8,000 per unit for the subject properties using market rents and market occupancy. The sales data indicates a value less than the value indicated by the income approach. This indicates that the market value of these properties is based on their market rent and not on the contract rent at projects which have above-market rental rates. Otherwise, investors would purchase these projects for slightly less than the value indicated using subsidized rent and limit residents to subsidized rent program participants. It also demonstrates that investors require a capitalization rate of above 15 percent in this area.
Valuation of LIHTC Projects
The key difference between Low Income Housing Tax Credit project (LIHTC) and a market rent project is that the LIHTC project has deed restrictions which limit the maximum rent that can be charged. The restrictions also limit the maximum income of the residents. The Oregon Supreme Court ruled that the assessed value for LIHTC projects should be less than the assessed value for market rent projects since the rent at LIHTC projects is less than market rent, and the rents restrict the market. In Texas and most other states, the LIHTC project is limited by a 30-year deed restriction which runs with the land. In other words, it may not be revoked unilaterally by the property owner even if the property is sold or foreclosed. In exchange for these onerous restrictions, the LIHTC property owner receives a generous tax credit allowance from the U.S. government. Developers typically sell the tax credits for approximately 45 percent to 60 percent of the project development cost.
The primary difference between LIHTC projects and market rent projects is the rental rate. Operating expenses will be similar in either case, but the LIHTC project will likely have higher occupancy due to its below-market rents. Section (b) of the definition of market rent in the Texas Property Tax Code is as follows: both the seller and the purchaser know of all the uses and purposes to which the property is adapted and for which it is capable of being used and of the enforceable restrictions on its use.
The LIHTC projects are located in targeted areas established by the federal government which have below-average income levels.
The following are three income analyses of hypothetical 200-unit apartment complexes which each has 160,000 net rentable square feet. Contract rent is estimated to be $0.62 per square foot at the LIHTC project based on what is typical in the Houston area. (Our firm prepares approximately 20 market studies for LIHTC projects each year.) Market rent at new complexes in the Houston area is typically $0.80 to $1.10 per square foot per month. For the purposes of this analysis, market rent for new complexes is estimated to be $0.85 per square foot. Market occupancy is estimated to be 96 percent for the LIHTC project due to the below-market rents and 92 percent for the market project. Operating expenses may be slightly higher at the LIHTC project to account for accounting and communication with government agencies because of the LIHTC requirements, but this amount is expected to be offset by the lower ad valorem taxes. The analysis shows three income approaches. In addition to the LIHTC and upscale market rent projects, a mid-range project with rental rates roughly between the others is included for comparison purposes. A 10 percent capitalization rate for the LIHTC project has been included based on its below-market rents, which appear to make the income stream more stable. An 11 percent capitalization rate is used for the mid-range project since its rental rates would be far above market for the area. The capitalization rate for the upscale market rent project is 9.5 percent based on data in our files.
|Gross potential income @ $0.62/SF||$1,190,000|
|Less vacancy @ 54%||$47,616|
|Effective gross income||$1,142,784|
|Opr. Exp @ $4.00/SF||$640,000|
|Cap Rate @ 10%|
|Indicated value by income approach||$5,027,840|
|Gross potential income @ $0.75/SF||$1,140,000|
|Less vacancy @ 8%||$115,200|
|Effective gross income||$1,324,800|
|Opr. Exp @ $4.00/SF||$640,000|
|Cap Rate @ 11%|
|Indicated value by income approach||$6,225,455|
|Gross potential income @ $0.85/SF||$1,632,000|
|Less vacancy @ 8%||$130,560|
|Effective gross income||$1,501,440|
|Opr. Exp @ $4.00/SF||$640,000|
|Cap Rate @ 9.5%|
|Indicated value by income approach||$9,067,789|
The income approach indicates $5,030,000 for the LIHTC project based on maximum rents versus $9,070,000 for the new project using market rents. The value for the mid-range project is $6,230,000. The 80 percent range between the LIHTC and new, market rent cases illustrates the magnitude of the difference. A discussion of the value indications provided by the income and sales comparison approach follows the comparable sales.
|KMC||Sale Date||Address||Sales Price||Year Built||# Units||Price/Unit|
|370F||12/15/94||13222 Champions Court||$9,984,000||1994||192||$52,000|
|409B||02/28/94||11220 West Road||$12,000,000||1992||260||$46,154|
|488M||09/27/94||1200 Dairy Ashford||$12,450,000||1993||183||$68,033|
|488R||09/20/95||1275 Briar Forest||$9,500,000||1994||224||$38,934|
|KMC||Sale Date||Address||Sales Price||Year Built||# Units||Price/Unit|
|373N||11/01/94||17030 Imperial Valley||$3,100,000||1977||244||$7,582|
|374Z||10/11/94||14400 Eastex Frwy||$1,050,000||1970||110||$9,545|
The average sales price for recently built apartment complexes in upscale areas of the city is $57,414 per unit versus an average sales price unit of $9,830 per unit in the Greenspoint/Northbelt area. To the knowledge of the author, there are no sales in the Greenspoint/Northbelt area with sales prices of $20,000 to $25,000 per unit and higher. Sales in the $10,000 to $15,000 per unit range tend to indicate the upper range of values for well-maintained projects in this area. The quandary for valuation of the LIHTC properties in this low-income area is compounded by the relatively low per-unit sales prices of existing projects in the area. It is noteworthy that the existing projects are older (built between 1970 to 1982) than the new apartment complexes in upscale areas (built between 1992 to 1994). Further, it is not clear that the newer projects within the Greenspoint/Northbelt area sell for appreciably more than the existing properties based on the data. Several projects which demonstrate this are 13030 Northborough and 16700 Northchase. The first project sold for $8,317 per unit and was built in 1982, while the second project sold for $11,979 per unit and was built in 1979. To date there have been few, if any, sales of LIHTC apartment complexes in the Houston area. However, it is not clear if a LIHTC project in the Greenspoint/Northbelt area would sell for $25,150 per unit (the value indicated by the income approach) while most of the complexes in the area are selling for $5,000 to $15,000 per unit. However, it does appear clear that the LIHTC project in the Greenspoint/Northbelt area would clearly not sell for $45,350 per unit (the value indicated for the upscale market rent project).
It appears clear that using market rent in the valuation of an LIHTC project would produce an appropriate result. Further, it appears the capitalization rate used in valuation of the LIHTC project using contract rents would overstate the values based on comparable sales. While investors would appreciate the stable income stream due to the below-market rents, few investors would want to pay $25,000 per unit for an apartment complex in an area where most complexes sell for $5,000 to $15,000 per unit.
Valuations of real property with above- and below-market rental rates offer challenges to property owners and assessment officers. There will likely be legitimate differences of opinion for the foreseeable future. Using the sales comparison and income approaches to value indicates a wide range of value. Thoughtful consideration and negotiation will be required to form a consensus on these issues.