Mr. Plotka

Finance & Investment

Appraisal Methods Used For Facade Preservation Easement Valuations: Valuing Facade Preservation Ease

By Robert Plotka, Managing Director, CityScape Capital Group

Based upon generally accepted appraisal practices, real property appraisals should be supported by adequate market data analysis using one or more of the three traditional appraisal approaches: Sales Comparison, Income Capitalization and Cost. The two-step "before and after" approach for valuing a facade preservation easement involves estimating the fair market value of the historic property and then using this historic property valuation as a basis for valuing the facade preservation easement.

Step 1: Property Valuation.

The first step is estimating the fair market value of the historic property at its highest and best use under current conditions. In arriving at an opinion of market value, one or more of the three traditional appraisal approaches are considered.

• The Sales Comparison Approach estimates market value by analyzing sales of similar properties and making logical adjustments for dissimilar characteristics. Comparing factors such as location, time of sale, physical characteristics, conditions of sale and terms of financing, adjustments are made to the sale price of each selected comparable property. Then, these adjusted sale prices, usually converted into price per square foot of building area, are correlated into an opinion of market value for the historic property.
  
  Since the Sales Comparison Approach utilizes the sales of reasonably similar properties as a basis for comparison, it is most effective when relevant and reliable comparable sales market data is available which can then be analyzed on the basis of pertinent appraisal indicators. Also, the Sales Comparison Approach is most applicable in understanding the fee simple interest of owner-occupied properties whereas, for leased buildings, it tends to be considered a secondary, but still useful, methodology for estimating market value.

• The Income Capitalization Approach estimates market value based upon the future cash flows expected to be generated from the historic property. Using property specific information as well as available market data, net operating income is calculated by deducting anticipated expenses from projected gross income. These annual cash flows, plus the reversionary property value, are discounted at an appropriate rate that is commensurate with the investment's expected return and risk level, which is typically an estimate of the yield currently being sought by real estate investors in the market. In this context, the resulting present value of future cash flows is an opinion of market value for the historic property.
  
  Under the Income Capitalization Approach, there are two different techniques for converting net operating income into a value indication: 1) Direct Capitalization which employs an overall capitalization rate on the net operating income from a stabilized 12-month period; and, 2) Yield Capitalization, also known as Discounted Cash Flow, which employs an internal rate of return on a stream of annual cash flows and a residual capitalization rate on the reversionary property value at the end of the projected investor holding period.
  
  For income-producing properties, the Income Capitalization Approach is considered to be the most reliable and relevant appraisal method for estimating market value. In addition, when addressing complex multi-tenant properties with variable lease terms, the Yield Capitalization, rather than Direct Capitalization, is typically utilized for converting net operating income into a value indication.

• The Cost Approach estimates the cost of acquiring a site and constructing a substitute property with the same utility by generating a reproduction cost analysis based upon original building materials and the historic structure's unique characteristics. Under this approach, an estimate is made of the current cost of reproducing the historic structure on the site, deducting for any lost value through diminished utility or depreciation. The underlying land value, derived from recent sales comparisons, is then added to the depreciated value of reproducing the historic structure in order to produce an opinion of market value for the historic property.

Since preservation easement donors must reduce their building basis in the property in proportion to the reduction caused by the preservation easement, the Cost Approach is helpful because it separates the land and building components. However, in the context of a historic structure, an opinion of market value using the Cost Approach is sometimes difficult to determine because of the inherent ambiguity associated with reproducing a substitute property of a historic structure that somehow offers the same utility coupled with the high subjectivity associated with estimating the accrued depreciation from a variety of sources. As a result, some real estate appraisers may choose to omit the Cost Approach from the property valuation process.

Step 2: Easement Valuation

The second step, which is significantly more challenging, is to derive a value associated with the loss in property rights resulting from the facade preservation easement donation. To arrive at an "after" easement valuation, any appraisal approach used in the "before" easement valuation should also be used in the "after" easement valuation; however, due to the lack of relevant market data and the subjective nature of the adjustments, the opinions of "after" easement value tend to be somewhat tenuous.

Because of these inherent shortfalls and difficulties associated with estimating the "after" easement value, in the past, some appraisals tended to rely heavily on the concept of a 10% to 15% safe harbor for facade preservation easement valuations which originated from a series of court cases dating back to the 1980's. In fact, for many years, the Internal Revenue Service seemed to endorse this notion of a safe harbor for facade preservation easement valuations, by stating on the IRS Connection website that "Internal Revenue Service Engineers have concluded that the proper valuation of a facade easement should range from approximately 10% to 15% of the value of the property." However, in 2003, the Internal Revenue Service dropped the safe harbor concept while continuing to require meaningful market analysis to support the opinion of the "after" easement value.

Rules of thumb and one-size-fits-all approaches are simply inadequate methodologies for estimating the market value of a facade preservation easement. This highly complex appraisal problem requires the services of impartial appraisers, with professional accreditations, such as the MAI and SRA designations, and experience in facade preservation easement valuations.

Stemming from the dramatic growth in the number of facade preservation easements over the last few years and marked by recent media reports of abuses involving the federal preservation easement program, the Oversight Subcommittee of the Committee on Ways and Means held a hearing on June 23, 2005 to review the tax deduction for the donation of facade preservation easements, including the valuation process for facade preservation easements. Hopefully, as an off-shoot to these Congressional hearings, specific facade preservation easement appraisal standards will be established requiring qualified real estate appraisers to meet specialized professional educational guidelines that have been specifically developed for facade preservation easement valuations.

As a qualified 501(c)(3) nonprofit charitable organization, Preservation Easement Trust, Inc. is dedicated to preserving our nation's historic buildings and sites through the acceptance and responsible management of historic preservation easements. Preservation Easement Trust works closely with property owners to ensure that the preservation easement restrictions meet their goals and are appropriate to the unique characteristics of their historic properties.

Robert Plotka, CFA is a Managing Director and Co-Founder of CityScape Capital Group, LLC based in Princeton, NJ. Mr. Plotka holds a bachelors degree in economics from the University of Pennsylvania and a masters degree in finance and marketing from the Marshall Graduate School of Business at the University of Southern California, where he graduated with high honors and received the Albert T. Quon University and Community Service Award. In addition, Mr. Plotka is a Chartered Financial Analyst. Mr. Plotka can be contacted at 609-951-2200 or robert@cityscapecapital.com Extended Bio...

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