FIN 350 – Real Estate Principles

Real Estate Analysis Project

Kyle Barrett

This project will evaluate a piece of real estate to determine whether or not it would be a

worthwhile investment. The property that I have chosen for this research is a two-story

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professional office building located at 2301 East Paris Avenue SE, Grand Rapids, MI 49546 on

1.46 acres of property. This building formerly housed the offices of the real estate company

RE/MAX and was built in 1996. The dimensions of the office are 13,125 square feet and it

includes three kitchens, five bathrooms, an elevator, and security and sprinkler systems. The

building is of a steel construction type with a brick stone exterior. Utilities include central air-

conditioning, a forced-air natural gas furnace, electric, telephone, broadband cable, and public

sewer access. The list price of this office building is $1,100,000, which was decreased from

$1,150,000 on June 27, 2014, and it has an assessed value of $529,900, assessed in 2014. When

this property was initially listed in October 2013 the price was set at $1,379,500. Annual

property taxes for Winter 2013 and Summer 2014 combined were $24,804.14. This property has

three of the four suites available for lease. The sizes of the suites are 6,676 square feet, 2,482

square feet, 1,119 square feet, and 2,848 square feet.

The target customer demographic for office buildings of this type includes a variety of

professional small businesses such as CPA firms, medical offices, insurance agencies, real estate

agencies, and law firms. With four separate suites, this property could house up to four

businesses. The vast majority of employees these organizations will hire will need to be college-

educated, so I decided to research the typical education level of this location. An ideal resource

that I found for this type of research is city-data.com. The population located in the 49546 zip

code is more educated than the state average, with 51.8% of the population 25 and over holding

at least a Bachelors degree. The bordering zip codes of 49506 and 49301 have an even higher

education level, at 55.1% and 58.2% respectively. This supply of educated employees is a sign

that there is at least a reasonable level of demand from employers for office buildings in this

area. The average adjusted gross incomes for 49546, 49301, and 49506 were estimated in 2011

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to be $63,560, $109,413, and $62,023 respectively. These numbers are significantly higher than

the state average incomes which implies a high concentration of professional employees.

However, there is noticeable deflation in these numbers when compared with 2004 income

levels, implying an influx of lower-skill workers and/or a migration of high-skill workers from

the area over the last several years. This raw population data implies that, geographically, this

professional office building is located in a good strategic area. Although transportation options

for commuting are fairly limited, this holds true for the rest of the West Michigan area as well.

What sets the East Paris corridor this property is located on apart from some other areas is that

the Rapid bus route 24 travels past this location at 30-minute intervals during weekdays; this

route runs all the way from Grandville down Burton Street to East Paris. This creates an

alternative transportation option for commuters living in the East Grand Rapids area. Another

transportation feature of this location that may be a potential draw for some businesses is its

close proximity to the Gerald R. Ford International airport, located 4.8 miles or a 10-minute

drive away. For employees with families, all of the schools in East Grand Rapids and some

Forest Hills district schools are also located within a 10 minute drive. Additional draws that

would serve to attract an employer to the area are the many nearby restaurants as well as the

MVP Sportsplex and East Hills Athletic Club fitness centers. Employers that offer professional

services try to locate in areas that provide convenience for their employees in order to minimize

the amount of interruptions during the workday and maximize efficiency, and this location is

ideal in that regard.

There are multiple properties in this area that are fairly similar to the office building at

2301 East Paris; examples include the consulting firm Rehmann, AAA insurance group,

Associated Family Dentists, and OMM Engineering. While this is a sign that the location is

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right, it also means that there will be multiple office spaces competing for tenants. Sure enough,

research into competition for leasing office spaces in the 49546 zip code confirms a market with

many options available; a quick web search led to the discovery of 61 properties, many with

multiple office spaces, available for lease in the immediate geographic area. Rental rates for the

building at 2301 East Paris are listed at $14.50-$16.00 per square foot per year, which places it

roughly in the middle when compared to the other 61 properties. This is a negative sign for

potential sellers of professional office buildings in the current market conditions; a wide and

diverse pool of competing spaces means that potential buyers and leasers will hold the power

when choosing locations and negotiating lease contracts. This also explains why there are three

vacant office suites at this location that have not been filled within the past year that this property

has been on the market. There are simply newer, better buildings out there that lease at

comparable rates to this eighteen-year-old building. Another potential risk in the current market

include economic volatility in the past ten years. While this does have a strong effect on

residential markets, the impact of economic conditions is magnified when considering small

businesses. Small businesses are the main target demographic for this building, and they are

vulnerable to failure even in the best of economic times. The three following valuation methods

will serve to evaluate whether the asking price for this office building is reasonable in the current

market.

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Sales Comparison Analysis

Elements of Comparison Subject Comparison 1 Comparison 2 Comparison 3Sale Price $1,100,000 $1,500,000 $1,250,000 $1,175,000

Assessed Value $529,900 $584,400 $459,600 $566,404 Transaction Characteristics Property Rights Conveyed Fee Simple Same Same Same

Financing terms Cash to Seller Same Same SameConditions of sale Arm's Length Same Same SameMarket Conditions Current Same Same Same

Property Characteristics Location 2301 E Paris Ave,

Grand Rapids, MI3020 Charlevoix Dr

SE, Grand Rapids, MI5360 Cascade Rd SE,

Grand Rapids, MI2855 Michigan St NE,

Grand Rapids, MI Proximity to Airport 4.8 Miles 4 Miles 5.4 Miles 8.8 Miles

Bus Stop Yes No No No

Construction qualityClass A Office

Building Class B Office Building Class A Office BuildingClass C Office

Building

Construction materialSteel frame with

brick Steel frame with brick Wood frameWood frame with

brickYear built 1996 1990 2001 1981

Square Footage13,125 Square

Feet 13,060 Square Feet 10,000 Square Feet 11,153 Square FeetElevator Yes Yes Yes No

Annual Property Taxes $24,804 $28,665 $18,457 $27,334 Lot Size 1.46 Acres 1.37 Acres 2.22 Acres 1.15 AcresParking 40 Surface Spaces 59 Surface Spaces 41 Surface Spaces 60 Surface Spaces

Elements of Comparison Subject Comparison 1 Comparison 2 Comparison 3

Sale Price $1,100,000.00 $1,500,000.00 $1,250,000.00 $1,175,000 Proximity to Airport -$4,000.00 $3,000.00 $2,000.00

Bus Stop $5,000.00 $5,000.00 $5,000.00Construction quality $20,000.00 $0.00 $40,000.00

Construction material $0.00 $15,000.00 $7,500.00Year built $15,000.00 -$12,500.00 $37,500.00

Square Footage $975.00 $46,875.00 $29,580.00Elevator $0.00 $0.00 $10,000.00

Annual Property Taxes $3,861.00 -$6,347.00 $2,530.00Lot Size $2,250.00 -$19,000.00 $7,750.00Parking -$950.00 -$50.00 -$1,000.00

Indication of Subject Value $1,542,136.00 $1,281,978.00 $1,315,860.00

Source Final Weight (%) Weighted Price

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Adjusted Sale Price

Comparable Property 1$1,542,136.0

0 30% $462,640.80

Comparable Property 2$1,281,978.0

0 65% $833,285.70

Comparable Property 3$1,315,860.0

0 5% $65,793.00Indicated Value (using the

Sales Comparison Approach) $1,361,719.50

The Sales Comparison approach resulted in the indication that the subject property is

valued at $1,361,719.50. This means that given the current listing price of the property, it is

undervalued by $261,719.50. This number is interesting because it is actually very close to the

initial price that was set for the property in October 2013, when it was listed at $1,379,500. The

adjustments for the Sales Comparison approach were calculated as follows.

The square footage adjustment was calculated using the typical square foot leasing rate

(per year) that I observed while searching for office properties in the Grand Rapids area, which

was about $15 per square foot. To calculate the value adjustment for the age of the building, I

made an adjustment of $2,500 per year for each year older or newer the comparison properties

were. For the proximity to the airport I decided it to add or subtract $500 for every tenth of a

mile variance from the subject property; this adjustment was minor but I still included it because

the airport location holds relevance where businesses are concerned. Since the comparison

properties were not near any bus stops like the subject property, I added $5,000 to their values;

alternative transportation options may not be the first consideration for a buyer, but the presence

of the bus stop adds value nonetheless. Because comparison property 1 is a Class B office space,

I added $20,000 to its value to level with the subject property’s Class A space. And because

comparison property 3 is a Class C office space, I added $40,000 to its value. The class rating

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system for buildings is a valuable indicator of the market the property competes in, requiring a

more significant adjustment in this case. Comparison property 2 is built with wooden

construction, rather than the subject’s steel frame structure with brick, so $15,000 is added to that

property due to its inferior materials. $7,500 was added for comparison property 3’s materials

because it has brick construction with a wood frame. The difference in property tax amounts

was taken as a dollar-for-dollar adjustment. For lot size adjustments, I used $25,000 per acre,

and for parking I adjusted $50 per parking space as well. Because comparison property 3 does

not have an elevator like the other properties, I added $10,000 to its value. To apply the weight

and determine an indication of value for the subject property, I put a significantly heavier weight

on comparison property 2 because I believe that this property is much more similar to the subject

property given its younger age and same building class. I also applied more weight to this

property because I wanted to be more conservative with my estimate for the subject value of the

property. I used 30% weight for comparison property 1 and 5% for comparison property 3

because it is the least like the subject property because of its location and construction class.

Cost Approach

Replacement cost of improvement

Office Building $2,100,00

0Less: Depreciation of improvement Physical deterioration $756,000 Functional Obsolescence $0 External Obsolescence $0 -$756,000

Depreciated value of improvements $1,344,00

0Plus: Value of the site $36,500Plus: Depreciated Value of site improvement $27,400Indicated value by cost approach $1,407,90

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0

Since the subject property is eighteen years old, I can only assume that using the

reproduction cost for the cost approach would be too difficult to estimate since there is no doubt

that construction techniques, materials, floor plan, and design elements would be quite different

today. Because of this, I decided to use the estimated replacement cost for the building instead.

According to charts from evstudio.com, the cost per square foot of building a two-to-four story

office building last year falls within a range of $140 to $240 for twenty-five major U.S. cities.

Since Grand Rapids is smaller than most major U.S. cities and larger cities have higher real

estate construction costs, I decided to stick with the lower end of this range and add $5 per

square foot for increased costs since the data is from last year. This gives a cost of $160 per

square foot, for a total building replacement cost of $2,100,000. For depreciation of the subject

property, I decided to use the age-life method of depreciation which calculates a depreciation

percentage based on the effective age of the property divided by the economic life of the

property. The property’s effective age seems to be fairly close to its actual age by all

appearances, so I used eighteen years. For the economic life of the office building I decided on

fifty years. This gives a depreciation percentage of 36%. I did not calculate functional

obsolescence because I chose to use replacement cost instead of reproduction cost, and I found

no evidence of external obsolescence as the area where the property is located is economically

healthy. A major improvement to the property is the 40-space parking lot, and according to 2012

data from the Traffic Engineering and Highway Safety bulletin, the rule of thumb is a range of

$1,500 to $3,500 per parking space. Since this is from two years ago and Grand Rapids is a

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smaller city, I decided to go with a cost of $2,000 per construction space, bringing parking lot

replacement costs to $80,000. Using a total life of 25 years for the parking lot, it has an

estimated remaining life of 7 years, and is therefore 72% depreciated. I estimated the current

value of landscaping and other site improvements to be $5,000. Value of the land was again

based on $25,000 per acre. This results in an indicated value of $1,407,900 using the cost

approach.

Income Approach

2301 East Paris Ave SE Office Building: Reconstructed Operating StatementPotential gross income $276,786Less: Vacancy and collection loss -$77,078Effective gross income $199,708Less: Operating expenses Fixed Expenses Real estate taxes $24,804 Insurance $13,913 $38,717 Variable Expenses Utilities $25,594 Garbage collection $1,200 Administration $14,569 Maintenance $27,300 $68,663 Total operating expenses $107,380

Less: Reserves for leasing and capital expenditures

Parking lot repair $1,094 Roof replacement $274 HVAC replacement $274 Leasing Commissions $5,991 $7,633 Total reserves for capital expenditures $7,633Net operating income (NOI) $84,695Value using income approach (NOI / 10% ) $846,950

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I calculated potential gross income using quoted monthly lease rates for the three

available suites and applying the same rate for the occupied suite:

((11,961.16+4136.66+1865.01+5102.66)*12 = ). Since three suites are currently vacant, I

decided that realistically they could be filled by charging $12.50 per square foot per year (CAM

fees included) instead of their quoted rates of $20.00 per square feet per year, so the amount

above that was included as vacancy and collection loss. Subtraction of the vacancy and

collection loss results in $199,708 of effective gross income. Fixed operating expenses include

real estate taxes of $24,804 and estimated insurance expenses of $13,913, calculated using the

square foot rate of $1.06 from IREM’s 2012 office building expense template. I calculated

utilities expenses combining electricity and natural gas costs, multiplying a square footage rate of

$1.95 (also from IREM) by office space of 13,125 square feet. Garbage collection costs were

based on a monthly service quote from Waste Management for a 6 cubic yard dumpster.

Administration costs were calculated by multiplying IREM’s rate of $1.11 by the square footage,

and maintenance costs were set at $27,300 using a rate of $2.08 per square foot. To factor in the

capital expenditures, I started with an allowance fund for parking lot repair of $80,000 pro-rated

over 25 years. I included a fund of $20,000 spread over 25 years to replace the roof as well. An

additional fund of $20,000 for HVAC replacement is spread over 25 years. Each of these funds

assumes an 8% annual return on invested funds. Leasing commissions were based on 3% of the

effective gross income.

The value of the property was calculated using the NOI divided by a 10% required rate of

return. Factoring in operating and capital expenses, Net Operating Income was $84,695,

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resulting in a property valuation of $846,950. This approach resulted in a much lower valuation

compared to the Sales Comparison and Cost approaches due to the current lack of tenancy.

Final Value Determination

Reconciliation of the three valuation methodsMethod Calculated Value Weight Applied Sales Comparison $1,361,720 15% $204,257.93 Cost Approach $1,407,900 5% $70,395.00 Income Approach $846,950 80% $677,560.00 Final Valuation $952,212.93

The sales comparison and cost approaches to valuation produced results that did not vary

too much from either each other or the property’s asking price, but this does not mean that they

are the better approaches in this case. In a commercial property such as this office building that

requires sufficient tenancy to break even or earn the property owner a profit, my view is that the

income approach is much more accurate at estimating property value. The sales comparison

approach is certainly worthwhile because it compares this office building to other similar office

buildings in the area. The problem is that it makes the assumption that after making adjustments

for differences in the property there is still full tenancy at quoted rental rates for each property.

Because of this I have applied a 15% weight to sales comparison for the final value of the

property. I feel that using the cost approach for this building resulted in an inaccurate number

because the building is eighteen years old, causing depreciation to affect the valuation too much

and also skewing the replacement cost much higher than reproduction cost. Because of this, I

will only apply a 5% weight to the cost approach. The income approach I feel results in the most

solid valuation of the property. It shows that, in the current situation of three unoccupied spaces

(10,277 of the 13,125 square feet), this property cannot turn a reasonable profit for the property

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owner. It is clear now that lack of tenancy is the reason this property has been listed for over a

year, faced multiple asking price markdowns, and still not been sold. This is not to say that there

is no chance at tenancy for this office building; it is clearly a good property in a good location, so

there is a chance that this building will at least fill up one or two more of its office suites down

the road. But this will probably require that the owner reduces their rental rates. Unfortunately

for the brokers, the market for office buildings seems to be quite well-saturated with a variety of

properties at the moment, resulting in a buyer’s market with stiff competition. I am choosing

80% weight for the income approach valuation because of the nature of the property and its

vacancy situation. Nevertheless, from a real estate investor’s perspective this would be too risky

of an investment. The asking price for this property should not be $1,100,000; it should be about

$150,000 lower, or $952,213.

Tax Analysis and IRR

Part 1: Determine NOI

Year 1 Year 2 Year 3 Year 4 Year 5Potential Gross Income $276,786 $276,786 $276,786 $276,786 $276,786Less: Vacancy and collection loss -$77,078 -$77,078 -$77,078 -$77,078 -$77,078Effective Gross Income $199,708 $199,708 $199,708 $199,708 $199,708

Less: Operating Expenses -$107,380 -$110,601 -$113,919-

$117,337-

$120,857Less: Capital Expenditures -$7,633 -$7,633 -$7,633 -$7,633 -$7,633Net Operating Income $84,695 $81,474 $78,156 $74,738 $71,218

Part 2: Annual Tax Effect Year 1 Year 2 Year 3 Year 4 Year 5Net Operating Income $84,695 $81,474 $78,156 $74,738 $71,218Less: Interest Expense -$64,745 -$63,137 -$61,413 -$59,564 -$58,582Less: Depreciation -$27,231 -$27,231 -$27,231 -$27,231 -$27,231Before Tax Income -$7,281 -$8,894 -$10,488 -$12,057 -$14,595Less: Tax Liability $2,184 $2,668 $3,146 $3,617 $4,379

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Income After Tax -$5,097 -$6,226 -$7,342 -$8,440 -$10,217Annual Cash Flow $22,134 $21,005 $19,889 $18,791 $17,015

Part 3: Terminating Cash Flow Purchase Price of Office $1,100,000Office Basis $1,100,000Land Value Portion (10%) $110,000Office Building Value Portion $990,000Depreciation Per Year $25,384.62 After five years: Office Basis $990,000Accumulated Depreciation $126,923Book Value $863,077Add back Land: $110,000Total Book Value of Property $973,077Value of property $1,275,201 Tax Effect on Sale: Selling Price of Property $1,275,201Recaptured Depreciation $126,923Gain on Sale $175,201Tax on Gain $35,040Tax on Depreciation $31,731Total Tax $66,771 Sale Price $1,275,201Less: Taxes $66,771Net Proceeds $1,208,430

For tax analysis, I used the Net Operating Income calculated from the income approach

of $84,695 for year 1. For later years, I increased operating expenses by an estimated rate of

Part 4: Calculate IRR

Cash FlowsYear 0: -$1,100,000Year 1: $22,134Year 2: $21,005Year 3: $19,889Year 4: $18,791Year 5: $1,225,445 Internal Rate of Return 3.64%Net Present Value (I=10%) -$248,941

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inflation of 3%, but I did not increase income because I believe that the market for renting office

space will not provide revenue growth over the next few years for older properties like this one.

To calculate interest, I used an amortization table to estimate the interest portion of the loan that

would be required. Since this is a commercial property and would be purchased by a pool of

investors who would also manage the property, I am assuming a commercial loan that requires a

15% down payment and therefore a loan size of $935,000. I am using an interest rate of 7%

although in reality this would most likely be an adjustable rate mortgage, and the loan will be

amortized over a 20 year period. To calculate the annual tax effect I summed the interest

expense of each year from the amortization table and depreciated the purchase price of

$1,100,000 using the straight-line method over 39 years since it is an office building. I used a

30% tax rate to estimate the taxes for each year, but since each of the 5 years shows a before-tax

loss I added this amount back to determine income after tax (this assumes that investors would

have other income-producing properties to net the losses against). The annual cash flows add

back depreciation to income after tax. To calculate the terminating cash flow, I estimated the

land value to be 10% of the purchase price since the structure itself likely accounts for most of

the property value. The value of the property at the end of year 5 is estimated to be $1,275,201,

and assumes a 3% gain per year on the purchase price. This would result in a capital gain of

$175,201 that would be taxed at 20%, and depreciation recapture of $126,923 would be taxed at

25%. After calculating the terminating cash flow of $1,225,445, I calculated the Internal Rate of

Return to be 3.64%; this is 6.36% lower than the required rate of return of 10%. The Net Present

Value using these same cash flows and a required rate of return of 10% coincides with this at

-$248,941. Using the net present value function again to determine an appropriate purchase

price at the 10% required rate of return gives me a price of $826,164, and this is the price that I

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would offer for the property. The conclusions based on Tax Analysis and IRR are that this

property’s returns are not up to par with what an investor would require.

Conclusions, Summary, and Recommendations

In summary, this commercial office building is in an ideal location but the current asking

price makes it a bad investment. Although two of the three valuation approaches showed the

building to be undervalued, the income approach, which matters most for a commercial office

building, showed it to be overvalued. By using the Net Operating Income to estimate cash flows

and taxes, this property would produce an after-tax loss each year over a 5-year holding period,

and the property value appreciation would not make up for the cost of the asking price plus the

necessary capital improvements. The results of this valuation give the likely reason why this

property remained on the market for over a year and was unsold despite multiple reductions in

asking price. It seems that the property owners have decided to hold on to the property for the

time being, because it was taken off the market in mid-October of 2014. Perhaps if they can take

on one or two new tenants to fill up much of the vacant space they can get the sale price they

want, but the current market for office buildings in the Grand Rapids area is saturated with many

properties for buyers to choose from; just driving down some of the main roads in Grand Rapids

you will almost certainly see brand new office buildings being built. This puts the property

owners of this 18-year old structure in a difficult position because the rental rates they need to

cover their expenses are very close to the rates charged for new office space. So, in conclusion, I

would recommend that real estate investors not purchase this building.