Appraisal – Subsidized Housing (Real Estate Appraisal)

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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% to 60% 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.

Income Approach:

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:

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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:

Market Rent Projects

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Note that the average occupancy rate for market rent projects in only 73% compared to 97% 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 300-unit apartment complex with 160,000 net rentable square feet.

Market Rent Projects

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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.

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