This month the ideas and requests of readers raise the issue of appraising office complexes with associated retail space. This comes about because of the high number of these type projects coming into our market, and because of the continuing problem of having few actual sales of such properties from which to observe and measure the market’s reaction to them in terms of value.

Why marry retail and office?

There are true mixed-use office and retail projects, like Smolensky Passazh, Novinsky Passazh, and the coming Lotte project at the Arbat, where the retail component is a significant part of the total revenue and is targeted at the wider audience, and not dependent on the associated office tenants. In contrast, there are the other office complexes that benefit from having retail spaces available, and whose tenants or their visitors make up the majority of potential retail customers. For this discussion we limit consideration to the latter group of relatively large buildings, or clusters (totaling 15,000 to 100,000 sqm or more), containing primarily office space with associated retail and commercial space used by service businesses. This format is recognizable in projects like Riverside Towers (73,000 sqm, 1996-98), Romanov Dvor (58,530 sqm, 1998-2007), Paveletsky Towers (59,481 sqm, 1997-2003), and Avrora Business Park (147,000 sqm, 2002-2009).

There are (and will be) larger mixed-use complexes, of course, like the MoscowCity project, but these will have their own special considerations for the appraisal process. For the more typical large office complex with associated retail space, several questions come into the minds of appraisers in this market when developing the three approaches to indicate market value.

Common appraisal issues

Cost Approach: In this approach, how should I account for the value added by separate rights not usually included in the construction cost estimates?

Income Approach: Should I apply the same discount rate to office revenues and retail revenues?

Sale Comparison Approach: Is it correct to use separate retail and office sale price indexes, calculating the sale price results for each type area separately, and then adding them together to get the total project sale price indication? The easy general answer for any appraisal question, of course, is to do what the market does. In our case, since there are not yet sales of this type property in our market, we can only do what we believe the typical market buyers and sellers would do.

Cost Approach

In theory, the three approaches developed properly will provide identical indications of value. In practice many factors can be impossible to accurately account for in each approach, causing discrepancies. One such factor can be additional rights, the costs for which are not related to the resulting revenues and which can be overlooked in the development of any of the approaches to indicate value.

The easiest way to account for these factors is to add a separate line in the cost approach summary with a lumpsum estimated adjustment. For example, a new building (no depreciation, and 20,000 sqm gross area) with revenue from parking spaces on extra land and from associated outdoor advertising sign structures, may have a Cost Approach summary as seen in Table.

This example shows a 5% difference between the initial and final cost approach indications by not forgetting about the additional rights included in the project.

Income Approach

There is no easy answer for the problem of whether the net revenue from the two different types of uses should be capitalized with different rates. This depends on whether there really is a difference in the risk of the two income streams, and how the discount rate was estimated. If the discount rate was estimated from the income/price relationship of similar buildings sold in the market, there would be no need for separation of the revenues or adjustment. Since we have no similar sales yet of such mixed-use properties, it is likely the discount rate being used was derived from a buildup method, or comparison with less similar projects.

In my experience, for properties where the project’s purpose for existence is office space, buyers and sellers do not consider these revenue streams separately. However, if there is a factor that significantly increases the risk of one or the other type of rent then such separate treatment could be justified.

Another reason to consider the combined space jointly for these approaches is that the retail space generally is dependent on the existence of the office space around it. The viability of the market for the retail types of users (gift shops, dry cleaners, office supply, restaurant/coffee shops, flower shops, pharmacy, and banks) mostly depends on the flow of business from tenants in the associated office building. The financial risk of the retail space rent is more dependent on the viability of the office space occupants than on the retail operator, or the wider retail market area for the location; thus justifying the use of the same discount rate for both types of revenue.

Sale Comparison Approach

The answer is largely the same for the question of whether to use retail sale prices (per square meter) to calculate the value of the retail area, and add that to the result of the sale price indication from the office space calculation (square meter area times comparable office sale prices per square meter). In our market, and from my observation in other more developed markets, quality office buildings and their retail space are not sold in pieces; rather they are operated and marketed as a single project. Unless there are other clear indications in the market, appraisers should develop the sale comparison approach in the same way, estimating a sale price index for the combined space. This means using comparables that have the same type of retail tenants (quality of income) and the same relative proportion of retail space (weighted average rent), or at least making appropriate adjustments.

Of course, if there is no data available to extract a combined price index, we can use the benchmark indications from similarly situated pure retail space and office space sales. However, these benchmarks should not be applied directly, but should be adjusted to take into account the factors that influence the combined space at the subject location.

Conclusions

In our Moscow market, the data to appraise the simplest property is precious and appraisers still struggle to piece together enough comparable information to feel comfortable with their results. When we move to more complex properties of mixed use, we introduce an additional layer of problems and appraisal issues to join with our small population of direct data points. Appraisers who recognize the complexity and are still able to be true to the basic principle of matching the perceptions and actions of the market, will produce the most wellsupported and reliable value opinions.