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Appraisal - Valuation of Subsidized Housing

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:

1. low-income subsidized apartments, which receive above-market rental rates from HUD or
another government agency, and
2. 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:

a. exposed for sale in the open market with a reasonable time for the seller to find a purchaser,
b. 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
c. 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

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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.

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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:

1. to compensate for the inconvenience of dealing with a bureaucratic government program

which mandates detailed inspections not typically required in the private market; and
2. 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:
http://www.poconnor.com/article.asp?id=48

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