Property Valuation: The Endowment Effect

Property Valuation: The Endowment Effect

We’ve been working on acquiring a portfolio of properties in the Maryland suburbs of Washington DC. This portfolio is largely older buildings, a mix of industrial, medical, neighborhood retail and office. We carefully developed assumptions for leasing these properties and what the likelihood of deferred maintenance would be. We combined this with a cap rate approach for both the portfolio and on all the properties holistically. We proposed a number at a 7.5% Cap Rate based on the owner’s 2018 projections. The owner, after discussing with his accountant decided that his property was worth a number that placed the cap rate at 4.6%.

Also, recently, we looked to acquire an office building located in the North Rockville submarket. I underwrote this building and determined that a high 8 cap would be appropriate. With high competition and vacancy in the market, this building was going to have a difficult time competing in the long run. We thought our offer would allow us to offer generous TI packages to tenants and make cosmetic upgrades to the building. The owner said he wouldn’t sell for anything worse than a 6% cap rate.

These two experiences made me think about the endowment effect. The endowment effect describes our tendency to value things more highly when we already own them. If I’m trying to sell you my car, I might think it’s worth $10,000, while you might think it’s only worth $7,000. When it comes to buying a less than perfect asset, unless you have a radically different vision for a property it is very difficult to overcome the endowment effect. The owners of these properties aren’t considering the many flaws their properties have and the risks we would have to take to keep them competitive. To be competitive as a value-add owner you have to have your unique talent or value to bring to a project. Can you bring a tenant into the fold that the current owner can’t? Can you completely change the use of the building, say from office to lab? Do you see untapped value such as abundant parking that could be rezoned for housing? Overcoming an owner’s overestimation of the value of their property is hard and requires a new perspective.

Posted by Matt Brown, Director of Acquisitions

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