Seismic-prone Wellington office: 'as is' versus 'as if strengthened'
You are valuing a 1980s six-level office building in central Wellington for mortgage security. Net lettable area is 4,200 m². It is 60% leased at an average net rent of $420/m², with a weighted average lease term of 3.2 years; market net rent for comparable space is $480/m². The council has issued an earthquake-prone building notice; the seismic assessment gives 18% NBS. An engineering estimate puts strengthening at $6.5m, with 12 months' disruption and likely loss of two floors of rent. The vendor's marketing valuation, described as 'as if strengthened', is $28m. Indicative 'as is' bids are around $18m. Recent sales include a 25% NBS building at a 7.25% cap rate and a 70% NBS building at 6.50%. The bank wants a mortgage valuation; the borrower wants you to adopt the vendor's $28m. The valuation date is 30 June 2025.
1. Set out the valuation approach and the key adjustments you would make.
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Confirm the instruction as a market valuation for mortgage security, on an 'as is' basis, with the 'as if strengthened' figure only as a clearly labelled hypothetical if the bank asks for it. The two are not interchangeable.
Use the income approach as the primary method because the building is an investment asset. Start with market rent for the lettable area, not the passing rent. The passing rent of $420/m² is below market at $480/m², but the 40% vacancy, 3.2-year WALT and incentives must be reflected. Build a cash flow that models lease expires, downtime, incentives, operating costs, capital expenditure and the cost and timing of strengthening. A 12-month disruption with loss of two floors is a real cost and a real uncertainty.
Capitalise the stabilised net income at a rate derived from the sales. The 25% NBS sale at 7.25% and the 70% NBS sale at 6.50% bracket the market, but 18% NBS is below both. Add a risk premium for earthquake-prone status, remediation uncertainty and letting risk; alternatively use a direct comparison adjustment. Cross-check with the cost approach: land value plus depreciated improvements, less remediation cost and risk, and with the 'as is' bids around $18m.
Reconcile to a range and explain the main sensitivities: strengthening cost, downtime, leasing and cap rate.
2. How should seismic risk and the existing leases be treated in the valuation?
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Seismic risk is not a single line item to be deducted mechanically. It affects the capitalisation rate, the buyer pool, financeability, insurance and the building's ability to retain tenants. The earthquake-prone notice is a material fact that must be disclosed. An 18% NBS building may be difficult to insure and may face tenant reluctance, so the effective market rent and vacancy allowance should reflect that.
Analyse the leases. The 60% occupancy and 3.2-year WALT provide some income certainty, but the passing rent is below market. On reversion, income may rise, but only after incentives and downtime. The strengthening work may require tenants to vacate or relocate; check lease clauses for access, abatement and termination rights. The loss of two floors of rent during the 12-month works is both a cost and a loss of income; avoid double counting by modelling it once in the cash flow.
For the 'as if strengthened' valuation, assume completion of the works, a building at an improved NBS rating, and lease-up to market. Use a lower cap rate consistent with the 70% NBS sale, but deduct the cost of works, lost rent, professional fees, contingency and an entrepreneurial profit/risk allowance to derive an 'as is' value. The vendor's $28m appears to assume the end state without adequately discounting for cost, time and risk. Test it against the $18m bids and the income evidence.
3. The borrower wants you to adopt the vendor's $28m figure. How do you respond, and how should the report present the two bases?
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Tell the borrower and the bank, in writing, that you cannot adopt a predetermined figure. The valuation must be your independent opinion based on evidence. The vendor's marketing valuation is a useful data point only; it is not evidence of market value, particularly where it is described 'as if strengthened' and the building is currently earthquake-prone.
If the bank requires both bases, present them separately. The 'as is' market value is the primary figure for mortgage security. The 'as if strengthened' value is a hypothetical value subject to stated assumptions: completion of the $6.5m works, no cost overruns, 12 months' disruption, successful lease-up, and the building achieving a specified NBS rating. Label it clearly and explain that it is not the value of the property in its current state.
Reconcile the 'as is' value to the market evidence, including the $18m bids, the 25% and 70% NBS sales and the income approach. Explain why $28m is not supported on an 'as is' basis: it implies a much lower effective risk premium and ignores remediation cost and downtime. Disclose the earthquake-prone notice, the engineering estimate, the lease profile and the key sensitivities. If the borrower continues to pressure you, decline the instruction rather than compromise the report.