A Tale of Two Fire Stations

Fire trucks inside a fire station
Fire trucks weigh around 11.2 tons

Recently, North by Northwest tackled two complex appraisal assignments. Both assignments involved appraising fire stations, one in a small town and one in a larger city. Fire stations are, by virtue of their being public sector properties, special use properties and have limited marketability.  Accordingly, the cost approach typically is the only method used.  Also, worth noting – fire stations are not built with the expectation of a sale. Therefore, the cost approach does not include a developer profit.

Fire Station 1

The fire station in a small town had purchased an adjoining site with a defunct car wash. They intended to allow for expansion of their existing fire station building.  However, in addition to $30,000 in demolition costs of the car wash and typical $50,000 for site development, the budget of the building expansion called for approximately $160,000 in costs related to the new structure being able to support 40,000 pound fire trucks. This was an issue due to the site’s inadequate soil compaction.  Therefore, no value was given to the costs related to the additional $160,000. Because these would be needed solely to deal with the site’s deficiencies.

The only charge to the “as-is” land value was the cost of demolition. The typical purchaser, not a fire department, could utilize the site for development of a small commercial building. In that case, the soil compaction would not be an issue.  For the “as-completed” value, the demolition costs were added back to the land value, because these will have been incurred.

Fire Station 2

The second fire station posed a thornier problem for NxNW to work out. Some 7 years prior, a local real estate developer wanted to assure prospective homeowners in its subdivision of quality fire protection. Therefore, they gave 30 years free ($1 per year) use of a site. It otherwise would have been utilized for a single-family home.  The fire department developed a high-end fire station. It had a similar curb appeal as that of the quality homes typical of the subdivision.  NxNW Consulting was asked by the lender to value its collateral. That’s the leasehold interest that had been created by the free use of the land and the fire station constructed.

We estimated the “as-is” fee simple value at approximately $1,800,000.  The fee simple interest is comprised of the leased fee interest owned by the landlord (i.e., the developer), and the leasehold interest owned by the tenant (i.e., the fire department).  The conundrum, also referred to as the Extraordinary Appraisal Problem, was to estimate the reversionary value of the property 23 years from now. 

The Extraordinary Appraisal Problem

A buyer of the leased fee position would be cautious not to over value the then value of the fire station. That’s because there would be no guarantee the fire department would renew its lease, or at what rent.  The Town, subsidizing through its tax base, might decide on a lower priced facility (land and building) in 23 years, and in a more central location.  A buyer of the leasehold estate likewise would be cautious and not assume any value of its interest would remain in 23 years.  Keep in mind, the higher the estimated reversionary value, the higher the leased fee value, and the lower the leasehold value. 

The solution for NxNW was simple – inasmuch as its client’s collateral is the leasehold interest. Today’s value of the reversion was based on the assumption of nearly full value projected 23 years from now. Even though a prospective buyer of the leased fee interest would be unlikely to be so optimistic.  Today’s $1,800,000 fee simple was assumed to increase by 1.5% per annum. 10% disposition costs were deducted, and a discount rate of 10.5% was applied to the projected cash flow in 23 years.  The resulting leased fee value is then deducted from the “as-is” fee simple value.  These calculations are illustrated as follow:

A Test of Reasonableness

NxNW assumed what a sale leaseback of the fire department’s leasehold interest might look like today.  The following assumptions were utilized to express what the lease terms could be:

(a) The $1,800,000 “as-is” fee simple value was assumed to generate an absolute net rent at 7.5%. This is a prevailing capitalization rate in today’s market for commercial properties. Thereby, it indicates a starting rent of $135,000 (7.5% of $1,800,000).

(b) The lease would call for 2% per annum increases, to simulate projected inflation (CPI adjustments).

(c) A discount rate of 8.5% was estimated as reflection of the creditworthiness of the Town funding the costs of the fire department. 

Once again, keeping in mind that the leasehold interest is for only the duration of its remaining 23-year estate. No reversionary value is attributed.  The following table shows the results, based on the foregoing assumptions of a plausible lease scenario:

Conclusion

The test leasehold value of $1,575,000 was based on fictitious, but very plausible, terms of a sale leaseback. It supports the $1,570,000 concluded value. This was based on deducting the leased fee value from the fee simple value.

Lesson Learned

The developer should have offered, and/or the fire department insisted on, a long-term option to renew at reasonable rent.  One solution would have been to base the renewal rent on the then value of the land. Thereby letting the fire department retain the value it created in constructing the fire station.  This likely would have eliminated guessing what might happen at the end of the initial lease term. In other words, guessing what the reversionary value would be.

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If you’d like to read more examples of times our firm solved tricky appraisal problems check out another challenging appraisal problem in our write-up on a Mobile Home Park report. Or read about the time CEO Anthony Alderman appraised a track of land on Colington Island in the Outer Banks where flooding and swampy land caused a major issue. We love a new challenge. If you enjoyed this article on complex fire stations, leave a comment. We want to keep bringing you helpful and relevant articles in the world of commercial real estate appraising.

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