Property Obsolescence and Its Impact on Value Trends

When Obsolescence is Accelerating Presented to: The 46th Annual Wichita Program Appraisal For Ad Valorem Taxation for Communications, Energy and Transportation Properties July, 2016 Presented by: Mark Pomykacz, MAI, MRICS, Federal Appraisal & Consulting LLC Mike Bekech, Assessor, Waterford, CT Tom Flowers, FPL 1

Synopsis of When Obsolescence is Accelerating Most often the value of a property persists for many years, and over the years the property value changes only moderately but usually predictably from year to year. However, sometimes property values change dramatically from one year to the next. Sometimes they fall rapidly to zero value. These events are more likely to happen near the end of the economic life of a property. This is more likely to occur in special properties that are susceptible to incurable physical deterioration, such as power plants, or that are susceptible to technologically driven functional obsolescence, such as telecomm facilities. Values may change from stabilized values in the $100 s of millions to transitional values of merely $10s of millions and even to $0 within a period of a few years. When such value change events happen, they often take appraisers by surprise. In order to account for such events and conditions, special efforts must be made to understand the market and industry, the property condition and functionality, and the timing of events. This presentation will review examples of situations where property values are likely to change dramatically and surprisingly, such as new environmental regulations, newly obsolete technology, nearly fully deteriorated assets, changes in highest and best uses, and financial feasibility. The presentation will then review the key appraisal concepts and applications for these problems. 2

Federal Appraisal & Consulting LLC Provides real estate and business appraisal and advisory services, nationally and internationally, concerning conventional and non-traditional appraisal issues. Power Plants and Fuels Refineries Utilities and Special Purpose Properties Development, Acquisition/Disposition Financing & Feasibility Investor Reporting, GAAP Accounting Tax (i.e. Property Tax or Income Tax) or Audit Litigation Conventional Commercial Real Estate When Obsolescence is Accelerating Federal Appraisal & Consulting LLC 3

Mark Pomykacz, MAI, MRICS Managing Partner Federal Appraisal & Consulting, LLC 30 years appraising Appraisal Specialties = Special Properties Power Plants Fuel Refineries Transmission Systems Water Companies Rail Roads Telecommunications MAI, AI-GRS Appraisal Institute MRICS, Member of the Royal Institution of Chartered Surveyors State Certified General Real Estate Appraiser, multiple states When Obsolescence is Accelerating Federal Appraisal & Consulting LLC 4

The Laypersons Basic Perception of Value Trends Constant Value Appreciation $6.00 $20.00 $5.00 $15.00 $10.00 $4.00 $5.00 $3.00 $0.00 1 11 21 31 41 51 61 71 81 91 $2.00 The Constant Value Appreciation Hypothesis. A mistake? $1.00 $- 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49 51 53 55 When Obsolescence is Accelerating Federal Appraisal & Consulting LLC 5

But Value is based on Years of Income Remaining Years of Remaining Cash Flow 60 50 40 30 20 10 - 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49 51 53 55 When Obsolescence is Accelerating Federal Appraisal & Consulting LLC 6

So how do you reconcile this? Constant Value Appreciation Hypothesis Years of Remaining Cash Flow 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49 51 53 55 When Obsolescence is Accelerating Federal Appraisal & Consulting LLC 7

Property Values Change over Time, Usually Predictably Sometimes properties appreciate regularly, indefinitely, more or less predictably. SFHs, Apartment Buildings, Office Buildings Sometimes properties depreciate regularly, until retired, more or less predictably. Quarries, Batch Plants When Obsolescence is Accelerating Federal Appraisal & Consulting LLC 8

Prices of New Homes Sold in US Census Bureau: Median and Average Sales Prices $450,000 $400,000 y = 664.63e0.0001x $350,000 US Recessions $300,000 Median Prices $250,000 Average Prices $200,000 Expon. (Median Prices) $150,000 $100,000 $50,000 $0 January-63 January-65 January-67 January-69 January-71 January-73 January-75 January-77 January-79 January-81 January-83 January-85 January-87 January-89 January-91 January-93 January-95 January-97 January-99 January-01 January-03 January-05 January-07 January-09 January-11 January-13 January-15 When Obsolescence is Accelerating Federal Appraisal & Consulting LLC 9

Sometimes, Property Values Change over time unpredictably. Sometimes property values vanish, within a few years, and/or unpredictably Values may change from stabilized values in the $100 s of millions, to transitional values of merely $10s of millions, and even to $0 within a period of a few years. Power plants, telecomm assets When Obsolescence is Accelerating Federal Appraisal & Consulting LLC 10

DCF Model Cost New, plus land M&S % Good 100% 99% 99% 99% 98% 98% 97% 97% 96% 96% Year NOI Cost New RCNLPD Value Land Value 1 $0.05 $0.88 $0.98 $0.98 $0.98 $0.10 2 $0.06 $0.91 $1.01 $1.00 $1.00 $0.10 3 $0.06 $0.93 $1.04 $1.03 $1.03 $0.10 4 $0.06 $0.96 $1.07 $1.06 $1.05 $0.11 5 $0.06 $0.99 $1.10 $1.08 $1.08 $0.11 6 $0.06 $1.02 $1.13 $1.11 $1.10 $0.11 7 $0.06 $1.05 $1.17 $1.14 $1.13 $0.12 8 $0.07 $1.08 $1.20 $1.17 $1.15 $0.12 9 $0.07 $1.11 $1.24 $1.19 $1.18 $0.12 10 $0.07 $1.15 $1.28 $1.23 $1.21 $0.13 38% 47 $0.16 $3.43 $3.81 $1.68 $0.67 $0.38 36% 48 $0.14 $3.53 $3.92 $1.66 $0.56 $0.39 34% 49 $0.13 $3.64 $4.04 $1.64 $0.46 $0.40 32% 50 $0.12 $3.75 $4.16 $1.61 $0.38 $0.42 30% 51 $0.11 $3.86 $4.29 $1.60 $0.30 $0.43 29% 52 $0.09 $3.97 $4.42 $1.59 $0.24 $0.44 27% 53 $0.09 $4.09 $4.55 $1.57 $0.17 $0.45 26% 54 $0.08 $4.22 $4.68 $1.55 $0.12 $0.47 25% 55 $0.07 $4.34 $4.83 $1.57 $0.06 $0.48 25% 56 $0.00 $4.47 $4.97 $1.62 $0.00 $0.50 11

Constant Income Appreciation, but Finite Cash Flow $2.00 $1.80 $1.60 $1.40 $1.20 Constant Value Increase Hypothesis is true in only some periods of life of asset. Constant Value Decrease Hypothesis is true in only some periods of life of asset. Transition periods also likely exist $1.00 $0.80 $0.60 $0.40 $0.20 $- 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49 51 53 55 NOI Value When Obsolescence is Accelerating Federal Appraisal & Consulting LLC 12

Constant Income Appreciation, except for last 10 years, and Finite Cash Flow $1.80 $1.60 $1.40 $1.20 $1.00 $0.80 $0.60 $0.40 $0.20 $- 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49 51 53 55 NOI Value When Obsolescence is Accelerating Federal Appraisal & Consulting LLC 13

Income, versus Land, versus Cost Constant Income, Cost New and Land Appreciation $5.00 Straight Line Depreciation $4.00 Economic Obs Change in Highest and Best Use $3.00 Clich : Cost approach is always higher? No! $2.00 $1.00 $0.00 1 6 11 16 21 26 31 36 41 46 51 56 NOI Value Land Value Cost New, plus land RCNLPD When Obsolescence is Accelerating Federal Appraisal & Consulting LLC 14

Income, versus Land, versus Cost Constant Income, Cost New and Land Appreciation $5.00 M&S Depreciation Curve $4.00 Economic Obs $3.00 Change in Highest and Best Use Clich : Cost approach is always higher? Yes! $2.00 $1.00 $0.00 1 6 11 16 21 26 31 36 41 46 51 56 NOI Value Land Value Cost New, plus land RCNLPD When Obsolescence is Accelerating Federal Appraisal & Consulting LLC 15

Constant Appreciation Hypothesis Hypothesis is true for: Land Values Cost New Stabilized Income Expectations for property lasting indefinitely Hypothesis is false for: Cost New Less Physical Deterioration Income from real cash flows Value When Obsolescence is Accelerating Federal Appraisal & Consulting LLC 16

Historical Assessment of Two, Now Retired, Special Industrial Properties Property #1 Property #2 Property #1 Land Value Property #2 Land Value 1956 1958 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2014 When Obsolescence is Accelerating Federal Appraisal & Consulting LLC 17

Reasons for Predictable Depreciation Foreseeable incurable physical deterioration and/or depletion Foreseeable technological (functional) obsolescence Subsidies; new and retiring When Obsolescence is Accelerating Federal Appraisal & Consulting LLC 18

Reasons for Unpredictable Depreciation Market Disruptions Cell phone vs land lines vs cable New Competition New alternative technologies or suppliers Shale Natural Gas Telecomm Convergence Solar and Wind New Government Regulation Pollution control regulations; new Subsidies; new, expiring and retiring When Obsolescence is Accelerating Federal Appraisal & Consulting LLC 19

EG. Natural Gas Fracking New technology displaces old Intensity, speed and longevity of impact was surprising Dramatically lower electricity prices Now, some new winners and losers Winners New Nat Gas Users Gas Pipelines LNG exporters Losers Oil Users Old (less efficient) Nat Gas Users & other fuel types Oil Refineries & Pipelines Railroads When Obsolescence is Accelerating Federal Appraisal & Consulting LLC 20

Henry Hub Natural Gas Spot Prices 16 US Recession 14 Source: Thomson-Reuters, NBER Henry Hub Spot Natural Gas Price 12 Dollars per Million Btu Hurricane Katrina 10 2008 Oil Price Spike 8 6 4 2 0 Jan-97 Oct-99 Jul-02 Apr-05 Jan-08 Oct-10 Jul-13 Apr-16 When Obsolescence is Accelerating Federal Appraisal & Consulting LLC 21

EG. Lack of or Low Capacity Payments Changes in capacity payments can mean the difference between making money and losing money Changes in rules could greatly improve income. Changes competitive advantages Currently lowers income Winners Peaking Power Plants Nat Gas Power Losers Nuclear Power Coal Power Old (less flexible) Nat Gas Users Federal Appraisal & Consulting LLC When Obsolescence is Accelerating 22

EG. Environmental Regulation New substantial environmental regulations can cause substantial or even total obsolescence. Loss of financial feasibility, if large investments are needed at specific facilities Winners Losers New Nat Gas Users Coal Solar Low-price Dependent Wind Consumers Environmentally- motivated consumers When Obsolescence is Accelerating Federal Appraisal & Consulting LLC 23

EG. Old Technology Telecomm the obsolescence rate is sometimes only several years, while the physical life may be a decade. What cost $10 s of millions five years ago, can be replaced with what costs only $1 millions today while providing better functionality. Solar costs of manufacturing have reduced the costs of solar power by half in last 5 years. A cost approach from several years ago bears no resemblance to value today.When Obsolescence is Accelerating 24 Federal Appraisal & Consulting LLC

Solar Panel Prices When Obsolescence is Accelerating Federal Appraisal & Consulting LLC 25

EG. Refineries and Other Margin Operations Businesses that operate on fine financial margins or spreads between feed stocks and outputs A relatively small change in either input or output prices can wipe out all cash flow, cause bankruptcy. When Obsolescence is Accelerating Federal Appraisal & Consulting LLC 26

EG. Refineries and Other Margin Operations Industry Petroleum Refineries Crack spread: crude vs gas prices Ethanol Refineries Crush spread: corn vs ethanol prices Coal Power Plants Spark spread: coal vs electricity prices Spreads Industry Petroleum Refineries 17% 8% Ethanol Refineries Coal Power Plants 55% 20% Gross Net Margin Margin to Obsolescence Price Change 10% 7% 44% 25% 5% When Obsolescence is Accelerating Federal Appraisal & Consulting LLC 27

EX: Ethanol Crush Spreads Contract, Crush New Ethanol Plant Profitability U.S. Ethanol Plants, Capacity, and Production Ethanol Plants Capacity (MGY) 1999 50 2000 54 2001 56 2002 61 2003 68 2004 72 2005 81 2006 95 2007 110 2008 139 2009 170 2010 189 2011 204 2012 209 2013 211 Year Production (MGY) 1,779 1,840 2,007 2,738 3,190 3,699 4,398 6,317 11,623 13,424 14,541 14,460 14,631 15,047 14,887 1,465 1,622 1,765 2,140 2,810 3,404 3,904 4,884 6,521 9,309 10,938 13,298 13,929 13,218 13,312 Source: Renewable Fuels Association. Ethanol Industry Statistics. http://www.ethanolrfa.org/pages/statistics But in those 3 years the number of ethanol plants in the US increased 79%, while total capacity increased 130%. Ethanol returns peaked in 2006, and by 2009 had gone negative When Obsolescence is Accelerating Federal Appraisal & Consulting LLC 28

EG. Pipelines and Transmission Lines High capital costs and long payback periods exposes them to risk of unseen market and industry changes Water Companies Oil Pipelines Natural Gas Pipelines Power Transmission Line Telecomm/Fiber Optic Lines When Obsolescence is Accelerating Federal Appraisal & Consulting LLC 29

EG. Pipelines New oil pipelines can make rail transport for oil or distillates less competitive. New natural gas pipelines can support more gas- fired generation, hurting coal and nuclear power production Most likely to impact New England states in the next few years Increased domestic oil and natural gas production decreases volumes at import facilities, negatively impacting values When Obsolescence is Accelerating Federal Appraisal & Consulting LLC 30

EG. Government Subsidies Some large projects require government subsidies for financial feasibility Costs to development only equal cash flows when cash flows from operations are enhanced with subsidies Cost = value of cash flow from operations + value of subsidies EG. ARRA1603 for Wind and Solar. When Obsolescence is Accelerating Federal Appraisal & Consulting LLC 31

Appraisal Issues Market and Industry Knowledge Physical Deterioration, engineering Functional & Economic Obsolescence Highest and Best Use Changes through years Changes occurring right around appraisal date Financial feasibility, lack of Legally permissible Maximally productive, new When Obsolescence is Accelerating Federal Appraisal & Consulting LLC 32

Appraisal Issues, continued Changes in Income Stream Dollar Amounts Timing of Changes Risks, impacts on Cap and Discount Rates Addressing Retirement When Costs Salvage Value, Scrap Value, Land and Building Residual Uses and Value When Obsolescence is Accelerating Federal Appraisal & Consulting LLC 33

Impacts to Highest and Best Use Floor value lowest value before required consideration of alternative uses. Retooling Redevelopment Liabilities and social costs Scrap and salvage value When Obsolescence is Accelerating Federal Appraisal & Consulting LLC 34

EG. Change in Highest and Best Use Dec. 2011- Sunoco closed the 178,000 barrel per day Marcellus Hook refinery in Philadelphia, citing uneconomic returns Sept. 2012 Sunoco announces plans to redevelop site and infrastructure to support LNG exports Nov 2014 Sonoco Logistics announces plans to build second pipeline to serve Marcellus Hook, bringing the total announced investments since Sep 2012 to $3+ billion. When Obsolescence is Accelerating Federal Appraisal & Consulting LLC 35

Highest and Best Use Continued When Obsolescence is Accelerating Federal Appraisal & Consulting LLC 36

Change in Highest and Best Use Constant Income Appreciation but Finite Cash Flow, except for last 10 years, or until Change in H&BU $1.80 $1.60 $1.40 $1.20 $1.00 Point of Change in Highest and Best Use. (Must account for decommissioning expense.) $0.80 $0.60 Red Line = Land Value less Decomm $0.40 $0.20 $0.00 1 3 5 7 9 11 13 15 17 19 21 23 25 27 29 31 33 35 37 39 41 43 45 47 49 51 53 55 NOI Value Land Value When Obsolescence is Accelerating Federal Appraisal & Consulting LLC 37

Cause of Conflicts Conflicts arise from Reconciling different approaches Cost approach on solar vs income after subsidies are finished. Cost approach on old telecomm equipment vs new Failing to account for the market or industry change Falling natural gas prices Falling crude oil prices Effects on demand from Great Recession When Obsolescence is Accelerating Federal Appraisal & Consulting LLC 38

Case Study Biomass to Energy Plant Cost New: $75 million Value from Cash Flow from Operations: $60 million Value of Subsidies: $15 million Net present value Total Value of Plant: $75 million, as of beginning of subsidies. Feasibility???: Yes If subsidies are paid in full in year one, then in year two value is only $60 million. While originally feasible, plant now suffers $15 million in obsolescence. When Obsolescence is Accelerating Federal Appraisal & Consulting LLC 39

Cost Approach In Year One $75 M $ 0 $75 M $15 M $60 M $ 0 $75 M In Year Two $77 M $ 2 M $75 M $ 0 $75 M $15 M $60 M Cost New Phy. Depre. RCNLD Value of Subsidy Effective RCNLPhysD Eco Obs. Cost RCNLAD DCF from operations Value of Subsidy DCF Oper. & Sub. $60 M $15 M $75 M $60 M $ 0 $60 M When Obsolescence is Accelerating Federal Appraisal & Consulting LLC 40

Case Study Base Load Plant in Low Capacity Price Market Value from Cash Flow from Operations: $100 million Profit Margin: 5%, a low margin Higher risk of unprofitably and full obsolescence Threat of need to close plant is real Value of proposed Capacity Revenue: $100 million Total Value of Plant: $200 million, if new Capacity Revenue rules are implemented Profit Margin: Doubled to 10%, Lower risk of unprofitably and full obsolescence Reduced risk of closure When Obsolescence is Accelerating Federal Appraisal & Consulting LLC 41

Economic & Functional Obsolescence Near the end of economic life issues often come down to economic and functional obsolescence. Issue is how to measure it. When Obsolescence is Accelerating Federal Appraisal & Consulting LLC 42

Economic & Functional Obsolescence Appraisal Theory Circularity Income Shortfall Cost * Ro = Required Income Required Income Actual Income = Income Shortfall Income Shortfall / Ro = Economic Obsolescence Court Decisions on Income Shortfall When Obsolescence is Accelerating Federal Appraisal & Consulting LLC 43

Reproduction versus Replacement Cost Constant Income, Cost New and Land Appreciation $5.00 Replace Cost New, plus land Replace CNLPD Repro Cost New, plus land Repro CNLPD $4.00 Value $3.00 $2.00 Economic Obs. Functional Obsolescence $1.00 $0.00 1 6 11 16 21 26 31 36 41 46 51 56 When Obsolescence is Accelerating Federal Appraisal & Consulting LLC 44

Windfalls: The Other Side of Economic Obsolescence If there is a big loser from a big change in a market or industry, there is often a big winner. Often, if one property value is decreased due to market forces, someone else s value is enhanced. If fracking gas hurts oil and coal, then it helps gas-fired turbines. If cable offers a triple play (tv, internet, and phone), then cell and land line values are hurt but cable company values are enhanced. An increase of the ethanol blend regulations hurts oil refinery and pipeline values but enhances ethanol refineries and corn farm values. 45 When Obsolescence is Accelerating Federal Appraisal & Consulting LLC

QUESTIONS Mark Pomykacz Federal Appraisal & Consulting LLC Alpha Power Development LLC 460 Route 22 West, Ste. 403 Whitehouse Station, NJ 08889 Office: (908) 534-3590 Mobile: (917) 992-8444 Fax: (908) 823-0575 mark@federalappraisal.com When Obsolescence is Accelerating Federal Appraisal & Consulting LLC 46