Valuation in Challenging Times

Overview of the Problem

To say the least, these past few months have been interesting for all involved in real estate.  Residential markets have taken the brunt of the value hit, and professionals involved in that segment of our industry—contractors, Realtors, appraisers, home inspectors, mortgage companies and the like—have seen their ranks considerably thinned.

In the commercial arena, the impact has been blunted by having started later, and by virtue of having shallower declines.  Nonetheless, for investment properties, vacancies are up, asking rents are down, cap rates are climbing; capital is hard to find unless a deal or a borrower is exceptional; and the mentality is one of bottom-feeding, predominantly.  For owner-occupied properties, more strength is indicated because by and large, buyers are buying with purpose (acquiring agents of production to run a business, not as an investment per se), rather than doing so opportunistically.  Yet they are not immune from the influences of the commercial investment market (as it sets expectations and impacts the supply of substitutable options).  And the commercial real estate sector is clearly impacted by the residential market (which is directly tied to job growth or losses, consumer confidence and effective demand).

Toward Reliable Valuations

How then does an appraiser estimate market value when the typical indicators are in retreat, and the data is scarce or non-existent?  There is no single answer that addresses the issue, but rather, a series of steps a diligent valuation consultant can employ to come to a reasonable and defensible opinion of market value.

Properly Identify Market Value Sales.

To understand what makes a good sale, one must first have an operating definition of the term “market value”.  We won’t recite the entire definition here, but will set forth the components of relevance to the discussion at hand per the FIRREA definition employed by federally-regulated lenders (with emphasis added):

“Market Value means the most probable price which a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus. Implicit in this definition is the consummation of a sale as of a specified date and the passing of title form seller to buyer under conditions whereby:

  • buyer and seller are typically motivated;
  • both parties are well informed or well advised, and acting in what they consider their own best interests;
  • a reasonable time is allowed for exposure in the open market;…”

Perhaps the best way to consider the proper identification of market value sales (or more accurately, identification of sales that meet the market value definition) is by way of example:

If a seller was under threat of foreclosure or was behind on his payments or was otherwise under duress, that sale would not generally meet the definition of market value.

Similarly, if the seller had to buy the property due to some contractual obligation, needed it for assemblage, or for some other reason it fit a particular need and there were no substitutable options, that sale might not pass the test of a market value sale (it could be a use value sale, or an investment value sale, but probably not a market value sale).

If a lender’s borrower defaulted, that lender took the property back, and then quietly marketed the property to some of its more solvent customers and one of them bought it, absent any open market exposure, the result is more likely a liquidation value sale than a market value sale.

If the typical time it takes to sell a 40,000-square foot manufacturing building is 6 to 12 months, and one sold in 2 months, that might not be a market value sale (the offering may have been underpriced).  This could go to the 3rd point in the market value definition on the page preceding as to market exposure; or it could go to the 2nd point, as to whether the seller was knowledgeable and acting in his own best interest.

If a bank asks an appraiser for an appraisal or a broker for a broker price opinion for a “disposition”, “liquidation” or “quick sale”, such as a sale in 6 months for a commodity that may take 24 to 36 months to sell under normal circumstances (e.g., a sizeable parcel of commercial or industrial development ground), then by definition that is not a market value premise.  Market value (what the property would likely sell for under a normal and typical market exposure) would likely be the starting place for an opinion, but from there discounts would need to be considered to move the property to the top of the list options for the available buyers active in the marketplace, and for the suspension of the normal course of due diligence required for a “quick sale”.

These are but a few examples, and as the reader can ascertain, they are not necessarily black and white.  Decisions as to whether or not a sale is a market value indicator must be made on the totality of available information.  Atypical or unusual situations should serve as red flags to appraisers and brokers contemplating a sale as a comparable, which is why it is imperative that appraisers and brokers alike understand and report the circumstances surrounding the sale, the motivations of the parties, and take the time to comment in their database record of the transaction as to any unusual circumstances that may affect its reliability as an indicator of market value.

It’s been said that something is worth what someone is willing to pay for it.  But obviously, that is not necessarily true.  Some buyers get good deals because sellers sometimes have atypical motivations making them need or want to sell quickly.  Some sellers pay too much, because they have a business goal that necessitates acquiring a specific parcel or being in a specific location.  Thus, to have a meaningful analysis, one must have enough data to sort out the outliers.  From this comes another saying that is worth remembering:  “One sale does not a market make.”

Talk to the Market Participants.

Over a year ago, one of the major players in the commercial lending arena came out with the following requirement in their appraisal bidding and ordering process:

“Due to concerns with changing market trends and conditions, we are requiring your analyses to consider:

Market Participant Interviews: Discussions with real estate market participants (buyers, sellers, property managers, real estate agents/brokers). Reference these interviews in a dedicated section, and report and analyze the most pertinent comments and how they impact the subject value.

Comparable Listings: In addition to consummated comparable sales and leases, listings should be considered, with the most pertinent ones reported and analyzed, and incorporated within your market data.”

More recently, other national and regional lenders have implemented this requirement, or expanded upon it, some requiring that the interviews have a specific minimum count, and be about some specific aspect of the specific property being appraised.  Another requires the analysis to consider expired, cancelled and withdrawn listings.

The evolution of this type of requirement is a direct reaction to the fact that the volume of sales has decreased dramatically, and many (arguably most) of the sales that are taking place either don’t meet the market value definition, or stretch its limits considerably.

The requirement to talk to market participants—to move beyond trying to time-adjust historical sales for changed (declining) market conditions, and to try to ascertain what buyers and sellers are looking for in today’s market (what they are doing, what they aren’t doing, and why)—is a matter of common sense.  We should not need a lender to tell us to talk to market participants; we should have been doing this all along.

As useful and well-intended as this type of ongoing interaction is, it has its limitations and pitfalls.  One is that there are only so many brokers and agents who are actually leaders in their respective specialties.  Calling on those same people multiple times a month to get their opinions about the potential of a specific property would surely wear out the appraiser’s welcome.  Thus, the temptation is to begin to interview them more generally and less frequently, about a neighborhood or a property type, rather than about the specific property being appraised.  Or, alternatively, to begin to call second- and third-tier brokers and agents who are more willing to field the appraisers’ calls, when times are slow.  Oftentimes they are as anxious to hear what we are seeing, so they are to some degree, more open to the interaction.

Caution must be exercised in the consideration of opinions solicited in this manner. Particularly when times are slow, brokers and agents can offer a very bleak forecast and low opinion of sale or rent potential in a conscious our unconscious effort to generate some activity.  With so many buyers and tenants out there falling into the opportunistic (bottom-feeder) category, and so many sellers and landlords remaining optimistic about pricing, they reason that the story needs to get out that lower values (lower rents, higher concessions, higher cap rate requirements) are the reality, before sellers (and landlords) will accept this “new reality” and begin to sell (lease).

When markets are rapidly appreciating, broker (investor and developer) opinions tend to be overly optimistic; and when markets are in decline, they tend to be overly pessimistic, to try to create a mindset conducive to getting some deals done, to try to set the tone for some acquisitions of their own, etc.

Consider Substitutable Options.

Market value is estimated using one or all of the three classic approaches to value:  cost, sales comparison, and income capitalization.  To one degree or another, all three approaches are premised on the economic theory of substitutable options.  The cost approach considers the value of a site relative to the option of acquiring an alternate site of similar utility for less money.  The replacement cost less accrued depreciation (the improvement component of the cost approach) considers the option of buying an existing, partially-depreciated property relative to building a new one).  In buying an existing property, the premise of the sales comparison approach, properties sold in the recent past are compared to the subject, and are adjusted for material differences.  In the income capitalization approach, rental comparables are compared and adjusted to the subject’s rent potential.  Expense loads are compared to those of the subject, and rates of return for competing real estate and non-real estate investments of similar risk and liquidity are weighed in the selection of a cap rate for the property being appraised.

As the lender requirements previously cited would indicate, many lenders want a summary of the most relevant properties in a market that could compete with the property being appraised.  They simply want to know that, if the analyst concludes the subject property would sell for $120/SF, there is not an equally desirable property that could be bought that is openly listed for $100/SF (that will likely sell for even less).

The advantages of the listing summary are 1) it addresses the expectation that before a knowledgeable buyer buys a property, he would look to see what else is on the market that might meet his needs, or might shape his thinking in terms of value; 2) the information necessary to compile such a comparison these days is readily available on the web sites of more sophisticated brokerages, and/or subscription services like Loopnet and CoStar (it is not an intrusive process dependent on the cooperation of others, as compared to broker interviews or tracking down the details of closed sales).  The disadvantages are 1) properties generally sell for less than their asking prices, sometimes considerably less; and 2) despite all the evidence of a decline, many sellers have yet to get realistic in their pricing, indicating that their desire to sell is not that great, or they have not properly educated themselves as to the economic climate in which their property must compete.

In summary, historical sales can set a high end, a low end, or a reasonable indication of value, depending on the application of a credible (and these days, a multi-tiered) time adjustment, and a good understanding of the motivation of the parties involved (to weed out distress sales).  In a declining market where transaction volumes are off, broker / agent and other market participant interviews tend to set a low end on potential.  Listings, on the other hand, tend to set a high end; market value cannot be any greater than the lowest cost of acquiring a truly comparable substitute.  With these sidebars properly developed and considered, a relatively narrow range of reasonable, logical and defensible market value potential can be opined, even in a slow market.


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