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One Step Further – Implementing the Recommendations of Guide Note 12

Final Draft of Article by Kerry M. Jorgensen , MAI and Stephen F. Fanning, MAI

Scheduled to be published in the Appraisal Journal , Summer of 2013

In releasing Guide Note 12, the Appraisal Institute has shown how an appraisal can become a more valuable tool for users by going one step beyond a single point in time value opinion, and adding an opinion of the sustainability of the value over time.[1] By analyzing current transactions, competent appraisers generally do a reasonable job of estimating what a property would currently sell for; but, in a “bubble” or “bust” market, or even in more typical market cycles, clients may need more information to make good decisions. The intent of this article is to introduce practical ways the recommendations in the guide note can be implemented into everyday appraisal assignments, and perhaps even expand on the recommendations.

The Problem

Real estate markets are cyclical and constantly changing. The Dictionary of Real Estate Appraisal, 5th Edition defines market equilibrium as, “The theoretical balance where demand and supply for a property, good or service are equal. Over the long run, most markets move toward equilibrium, but a balance is seldom achieved for any period of time [italics added]”. After an appraisal goes out the door, it very quickly becomes outdated.

For decades, through a number of market cycles, appraisers have struggled with a disconnection between what we have viewed as our role and what users of appraisal services believe they should receive. The viewpoint of most appraisers has been quite simple; a market value appraisal is single point in time analysis, based entirely on the current behavior of buyers and sellers, no matter how hot or cold the market may be. In fact, appraisers typically would go so far as to say that an appraiser’s own opinion regarding the propriety of market prices, the likely future trends, or the risk in a particular investment is immaterial to a market value opinion. The only consideration is what buyers and sellers are thinking, as reflected in current transaction prices. It has even been suggested that the only reason we do fundamental market analysis is to mimic the analysis that market participants are making.[2] If our definition of market value is strictly construed as the most probable selling price, perhaps that interpretation is entirely reasonable.

The problem is that our clients, the users of appraisal services, apparently have a different view of our role. When the housing market collapsed, fingers were pointed at appraisers for not doing more to prevent bad loans from being made when the market was hot.[3] When we point out that we only report on current market prices, so an appraisal in a bubble market will naturally be high to reflect current market conditions, they are troubled that our focus is so narrow. They ask, “If appraisals only report what properties would sell for on a certain day, what good they do in protecting us from the effects of a bubble market?” When the bubble burst, numerous articles appeared in real estate, banking, finance and economics publications pointing out the shortcomings of the traditional appraisal process, and calling for change. These calls were not new; we heard them in the 1980’s after the last big collapse and to a lesser extent at other times. More recently, appraisers have been accused of preventing the market from recovering by including distressed sales in our analyses. [4]At the 2011 Appraisal Institute national meetings in Las Vegas, a guest speaker was the president of the National Association of Home Builders, who leveled that charge at us quite directly. Attempts have even been made to legislate how an appraisal is to be completed and what may be used as a comparable. Thankfully, the Appraisal Institute has been at the front in fighting those movements.

Unfortunately, however, most of our response to the complaining and finger pointing has been defensive. We grumble that they are “shooting the messenger,” and that they fail to understand what we do. But, we should not forget, these are our clients, and if they have a need we should be looking for a way to fill it. They are asking for more than a single point in time estimate. They want something more forward looking to assist them in answering questions like, “is now a good time to buy,” “should I make this loan,” “is this loan value sustainable,” “is the proposed development feasible,” and “what are the risks in the current market?” With markets like we had in 2006 and 2009, a traditional “point in time” market value opinion is not enough to help them answer those questions. If we ignore what our clients are asking for and refuse to provide anything else, can we be surprised that the perceived value of appraisals is declining, and that demand for appraisal services is falling? To insist that they should be happy with the same old product we have always delivered is a bit like a phone carrier insisting that phones are for talking to people and that phone customers should not expect them to do more.

The Solution

Guide Note 12 summarizes important considerations for analyzing market trends, and makes recommendations for proper appraisal practice. Among the points made are:

• Real estate markets are characterized by cycles. The change from one stage of the cycle to another may be gradual, but in a “bubble” and “bust” cycle the change can be rapid.

• Factors that cause markets to change are different than symptoms of change such as changes in vacancy rates, changes in rents and prices, frequency of concessions and seller financing, etc. (Our own thought is that an inferred analysis is more focused on the symptoms of change, while a fundamental analysis is more focused on the factors of change themselves.)

• Capital markets (buyers and lenders) and fundamental markets (space users) each have their own set of factors that cause real estate markets to change.

• Market analysis is generally completed using a six-step process, and allows the appraisal to be forward looking rather than backward looking. The level of analysis can range from highly sophisticated to very simple, depending on the scope of work. (The six-step market analysis process allows the appraiser/analyst to predict future changes in market conditions. If you are not familiar with the six step process, you would find one of the Appraisal Institute’s market analysis courses to be a helpful update.)

• Even when the market analysis is well developed, unforeseen events can invalidate the conclusions.

• Two risks are inherent in the use of an appraisal; (1) that the value conclusion is unreliable due to a lack of quality data, and (2) that the value might not be sustainable over time. (Appraisers strive to minimize the first risk by assembling the best possible data. However, they have often not concerned themselves with the second risk because they have considered it to be outside their responsibility.)

• As part of the reconciliation, the appraisal should discuss, as appropriate, the likelihood that the value might not be sustainable into the foreseeable future.

So, here is something new to many appraisers. Guide Note 12 is suggesting that, beyond reporting what a property would currently sell for, an appraisal may need to go one step further, by providing the reader with an opinion as to the future trend in market conditions. And, that opinion should not merely mimic the expectations of buyers and sellers. The first paragraph of the Guide Note states, “The market trends study should include what market participants (buyers, etc.) believe will happen to market conditions in the future as well as [italics added] current supply and demand and anticipated changes to supply and demand.”

Of course, the need for an opinion regarding the sustainability of value or the future trend in market conditions will depend somewhat on the intended use and intended users. For ad valorem taxes or eminent domain, such a prediction may well be unnecessary if ample comparable sales are available, because the only question being asked by the client is what the property would currently sell for.[5] However, when the intended user will rely on the appraisal to decide on an investment or underwrite a loan, it is not enough to know what a property would currently sell for without some analysis of future market trends.

Faced with this realization, and seeing the recommendations of Guide Note 12, appraisers naturally have some concerns. Some doubt any prediction of future market trends would be meaningful. Our advice would be to get into some courses and learn market analysis, and start using it in your work. We are naturally skeptical about procedures we do not understand. Appraisers who are not well trained in discounted cash flow analysis doubt that it is helpful, and appraisers who do not understand statistics doubt that they are meaningful. It is only after using these tools that we realize their value. An appraiser with advanced training in market analysis can often predict changes in market conditions before those changes are widely recognized by market participants.

Another concern is that predicting market trends is inherently risky. Appraisers fear an incorrect projection or forecast could result in a loss of credibility, or even a lawsuit. Consider, however, that appraisers already make predictions in their work. In a discounted cash flow analysis, they predict income and expenses over a number of years. In direct capitalization they directly predict income for the next 12 months. Many also estimate stabilized income for comparables to extract a cap rate which is forecasting for each comparable as well as the subject. Even in selecting and adjusting comparable data, appraisers predict how one property will do in the future compared to another. Successful lawsuits are almost always based on factual errors or omissions in a report, not on opinions or projections. Guide Note 12 acknowledges that unforeseen events can invalidate the conclusions of a market analysis, and it would be reasonable to have such a limiting condition in any report.

A third concern is that clients will react poorly to having this information included. Some have worried, “if I indicate in an appraisal that the future trend is downward, the client will never use me again.” However, we probably underestimate our clients. Most appreciate this additional information. Those that do not are the same clients who ask appraisers to delete negative comments from reports or to do other biased and unethical things. Stand your ground, and the best clients will naturally gravitate toward you.

One final concern of appraisers is that they will be asked to do more work with little or no additional compensation. Our hope is that this article can present some practical suggestions regarding fulfilling our obligations to clients under Guide Note 12, without spending an inordinate amount of time.

The Theory

Real estate values are dependent on two somewhat distinct markets; the fundamental (space user) market and the capital (investor) market. “While the space market is the most fundamental type of market relevant to the real estate business, the asset market is of equal importance… The real estate asset market must be viewed as part of the larger capital market, the market for capital assets of all types”[6] Both markets are subject to cycles and face constantly changing forces of supply and demand. The space user market is made up of landlords and tenants. Fundamental supply is represented by the amount of space in a market, which can grow through new development or shrink through demolition or conversion to other uses. Fundamental demand is the amount of space for which tenants have desire and adequate purchasing power. Changes in fundamental demand are the result of changes in the number of jobs, household income and the number of households. The result of changes in the supply of space and demand for space is changing occupancy and changing rental rates (or retail prices in owner-occupied markets).

Capital markets consist of persons and entities with money to invest in all types of assets such as stocks, bonds, precious metals and real property. In real property, capital comes from both equity investors and mortgage lenders. Demand is represented by the total amount of capital looking for investment in a particular market; supply is represented by the number of investment properties available in that market. If investor demand increases without a commensurate increase in supply, prices increase. If investor demand decreases and the number of investment properties does not change, prices decline. The result of changes in supply and demand for real estate capital is changes in equity capitalization rates and equity discount rates on the equity side; and changes in interest rates, loan-to-value ratios and debt coverage ratios on the debt side.

For a long time, Appraisal Institute advanced education has included discussion of market cycles. That material generally focuses on the fundamental (space user) market and breaks the cycle into four typical stages: expansion, contraction, recession and recovery (See Figure 1). Of course, the capital market also experiences cycles. In fact, some of the most severe real estate cycles of the past 70 years have been the result of swings in the amount of capital flowing into real estate, rather than imbalances in the supply and demand of space. The fundamental market cycle has been called a market cycle within the market cycle.

Figure 1

[pic]

Market forces naturally pull markets toward equilibrium over the long run.[7] However, because real estate markets are imperfect, a true balance of supply and demand is seldom achieved for long. Nevertheless, the concept of equilibrium is vital to our understanding of market cycles, and to our ability to estimate where a market is in the cycle and what the future trends are likely to be.

Tools for Analyzing the State of the Market Cycle

The following are some tools that can be used to estimate where in the fundamental cycle a market is currently.

• Entrepreneurial Incentive (Profit Potential)

One important concept is that, when the market is at equilibrium, potential profit on a fully functional new construction is equal to what real estate appraisers refer to as entrepreneurial incentive. Entrepreneurial incentive is the minimum amount of profit necessary to entice a developer to take on the time, effort and risk of a new development. When the market is below equilibrium, potential profit on a development is below entrepreneurial incentive. It is for that reason that the rate of new construction declines, often very sharply. When the market is above equilibrium, potential profit is above entrepreneurial incentive. Near the peak of a market, these excessive profits can result in over-exuberance on the part of developers and result in surplus inventory being developed. (This over-exuberance can be evident in the fundamental and/or capital market.) In a bubble market, the excess can be quite severe, and can take years to correct.

In the Appraisal Institute course Advanced Concepts and Case Studies, it is noted that when the market is weak and would not currently support new construction, a proper cost approach will nevertheless include an entrepreneurial incentive that is adequate to attract a developer to take on the project. Any loss in value due to the weak market conditions should be accounted for as external obsolescence, rather than as a decrease in the entrepreneurial incentive. Likewise, when the market is above equilibrium and potential profits are high, the entrepreneurial incentive in the cost approach should be limited to the minimum amount necessary to justify construction. Any additional value enhancement from favorable market conditions should be accounted for separately as an external impact. Such an adjustment is sometimes referred to as “positive external obsolescence.” The course notes that some appraisers simply increase the entrepreneurial incentive in the cost approach to the amount the market would currently support. However, that method results in an overstated replacement cost which masks risk and could be misleading.

An analysis of potential profit can be a very helpful tool in determining where in the cycle a market is, and what the future trends are likely to be. Profit comparisons can be extracted directly from sales of recently completed developments. Another check can be made by comparing the results of the cost approach (before consideration of external obsolescence due to market conditions) to the results of the income and sales comparison approaches.[8] Unfortunately, appraisers and their clients have sometimes been too quick to dismiss the cost approach as being unreliable in determining market value. As an industry, our skills with the cost approach have become rusty. But, to meet the vision of Guide Note 12, a cost approach may be an important part of the process. A well developed cost approach, supported by a good market analysis, can even help show the severity of the cycle by measuring how large the difference is between current profit potential and entrepreneurial incentive. One problem, however, is that when the market is very strong, land prices and construction costs tend to be artificially bid up, and the reverse can be true when the market is very weak, so appraisers will need to become better at recognizing those circumstances.

• Frictional Vacancy

Another tool that can be used to analyze the state of the current market is to compare the current market vacancy rate to the frictional vacancy rate. Frictional vacancy is[9], “Vacancy unrelated to disequilibria in supply and demand… a typical vacancy rate in a given market operating in equilibrium.[10]” Market vacancy rates above frictional vacancy tend to discourage new construction. When market vacancy rates fall below frictional vacancy, the rate of construction typically accelerates. Frictional vacancy is different for every market. Frictional vacancy might be 35% for a hotel market in a given location, 10% for an office market in that same location, and only 5% for an apartment market. The frictional vacancy rate for office buildings is not the same in Dallas as it is in Manhattan. Frictional vacancy can also vary by class (Class A vs. Class B or Class C).

By studying past market cycles, an appraiser can estimate the frictional vacancy rate for a particular market. For example, in a recovering market frictional vacancy relates to the point in time when new construction becomes feasible and new projects are announced. In a contracting market, frictional vacancy can correspond to the point in time when rent discounts or concessions begin appearing. A comparison of current market vacancy to frictional vacancy can assist in determining where in the cycle a market is currently. Because markets naturally gravitate toward frictional vacancy, an understanding of this concept can be a powerful tool in predicting where vacancy rates will be in the future and what the trend in rents is likely to be.

• Feasibility Rent

When the market is at equilibrium, the rental rate for new, fully functional space is equal to feasibility rent. Feasibility rent is calculated by multiplying replacement cost (including land and entrepreneurial incentive) by an appropriate capitalization rate to figure the amount of net operating income necessary to make construction feasible. The net income is then adjusted upward for fixed expenses, variable expenses and frictional vacancy to estimate potential gross income (rent) necessary to make construction feasible. The calculation is not overly difficult, and consists mostly of components of the cost and income approaches that may already be part of the appraisal. By comparing feasibility rent to current market rent for new, fully functional space, the appraiser has an additional tool in determining whether the market is above or below equilibrium, and where in the cycle the market is at a given point in time.

Table 2

|Feasibility Rent Example |

|Replacement cost new (per square foot or per unit) for fully functional space, including |$100.00 |

|land and entrepreneurial incentive | |

|Multiply by the overall capitalization rate |x 0.085 |

|Feasibility net operating income per square foot or per unit |$8.50 |

|Add fixed expenses per square foot or per unit |+ $1.50 |

|Subtotal |$10.00 |

|Divide by (1 – variable expense ratio) |÷ 0.80 |

|Feasibility effective gross income per square foot or per unit |$12.50 |

|Divide by (1 – frictional vacancy) |÷ 0.92 |

|Feasibility rent per square foot or per unit |$13.59 |

• Equilibrium Rent

A variant of feasibility rent is a calculation of what market rent should be for a subject property when the market is at equilibrium. The calculation is very similar to feasibility rent, but rather than being based on the cost of new construction, the equilibrium rent calculation uses the replacement cost of the subject minus all forms of depreciation except external obsolescence due to market conditions. The other inputs to the calculation are also based on the subject rather than new space. Rather than frictional vacancy, which relates to a market overall, the vacancy adjustment should be what the subject’s vacancy would be expected to be when the market is at equilibrium. The expense ratio could be different than new space and the capitalization rate could also be different.

The advantage of a subject-specific equilibrium rent calculation is that it allows an appraiser to go beyond an opinion of whether market rents are above or below equilibrium; it allows the appraiser to make an estimate of what a subject’s rent will be when the market corrects itself. For example, in a depressed market where rents are well below the amount necessary to justify new construction, an equilibrium rent calculation provides an estimate of what a subject’s market rent will be when the oversupply is fully leased up. Near a market peak, in a so-called landlord’s market, an equilibrium rent calculation can estimate how far the subject’s rents are likely to decline when new space comes on line. When appropriate, the cost basis for the calculation can be trended for inflation to provide an estimate of equilibrium rent at a point in the future when fundamental analysis indicates the market will likely be near equilibrium. This can be a helpful tool in making income projections for a discounted cash flow analysis.

Table 3

|Subject Equilibrium Rent Example |

|Subject replacement cost new (10,000 sq. ft. @ $70) |$700,000 |

|Entrepreneurial incentive (Minimum necessary to justify new construction when |$70,000 |

|the market is at equilibrium) | |

|Depreciation (excluding external obsolescence due to market conditions) |($170,000) |

|Subject depreciated improvements cost |$600,000 |

|Land value |$200,000 |

|Subject depreciated replacement cost including land |$800,000 |

|Multiply by the overall capitalization rate |x 0.0875 |

|Subject equilibrium net operating income |$70,000 |

|Add fixed expenses |+ $17,000 |

|Subtotal |$87,000 |

|Divide by (1 – variable expense ratio) |÷ 0.80 |

|Subject equilibrium effective gross income |$108,750 |

|Divide by (1 – vacancy rate estimate for subject when the market is at |÷ 0.90 |

|equilibrium) | |

|Subject equilibrium potential gross income |$120,833 |

|Divide by rentable sq. ft. or units |÷ 10,000 sq. ft. |

|Subject equilibrium rent estimate |$12.08/sq. ft. |

Table 3 is an example of an equilibrium rent calculation. Say, for instance, that the actual market rent for this property is currently $13.50 per square foot because a strong economy has left the market undersupplied. The equilibrium rent calculation of $12.08 per square foot indicates that, in a balanced market, market rent would be expected to be about $12.08 per square foot. Depending on other aspects of the market analysis, the appraiser might now predict that, when new supply comes on line and the market moves back to equilibrium, market rent for the subject will decline to about $12.08 per square foot. This is a powerful tool in meeting the vision of Guide Note 12, because the appraisal now communicates to the reader that there is a risk the current market value might not be sustainable into the future. By increasing the appraiser’s ability to predict the future pattern of rent, it also improves the inputs to a discounted cash flow analysis or the selection of a property capitalization rate for direct capitalization.

• Affordability Analysis

Another very helpful tool for judging current market conditions is to determine the affordability of current market rents or current market sales prices. Tables 4 and 5 show the calculation of affordable home price or apartment rent, and an affordability index.[11] The technique is to calculate the home price or apartment rent a median income household could afford, and compare that to the actual median home price or the actual median apartment rent. If the sales prices or rents are significantly above the median affordability limit, the prices or rents may not be sustainable and could decline in the future. In the opposite case, sales or rents significantly below affordability can show the market is below equilibrium and could eventually increase.

Table 4

|Residential Affordability Analysis (Owner Occupied) |

|Affordability Loan Terms |

|Down payment ratio (at sustainable ratio) |10% |

|Mortgage interest rate (at sustainable rate) |5.00% |

|Mortgage term in years |30 |

|Ratio of income available for mortgage payments (at sustainable ratio) |25% |

|Analysis of Affordable Median Home Price |

|Median household income in competitive market |$67,750 |

|Ratio available for mortgage payments[12] |25% |

|Annual income available for mortgage payments |$16,937.50 |

|  |÷ 12 months |

|Monthly income available for mortgage payments |$1,411.46 |

|Monthly loan constant (by financial calculator or spreadsheet) |÷ 0.0053682 |

|Affordable mortgage amount |$262,929 |

|Mortgage ratio (loan-to-value ratio) |÷ 0.90 |

|Affordable median home price |$292,143 |

|Actual current median home price |$312,000 |

|Affordability index (affordable ÷ actual current) |0.936 |

Table 5

|Residential Affordability Analysis (Renter Occupied) |

|Affordability Rent Limit |

|Ratio of income available for rent (at sustainable ratio) |25% |

|Analysis of Affordable Median Home Price |

|Median household income in competitive market |$52,500 |

|Ratio available for rent |25% |

|Annual income available for rent |$13,125.00 |

|  |÷ 12 months |

|Affordable median rent |$1,094 |

|Actual current median rent |$1,025 |

|Affordability index (affordable ÷ actual current) |1.067 |

Market segmentation or some judgment may be necessary to interpret the results of an affordability analysis. Owner households typically have higher median income than renter households, so an affordability analysis can be strengthened by using median income for owner households when calculating affordability of single family and condominiums, and by using median income for renter households when calculating affordability of apartments. Some markets tend to be more or less affordable over the long run, even when the market is in balance. By recording the affordability ratio over time, an appraiser can develop an index that identifies when prices or rents are increasing faster than income, or visa-versa. The National Association of REALTORS© and others publish affordability indexes for major metro areas, but a more refined analysis relating to one particular market may be more meaningful.

Figure 6 is an example of a simple graph that could be used in an appraisal report to help communicate the result of an affordability analysis. The information in such a graph would be rather easy for an appraiser to compile and maintain for a market they work in routinely, and would go a long way in establishing how sustainable rents and values may be over time.

Figure 6

[pic]

Affordability can also be used to analyze non-residential markets. For example, rent affordability in retail can be analyzed based on the ratio of rent to expected sales.[13] If market rent for retail space exceeds the typical ratio to expected sales, it could be an indication the market is above equilibrium and there could be downward pressure on rents over time. Actual sales can usually be obtained for a subject property and are a helpful consideration, but a fundamental forecast of potential sales is advisable in some situations to check if the subject is operating at market levels. For a general check the comparison can also be based on national or typical store sales. For this example we will use national averages of $300 per square foot and 7% of sales as the average amount retail tenants can afford to pay.

Table 7 is an example of a retail rent affordability calculation. The calculation assumes the national average sales for the type of retail space under consideration is $300 per square foot, that 7% of sales is the average amount retail tenants can afford to pay, and that current market rent is $30 per square foot. The comparison suggests a tenant would have to sell 43% more than the national average to afford that rent. This gives the appraiser and the client a gauge to judge the sustainability of a value conclusion based on $30 rents.

Table 7

|Retail Affordability Analysis |

| Gross rent Indicated by comparables | $ 30.00 |

|Affordability % for subject-type retail |7.0% |

|Indicated required sales per square foot | $ 428.57 |

|National average sales per square foot | $ 300.00 |

|Percentage over national median sales |43% |

This analysis can also be reversed if the appraiser knows the sales at the subject and it is determined the subject sales are typical in the market for this type of store at this location (See Table 8). This affordability analysis can now determine the rents needed to have a sustainable value if the current sales volume is forecast to continue.

Table 8

|Affordability Rent Estimate |

| Current or forecasted subject sales/square foot |$250 |

|Affordable rent ratio (% of sales) |7.00% |

|Affordability rent |$17.50 |

• Market Analysis

Of course, a well developed market analysis is critical to meeting the goal of Guide Note 12. In some cases, inferred demand analysis is adequate. In those cases, the appraiser can consider what the guide note calls symptoms of change. The analysis could include a discussion of the trend in rents and prices, the trend in vacancy rates, and the frequency of seller or landlord concessions. A general discussion of buyer and seller attitudes is also appropriate. However, it is important for an appraiser/analyst to be somewhat contrarian in their view. Because real estate markets are imperfect, general market perceptions tend to lag behind reality. Near the peak of a market, developer and investor attitudes can be very rosy, whereas the actual risk in the market can be high if substantial new construction is in the pipeline. At the bottom of a cycle, buyers can be quite pessimistic when it may, in fact, be the perfect time to buy. Future market trends can be quite at odds with current market conditions. Here is where Guide Note 12 envisions an appraisal becoming a more helpful tool, by alerting the reader of a report that the high rents and prices at the top of a cycle may not be sustainable over time, and by showing that the low rents and prices at the bottom of a cycle are likely to improve over time.

The key to inferred analysis is to look at data trends with an eye to the supply and demand market cycle. Table 9 is an example of the kinds of data that are common in an inferred analysis

Table 9

|Market Area Class A Apartment Statistics |

|Year |Average Rent/Sq. Ft. |Increase in |Average |

| |(Current Dollars) |Average Rent/SF |Vacancy Rate |

|4 years ago |$0.80 | - |3.7% |

|3 years ago |$0.85 |6.3% |3.5% |

|2 years ago |$0.90 |5.9% |4.9% |

|1 year ago |$0.95 |5.6% |6.2% |

|Current |$0.98 |3.2% |7.9% |

Transaction prices in the market illustrated in Table 9 could be quite high. Although vacancies have increased, rents have continued to increase. However, a well trained appraiser would recognize the pattern as evidence the market could have peaked, and that current market prices might not be sustainable. A common misread of market conditions is that a large amount of construction is many times interpreted as a good market. In reality it may be evidence of a developing oversupply.

When appropriate, an appraisal should include a full fundamental demand analysis. That process allows the appraiser to go beyond simply saying where the market is in the cycle. In fundamental demand analysis, the appraiser actually predicts the amount and timing of future changes in supply and future changes in demand, and estimates the time remaining before the market returns to equilibrium.

For example, consider an assignment to appraise a 100,000 square foot office building that is 80% leased. The market is generally recognized as being oversupplied because competitive properties show higher-than-normal vacancy and rents have stopped rising. This type of assignment might benefit from a marginal demand study like the example in Table 10. The forecast of future demand is based on an analysis of office employment patterns of the market area. An analysis of this type can help the appraiser predict the pattern of occupancy and rent in the future.

Table 10

|Fundamental Analysis of Supply and Demand |

| |Current |Forecast |Forecast |

| | |+5 Years |+10 Years |

|Current and forecasted demand (occupied sq. ft.) |1,377,000 |1,593,000 |1,791,000 |

|Adjustment for frictional vacancy (10%) |÷ 0.90 |÷ 0.90 |÷ 0.90 |

|Supportable space (sq. ft.) |1,530,000 |1,770,000 |1,990,000 |

|Current supply (sq. ft.) |1,800,000 |1,800,000 |1,800,000 |

|Net new construction* |- |- |- |

|Forecasted supply (sq. ft.) |1,800,000 |1,800,000 |1,800,000 |

|Marginal demand - (excess)/shortage of supply |(270,000) |(30,000) |190,000 |

|Current and forecasted occupancy rate (demand ÷ supply) |76.5% |88.5% |-* |

|* New competition is left at "0" for the initial look at the market, and then adjusted in the next study phase, if warranted. In this case, more study on |

|probability of new construction in years 5-10 may be warranted because the analysis indicates unsatisfied demand in that period. |

Based on the analysis in Table 10, an appraiser could forecast the market will return to equilibrium occupancy of 90% (10% frictional vacancy) in about 5 to 6 years. Market rents can be predicted to start increasing when the market has reached equilibrium. If development land is available, the higher rents and lower vacancies will likely spur new construction activity by year 6 or 7.

Table 11 summarizes some typical characteristics of the fundamental market at various stages of the cycle. A good market analysis will identify current market characteristics and will enable an appraiser to reasonably establish where in the cycle a market is, what the future trend is likely to be, and therefore how sustainable a market value opinion is.

Table 11

| |Market Rent |Market |Construction |Development |

| |(For New Construction) |Vacancy |Volume |Profit |

|Expansion |Above feasibility rent and |Below frictional vacancy and |Less than growth in demand |Above entrepreneurial incentive |

| |increasing |decreasing | | |

|Contraction |Above feasibility rent, but |Below frictional vacancy, but|More than growth in demand |Above entrepreneurial incentive |

| |flat or decreasing |increasing | | |

|Recession |Below feasibility rent and |Above frictional vacancy and |More than growth in demand |Below entrepreneurial incentive |

| |flat or decreasing |increasing | | |

|Recovery |Below feasibility rent and |Above frictional vacancy, but|Less than growth in demand |Below entrepreneurial incentive |

| |flat to increasing |decreasing | | |

Graphics can sometimes be used very effectively to convey conclusions regarding market conditions to a reader. Some appraisers have begun including graphics in the market analysis sections of appraisal reports, to illustrate their conclusions regarding current market conditions. Two common alternative methods of illustrating the typical cycle are a wave graph or a circular graph. Some appraisers are using arrows to illustrate a conclusion regarding where a market is in the cycle. Others prefer to use a set of arrows, brackets or shading to illustrate a range rather than a single point estimate. These graphics are similar to illustrations in national publications relating to national or regional markets, but are based on the specific market area addressed in an individual appraisal. Figures 9 and 10 are very simple examples created in Word. With a little practice, appraisers should be able to create better graphics of their own.

Figure 5

[pic]

Figure 6

[pic]

The Capital Market

Appraisal Institute coursework includes a quite refined process for analyzing the fundamental (space user) market, based on a comparison of the supply of space available in a market with the demand from tenant users. Our understanding of capital market cycles is weaker. Nevertheless, if we are to comment on the sustainability of a value opinion over time, as discussed in Guide Note 12, some consideration must be given to the capital market.

The real estate capital market is sometimes referred to as the buy-sell market, because it consists of demand for investments from both debt and equity sources and the supply of available investment properties from willing sellers. Like the fundamental market, the capital market cycles over time. On a large scale, real estate is viewed more favorably by investors in some periods than in others. When a larger share of investment funds is directed to real estate, prices are driven up. Later, investors may view stocks, bonds or other investments more favorably, so capital flows out of the real estate market and prices go down. On a smaller scale, capital flows may be targeted at a particular type of real estate or at real estate in a particular location. In a bubble market, investor exuberance can become irrational and prices get bid up to unsustainable levels. A bust can follow, with buyer confidence irrationally low.

The question becomes, how can an appraiser spot situations when a market is out of balance on the capital market side of the equation? Consideration must be given to both equity capital and mortgage debt capital. On the mortgage side, disequilibrium can be evidenced by underwriting criteria that are out of line with what has been the norm historically. Measurement could be based on loan-to-value ratios, debt-coverage ratios or borrower qualification criteria. When underwriting is atypically lax, it is likely that loan terms will be tighter in the future, which could drive down prices.

On the equity side, capitalization rates might be the best measure of market balance. In the property model formula R = Y – CR (or, alternatively Y = R + CR), we note that the yield rate (Y) is equal to the capitalization rate (R) plus the compound rate of change in income and value (CR). If CR is assumed to be somewhat related to general inflation over the long run, the capitalization rate can be construed as a risk premium of sorts. That is, the capitalization rate is the amount by which the required yield on an investment exceeds inflation. If inflation increases, investor yield requirements increase to cover the inflation and net the same real rate of return. However, if the rate of change in income and value is assumed to increase with inflation, the overall capitalization rate remains the same. Therefore, if capitalization rates decline, the risk in the market increases. Unless the risk characteristics of the market change, the likelihood is that, over the long run, capitalization rates in a particular market will move back to their historic range. If capitalization rates for a particular market are above what has been typical historically, it could indicate the capital market is below equilibrium, which could signal a buying opportunity for investors.

In a similar vein, a prescient research paper was published in the October 1, 2004 Federal Reserve Bank of San Francisco Economic Letter.[14] It suggested that a developing bubble market might be identified in the housing sector by a large and long-lasting deviation in the price-to-rent ratio from its historical average. The paper noted that housing prices had been increasing much faster than rents, so that the price-to-rent ratio was 18% above its long-run average (as of 1st quarter 2003). At that time, the analysts suggested the high ratio could mean slower house price appreciation going forward. Of course, the bubble eventually became much more pronounced and resulted in a collapse a few years later. Since then, the price-to-rent ratio has been pointed to as a statistic that should have been given more attention by analysts.

• Fundamental (Intrinsic) Value

Because of price volatility over the past decade, many real estate experts have been discussing a fundamental value or intrinsic value concept for real property, contrasted with market value. Fundamental/intrinsic value can be defined as, “what an asset is actually worth, rather than its current market value, which is overly influenced by market conditions such as a recession or a speculative bubble.”[15] Because markets are imperfect and market participants do not always have good information available, it is possible for market prices to get out of line with the value that would be indicated by a reasonable projection of future income or benefits.

In securities markets, it is not unusual for an analyst to suggest that the fundamental value of stock is, say, $50 per share, when the market price is $45 per share, and recommend a buy; or to say the fundamental value of another stock is, say, $20 per share when the market price is $24 per share, and recommend a sale. The ASA Business Valuation Standards define intrinsic value as, “The value that an investor considers, on the basis or an evaluation of available facts, to be the “true” or “real” value that will become the market value when other investors reach the same conclusion.”[16] Another source indicates, “…fundamental value is the market price that would prevail if all the market participants were perfectly informed investors.”[17] Most texts indicate that fundamental value is calculated by discounted cash flow analysis, with the discount rate being the normal rate for the asset given its risk characteristics (as opposed to the rate that would be indicated by current transactions). In a normal market, fundamental value and market value would presumably be the same. However, in a bubble market, buyers are motivated by potential price appreciation and focus less on potential income or ownership benefits, so fundamental value can become out of line with market value.

Real estate appraisers have historically focused almost exclusively on market value, and have little exposure to fundamental value concepts. [18] However, a better understanding and some training in this area could be a valuable tool in estimating what future value trends are likely to be. We recommend more research needs to be done if appraisers are to be trained to make meaningful statements as to the sustainability of value opinions from the capital market side.

Conclusions

By analyzing such measures as entrepreneurial incentive, feasibility rent, frictional vacancy, affordability analysis, fundamental market analysis and capital market analysis, an appraiser can reasonably estimate where in the cycle a subject’s specific market is currently. With an understanding of market cycles, he/she can then meet the goal of Guide Note 12 by going one step beyond a traditional value opinion tied to one particular valuation date, and also provide an opinion regarding the sustainability of that value. In that way, the appraisal report becomes a more valuable and helpful tool for clients who need to need to know the likely market trend in order to make good decisions. Of course, no prediction of future market conditions is going to be perfect, but we have the ability to provide the general information that users of appraisal services are looking for. It is a vital addition to our role in the market, and will result in greater confidence in appraisal work and in a brighter future for our profession.

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[1] Guide Note 12 starts with this theme- Page 1, “Since the value of a property is equal to the present value of all of the future benefits it brings to its owner, market value is dependent on the expectations of what will happen in the market in the future.” The Guide Note ends with this theme – “When necessary, the appraisal report should include a discussion of evidence that the value conclusion may not be sustainable into the foreseeable future.”

[2] An example of this viewpoint is expressed by Richard L. Parli, MAI in a letter to the editor of the Appraisal Journal commenting on “Price versus Fundamentals – From Bubbles to Distressed Markets” (Spring 2011). His opinion is that the issue in market analysis is, “…not what the market ought to know but what the market does know.” He further states that fundamental analysis, “…is not a proprietary appraisal procedure but a process developed by market participants. Appraisers adapted the process to better model and better understand market behavior.” (The Appraisal Journal (Summer 2012): 254-255)

[3] In one online article, the author briefly explained the three approaches to value and stated that, if appraisals are done correctly, no speculative bubble can develop. However, the author indicates, “The most common thing they [appraisers] did was to use the market data method, only, and ignored the other two tests. By ignoring fundamental values, prices simply leap-frogged sale after sale. Up and up and up, into a speculative bubble.” (Bushong, Ned. "You're All Wrong. Blame The APPRAISERS For The Mortgage Crisis." Business Insider. N.p., 07 Apr. 2010. Web. 05 May 2013

[4] In June 2009, NAR Chief Economist Lawrence Yun released a report indicating, “…the increase in sales is less than expected because poor appraisals are stalling transactions. Pending home sales indicated much stronger activity, but some contracts are falling through from faulty valuations that keep buyers from getting a loan.” He further stated, “There is a danger of a delayed housing market recovery and a further rise in foreclosures if the appraisal problems are not quickly corrected.” (Yun, Lawrence. "Existing-Home Sale Continue to Rise." REALTOR® Magazine-Daily News. N.p., 23 June 2009. Web. 05 May 2013) An AP report article July 15, 2009 indicated critics of HVCC were saying low appraisals were delaying or undermining sales, and quoted Marc Savitt, president of the National Association of Mortgage Brokers saying, “This thing is not only preventing the housing market from recovering, it’s destroying the housing market.” (Veiga, Alex. "New Home Appraisal Rules Stir Industry Backlash." USA Today. N.p., 15 July 2009. Web. 05 May 2013.)

[5] This does not suggest that forecasting is not required for these intended uses, as market value is still the present worth of future benefits. The future benefits can be based on data from buyers and on data from the fundamental market, as Guide Note 12 suggests. Thus forecasts are still required to select the comparable sales and adjustment them, to forecast income in the income approach, and to estimate economic obsolescence in the cost approach. However, the difference is that for intended uses like ad valorem taxes or eminent domain, the client does not need the report to estimate what point the market is in the cycle, or how sustainable the value opinion is.

[6] Geltner, Miller, et al, Commercial Real Estate Analysis & Investment, (Cengage Learning, 2007), pg. 11

[7] In one context, market prices are a reflection of constantly changing supply and demand and are said to be an equilibrium point where the amount sellers are willing to sell (supply) equals the amount buyers are willing to buy (demand). Use of the term equilibrium as it is used in this article is long run equilibrium, consistent with the definition of equilibrium in The Dictionary of Real Estate Appraisal, 5th Edition.

[8] For property types that potentially include intangible assets, the difference between the cost approach and the other approaches could be an indication of intangible property rather than an indication of an undersupplied market. For those property types, other methods may be necessary to decide if a market is above equilibrium.

[9] Historically, the concept of frictional vacancy was tied to a market in equilibrium. That connection was removed from the definition of frictional vacancy in The Dictionary of Real Estate Appraisal, 5th Edition. The authors consider the equilibrium tie to be important to the concept, and have therefore relied here on the definition from the 4th Edition.

[10] Appraisal Institute, The Dictionary of Real Estate Appraisal, 4th ed. (Chicago: Appraisal Institute, 2002), 121

[11] Affordability analysis can also be performed on other property types like retail and, to some extent, office.

[12] A more refined version of this calculation is based on the front-end ratio, which is based on the ratio of principle, interest, taxes and insurance (PITI) to income. In that case, the monthly loan constant in the calculation must be loaded to include property tax and insurance.

[13] Subject of an article by Raymond T. Cirz, “Retail Sales Set Rent Levels: Real Estate Issues Journal of Counselors of Real Estate, Vol 37.

[14] FRBSF Economic Letter 2004-27; October 1, 2004 House Prices and Fundamental Value

[15] Campbell, Harvey R. "Intrinsic Value." Farlex Financial Dictionary. N.p., 2012. Web. 5 May 2013.

[16] "Glossary." ASA Business Valuation Standards. 2009 ed. N.p.: American Society of Appraisers, n.d. 29. Web.

[17] Mathiesen, H. "Value Concepts regarding Stock Price Theory." ENCYCOGOV Encyclopedia of Corporate Governance. . , n.d. Web. 05 May 2013

[18] One school of thought holds that market value should equal fundamental value because exuberant and distress sales do not meet the definition of market value and thus should not be used, or should at least adjusted. However the most typical thinking is that market value is the most probable selling price and thus exuberant sales and distress sales are important considerations if they are the dominant transactions at the time.

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Expansion

Recession

Contraction

Recovery

Market Trough

Equilibrium

Market Peak

Equilibrium

Expansion

Recession

Contraction

Recovery

Midvale Office Market

Equilibrium

Equilibrium

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