Quantifying hidden risks, or opportunities, of an otherwise well supported current market value opinion collapsing in the near future
THE PROBLEM
A disconnect between our appraised value opinions and our clients' expectations
ABSTRACT
The Appraisal Institute's Guide Note 12 Analyzing Market Trends raises concerns that a single-point-in-time market value opinion could be unknowingly misleading without a value sustainability analysis.
This article discusses practical valuation techniques and tools the appraiser can use to uncover hidden risks and opportunities that might be associated with an appraiser's market value opinion.
These tools add more relevancy, income potential and longevity to the valuation industry without significant training or added effort to the appraisal process.
Adopting these techniques will have a positive effect on our economy and provides leadership to our international friends.
INTRODUCTION
Appraisal Journal article was written by Messrs. Kerry M. Jorgensen, MAI and Stephen F. Fanning, MAI, CRE, AICP, and Lance Coyle, MAI, Appraisal Institute's 2015 President, discussed the disconnect between appraisers and users of appraisal services.
For decades, through several 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.
Our clients ask, "If appraisals only report what properties would sell for on a certain day, what good do they do in protecting us from the effects of a bubble market?" (1)
First, the viewpoint of most appraisers has been quite simple; a market value appraisal is a 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.
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. (2)
As the Appraisal Institute's Guidenote 12 indicates, "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. (3)
(1) One Step Further - Implementing the Recommendations of Guide Note 12, Kerry M. Jorgensen, MAI and Stephen F. Fanning, MAI, CRE, AICP, Appraisal Journal, Summer 2013, P. 213
(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 opinions 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): p. 254-255
(3) Guide Note 12, Appraisal Institute, Page 1
Consequently, this first appraiser viewpoint defines "the expectations of what will happen in the market in the future" solely as the collective market participants' expectations whether the market participants are right or wrong in their market analysis and/or market trends analysis.
This first predominant appraiser viewpoint only concerns itself with the actions of market participants and their current interpretations of a property's forecasts. For any single property, the collective market participants' forecasts (including the ending sale price reversion) can be reversed engineered from its "most probable" market value opinion or sale price.
If our definition of market value is strictly construed as the most probable selling price, perhaps this interpretation is entirely reasonable. This is what we refer to as "appraising in a vacuum". The problem with this approach is it maintains the status quo and does nothing in resolving the disconnect between our appraised value opinions and our clients' expectations.
The second viewpoint in resolving the disconnect between the role of the appraiser and users of appraisal products is promoted by a small minority of field appraisers. According to Guidenote 12, "The market trend study should include what market participants (buyers, etc.) believe will happen to market conditions in the future as well as (emphasis added) current supply and demand, and anticipated changes to supply and demand."
The question concerning this viewpoint is, "Does the current supply and demand and the changes to supply and demand” reflect the collective market participants' market analysis and trends forecasts, or does it reflect the appraiser's interpretation and forecasts of current and future supply and demand?
If the appraiser's forecasts conflict with the collective market participants' forecasts (either factor of change or symptoms of change), which of these forecasts should find their way into a property's market value opinion?
Combining market participants forecasts and conflicting appraiser forecasts in determining a property's market value have been rejected by the majority of field appraisers on the front line. According to viewpoint one, this type of appraisal "dictates" an opinion of market value instead of "reflecting" an opinion of market value. The problem is appraisers and reviewers that practice this viewpoint could be violating USPAP that result in "conservative" or "liberal" market value opinions that might appear to advocate their clients' interests.
The third and most innovative viewpoint in resolving the disconnect between the role of the appraiser and users of appraisal products is promoted by the Appraisal Institute and forward-thinking active field appraisers.
In the Appraisal Journal's article, One Step Further - Implementing the Recommendations of Guide Note 12, influential and forward-thinking field appraisers that authored the article are advocating a value sustainability analysis as a compromise between the first two viewpoints.
The authors advance the value sustainability analysis methodology mainly from the Fundamental Market Wave Cycle and not from the Transaction Market Wave Cycle that they rightfully indicated is equally important.
The article concludes "The question becomes, how can an appraiser spot situations when a [Fundamental] Market is out of balance on the capital [Transaction] market side of the equation?"
Consequently, the purpose of our article is to provide a solution to this question. No matter if you subscribe to viewpoint one or two, we will give you practical value sustainability methodologies and graphics you can use in your reports without violating your viewpoints on market value. This complete solution will help bridge the gap between our role as appraisers and the expectations of our clients.
HOW TO SPOT SITUATIONS WHEN A FUNDAMENTAL MARKET IS OUT OF BALANCE ON THE TRANSACTION MARKET SIDE OF THE EQUATION?
Two distinct market cycles
The valuation industry has identified two somewhat distinct markets for any single property: Capital (transactional) Market Wave Cycle and Fundamental (space users) Market Wave Cycle. These two markets can be in alignment (See Figure 1) or out of alignment (see Figure 2, 3 and 4).
Market Value opinions that adhere to the definition of market value reside along the Transactional Market Wave Cycle if this cycle has detached from the Fundamental Market Wave Cycle (See Figures 2, 3 and 4). Some of the most severe real estate Transactional Market Wave Cycles that have detached from their Fundamental Market Wave 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.
Fundamental Market Wave Cycle
For a long time, the Appraisal Institute advanced education has included discussion of market cycles. According to the "One Step Beyond" article, "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 No. 1). In normal markets, this market can be in alignment with the Transactional Market Wave Cycle.
Figure 1 - Fundamental Market Wave Cycle
The Fundamental market Wave Cycle is made of landlords and tenants (space users) and resides within the Transactional Market wave cycle. That's why the Fundamental Market Wave Cycle has been called a market cycle within the market cycle. (See Figure 2)
The current and successive single-point-in-time values that make up the Fundamental Market wave cycle is a property's Fundamental Values. Fundamental value (sometimes called Intrinsic Value) can be defined as, "The market price that would prevail if all the market participants were perfectly informed investors".
The beginning current fundamental value as of the same date as a market value appraisal represents the present value of the appraiser's forecasts obtained from a fundamental analysis and trend study. These forecasts might not be in alignment with the collective market participants' forecasts.
"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 (See Figure 1). "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." (See Figure 2 and 3)
The same detachment of wave cycles can occur for depressed markets. In depressed markets, buyers are motivated by potential income or ownership benefits and focus less on potential price appreciation. (See Figure 4)
Lastly, the Fundamental Market wave cycle successive periods of expansion, peak levels of activity, contraction, and troughs revolve around a Fundamental Market Equilibrium Trend Line (See Figures 1 and 2)
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]".
The starting point of constructing the Fundamental Market Equilibrium Line within the Fundamental Market wave cycle is the property's single point in time fundamental value as of appraiser's date of value.
The ending point of the Fundamental Market Equilibrium Line is the fundamental value's reversion (ending sale price forecasts) at the end of the wave cycle. As time elapses during the Fundamental Market wave cycle, updated fundamental values of the subject property will indicate how future fundamental values that make up the Fundamental market wave cycle revolves around the initial equilibrium trend line.
Transactional Market Wave Cycle
The Transactional Market wave cycle is also characterized as successive periods of expansion, peak levels of activity, contraction, and troughs. During periods of bubbles and busts, troughs can be further sub-divided into recession and recovery.
The transactional market is made up of buyers, sellers, equity investors, and lenders. This wave cycle represents a current and future single point in time market values for a specific property along the cycle's defined trend lines during a typical wave cycle life.
Figure 2 - Transactional Market Wave Cycle & the Fundamental Market Wave Cycle
As previously indicated, the Fundamental Market Wave Cycle resides within the Transactional Market Wave Cycle. In normal markets, these two cycles will be in alignment. (See Figure 1) In bubble or depressed markets, the Transactional Market Wave Cycle can detach above or below the Fundamental Market Wave Cycle. (See Figures 3 and 4, respectively)
Figure 3 - Transactional Market Wave Cycle detached above the Fundamental Market Wave Cycle
Figure 4 - Transactional Market Wave Cycle below the Fundamental Market Wave Cycle
How to reverse engineer your property's already determined market value opinion into the collective market's forecasts (including reversion)?
With the sophistication and ease of use regarding modern computer software, the yield capitalization valuation technique in the Income Approach can be used to reverse engineer the appraiser's market value opinion.
Most appraisers are familiar with this yield capitalization technique as well as using commercial software such as Microsoft Excel, Argus, and Valuexpose in setting up DCF financial models based on generally accepted appraisal standards. The holding period for most DCF models is generally 5 to 15 years which is the typical Transaction Market's ownership holding period and/or market cycle (4)
(4) The Appraisal of Real Estate, Thirteenth Edition, Appraisal Institute, p. 541
These stabilized current or prospective (if the property is currently at non-stabilized) forecasts are obtained from due diligence the appraiser normally performs in the appraisal process, market study and trend analysis. "Typical collective market's forecasts to be addressed in DCF analysis include: (5)
Current market rental rates, lease expiration dates, and expected rental rate changes:
- Lease concessions and their effect on market rent
- Existing base rents and contractual base rent adjustments
- Renewal options
- Existing and anticipated expense recovery (escalation provisions)
- Tenant turnover
- Vacancy loss and collection allowance
- Operating expenses
- Net operating income
- Capital items including leasing commissions and tenant
- Improvement allowances
- Reversion and any selling or transaction costs
- Discount rate(s) or the all-cash property yield.
The discount rate (or all-cash property yield) can be obtained from numerous data sources of different property types and subtypes in different locations around the country. These data sources publish investor expectations and actual property yields extracted from property sales. This discount rate can also be extracted from comparable sales.
Other than the reversion (ending sale price), all of the other selected forecasts have a disproportionate present value effect on the already established market value opinion. Combining the present value of the collective market forecasts together with the ending sale price net reversion will equal the current "most probable" market value opinion established by comparable sales.
Typically, a large proportion of the already developed market value opinion will represent the present value of the reversion (ending sale price forecast). Fortunately, you don't necessarily have to do any research on the going-out cap rate to arrive at this forecast. Simply iterate this final value until the present value of the annuity and the present value of the reversion equal your already developed market value opinion.
Once this preliminary reversion and NOI annuity equal your market value opinion, you must increase this reversion value by the cost of expected sales commissions and sales expenses the seller is forecasted to pay. This technique will now uncover the going-out cap rate the collective market participants are forecasting for the ending sale price for your property.
Now you are reporting to your client a market value opinion based on historic comparable sales data and its corresponding future forecasts that are in present value alignment with your market value opinion. The user of your report will appreciate and find useful the breakdown of your market value opinion into the collective market participants' future forecasts.
How to determine the Fundamental Value and its corresponding ending sale price reversion?
The second distinct market is the Fundamental Market that consists of landlords and tenants (space users) for a specific property. This market analysis solves for a specific property's single point in time fundamental value and its ending sale price reversion.
"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." (6)
(6) One Step Further - Implementing the Recommendations of Guide Note 12, Kerry M. Jorgensen, MAI and Stephen F. Fanning, MAI, CRE, AICP, Appraisal Journal, Summer 2013, P. 10
These "reasonable projection(s)" are the appraiser's forecasts from a market analysis and trend analysis, not necessarily the reversed engineered collective market participant's forecasts that make up the present value of the property's already determined market value opinion.
This is where most appraisers have a problem in trying to second guess the collective market participant's forecasts that make up the present value of the property's market value.
Appraisers can confront this dilemma using one of two approaches. In the first approach, the appraiser uses the same collective market participants forecasts (except for the forecasted discount rate and the forecasted ending sale price or reversion) that were reversed engineered from the already developed market value opinion.
The appraiser must use a normalized property yield (discount rate) and ignore the reversed engineered market value ending sale price or reversion (more on how to estimate the fundamental value's ending sale price later in this article). This first approach is appropriate for existing normalized markets where the reversed engineered collective market forecasts seem to be reasonable and equivalent to the appraiser's market analysis and trend study.
The second approach in determining a property's fundamental value is for those appraisers who have determined the reversed engineered collective market participants forecasts from the already developed market value opinion might be out of alignment with market evidence. "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." (7)
(7) One Step Further - Implementing the Recommendations of Guide Note 12, Kerry M. Jorgensen, MAI and Stephen F. Fanning, MAI, CRE, AICP, Appraisal Journal, Summer 2013, P. 17
Armed with the appraiser's market analysis and trend study, the appraiser's conflicting forecasts from the collective market participants forecasts can be used to determine the property's fundamental value. Like the first approach, the normalized property yield (discount rate) and the fundamental value ending sale price must be estimated separately. This approach is appropriate if the market is purchasing properties in a quickly rising or falling market of property prices.
Intrinsic in these comparable sale prices can be “irrational exuberance” or "irrational pessimism" of the market’s forecasts. In this case, the collective market participants' forecasts should be given lesser weight if your market analysis appraiser forecasts significantly differ.
Even in these quickly rising or falling markets, the appraiser's market analysis can indicate the collective market participants' forecasts seem reasonable. It's the market's reversion speculation that is mainly driving the market prices higher.
Valuation techniques in obtaining a property's fundamental value ending sale price (reversion)
Here are three practical ways in determining a fundamental value ending sale price. First, determine if you think the going-in cap rate for your market value opinion is unusually low or high. Try to find historic going-in cap rates for your property type when supply and demand were more normalized. Using your normalized going-in cap rate, capitalize the property's stabilized first year forecasted net operating income into an indication of the property's fundamental value. Follow the reverse engineer technique outlined in the Transaction Market section of the article to obtain the fundamental value ending sale price.
The second way in determining your property's fundamental value ending sale (reversion) is to extend your stabilized DCF financial model together with your already estimated appraiser forecasts. Extend the DCF out to the end of the economic life of the building improvements (possibly 45 to 50 years). In this extended DCF model, don't include an ending sale price. Solve only for the present value of the property's NOI annuity income for a 45 to 50 year holding period. This technique takes out of play the disproportionate present value effect of including a "guessed" ending sale price has on the current fundamental value if only a 5 to 15 year holding period is used. Once the present value current fundamental value is calculated, use the reverse engineer technique outlined in the Transaction Market section of the article to determine the property's Fundamental Value's ending sale price reversion.
The third way in determining your property's fundamental value ending sale price (reversion) is to divide (capitalize) your already derived normalized all-cash yield rate (discount rate) into the DCF's ending net operating income (NOI) forecast. The "ending NOI" means the forecasted subsequent year after the final year of your 7 to 10-year typical market wave cycle. Be sure to increase this "capitalized" value by the expected sells commission and sellers closing costs. The present value of the completed DCF model will indicate the subject's fundamental value together with its ending sale price reversion.
Our research indicates these three techniques have very similar fundamental value results on the same property. These techniques strip away any excess ending sale price speculation and irrational collective market participants forecasts that might be found in a market value opinion.
To support these findings, we observed actual sale properties that had sold in markets where supply and demand, as well as other market symptoms, were mostly in balance (normalized). The reversed engineered collective market participants' forecasts were considered reasonable when compared to market analysis and trend study for each particular property. This meant each property's market value (selling price) should be roughly equivalent to its fundamental value on the same date. Applying any of these three techniques in determining a property's fundamental value ending sale price resulted in a present value fundamental value equivalent to the property's "normalized" selling price.
Why is it now important to give opinions of a property's market value and fundamental value?
New techniques and automated tools have now been developed to assist the appraiser in qualitative analysis of the relationship between a property's market value and its fundamental value. With the ability to now construct the Fundamental Market Equilibrium Trending Line helps determine whether the current market value opinion is sustainable or not during the current Transactional Market wave cycle.
"Appraisers employ mathematical applications to derive quantitative adjustments. When sufficient market data to support a quantitative adjustment is not available, appraisers investigate qualitative relationships, also using mathematical applications to identify market trends. Only when the market data is insufficient to apply mathematical applications should the appraiser resort to direct or relative comparisons" (8)
(8) The Appraisal of Real Estate, Thirteenth Edition, Appraisal Institute, p. 307
Using these new mathematical applications in estimating fundamental values that construct the fundamental market equilibrium trend line within the current Fundamental Market's real estate wave cycle for a specific property provides the following qualitative relationships:
- The appraiser or the client will be able to identify how severe the hidden risks might be as to where the appraised market value lays on the Transactional Market wave cycle and if it is above the Fundamental Market Equilibrium Value Trend Line.
- The appraiser or the client will be able to identify how much opportunity might exist for a greater than forecasted property yield. This opportunity depends on where the appraised market value lays on the Transactional Market wave cycle and if it is below the Fundamental Market Equilibrium Value Trend Line.
- 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.
- 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 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.
Our traditional appraisal process continues to appraise properties in a vacuum. This traditional process does not qualitatively uncover the potential severity of hidden risks or the financial windfall of hidden opportunities that are possibly impacting the appraiser’s accurate but potentially misleading single-point-in-time market value opinion.
PLOTTING YOUR MARKET VALUES AND FUNDAMENTAL VALUES ONTO THE SUSTAINABILITY MODEL
If the appraiser creates a made-to-order DCF's or uses a commercial software programmed or pre-programmed for this purpose, he or she can plot the current market value result and its ending sale price reversion on a value sustainability model. Also, the appraiser's current fundamental value opinion and its ending fundamental sale price reversion can be plotted onto the value sustainability model. If the appraiser intends to personally build the financial models, this article assumes the appraiser already knows how to construct the necessary DCF models based on generally accepted appraisal standards and principles.
(Figure #5 - Complete Value Sustainability Model ) (9)
(9) ValuexposeTM Software
In our example, the appraised current market value opinion of our example is $3,792,133 together with the collective market participants forecasted ending sale price of $4,957,625. The current fundamental value (or intrinsic value) is $2,471,960 with the forecasted ending fundamental value of $2,702,604. (See Figure 5)
In overlaying the Transactional Markets wave cycle, the "increasing" portion of the wave cycle must intersect the property's market value opinion ($3,792,133). The height of the Transactional Market's wave cycle is equivalent to the known height of the market value's ending sale price ($4,957,825).
The decreasing portion of the Transactional Market's wave cycle intersects the fundamental value's ending sale price ($2,702,604). If the property's market value opinion ($3,792,133) exceeds the fundamental value's ending sale price ($2,702,604), then the last two portions of the Fundamental Market's wave cycle that drops below the equilibrium line should be labeled "Recession" and "Recovery", respectively.
Once the property's market value ($3,792,133) has eclipsed the fundamental value's ending sale price ($2,702,604), the property's current market value is considered to have entered the beginning of a real estate bubble. The farther the property's current "most probable" value opinion separates from the prospective fundamental reversion value will determine the severity of the bubble and the likelihood of a significant decline of the property's current well-supported market value.
Overlaying the Transactional Market's wave cycle indicates an opinion of:
- Where the appraiser's current market value opinion lies on the wave cycle (Expansion portion of the wave cycle);
- How high the Transactional wave cycle peaks based on the current market's known ending sale price forecast ($4,957,625 reversion)
- How far the current market value ($3,792,333) has detached from the property's current fundamental value ($2,471,960 equilibrium or intrinsic value) or 53%+/-;
- The estimated direction in which the property's current market value ($3,792,333) is headed in the future. This direction is based on the qualitative relationship between the collective market's forecasted ending sale price ($4,957,625) and the fundamental ending sale price ($2,702,604 fundamental reversion equilibrium).
- If the appraiser completes a full fundamental demand analysis, the appraiser can even predict the time remaining when the property's current market value opinion will peak and start to fall back to equilibrium. (10)
(10) One Step Further - Implementing the Recommendations of Guide Note 12, Kerry M. Jorgensen, MAI and Stephen F. Fanning, MAI, CRE, AICP, Appraisal Journal, Summer 2013, P. 213
(Figure #6 - Complete Model Indicating How the Current Market Value will gravitate toward the equilibrium value of $2,702,604) (11)
(11) ValuexposeTM Software (Patent Pending No.14/463512 & International PCT/US2014/051540)
In our example, reasonable qualitative relationship evidence now indicates the property's "frothy" current market value opinion of $3,792,333 has a high probability of moving toward equilibrium indicated by the ending fundamental value (equilibrium or intrinsic value) of $2,702,604 during a typical 7-year economic wave cycle. (See Figure 6)
Froth in the market is defined as "Market conditions preceding an actual market bubble where asset prices become detached from their underlying intrinsic value (also called fundamental value or equilibrium value) as demand for those assets drives their prices to unsustainable levels. Market froth marks the beginning of unsustainable rates of asset price inflation. (12)
(12) Investopedia definition of Froth
Conversely, this graphic indicates there is a qualitative low relationship probability the collective market's forecasted ending sale price (reversion) of $4,957,825 is not achievable during the current wave cycle. This indicates a supply and demand imbalance most likely from the collective market's ending price speculation (reversion) that has caused the property's current market value to separate from equilibrium fundamental values. (See Figure 7)
(Figure #7 - Complete Value Sustainability Model Indicating a Low Qualitative Relationship Probability of Achieving Market's Reversion Forecast)
Notice how this value sustainability analysis now addresses our clients requests for appraisals that are 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,” and “what are the risks in the current market?" (13)
CASE STUDY NO. 1
Let’s look at some examples of how this model works in a real-world situation. Suppose you are asked to appraise a multi-family apartment complex that is currently at stabilized occupancy and at market rent. Your analysis indicates this property is currently at its highest and best use.
In your initial investigation, you find out the property is in escrow for $3,500,000. There are five backup offers for $3,500,000. All the sales and comparable data support the $3,500,000 in the development of the appraisal. The average current rent is $1,055/mo and the market expects the rent to rise an average of 2% annually. Your market rent study indicates the current average rent is considered market rent. The demographic household income that uses the subject property is expected to also rise at 2% annually. The market estimates an all-cash annual yield of 7% would be appropriate considering the risk of this property. You, therefore, report the single-point-in-time market value at $3,500,000 and deliver to a bank review appraiser.
The bank reviewer agrees with your report and value conclusion. This $3,500,000 single-point-in-time market value (please ignore the slight rounding difference) is inserted into the DCF model to iterate the market's reversion (ending sale price). All forecasts can be changed which automatically updates the DCF model until all the market forecasts equal the present value of the already appraised current market value of $3,500,000.
- First, the $3,500,000 (please forgive the slight rounding differences) is reverse-engineered into the collective market participants' future benefit forecasts inputted by the appraiser. These future benefits include the net operating income annuity of the collective market forecasts. The ending sale price reversion is iterated until the collective market participants' forecasts (annuity and ending sale price) equals the already developed market value opinion. The DCF model's graphic indicates the market’s $4,547,040 reversion forecast in a seven-year typical Transaction Market wave cycle. (See Figure 8)
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(Figure #8 - First Case Study Market Value Timeline) (14)
(14) ValuexposeTM Software (Patent Pending No.14/463512 & International PCT/US2014/051540)
- Second, insert the appraiser's current market value opinion and its ending sale price reversion forecast into a value sustainability model. These market values represent the present value of the collective market participant forecasts. At the same time, the property's current fundamental value (intrinsic value) and its ending fundamental value (reversion) are inserted into the same value sustainability model. (See Figure 9)
(Figure #9 - First Case Study Value Sustainability Model with Values) (15)
(15) ValuexposeTM Software (Patent Pending No.14/463512 & International PCT/US2014/051540)
- Third, the real estate wave cycle is overlaid onto the model giving a visual representation of where the property's market value resides on the cycle (Expansion portion of the cycle). (See Figure 10)
(Figure #10 - First Case Study with Economic Wave Cycle Overlay) (16)
(16) ValuexposeTM Software (Patent Pending No.14/463512 & International PCT/US2014/051540)
An analysis of our example indicates the following:
- Forth, our confirmed single-point-in-time market value opinion $3,500,000 has penetrated a market bubble for this property type in its specific market. The $3,500,000 value opinion is higher than the ending fundamental expected sale price [emphasis added] of $2,702,604 that represents the fundamental equilibrium value in seven years.
- Fifth, there is a high probability the $3,500,000 will deflate back down to the equilibrium line of $2,702,604 during the rest of the business cycle. This 29.50% +/- difference between these two values will either slowly deflate during the wave cycle towards the $2,702,604 fundamental equilibrium value if the bubble does not burst. If the bubble bursts, the current market value of $3,500,000 could fall beneath the equilibrium line into the recession portion of the wave cycle. This graphic illustrates the buyer is purchasing at the latter stages of a "frothy" business cycle. (See Figure11)
(Figure #11 - Direction Current Market Value Is Headed) (17)
(17) ValuexposeTM Software (Patent Pending No.14/463512 & International PCT/US2014/051540)
What is causing the “frothy” market in this example?
- First, the 7% all-cash risk rate (annual yield) is considered appropriate and in balance for the markets' perceived risk associated with the property. This risk applies to the Transaction Market and the Fundamental Market. Also, this risk rate is in alignment with alternative investments with similar risks.
- Second, the typical district's household tenant income in the market that uses this property type is in alignment and balances with the average current market rent of $1,055/month.
- Third, for both the Transaction Market and the Fundamental Market, the market’s forecasted 2% annual rental increase is in alignment and in balance with the tenant's demographic income expected increases over the next seven years.
So what is causing the market value of our property to enter a dangerous bubble?
The answer is the market’s speculation on the ending sale price forecast (reversion). The automated DCF model will calculate the beginning and ending stabilized net operating income at the end of the seven-year holding period. In this case, the beginning NOI is $151,685 and the ending NOI is $171,423 (actually represents the eighth year anticipated income and expense based on generally accepted appraisal standards).
Dividing the market’s forecasted beginning and ending values of $3,500,000 and $4,547,040 respectively indicates a 4.33% going-in capitalization rate and a 3.77% going-out capitalization rate. The going-in cap rate is considered well below historic going-in cap rates when the market was considered in supply and demand balance. Also, the going-out cap rate of 3.77% is below the going-in cap rate of 4.33% which is generally contrary to appraisal capitalization rate relationships in normal markets.
In contrast, the going-in cap rate for the current fundamental value of $2,471,960 is 6.14% and the ending fundamental value of $2,702,604 is 6.34%. "The terminal or residual (going-out) capitalization rate is generally, though not necessarily, higher than the going-in capitalization rate." (18)
The all-cash annual yield is 7% for the fundamental value and the fundamental ending sale price. "If the income is expected to grow then the all-cash yield rate (discount rate) is greater than the going-in capitalization rate". (19)
These two relationships of DCF assumptions for the fundamental values are indications of supply and demand at equilibrium for the property.
CASE STUDY NO. 2
Let’s look at another example. We’re appraising the same property on the same date of appraisal as the first example. The only difference is there are different market conditions.
You as the appraiser find out the property is in escrow for $2,500,000. There are five backup offers for $2,500,000. All the comparable sales and data support this sale price in your development of the appraisal. This sale price coincided with the elements of the market value definition.
As in Case Study No. 1, the current average rent of $1,055/mo, increasing 2% annually, and the all-cash property yield is 7%. Consequently, you report the appraisal at a single-point-in-time market value of $2,500,000. You give your appraisal to the bank reviewer who concurs with your appraisal and value result.
The $2,500,000 current market value result (please ignore the slight rounding difference) is introduced into the automated DCF model. The property’s ending sale price (the collective market is forecasting) is reversed engineered in the same manner as previously described. The collective market's forecasted ending sale price is $2,799,664 on the timeline graphic. (See Figure 12)
(Figure #12 - Second Case Study Market Value Timeline) (20)
(20) ValuexposeTM Software (Patent Pending No.14/463512 & International PCT/US2014/051540)
Next, the DCF model creates the property’s current fundamental value of $2,471,960 and its ending fundamental sale price of $2,702,604 that creates the equilibrium line. It is important to note these two fundamental values and the resulting equilibrium line are exactly the same as the first example where the same property sold for $3,500,000. (See Figure 13)
The reason the fundamental values and its equilibrium line stay the same as in Case Study No. 1 is that these values represent a normalized market.
(Figure #13 - Second Case Study With Completed Value Inputs) (21)
(21) ValuexposeTM Software (Patent Pending No.14/463512 & International PCT/US2014/051540)
When the Transactional Market wave cycle is overlaid onto the model, the reader can see this wave cycle and the Fundamental Market wave cycle are the same. This is because the property’s single-point-in-time market value opinion is in alignment with its fundamental value. (See Figure 14)
(Figure #14 - Second Case Study with Economic Wave Cycle Overlay) (22)
(22) ValuexposeTM Software (Patent Pending No.14/463512 & International PCT/US2014/051540)
CASE STUDY NO. 3
Let’s look at a third and final example. We’re appraising the same property on the same date of the appraisal. The only difference between the first two examples is market conditions have changed for the worse. The current supply exceeds demand for the subject property.
You as the appraiser find out the property is in escrow for $1,500,000 and has three backup offers at $1,500,000. All comparable sales and data support this sale price in your development of the appraisal. This sale price coincided with the elements of the market value definition.
The property's current average rent is $1,055/month, with rents and demographic income expected to increase at 2% annually. The all-cash annual yield is 7%.
Consequently, you report the appraisal at $1,500,000 (please ignore the slight rounding difference) and deliver to a bank review appraiser who concurs with your appraisal. This single-point-in-time market value opinion is inserted into an appropriate DCF model to solve for the market's ending sale price reversion. (See Figure 15)
(Figure #15 - Third Case Study Market Value Timeline) (23)
(23) ValuexposeTM Software (Patent Pending No.14/463512 & International PCT/US2014/051540)
Notice the $1,500,000 single-point-in-time market value opinion is significantly below the equilibrium line. Also, notice the two fundamental values that make up the equilibrium line are the same [emphasis added] as in the other two previous examples.
Once again, the fundamental values that make up the equilibrium line represent a normalized market together with normalized forecasts.
(Figure #16 - Third Case Study With Completed Value Inputs) (24)
(24) ValuexposeTM Software (Patent Pending No.14/463512 & International PCT/US2014/051540)
When the Transactional Market's wave cycle in overlaid onto the model, the reader can see how far this market cycle has detached from its Fundamental Market wave cycle. The reader can see there is an awesome buying or lending opportunity at this single-point-in-time market value. The subject’s current market value of $1,500,000 should gravitate towards the equilibrium line at $2,702,604, not towards the collective market’s ending sale price of $1,055,000. (See Figure 17)
Figure #17 - Third Case Study with Economic Wave Cycle Overlay) (25)
(25) ValuexposeTM Software (Patent Pending No.14/463512 & International PCT/US2014/051540)
In this example, the property's current market value of $1,500,000 has a going-in cap rate of 10.11% and an ending fundamental going-out cap rate of 16.25% (over 600+ basis points above the going-in cap rate). The going-in cap rate is well above the historic going-in cap rate trends when the market was more in balance. Also, the going- out cap rate is well above the going-in cap rate that possibly indicates an unbalanced market. Lastly, the all-cash annual yield rate of 7% is below both of these cap rates and violates the balanced relationship that yield rates must be above the going-in cap rate if income is expected to grow. "If the income is expected to grow then the all-cash yield rate (discount rate) is greater than the going-in capitalization rate". (26)
(26) Comprehensive Real Estate Study Guide, Relationships of DCF Assumptions, p. 148, Ted Witmer, MAI, 1990.
NON-STABILIZED PROPERTIES
Up until now, we have been discussing income-producing properties at stabilized occupancy and market rents. However, many times you will be appraising income-producing properties at non-stabilized occupancy.
- Module 1 - Income producing properties HAVE reached stabilized occupancy and market rents (we have already discussed)
- Module 2 - Income-producing properties that HAVE NOT reached stabilized occupancy and/or market rents.
- Module 3 - Income-producing properties that physically HAVE NOT reached their highest and best use.
- Module 4 - Income-producing properties that are going to be developed from a vacant entitled finish lot.
- Module 5 - Income-producing properties that are going to be developed from vacant raw unentitled land.
All four of these non-stabilized scenarios will require the appraiser to appraise the single-point-in-time market value of the property’s “as is” condition among possibly other prospective market value opinions. (See Figure 18)
(Figure #18 - Non-Stabilized Timelines Indicating “As Is” Values) (27)
(27) ValuexposeTM Software (Patent Pending No.14/463512 & International PCT/US2014/051540)
How does the value sustainability model handle income-producing properties that are currently non-stabilized? For non-stabilized modules 1, 2, and 3 (development or remodeling properties), standard appraisal procedure dictates the highest and best use economic feasibility study be performed that indicates whether or not the “as is” current condition of the property is ready for immediate development.
An example of a non-stabilized property that is going to be developed from unentitled vacant land (Module 1) indicates the current "as is" market value of $4,299,052. It also indicates all the other prospective market values up to 100% completed construction, at stabilized occupancy and at market rents of $11,958,726. In addition, this module indicates the proposed project is economically feasibility ($9,819,041 Completed Prospected Non-Stabilized Market Value is greater than $9,582,863 Cost of Production). (See Figure 19)
(Figure #19 - Non-Stabilized Module 1 Timeline w/ Prospective Stabilized Value) (28)
( 28) ValuexposeTM Software (Patent Pending No.14/463512 & International PCT/US2014/051540)
If this prospective stabilized market value ($11,958,726) is determined not to be sustainable when inserted into the value sustainability model, the inference is that the subject’s current “as is” single-point-in- time market value will also not be considered sustainable. (See Figure 20)
This non-sustainability qualitative relationship conclusion is indicating a proposed property development or major remodeling project might be starting at the wrong time of a "frothy" real estate wave cycle.
(Figure #20 - Non-Stabilized Module 1 Value Sustainability Analysis) (29)
( 29) ValuexposeTM Software (Patent Pending No.14/463512 & International PCT/US2014/051540)
If this prospective stabilized collective market value is determined not to be sustainable during the prospective Transactional Market real estate wave cycle, the subject’s current “as is” single-point-in-time market value might also not be considered sustainable.
(Figure #21 - Non-Stabilized Timelines w/ Prospective Stabilized Values) (30)
(30) ValuexposeTM Software (Patent Pending No.14/463512 & International PCT/US2014/051540)
NON-INCOME PRODUCING PROPERTIES
Many commercial and residential properties to be appraised are considered non-income producing owner-occupied properties. These include owner-occupied commercial properties as well as owner-occupied single-family dwellings and single condominiums.
These types of properties can also be analyzed for value sustainability. The analysts must treat non-income properties as if they were income-producing. It is perfectly acceptable to establish a market rent for non-income producing properties together with a stabilized income and expense estimate.
With this income information together with the appraiser’s single-point-in-time market value opinion, the value sustainability analysis can be performed.
SUBDIVISION PROPERTIES
Lastly, if the appraiser is appraising a subdivision property, the value sustainability model can also be used. Subdivisions come in four basic “as is” conditions.
Module 4 - Existing finished subdivisions or condos with unsold finished units/lots. (31) (See Figure 22)
(31) VauexposeTM Software, Module 3 "Partially Finished Subdivisions/Condos (or needs significant remodeling)
Figure #22 - Existing finished subdivisions or condos with unsold finished units/lots)
Module 3 - Partially finished subdivisions or condos (or needing significant remodeling) (32) (See Figure 23)
(Figure #23 - Partially finished subdivisions or condos (or needing significant remodeling)
Module 2 - Subdivisions or condos to be developed from a vacant finished entitled lot. (33) (See Figure 24)
(33) VauexposeTM Software, Module 2 "Subdivisions/Condos to be Developed from a Vacant Finished entitled lot.
Figure 24 - Subdivisions or condos to be developed from a vacant finished entitled lot.
Module 1 - Subdivisions or condos to be developed from raw unentitled land. (34) (See Figure 25)
(34) ValuexposeTM Software, Module 1 "Subdivisions/Condos to be Developed from Raw Unentitled land
(Figure #25 - Subdivisions or condos to be developed from raw unentitled land)
If the appraisal concerns an existing or proposed condominium development or finished lots with dwellings, the value sustainability model can be used.
Using the Non-Income Producing property techniques as described earlier in the article, the subdivision or condo developments current or proposed unit/lot price point can be analyzed for value sustainability.
If the value sustainability analysis indicates the existing or proposed unit/lot price point(s) is not sustainable, the developer might be starting the development at the wrong time of the real estate wave cycle. If this analysis is ignored by the developer, the proposed unit/lot price point forecast might have substantially changed when the developer delivers the product into the market place.
If the developer is purchasing an existing subdivision or condo development with finished but unsold units/lots, the forecasted price points that are deemed not sustainable by the value sustainability analysis might slow down expected sales absorption.
Another scenario would be the expected absorption is achievable but at significantly reduced price points from the originally forecasted price point forecasts. Either one of these scenarios could affect the sustainability of the appraiser’s single-point-in-time “as is” market value opinion of the subdivision or condo development.
THE SOLUTION TO MANAGING BUBBLES
"Real estate appraisers have historically focused almost exclusively on market value and have little exposure to fundamental value concepts. 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." (35)
(35) One Step Further - Implementing the Recommendations of Guide Note 12, Kerry M. Jorgensen, MAI and Stephen F. Fanning, MAI, CRE, AICP, Appraisal Journal, Summer 2013, P. 225
This article addresses the problem of appraising properties in a vacuum by offering a meaningful solution in how to uncover the hidden risks or opportunities using value sustainability analysis. "There are two risks inherently associated with any appraisal that are of particular concern to the intended user. The first is the risk that the reliability of the value conclusion may be adversely impacted by a lack of quality data. The second is the risk that the value might not be sustainable over time. A well-thought-out and clearly presented reconciliation process can assist the intended user with these risks." (36)
(36) One Step Further - Implementing the Recommendations of Guide Note 12, Kerry M. Jorgensen, MAI and Stephen F. Fanning, MAI, CRE, AICP, Appraisal Journal, Summer 2013, P. 225
This value sustainability solution:
- Does not disrupt the way the market chooses to price properties
- Does not disrupt the hard-earned appraisal process and appraiser training or USPAP standards that still produce accurate single-point-in-time market value opinions
- Does not change the definition of market value
- Does not call for more or less government regulation
- Does not call for extensive new appraiser training
- Does not call for the appraiser to spend an inordinate amount of time performing a value sustainability analysis using a modern software technology
Instead, this new process complements and improves the appraisal process already in place:
- By further safeguarding the users of our appraisal reports
- By better protecting the public trust
- By enhances the appraisal process relevancy in our client’s eyes
- By making the appraisal report more transparent;
- By protecting the appraiser from criticism and liability regarding future "Monday morning quarterbacking" or "hindsight bias" if values collapse in the future
- By prolonging the life of our profession.
- By helping to eliminate appraiser bias and user pressure
- By allowing banks and bank examiners to better stress test and monitor the health of the banks via the new CECL regulations
Hindsight Bias is defined as, "the predisposition to assume after the fact an event was predictable, even when it wasn't". (37)
(37) Business Dictionary
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