221 Week 4 F /For WIZARD KIM

What needs to happen now is difficult, but we need to get real estate back to the values that it’s worth. Todd Maclin1

Price is what you pay, value is what you get. Warren Buffett

The purpose of this article is to start a discussion about what the above statements mean and the implications for real estate valuation. Some famous examples of asset-bubble markets include the Dutch Tulip Bubble mania2 and the various stock market crashes like the dot.com crash in 2000. The real estate market bubble is not different. Both the Maclin and Buffett statements refer to hyper transaction markets with many purchasers buying on speculation in anticipation of rapid transaction price appreciation.3 James R. DeLisle, PhD, in his Spring 2009 “Financial Views” column for The Appraisal Journal,4 summed up the characteristics of these types of markets. He noted that the recent bubble (2005–2007) was caused in part by government intervention that created “renewed interest in real estate as an asset class attracting a wave of new players who were not sensitive to the importance of underlying real estate market fundamentals.” DeLisle went on to say that the recent real estate bubble is not new, but is similar to the 1980s bubble, and consequently its aftermath is

An earlier version of this article received the Union of Pan-American Valuation Associations President’s Award in the manuscript competition at the XXV UPAV Congress, Miami, November 2–4, 2010.

1. Todd Maclin, chief executive of commercial banking for JPMorgan Chase, commenting on the real estate mar- ket in 2010; see Marie Halkias, “No New Major Retail Projects in the Works for 2010,” Dallas Morning News, January 19, 2010.

2. The Dutch Tulip Bulb mania occurred in the early 1600s, when speculation drove the value of tulip bulbs to extremes. During the height of the market speculation, the rarest bulb traded for as much as six times the average person’s annual salary.

3. In a December 1996 speech, Allen Greenspan called it “irrational exuberance,” which became the title of a book by Robert J. Shiller. Shiller’s book, Irrational Exuberance, 2nd ed. (Princeton, NJ: Princeton University Press, 2005), was among the first to warn of the global financial crisis that began with the subprime mortgage debacle of 2007.

4. James R. DeLisle, “Too Much Pain, Too Little Gain,” Financial Views, The Appraisal Journal (Spring 2009): 97–111. DeLisle provides a very good historical overview of how and why previous real estate transaction markets have over heated and then bottomed numerous times.

Price versus Fundamentals— From Bubbles to Distressed Markets by Stephen F. Fanning, MAI, John A. Blazejack, MAI, and George R. Mann, MAI

FEATURES

Price versus Fundamentals The Appraisal Journal, Spring 2011 143

AbSTRAcT Real estate appraisal

requires recognition of

two different economic

concepts: (1) the capital

transaction market

(buy/sell transaction

market) and (2) the

fundamental value

of property use. This

article shows that these

economic concepts

can have differing value

indications when either

market is in great flux.

The problem is the two

market segments are

vacillating, at times with

some interaction with

each other, and at other

times independent of

each other. When the

data overlaps are not

correctly recognized

or analyzed, the value

conclusions can be

uncertain. The solution

may be to pick not just

one market segment

to use in a valuation—

transaction data only

or fundamental data

only—but to know when

to use data from each

market segment, when

to mix and when not to

mix the data, and when

to use the two different

market segments to

check results gained

from the other.

similar to the downturn transaction market of the early 1990s.

Thus, the statements “long-term value,” “values that it’s worth,” and “value is what you get” refer to the value obtained from the underlying fundamentals of the property, as opposed to the price one might pay in the transaction market for that asset at any particular point in time.

The Difference between Transaction Price and Fundamental Value Fundamental analysis is defined as “a study that focuses on the underlying factors that affect the property’s actual use and the ability to economically support that use.”5 In other words, the term, fundamental analysis refers to the analysis of the economic well-being of a financial entity—in this case real estate—as opposed to only its transaction price fluctuations. For example, a restaurant typically spends 7% of gross sales on real estate costs,6 so the capitalized net income could be considered the fundamental value of the real estate for that use. The actual purchase price for this property might vary significantly, depending on such things as too much investment capital chasing too little real estate or speculation that the market is increasing so fast that a buy in and quick resell can make a profit.

Historically, prices have not always been in sync with the underlying fundamentals,7 but what has often happened is prices typically rose due to good fundamentals in the market. Then the prices

tended to spike artificially due to such things as low interest rates and easy credit, a situation similar to what was observed in the recent bubble in the real estate market.

In a bubble market, prices continue to rise above the fundamental base on the hope or speculation that someone can be found to buy the asset above its previous price. The bubble period usually ends with the realization that properties are inflated well above their fundamental value, leaving the market prone to instability. The transaction prices typically drop below fundamental economics after a high period. The market will then tend to slowly recover toward fundamental value. Then the cycle starts over again. However, the key equalizer is always the economics of the underlying fundamentals: jobs, population growth, and increases in household income.

Figure 1 shows the various value concepts in a market cycle. The peak of the transaction market, noted as Value 1, represents high sale prices during very active markets, such as in 2004–2006 when financing was readily available from the commercial mortgage-backed securities products and real estate was bought at extremely low capitalization rates. The fundamental value line, called Value 2, represents the underlying fundamental value, which is what the property over time could support in terms of user ability to pay. Note that the fundamental line is not always a straight line, but over time it tends to cluster around a straight line. The bottom of the transaction

×××

××× ×××

Transaction Sales ××× Foreclosures/Distressed Sales

Value 1

Value 2

Value 3

Years 1 5 12

Transaction Market

Fundamental Market

Average Fundamental Market

Figure 1 Market cycle Pattern

5. Appraisal Institute, The Dictionary of Real Estate Appraisal, 5th ed. (Chicago: Appraisal Institute, 2010), 85.

6. Urban Land Institute, Dollars and Cents of Shopping Centers (Washington, DC: Urban Land Institute, 2008), 275.

7. Examples include the price of land in the 1980s prior to the Savings and Loan Crisis, Dot.com’s prices before the bust in 2000, and subprime housing in 2006.

The Appraisal Journal, Spring 2011 Price versus Fundamentals 144

market, Value 3, represents very low sale prices in the distressed transaction markets.

Figure 2 shows the relationship of the two economic segments that operate in the real estate market. At many times, these two markets differ greatly due to the availability of financing and investor motivation.

Review of Economic Literature on the Two-Market Concept The economic literature discusses the relationship of the transaction market and the fundamental market.

Geltner and Miller start their book, Commercial Real Estate Analysis and Investments,8 with a discussion of real estate markets, stating, “the two major markets that are relevant for analyzing commercial real estate: the space market and the asset market.” The Geltner and Miller terms space market and asset market are synonymous with the terms used in this article, fundamental user market and transaction market. Geltner and Miller also point out that the asset market is sometimes called the property market. However, since it competes with the bonds,

stocks, and other capital markets, real estate assets are also considered part of the broad capital market.

In a 1981 symposium on institutional land economics, Dr. James A. Graaskamp also notes the existence of two real estate markets, stating, “Not only is there a two-tiered market for real estate as a tool of production and as a commodity-money standard, but the market is further fragmented by financing terms offered, income tax considerations, and motivations for investment or arbitrage (conversions, syndications, trade).”9

Flood and Garber, two University of Virginia professors, point out that “a bubble can arise when the actual market price depends positively on its own expected rate of change, [and] in such conditions, the arbitrary, self-fulfilling expectation of price changes may drive actual price changes independently of market fundamentals.”10 Similarly, Youssefmir, Huberman, and Hogg indicate that “when speculative trends dominate over fundamentals then bubbles form, leading an asset’s price away from t heir fundamentals.”11 Clayton, Ling, and Naranjo point out that classical finance theory assumed that assets

Price Economic Potential

Capital Markets (Buy/Sell)

Fundamental Markets (Users)

Debt Equity Owner Tenants

Customers

Figure 2 Types of Real Estate Markets

Note: Adapted from Appraisal Institute, The Appraisal of Real Estate, 13th ed. (Chicago: Appraisal Institute, 2008), 174.

8. David M. Geltner and Norman G. Miller, Commercial Real Estate Analysis and Investment (University of Cincinnati, December 1, 2006), 3.

9. James A. Graaskamp, “Guidelines for Attributing Project Income to Real Estate Components” (proceedings of the Richard B. Andrews Symposium on Institutional Land Economics, May 21,1981), reprinted in James A. Graaskamp, Graaskamp on Real Estate, ed. Stephen P. Jarchow (Washington, DC: Urban Land Institute, 1991), 138.

10. Robert P. Flood and Peter M. Garber, “Market Fundamentals versus Price-Level Bubbles: The First Tests,” Journal of Political Economy 88, no. 4 (August 1980): 745–770.

11. Michael Youssefmir, Bernardo A. Huberman, and Tad Hogg, “Bubbles and Market Crashes,” Computational Economics 12, no. 2 (October 1998): 97–114.

Price versus Fundamentals The Appraisal Journal, Spring 2011 145

traded in relatively frictionless markets reflected rational risk adjustments to future income and that there was no role for what they call “investor sentiment.”12 However, they also point out the inability of the standard present value model to explain the dramatic run-ups and subsequent crashes in asset prices led to the development of the behavioral finance approach to asset valuation. Clayton, Ling and Naranjo state,

In these behavior models, investor sentiment can have a role in the determination of asset prices— i ndependent of ma rket f u nda ment a ls…T hus , i f relatively small frictions in the stock market can cause sustained periods of overvaluation, it seems plausible to posit that private real estate markets are potentially more susceptible to such episodes.

FIRREA Recognition of the Two-Market Concept In the past, federal appraisal regulations have rec- ognized the concept of transaction and fundamental markets. In 1990, it was proposed that appraisals for mortgage lending be based on their “economic potential” and stated that “market value is designed to provide an accurate and reliable measure of the economic potential of property involved in federally related transactions.”13

Apparently the 1990 FIRREA economic potential requirement was not enforced, since it appears most mortgage-lending appraisals during the last decade were based on the transaction (buy/sell) market and not fundamentals (economic potential).

Appraisals based on the transaction market followed the big market swings in 2005–2007, with very high mortgage lending appraisals that often outstripped the underlying economics to sustain these values. In the current depressed transaction (buy/sell) market, it seems the opposite is happening, with extremely low appraisals based on the current low transaction market. On the other hand, if mortgage lending appraisals were based on a property’s fundamentals (economic potential), values over time would tend to have more moderate swings and the underlying values would tend to be more sustainable over time.

Two Schools of Thought in Valuation One school of appraisal thought is that market value can and should be explained only by the transac- tion market. This method can sometimes create problems in valuation unless all three approaches are interconnected with the sales as the basis. The result is the three approaches are not independent and become another way to analyze the transaction market. In stable market conditions this methodol- ogy is usually reliable; however, unstable market transaction14 data or lack of current transactions can lead to widely ranging conclusions.

The other school of thought is that in valuation analysis the data for the transaction market should be separated from the data for the fundamental market data. This method makes the three approaches to value independent, and then these are reconciled into a final value opinion.

In practice, the valuation method is not absolute in all cases, but varies with property type, data availability, and market conditions. For example, in the 2009 market, when sales were scarce or nonexistent, the value by the fundamental method may have been given more weight. However, in stable markets with numerous sales and stable prices, the sales comparison approach would probably be the leading value indication.

The presence of two related but separate economic concepts (transaction and fundamental markets), which are running parallel in real estate markets and sometimes cross-pollinating the data, can lead to erroneous value conclusions. The following case studies illustrate a few of the areas in valuation that may create problems and show some potential solutions.

Case Study 1: Comparison of Transaction and Fundamental Data in the Income Capitalization Approach The following case study compares the two differ- ent valuation methods: (1) analysis of the stabilized pro forma income statement with the overall capi- talization rate derived from transaction data, and (2) discounted cash flow (DCF) analysis based on a fundamental forecast.

12. Jim Clayton, David C. Ling, and Andy Naranjo, “Commercial Real Estate Valuation: Fundamentals verses Investor Sentiment,” Journal of Real Estate Finance and Economics 38, no. 1 (2009): 5–37; published online July 17, 2008, Springer Science and Business Media, LLC, 2008.

13. Federal Register, August 22, 1990, Section C, Section 1608.2.

14. The term transaction is synonymous with the term property sales.

The Appraisal Journal, Spring 2011 Price versus Fundamentals 146

Consider an appraisal of a 100,000-square-foot shopping center in 2006 at the height of the recent speculator-driven real estate boom. The subject center was in a good location, but recently lost a couple of key tenants, thus current occupancy was down to 83%. However, the market was very active. Eighteen properties that sold from 2004–2005 were reviewed and other centers similar to the subject with occupancy in the 80% to 95% range had sold with very low pro forma capitalization rates in the 6% range. Most buyers in this market reported that they bought in this location on pro forma income statements as they expect to lease up within a year or less, so there is no discount for occupancy. As an example, one retail center in this market was 70% occupied at sale and sold for a 6.35% capitalization rate, while many 100% occupied centers sold for about the same capitalization rate. Properties in this market were selling on a bid basis, meaning a prospective buyer

could submit a bid, then negotiate a final price if the bid was near the top of those received. The average occupancy in this market had been over 90%. The buyers felt they could get this occupancy also.

With these factors in mind, the value was found to be $25,138,615, using typical valuation by stabilized occupancy and using a capitalization rate from the sales method; the value computation is shown in Table 1.

A fundamental study of this market found that other developers knew this was a good location and were building, or planning to build, more product in the market. The transaction market even used this common knowledge as a marketing tool to claim that this was a good investment market as evidenced by the large demand based on all the recent building activity. The implication, as told by the buy/sell brokers, was the buyer of the subject could expect to resell in a few years at a profit in such an active market.

Table 1 Estimate of Shopping center Value Using Overall capitalization Rate and Operating Pro Forma Data

Data Inputs       Net rentable area 100,000 sq. ft.

Revenue Expenses Gross revenue $20.50 per sq. ft. Property Tax $3.35 per s.f.

NNN reimbursements $6.12 per sq. ft. Insurance $0.17 per s.f. Vacancy and credit loss 10% of gross income C.A.M. $2.60 per s.f.   Management 5.00% of EGI   Reserves $0.25 per s.f.   Misc. $0.05 per s.f.

Data Analysis      

Revenue Gross rent revenue $2,050,000 Add: NNN reimbursement $612,000 Potential gross income $2,662,000 Less Vacancy and credit loss $266,200 Effective gross income $2,395,800

Less Operating Expenses % of EGI Property tax $335,000 14.0% Insurance $17,000 0.7% C.A.M. $260,000 10.9% Management $119,790 5.0% Reserves $25,000 1.0% Miscellaneous $5,000 0.2% Total expenses $761,790 31.8%

Net Operating Income $1,634,010    

Value at 6.5% capitalization Rate $25,138,615

Price versus Fundamentals The Appraisal Journal, Spring 2011 147

However, the fundamentals showed that there was not enough buying power in this market for so many shopping centers and that the subject could not compete as well as some of the newer properties with better locations and anchors coming into this market. In fact, the subject would be lucky to have 80% occupancy in a few years. Thus, the value by the fundamental method was $17,800,000 (rounded), about $7.3 million less than the sales comparison by capitalization rate method.

Table 2 shows the value computed using the DCF fundamental method, based on the appraiser’s

market/marketability study, to forecast the subject’s potential occupancy and rents.

case Study 1: The Reconciliation The reconciliation of the values indicated in the capi- talization rate and fundamental income approaches depends on the assignment question of the client. If the client is asking for the expected transaction price today, then the value is probably around $25 million. But if the client is asking for the underlying value of this property, then the value is probably around $17.8 million.

Table 2 Estimate of Shopping center Value Using DcF Analysis of Fundamental Forecast of Subject, Mid-Range Forecast

Income Occupancy Est. Market Leases/with Reimb.CAM\SF $26.62

Year Rent Increase Future Rent Year Occupancy Wt. Avg. Leases–> 2006 3% $27.42 2006 83% Wt. Avg. Leases–> 2007 3% $28.24 2007 83% Wt. Avg. Leases–> 2008 3% $29.09 2008 83% Wt. Avg. Leases–> 2009 3% $29.96 2009 80% Wt. Avg. Leases–> 2010 3% $30.86 2010 80% Wt. Avg. Leases–> 2011 3% $31.79 2011 80% Wt. Avg. Leases–> 2012 3% $32.74 2012 80% Wt. Avg. Leases–> 2013 3% $33.72 2013 80% Wt. Avg. Leases–> 2014 3% $34.73 2014 80% Wt. Avg. Leases–> 2015 3% $35.78 2015 80%

Financial Low Mid High Discount rate 9.50% 10.00% 10.50% Terminal capitalization rate 9.00%   Selling expenses 3.00%    

DcF Analysis 1 2 3 9 10 Year-> 2006 2007 2008.... ....2014 2015 Potential Gross Income Total Inc. Rent + CAM $2,741,860 $2,824,116 $2,908,839 $3,473,306 $3,577,505 Less Vacancy $466,116 $480,100 $494,503 $694,661 $715,501 Eff. Gross Income $2,275,744 $2,344,016 $2,414,337 $2,778,645 $2,862,004 Less Expenses Mgt./Misc. $113,787 $117,201 $120,717 $138,932 $143,100 Reimb./CAM $635,510 $654,575 $674,213 $805,045 $829,196 Total Expenses $749,297 $771,776 $794,929 $943,977 $972,297 Net Operating Income $1,526,447 $1,572,240 $1,619,407 $1,834,668 $1,889,708 Plus Reversion $20,366,850 Less Tenant/Capital $25,750 $26,523 $27,318 $32,619 $33,598 Total cash Flow $1,500,697 $1,545,718 $1,592,089 $1,802,048 $22,222,959

Note: Expenses are same as used in the Table 1 capitalization rate method, increasing at 3% per year for inflation.

Present Value @ 10.00% $17,844,640

The Appraisal Journal, Spring 2011 Price versus Fundamentals 148

In comparing the results of the sales capitalization rate method to the fundamental DCF method, a typical reaction is that the discount rate and/or the future occupancy of the DCF did not reflect the buyer’s perception; and if it had, then the DCF would have about the same value as the sales capitalization rate method. This may be true from the sales comparison point of view, but the property fundamentals point of view indicates that the underlying value also can be reflected by the fundamental DCF method, which is based on fundamental forecasts and discount rates derived independent of the transaction market.

The traditional dilemma is that many times appraisers cannot agree about which method—sale transactions or fundamentals—yields market value. Perhaps the value could be derived from both. If the appraiser’s job is to analyze the real estate and not make decisions for clients, then the appraiser could simply show both methods.

Regardless, the purpose of this article is not to debate the discount rate or to decide if appraisers should put the buyer’s forecast or the appraiser’s market/marketability study forecast in the DCF. The message of this article is to consider the implications of what might occur when the DCF is mixed with data from the buy/sell market and the appraiser’s forecast. Both methodologies have a place and can be used. The key seems to be an understanding of the differences in the transaction data and the fundamental data, and the bearing of each on the value conclusion.

case Study 1: Postscript Capitalization rates in the Case Study 1 market have increased about 2% points. If the previous pro forma net income is capitalized at 9%, then the value is back to fundamental value (net operating income (NOI) pro forma $1,634,010/0.09 = $18,155,667). If pro forma NOI is adjusted to a realistic average occupancy (about 80%), then the value would be in the $15 million range. The fundamental value inputs would not significantly change, and the fun- damental value in 2009 would be about the same as in 2006. However, between 2006 and 2009, the buy/ sell market dropped at least 30%. This is consistent with activity in this market in late 2009. This also shows that the buy/sell market overreacts both up and down, as now the buy/sell market is below this property’s fundamental value.

Case Study 2: Using Sales as Evidence of Fundamental Demand Case Study 2 presents another example of a problem that can be created by mixing the transaction (sales) market and fundament al market dat a. Appraisers may inadvertently accept that because there are recent sales of land to users who build, for example, convenience stores, it must be financially feasible to build a similar commercial building on the adjacent subject property, and therefore, that is the value of the land. In a relatively stable market of transactions (buy/sell) and fundamental factors (steady demographic growth), this conclusion of more demand may be correct. However, in a market wit h t he t ransact ions market or fundament al markets out of balance, the demand for more of the same type of commercial enterprise may not be indicated by the transaction market.

For example, if the transaction market is in some type of bubble, a buyer-developer may be motivated by factors other than fundamentals, such as unique financing (as seen in the 2006 period) or a client that has to “get money into real estate now and this is the only way.” On the other hand, there may not be a bubble market, but fundamental demand may show this market is oversupplied. The last sale of a convenience store, for example, may satisfy demand in this market, and now it is not financially feasible to build any more convenience stores. This situation is illustrated in the following case study.

Consider an appraisal some years ago of a vacant, one-acre pad site on the corner of two major thoroughfares.15 The subject pad site was part of a grocery-anchored shopping center, and the assignment was to find the market value of the vacant one-acre pad site.

Within six months prior to the appraisal date, three pad sites sold across the street: one for a 7-11 convenience store, another for a Pizza Hut, and one adjacent for a Kentucky Fried Chicken. The land for convenience stores consistently sold for about $16 per square foot and the land for fast food restaurants for about $10 per square foot. Figure 3 shows the location of the sales and their sale prices.

This shows all the typical qualities of a clear- cut appraisal. All of the sales were recent and were similar in size, zoning, utilities, curb cuts, location etc.; that is, they were alike in all ways except some

15. Stephen F. Fanning, Market Analysis of Real Estate (Chicago: Appraisal Institute, 2005), 399–402.

Price versus Fundamentals The Appraisal Journal, Spring 2011 149

were on a corner and some were not. The sale to users can be an indicator of more demand for this use, so without further study the subject’s highest and best use is concluded as convenience store, and its value is $16 per square foot.

However, sales to users can also be an indicator of oversupply, with the last sale satisfying near- term demand for this type of real estate product at this location for some time. The oversupply or undersupply question usually cannot be answered by just looking at the transaction market activity. Some fundamental analysis is needed.

In this case, the highest and best use conclusion by fundamental analysis was that convenience stores were oversupplied while fast food was not. Thus, the value was $10 per square foot. It turned out an Applebee’s restaurant was built on the subject site and paid just under $10 per square foot. This shows the appraiser’s dilemma of using sales transactions as indicators of fundamental demand and how the two can sometimes be at odds with each other.

Appraising in Markets with No Sales F undament al met hods of valuat ion become a nec essit y i n ma rket s w it h few t ra nsact ions. For example, in 2006 the average household in California spent 53% of its income on housing. When the bubble burst there were very few house sales, and many people said value of these houses could not be determined. It is more difficult, but it is not impossible to value houses in such a market.

One fundamental method to consider is to take the average household income in a neighborhood and use the proven criteria of 27% can be spent on housing. The maximum loan amount is added to a standard down payment, and the result is the average house price in that neighborhood. Each individual house can be adjusted from that.

L i kew ise, w it h c om mercia l proper t y t he f u nda ment a l approach bec omes t he g u id i ng approach, and then the cost approach and sales are adjusted off the results of the fundamental value. There are various methods that could be used,16 but the most explicit method is a discounted cash

Figure 3 case Study 2—Map of Neighboring Sales

Of�ce Complex

Major

Thoroughfare

Shopping Center Apartments

1 Mile

Single Family

New Conv. Store Land @ $16/SF

1

New Fast Food Land @ $10/SF

4

New Conv. Store Land @ $16/SF

5

New Fast Food Land @ $10/SF

3

New Fast Food Land @ $10/SF

2

Single Family

M a jo

r

Th o ro

u gh

fa re

M a jo

r

Th o ro

u gh

fa re

Not to scale

Subject

Apartments

16. Additional examples can be found in Appraisal Journal articles: Terry V. Grissom and Julian Diaz III, “Valuation without Comparables,” The Appraisal Journal (July 1991): 370–376; Judy Baumgarten, “Market Value When There Is No Market,” The Appraisal Journal (October 1978): 79–80; and Bruce R. Weber, “Market Value Without A Market,” The Appraisal Journal (October 1990): 523–532.

The Appraisal Journal, Spring 2011 Price versus Fundamentals 150

f low based on a Level C market /marketability study of future demand and absor pt ion. This method estimates what an investor could afford to pay for t he proper t y based on t he cu r rent market economics and t he most likely user ’s ability to pay for that use. Richard Ratcliff called this the simulation method17—use of the income capitalization approach to simulate what a buyer and seller would most likely pay for this property in the current market. Grissom and Diaz called this the behavioral approach,18 and the present article calls it the fundamental value approach. But all of the different labels are referring to the same method that calls for an appraiser to look at “feasibility and market analysis, forecasting, and the estimation of normal occupancy levels, effective dema nd , c ompet it ion , re asonable project ion periods and rates of capture and absorption.”19

Consider the previous case studies in this article, but now assume they are in a down market. Case Study 1 had numerous sales and building act ivit y but t hat all stopped in 2009. Lending stopped, sales stopped, and the planned projects did not come on line. This had an interesting effect; the rents went down because of income loss of the retail customers in the trade area. The lack of capital for new construction was a positive for future absorption prospects, however, as no new competition was expected for many years. Also, this market continued to grow in population in spite of the economic downturn. Thus, even though rents decreased about 15 % , future occupancy prospects were higher than the previous high- market cycle of 2006 because of the lack of new compet it ion and growing customer base. The result of the fundamental value of the shopping center was about 10% to 15% lower according to the fundamental valuation method. This was in contrast to expectations of local brokers and experts that indicated if the property sold in this down market it would have to be discounted up to 40% .

Case Study 2 was a land appraisal. Assume now that all the sales were three years old, and the current market is like the 2009 market, with no recent sales transactions. In this case, the three- year-old sales would have to be adjusted down

for market conditions. Suppose the fundamental study found it to be three more years until there would be demand for a new fast food restaurant and eight more years until a new convenience store would be needed. Based on a 15% discount rate, the case study’s user sales (fast food restaurant at $10 per square foot, convenience store at $16 per square foot) would have a present value of $6.58 per square foot for a fast food restaurant and $5.23 per square foot for a convenience store. Thus, the value by fundamental valuation method would be about $5.23 to $6.58 per square foot. The value by this fundamental approach would then need to be reconciled with the market transaction approach, which means adjusting old sales, conducting broker interviews, and using other similar techniques to gauge t he potent ial t ransact ion prices in a down market.

Appraisal Methods and the Two- Market Implications R ight or w rong, appra isers a re cr it ici zed for providing appraisals based solely on transaction (buy/sell) market data. Usually this is what the client request s in t he assig nment , but t hat is seldom remembered when extreme market cycles reverse themselves.

There could be many solutions to this problem, but perhaps one to st ar t wit h is making sure the clients know when they are asking for value based only on market analysis of the transaction (buy/sell) market, when they are asking for value based on the market/marketability analysis of the fundamental market, and when they are asking for both.

A not her solut ion m ig ht be for appra isers to disconnect the transaction and fundamental market segments in the appraisal analysis, and then connect them as appropriate in the final value reconciliation analysis. The disconnect would be to make the three approaches more independent and consequently give a good base for the reconciliation.

The income capitalization approach would be based on fundamental (users’) demand for space, i.e., what the users of the real estate can afford over time. This income valuation method would

17. Richard U. Ratcliff, Valuation for Real Estate Decisions (Santa Cruz, CA: Democrat Press, 1972), 79–83.

18. Grissom and Diaz III, “Valuation without Comparables.”

19. Ibid., 372.

Price versus Fundamentals The Appraisal Journal, Spring 2011 151

not use capitalization rates from sales (remember the goal is to disconnect the three approaches, and capitalization rates are a sales unit of comparison that will be used in the sales comparison section). Thus, some type of yield capitalization would be used, such as DCF, with the income forecast based on data of market/marketability fundamentals— not what buyers and sellers are forecasting, but based on t he appraiser’s interpret at ion of t he market fundamental data. Discount rates could be based on data such as historical real estate yield spread to treasury bills, alternative investments, or variations of the old lender cap rate method of NOI/coverage ratio, etc. Terminal capitalization rate selection would consider forecasted supply and demand.

The sales comparison approach would be just that—a sales comparison. It would try to reflect what those types of properties are selling for at that point in time, whether in a bubble market or in a greatly depressed market. The appraiser could include the capitalization rate approach here.

A lt er nat ively, t he appr a i ser c a n put t he capitalization rate method in its own section of the appraisal report if the income pro forma data is the appraiser’s forecast;20 then the capitalization rat e approach c ou ld be c onsidered a hybr id between the sales comparison and fundamental income approaches. This would depend on how the capitalization rate is generated and how the income forecast is made. If the capitalization rate is unadjusted for occupancy and adjusted only for consistency in expenses, then this is a straight ratio of the sales and is a pure sales comparison approach. However, if the income occupancy of the sales and subject are adjusted by the appraiser based on his or her forecast of the subject and sales, then it is a more hybrid approach of the sales comparison and income capitalization methods.

T he c o s t appr o ac h i s c omple t e d i n t he traditional methods, except external obsolescence

presents a challenge to keep independent of the other two approaches. If external obsolescence is measured by sales or is measured by capitalized income loss, then the data has been inbred with the sales or the fundamental income capitalization approach forecast. One possible solution might be to measure the net income difference between subject property current rents with rents in good location and/or good balanced market comparables and/ or new construction feasibility rent. Then take the percentage difference and apply for external obsolescence. Another solution could be to exclude external obsolescence, and the cost approach then becomes an analytical tool. For example, this type of value by cost approach without external obsolescence could be considered the value of the property in a stable market with a property equally competitive with all other properties. This will give a good analytical base to compare the results of the other two approaches in reconciliation. Another variation might be to make the cost approach part of the income section analysis by applying the capitalized income loss method of depreciation.

Reconciliation Becomes the Capstone to an Appraisal I f t he t h r e e appr o ac he s a r e s e p a r at e d i nt o independent valuation techniques, the reconciliation becomes the appraiser’s instrument to reconnect t he t hree approaches. In a st able market , t he t ra nsact ion ( buy/sel l) ma rket va lue a nd t he fundamental market value by the three approaches should be similar. However, in unstable markets (high or low extremes) the three approaches can have very different conclusions if they are analyzed independently of one another. The appraiser then becomes an analyst for the client instead of just a comparables researcher. The appraiser can conclude an opinion of which of the alternative values he or she considers to be market value, but the three approach method also gives the clients

20. Many appraisers use pro forma income estimates for comparables with varying occupancies to develop a “stabilized income” and to generate a capitalization rate; this capitalization rate is then applied to the subject’s forecasted stabilized pro forma income estimate. The pro forma income estimates for the comparables are often based on the appraiser’s forecast of each comparable (as opposed to verifying the buyer’s expectations and information on the pro forma comparables). Thus, the appraiser’s pro forma method becomes a form of a hybrid fundamental analysis since it is based on the appraiser’s forecast of the subject and the comparables future performance and then applied based on the overall rate yield method model of R = Y − ∆a. Note this is not necessarily a recommended method because it is hard enough to forecast the subject’s future performance much less forecast a number of comparable sales future performance. Nevertheless, it is a method observed as practiced by many appraisers. It would seem that a better method would be to use an overall rate based on buyers’ expectations to arrive at an overall rate and then apply that rate the same way to the subject’s income, and thus create a pure sales comparison method. Then the appraiser can use the fundamental forecast in the income capitalization approach by DCF.

The Appraisal Journal, Spring 2011 Price versus Fundamentals 152

(the ultimate decision makers) information to make their own informed decision. As a byproduct, the three approach method explains the apparent contradiction of varying value indications. The apparent contradiction actually is no contradiction at all; it is just simply two different markets at work—the transaction (buy/sell) market and the underlying fundamental (user) market.

Conclusions: Concepts of Two-Market Data in Appraisals The problem is that in real estate two market seg ment s are vacillat ing, at t imes wit h some interaction with each other and at other times independent of each other. When the data over- laps are not correctly recognized or analyzed, the value conclusions can be uncertain. The solution may be to not just pick one type of data to use in valuation—like transaction data only or funda- mental data only—but to know when to use data from each market segment, when to mix the data, when not to mix the data, and when to use the two different market segments to check results from the others.

D r. G r a a s k a m p m a y h a ve s a i d i t b e s t : “Appraisers would do well to always remember that real property prices are simply a reflection of the market’s optimism or pessimism (aka greed or fear) of the future. Prices do not always, and more likely rarely, coincide with the value of the underlying asset.”21

Stephen F. Fanning, MAI, cRE, AIcP, has been in the real estate and city planning field for over thirty

years, including the last twenty-five years as owner of a consulting firm in Denton, Texas, specializing in

planning, market analysis and real estate appraisals. Fanning has been an instructor and author for the

Appraisal Institute for twenty-five years, with emphasis on market analysis, and highest and best use.

contact: [email protected]

John A. blazejack, MAI, cRE, FRIcS, is president of Blazejack & Company Real Estate Counselors, a

Miami-based counseling and valuation firm founded in 1988. He is a graduate of Florida State University and

has a MSM in real estate from Florida International University. Blazejack has been an instructor for the

Appraisal Institute, teaching market analysis courses for twenty-five years. contact: [email protected]

George R. Mann, MAI, MRIcS, is managing director of Collateral Evaluation Services, LLC, and

has with a total of twenty-four years of valuation experience: four years as an independent fee

appraiser, two years as a real estate assessor, and eighteen years with banking institutions. Mann graduated from the University of Florida and earned his MBA from Averett University. He has published

articles in the RMA Journal and The Appraisal Journal. He has appraised and reviewed all types of commercial real estate in over thirty-five states and

seven foreign countries. contact: [email protected]

21. This quote was found in notes of one of the authors of this article, with reference to Graaskamp but no source. Regardless, whether or not Graaskamp said this, the authors consider it a true and significant statement to the point of this article.

Price versus Fundamentals The Appraisal Journal, Spring 2011 153

Web Connections Internet resources suggested by the Y. T. and Louise Lee Lum Library

American Economic Association http://www.aeaweb.org/index.php

Bureau of Economic Analysis, US Department of Commerce http://www.bea.gov

Capital Markets Update, Urban Land Institute http://www.uli.org//ResearchAndPublications/CapitalMarketsUpdate.aspx

CapRates.net (commercial real estate capitalization rate data) http://www.caprates.net/

Market Analysis Research and Data, James R. Delisle, PhD http://jrdelisle.com/

Real Estate Program, University of Wisconsin http://www.bus.wisc.edu/realestate/publications/

Wharton Real Estate Department, University of Pennsylvania http://real-estate.wharton.upenn.edu/

The Appraisal Journal, Spring 2011 Price versus Fundamentals 154

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