221 Week 4 F /For WIZARD KIM

The recession and the real estate downturn have created many questions for valuation experts. Sometimes an effort to address one area of uncertainty can lead to more questions on another related topic— which is the scenario that led to the development of the Appraisal Institute’s Guide Note 12: Analyzing Market Trends.

Many real estate professionals have raised questions about the appropriateness of using distressed properties as comparables in developing an appraisal. The AI Appraisal Guidance Panel began working on a guidance piece addressing this issue in the summer of 2011. During the development of that piece (which was published as Guide Note 11: Comparable Selection in a Declining Market in November 2011), the team realized there was a further need for guidance on market analysis and recognizing market trends.

Appraisers have been accused of failing to account for the economic bubble leading up to the recession and more recently, signs of improvements in certain markets. While appraisers cannot be expected to predict the future, competent valuation professionals should have the tools to recognize market trends. They must understand that market analysis is a critical step in the valuation process. As with all the other Guide Notes, Guide Note 12 does not provide step-by-step directions on how to perform a particular methodology or analysis. The Guide Notes offer a synopsis of the Appraisal Institute body of knowledge and provide guidance on how the AI Standards of Professional Appraisal Practice may apply in particular situations.

Drawing on the Appraisal Institute body of knowledge and member expertise in this area, Proposed Guide Note 12: Analyzing Market Trends was developed and released for member comment in February 2012. During the 30-day exposure period,

members were invited to review the document and offer comment and feedback. After reviewing the feedback and making some edits to the original document, the AI Board of Directors adopted the new Guide Note at their meeting on May 8, 2012.

Guide Note 12: Analyzing Market Trends recognizes that analysis of the market trend is a critical step in developing a market value opinion because the value of a property is dependent on the future benefits that a property will bring to its owner. It specifically discusses market changes, including the factors that cause change and the signs that may indicate a bubble or bust market. Guide Note 12 includes a summary of the applicable Uniform Standards of Professional Appraisal Practice rules and discusses steps an appraiser must take to ensure due diligence is done regarding analysis of market trends. Also included are resources to develop an adequate market analysis and information on its inclusion in the reconciliation process.

Guide Note 12: Analyzing Market Trends is reproduced in its entirety in the Appendix to this article. Guide Note 12, along with all other Guide Notes, also is available for download at www.appraisalinstitute.org/PPC/guide-notes.aspx.

Christina Austin is the manager of peer review programs for the Appraisal Institute and acts as staff

liaison to the Appraisal Standards and Guidance Committee and the Appraisal Guidance Panel. During

her six years at the Appraisal Institute, she has held positions in the Admissions and Professional Practice departments. Austin received a bachelor

of arts degree in political science from Monmouth College and a master of public administration degree

from the University of Illinois. Contact: [email protected]

Appraisal Institute Releases Guide Note 12: Analyzing Market Trends by Christina Austin

The Appraisal Journal, Summer 2012 Notes and Issues 248

NOTES AND ISSUES

Appendix

Guide Note 12: Analyzing Market Trends

Introduction 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 expec- tations of what will happen in the market in the future. Therefore, a critical step in the develop- ment of a market value opinion is analysis of the market trends. The market trends study should include what market participants (buyers, etc.) believe will happen to market conditions in the future as well as current supply and demand, and anticipated changes to supply and demand. The interaction of these factors profoundly impacts the highest and best use, and in turn the market value of a property.

Analyzing current and anticipated market conditions is more complicated—and more criti- cal—when a market is rapidly changing, either upward or downward. A “bubble” market might suddenly turn and decline; a “bust” market might suddenly start to improve. To what extent is an appraiser responsible for recognizing changes in market conditions? What steps must an appraiser take to ensure due diligence is done regarding the analysis of market trends?

Basis for Proper Evaluation The Uniform Standards of Professional Appraisal Practice (US PAP) include rules that address these questions.

Standards Rule 1-3 states:

When necessary for credible assignment results in developing a market value opinion, an appraiser must:

(a) identify and analyze the effect on use and value of existing land use regulations, reasonably probable modifications of such land use regulations, economic supply and demand, the physical adaptability of the real estate, and market area trends; and

Comment: An appraiser must avoid making an unsupported assumption or premise about market area trends, effective age, and remaining life.

(b) develop an opinion of the highest and best use of the real estate.

Comment : An appraiser must analyze the relevant legal, physical, and economic factors to the extent necessary to support the appraiser’s highest and best use conclusion(s).

(Emphasis added)

U S PAP’s Scope of Work Rule states that an appraiser must “determine and perform the scope of work necessary to develop credible assign- ment results.” Scope of work includes the type and extent of data researched, and the type and extent of analyses applied to arrive at opinions and conclusions. Thus, the extent of the analyses of market conditions and trends is a scope of work issue. Along with other aspects of scope of work, the extent of these analyses must be determined at the outset of each assignment.

Standards Rule 1-6 requires the appraiser to:

(a) reconcile the quality and quantity of data available and analyzed within the approaches used; and

(b) reconcile the applicability of the approaches, methods and techniques used to arrive at the value conclusion(s).

Reconciliation is an important step in the valua- tion process, especially when market conditions are such that good quality, current data is lacking.

Factors That Cause Markets to Change Real estate markets are characterized by cycles. Real estate cycles typically involve successive periods of expansion, peak levels of activity, contraction, and troughs.

Factors that cause markets to change are distinctly different from symptoms of change. Examples of symptoms of change include changes in vacancy rates (a leading indicator), falling or rising property prices, increases in the frequency of concessions and seller financing, sale prices exceeding listing price, and other conditions symptomatic of larger, more basic problems. Factors that cause markets to change are generally the product of macro-level

Notes and Issues The Appraisal Journal, Summer 2012 249

1. Appraisal Institute, The Dictionary of Real Estate Appraisal, 5th ed. (Chicago: Appraisal Institute, 2010), 121.

forces. They influence market psychology and drive behavior in profound, sometimes dramatic ways. Such causative factors can involve a single defining event or a slower moving series of events that are evolutionary in nature and sometimes not readily apparent to real time observers. Whether they consist of a single defining event or series of related events, these causative factors are indica- tive of shifts in underlying political and social as well as economic conditions.

Factors that cause markets to change may be capi- tal (transactional) based or fundamental (space user) based. Examples of capital-based factors that cause markets to change include:

1. Changes in public policy, particularly related to monetary policy and government spending, taxation, interest rates, the avail- ability of financing and capital formation, length and facilitation of the local entitlement process, and employment initiatives.

2. Inflationary/deflationary pressures on the regional, national, and global economies.

3. Overabundance of investment capital result- ing in increased competition (often too much money chasing too few deals), overly aggres- sive investment strategies, progressively lax underwriting standards.

Examples of fundamental (space user) based fac- tors that cause markets to change include:

1. Changes in migration patterns and population shifts which cause overcapacity in some areas and undersupply in others.

2. Economic shock caused by events such as 9/11, the Lehman bankruptcy, the dot.com bust of the early 2000s, the Arab oil embargo of the 1970s, and periodic spikes in the price of oil, all of which caused wide-scale disruption in property markets affecting everything from corporate strategy, personal live/work deci- sions, and increased cost of property operation to demand for hotel rooms and second homes.

3. Aging population with its increased demand for retirement communities, congregate care

facilities and smaller housing size.

4. Changes in technology such as green build- ings, cloud computing, and Internet shopping, which affect employment patterns, new indus- try formations, and new property types (e.g., server farms, disaster recovery facilities.)

5. Natural disasters and industrial accidents, which are usually local or regional in nature.

6. Changes in affluence and income distribution that influence affordability and consumer and discretionary spending habits.

7. Overbuilding and increases in competitive supply.

Market Analysis Market analysis is defined as “a process for exam- ining the demand for and supply of a property type and the geographic market area for that property type.”1

While appraisers generally analyze historic data (e.g., comparable sales) in the valuation process, it is important to recognize that the value of a property is dependent on the future benefits that a property will bring to its owner. Future benefits include the rights to use, occupy, and enjoy the property as well as the right to receive income it may produce. Market values are therefore forward-looking. Data used in the valuation process must be adjusted for market conditions as necessary so the market value conclusion reflects this forward-looking stance as of the date of value. Market analysis provides the frame- work for making determinations about market conditions adjustments.

Market analysis is a critical step in the appraisal process. Adequate market analysis must be com- pleted before highest and best use analysis, and the determination of highest and best use is critical to an appraisal assignment when market value is the objective.

Market analysis provides the data input to identify the highest and best use of a property in terms of (1) property use (2) market support (economic

The Appraisal Journal, Summer 2012 Notes and Issues 250

demand) and timing (absorption rates), and (3) market participants (probable users and buyers.)2

Most market analyses can be completed using a six-step process:

1. Define the product (property productivity analysis): Identify physical, legal and location attributes that shape productive capabilities and potential uses.

2. Market delineation: Identify the market for the use.

3. Demand analysis: Identify characteristics of the most probable user. Analyze demand driv- ers such as population, income, employment.

4. Supply analysis: Survey and forecast competi- tion. Analyze existing supply, new inventory coming on line in the near future, and pro- posed construction.

5. Analysis of the interaction between supply and demand: Determine if marginal demand exists, predict when market will move out of equilibrium.

6. Forecast subject capture: Analyze market penetration.

A seventh step, perform financial feasibility analy- sis of alternative uses and threshold testing, can be added for proposed properties.

The manner and degree to which these steps are carried out within an appraisal assignment are scope of work issues. The scope of work for an assignment must be appropriate given the intended use. It is the appraiser’s responsibility to determine the scope of work for the assignment. The scope of work must meet or exceed what the appraiser’s peers’ actions would be in the same or a similar assignment, and with the expectations of parties who are regularly intended users for similar assignments.

The appraiser must decline or withdraw from an assignment if the client will not allow the appraiser’s scope of work to be adequate for the assignment. The level of market analysis per- formed must be appropriate for the assignment

and not limited solely because the client wishes to reduce the appraisal cost.

The level of analysis can range from simple to highly sophisticated. On a simple level, demand may be inferred from current market conditions, or rates of change used to develop projections. On the more sophisticated level, an in-depth analysis of forecast (fundamental) demand is performed.

Fundamental market analysis may be useful and necessary when analyzing or performing an appraisal of a property for new construction, or when appraising property in a volatile or rapidly changing market. In terms of real estate products, whether it be apartments, industrial, retail or office properties, fundamental market analysis answers the questions of “when and how much.”

Competent appraisers continuously interact with buyers, sellers and agents of transaction activity. Ideally, appraisers have frequent and sustained interaction with buyers or lessees in particular. Such interaction allows appraisers to ascertain, analyze, and understand the motivations of market participants. Appraisers must be famil- iar with the local market dynamics and be able to perform trend analysis and/or fundamental market analysis to the degree necessary for the specific assignment.

However, appraisers are not expected to be prog- nosticators. Unforeseen events can completely eradicate conclusions that have been based in trend analysis or fundamental market analysis. A market value opinion is as of a particular date, and it is an attempt to reflect the anticipations of market participants as well as market fundamen- tal trends and analysis. Events subsequent to the date of value that were not anticipated by market participants can cause values to change—in some cases, significantly.

Signs of a Changing Market Signs of a changing market are symptoms, as opposed to causes. An appraiser observes the symptoms, but must understand the underlying

2. Stephen F. Fanning, Market Analysis for Real Estate: Concepts and Applications in Valuation and Highest and Best Use (Chicago: Appraisal Institute, 2005), 5.

Notes and Issues The Appraisal Journal, Summer 2012 251

cause or causes in order to properly analyze market trends.

For appraisers and market participants, a “bust” market is usually relatively obvious. However, it can be difficult to spot a “bubble” market when in the midst of one. Further, it can be difficult to tell when a bust market has started to turn and improve, or when a bubble market has begun to decline.

A bubble may be evidenced by:

1. Rate of return associated with a property type, economic characteristics of tenants or users are not typical and tend to be very low. For example, capitalization rates may be very low and/or indicate negative leverage, which is often a sign of speculation.

2. Buyers become emotionally involved and act irrationally, contrary to the market value definition.

3. Prices increase at a faster rate than rents.

4. Rates of return decrease below long-range trends.

5. Prices rise while rents and net incomes remain stable or are declining.

6. Traditional buyers are replaced by new ones. “Everyone” starts to invest in real estate.

7. The number of transactions increases.

8. Shorter marketing times.

9. Average days-on-market decreases.

10. Very few expired listings.

11. An increase in the number of properties remaining vacant after purchase.

12. Condominium conversions become more common.

13. The number of persons employed in the real estate sector (real estate sales, mortgage lend- ing) significantly increases.

14. Rents increasing faster than the ability of tenants to pay.

15. Sale prices above affordability of users.

A bust market may be evidenced by:

1. Sellers are reluctant to sell and realize losses; therefore, there are few sales, at least initially.

2. An increase in the rate of foreclosures, to

the point where foreclosures become the predominant sales.

3. An increase in seller concessions, both in terms of frequency and magnitude.

4. A tightening of credit markets. Traditional financing becomes more difficult to obtain.

5. An increase in the use of “creative” financing, generally involving seller financing. These arrangements serve to keep nominal prices from falling, at least in the initial stages of a bust.

6. Longer marketing times.

7. Average days-on-market increases.

8. The number of expired listings increases.

9. The number of persons employed in the real estate sector declines.

10. Job growth declining.

11. Rents not rising at the rate of the last few years.

12. Vacancy increasing.

Reconciliation 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.

In the reconciliation process, the appraiser must consider the quality as well as the quantity of data, and how those factors might have impacted the quality of the value opinion. In a slower market with fewer transactions, there are fewer sales available for analysis in the sales comparison approach. Also, when there are fewer transac- tions, there is less market evidence available for selection of capitalization and discount rates.

The reconciliation process may indicate that more research is needed or that new analyses must be performed. It may reveal conflicts or unresolved questions that need to be answered.

When necessary, the appraisal report should include a discussion of evidence that the value con- clusion may not be sustainable into the foreseeable

The Appraisal Journal, Summer 2012 Notes and Issues 252

future. This is potentially a controversial and chal- lenging conversation to have with one’s client, but it may be a critical issue to highlight.

Summary of Standard Practices 1. Make the appropriate scope of work determina-

tion for the assignment given the intended use.

2. Apply market analysis at the level appropriate for the assignment and consistent with the scope of work determination.

3. Understand the causes of a changing market.

4. Recognize the signs of a changing market.

5. Communicate the market analysis clearly in the appraisal report.

6. Clearly present the reconciliation process in the appraisal report and discuss as appropri- ate the likelihood that the value might not be sustainable into the foreseeable future.

(Please Note: The purpose of the Guide Notes to the Standards of Professional Appraisal Practice is to provide Members with guidance as to how the requirements of the Standards may apply in specific situations.)

Notes and Issues The Appraisal Journal, Summer 2012 253

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