Market Value As Is is not always the same as Market Value
August 24, 2015 – I had this email exchange with a review appraiser today. This is one of the situations where Market Value As Is and Market Value can differ.
Partially Leased Buildings – For proposed and partially leased rental developments, the appraiser must make appropriate deductions and discounts to reflect that the property has not achieved stabilized occupancy. The appraisal analysis also should include consideration of the absorption of the unleased space. Appropriate deductions and discounts should include items such as leasing commission, rent losses, tenant improvements, and entrepreneurial profit, if such profit is not included in the discount rate.
“Brief History of Valuation –
Price versus Value”
August 16, 2015 – My second White Paper in an ongoing series has been uploaded to the Articles web page. You can go to the link to download the PDF file.
As always, comments are welcome. Send to GeorgeRMann@Aol.Com
Even A Judge Knows Market Value Cannot Be Based On The Average of Sale Prices
August 15, 2015 – The number of appraisal reports that reviewers come across where the market value conclusion is based on the ‘Average’ of the adjusted comparable prices is astounding. Why do such erroneous methods become so popular in the appraisal industry? Laziness is probably one reason. An inadequate appraisal theory foundation is probably the bigger reason.
Page 84 of the Spring 2015 issue of The Appraisal Journal quotes the Tax Court of New Jersey decision in the case of Blum v. Township of Monroe, Block 42, Lot 25, Unit C455 (October 31, 2014 – 2014 WL 5573305):
“The court stated, ‘Thus, valuation of real property is not simply a mathematical exercise and cannot be replaced by a simplified mathematical computation.’ Case law precedent expressly disapproves the conclusion of a property’s fair market value based on an averaging of sale prices of comparables.”
Based on the above, it’s not just one judge, but many over the years, that are smart enough to know market value cannot be based on the average of sale prices. You would think the appraisal industry itself would know not to make this mistake!
Amazing, and thankfully, I have never had an appraiser try to defend the use of an average by saying that after all of the sales have been adjusted they are theoretically equal to the subject. Obviously this is not true. If Comp 1 is The Definitive Comp (a term I propose a definition for in an upcoming White Paper) and no adjustments at all are needed, how can we say that Comp 2 that was adjusted upward 20% and downward 20% for two differences is equally comp to Comp 1 after adjustments? We cannot.
Maybe if ALL comparables were adjusted EXACTLY THE SAME total % of Gross Adjustments, one could try to argue that an average would be ok then. However, that brings us to the main reason why averaging cannot be used….
Where is the logic in saying the market value of any property changes whenever an appraiser adds or deletes a comparable sale? e.g. An appraiser initially uses 4 sales that have an average adjusted price of $100/sf. But, he discovers he missed a current sale and when it is added now 5 sales average $105/sf. What does the number of sales used, much less the SUBJECTIVE adjustments made by an appraiser (!), have to do with the value of any property? NOTHING!
As such, I encourage appraisers not to conclude at an average. And don’t be lazy and say well I will conclude at the ‘mid-range.’ Do some analysis and thinking!
For 10+ years I have presented the following logic to classes I teach and never has one person disagreed – Is not the ‘best’ comparable the one that has the lowest % of gross adjustments? And the 2nd best comp has the 2nd lowest % of gross adjustments…and so on. Yes, it is. And the best part of this is it is the appraiser’s own data (he/she determined the adjustments!) so he/she cannot argue with it. The value conclusion should be reconciled to the best comp’s indication with weight maybe given to the 2nd best comp, etc. I have seen a handful of appraisers in the past few years do this. That is refreshing to see. Some people remember our Appraisal 101 class and being taught to find the best comp….then the next best comp….and so on. Not throwing a bunch of data on the wall and saying hey the average looks good.
((Let me interrupt myself and suggest that commercial appraisers follow the lead of residential appraisers and not just show the Net % Adjustment for each comp, but ALSO show the Gross % Adjustment for each comp. It is the Gross % that is important.))
Although referring to the reconciliation of 2 or more approaches to value, Page 642 of The Appraisal of Real Estate clearly states – “The final value opinion is not the average of the different value indications derived.’ Of course, this should apply to the reconciliation of each approach to value. And in the case of an appraisal report with only the Sales Comparison Approach developed, then this must be the case. Simply put, place a post-it note on your monitor and that of all appraisers working for you that says in all caps – NEVER BASE VALUE ON AN AVERAGE!
I encourage review appraisers nationwide to return appraisal reports that conclude market value at an average or any similar term (e.g. mid-range). Make the appraiser explain which comp is best (very tough for two comps to be equally best, but that can happen) and expect him/her to conclude at that adjusted value indication. Also, as noted above, averaging the approaches to value is not acceptable either. Appraisers need to provide some logic as to the value conclusion….which approach had better data, etc.
As always, you can send your thoughts to me at GeorgeRMann@Aol.Com
18%-20% IRRs just aren’t realistic for Subdivisions!
August 7, 2015 – Below is an actual email from a bank employee with my response that follows. And following my email are some more thoughts. Simply put, when in the heck are appraisers going to realize 18%-20% IRRs have NEVER been adequate for subdivisions!
I recently received an appraisal on a residential development located in ABC. The appraiser is located in XYZ. The original appraisal came to us and the appraiser used a 25% discount rate and also used a full year of discount for the remaining part of this year. Based on those items, the costs of improvements(not land value) exceeded the value he came up. I talked with 4 appraisers located in the ABC area and they all said that 25% was unheard of around here. They thought it should be in the 9% – 12% range maybe as high as 15% depending on if you expensed the developers fee into the expenses or not, which he did not. After talking with the appraiser, he was willing to lower the discount rate to 20% and did adjust the discount to account for a full year. That helped some but I feel we are still off due to the high discount rate of 20%. The development/city is called DEF Acres and is located on the north part of ABC. These lots are larger than your typical lot in the area averaging around 0.90 acres per lot and are in the $100,000+ range. However unlike every other development which has special assessments that can exceed the price of a lot, these lots do not have specials as the developer is doing all improvements on his own.
My question to you is if you reviewed the appraisal and came to the conclusion that the value should be higher based on discount rate or anything else you saw, could you give your opinion of value and could we use that for our lending purposes?
Thanks, looking forward to hearing back from you.
I probably wouldn’t be of much help as the 25% IRR inclusive of profit is on target and is as low as I like to see in appraisals of finished lots.
I have been telling appraisers for 20+ years they cannot break out entrepreneurial incentive as a line item expense and use a 10% or so discount rate. In 25+ years of seeing developer surveys I have only seen 1 (!!!!!!!!!!!) respondent separate the discount rate and profit for finished lots. NO appraiser can support a separated discount rate and profit %. For finished lots, the data is ONLY for an IRR inclusive of profit.
I will attach RealtyRates which applies to local/regional smaller subdivisions that most of us normally deal with. Another survey , PWC fka Korpacz, deals with national large projects with 8-10 year sellouts. Those have the lowest IRRs – around 18%. The shorter sellouts (local subdivisions) have higher discount rates 25%-30%+ for finished lots…..35%-40% for raw land, but we usually don’t discount back to raw land.
I will attach an award-winning article on the subject. As it shows, the shorter the sellout period the HIGHER the IRR….this is the opposite of what most every appraiser thinks it should be. In fact, the data shows IRRs for 1-year sellouts should be around 50%. I will never get an appraiser to admit to such though. They all think 25% is too high and want to use 15% or 18% inclusive of profit. They are all wrong and way off base and inflate values doing this.
The 20% IRR your appraiser lowered to is too low so I would stay with that number and move on. But, he is the only appraiser around who apparently understands that 25%+ IRR is needed when valuing finished lots.
As an aside, profit IS a line item deduction for condo projects. And the RealtyRates survey is the only survey that has such info – in the end the IRRs for condo projects are higher than for finished lots….once again, exactly the opposite of what most every appraiser in the country thinks. Appraisers think that because selling the houses or condos is the very last step in a project that started as raw land, the risk is lower and the IRR should be lower. The marketplace says no that is not the case. I think it is because the most money put at risk is in the end units and thus this is the highest risk part of an overall development. Just my guess at why the market says what it says.
Hope this and the attached help.
PS – The RealtyRates Developer Survey shows for your area… go to the chart on Page XY….Site-Built Residential…<100 units….ProForma Rates….Min 16%….Avg 24%…..Max 32%…..the Min is for the last few finished lots in a successful subdivision (we almost never have such appraised)….Average is for your typical s/d with decent sales and a new phase within the existing project….or it could be a totally new project if it is an awesome project….so I am thinking 23%-25% would apply to your subject. 32% for your area is for raw land. A bit lower than most places. So, 23%-25% is upported by the ONLY real survey out there.
Mann’s Additional Thoughts
The award-winning article I reference above is by Brian J. Curry, MAI, SRA. ‘The Trouble with Rates in the Subdivision Development Method to Land Valuation’ appears in the Spring 2013 issue of The Appraiser Journal. Every appraiser should read and follow the methods in this article. Banks should send this article to their fee appraisers.
Appraisal Myth #1 – In what I call ‘Appraisal Land’ (i.e. the unrealistic world that most fee appraisers live in), appraisers are of the belief that the shorter the sellout period the lower the IRR. Brian’s article clearly blows this myth out of the water. Yields are 40%-50%+ for sellout periods less than 1 year. The two prominent surveys in the marketplace also prove this point. PwC shows around 18% IRRs for projects with 8-10 year sellout periods. RealtyRates shows averages generally in the 23%-27% range for the more typical 2-3 year sellout periods. Since most of our appraisals are for the smaller local subdivisions, it is long overdue that appraisers use IRRs of 25% up to 50% for the appraisals of finished lots.
Appraisal Myth #2 – In Appraisal Land, there is the erroneous assumption that risk is lower for the end units in a project than back when the finished lots are being developed. In the RealtyRates Survey, the rates shown for condo projects excludes line item entrepreneurial incentive (Mr. Watts indicates a 10%-15% incentive should be used). Mr. Watts told me to simply add about 10% to the discount rates shown to convert this table to IRRs. When doing so we find that the IRRs for end unit condos are usually 0%-2% higher than IRRs for finished lots. I have contended for 20+ years that there is more risk in the end-unit phase than earlier in the project. The market agrees. Now, for fee appraisers to change their ways…
Apartment Appliances are FF&E, Not Real Estate!!!
It is 2015 and I continue to encounter appraisers (albeit fewer and fewer thankfully!) who do not value the FF&E in apartment properties. When I started appraising in 1986 we separately valued the appliances back then. Since 1990, FIRREA has required this. This issue should have been settled 25+ years ago.
The most common response I get when I ask an appraiser to separately value the FF&E is ‘In our market these items transfer with the real estate.’ To which a whole list of questions and replies come to mind:
Who cares how the FF&E is transferred – it is still FF&E!
FF&E in hotels transfers with the real estate – how does that differ from an apartment complex? The same goes for many other property types.
Having been frustrated by this issue for 23+ years as a reviewer, a few years ago I took the opportunity to have this item added to the 14th Edition of The Appraisal of Real Estate. There is a list of property types with FF&E and that list now includes apartments:)
For bank/credit union appraisals, appraisers need to realize that it is Federal Law that requires LTV (Loan-To-Value) ratios be calculated on the Market Value As Is of REAL ESTATE ONLY. Examiners have been focusing on this very item for the past 5 years. It is important that fee appraisers help their clients comply with Federal Law. Provide a value for the FF&E and be done with it. And do NOT include the amount in the Market Value ‘As Is’ figure as again it is supposed to be Real Estate Only.
I will agree that in some cases this amount is minimal. But, Federal Law still requires a separate value. There are many cases where this amount can be in the millions of dollars – e.g. those high end condo projects that did not sell out before the bubble burst and have been rented as apartments ever since.
Lastly, as one instructor told a class I was in – If I can drop it on my foot, it is FF&E:)
It Has ALWAYS Been Leased Fee Interest
Following is a recent conversation between a bank review appraiser and a fee appraiser:
Dear Fee Appraiser,
A review has been completed on your appraisal of the Apartment located at XYZ in City, ST and am wondering if you could provide some clarity in the following area:
I am wondering how the property rights appraised can be Fee Simple, when the subject apartment building is not vacant.
Thank you for addressing this item. Please make any necessary revisions and return a revised report to me at your earliest convenience.
Mr. Review Appraiser,
The subject property has current contract rents on a very short-term basis (most are month-to-month), and the rental rates at completion are based on market rental rates. In both analyses, market rental rates are utilized (see Page 78). Therefore, the market value opinion is fee simple. If contract rental rates are market rental rates, the fee simple and leased fee values are essentially equivalent.
The report date has been changed to the current date to comply with USPAP. Thank you for your input.
Mr. Fee Appraiser,
Your prompt response has been greatly appreciated.
Please refer to an explanation regarding the leased fee interest on Page 114 of the Appraisal of Real Estate (13th edition) as follows:
“The lessor’s interest in a property is considered a leased fee interest regardless of the duration of the lease, the specified rent, the parties to the lease, or any of the terms in the lease contract. A leased property, even one with rent that is consistent with market rent, is appraised as a leased fee interest, not as a fee simple interest ……”
If the contract rent is the same as the market rent, the leased fee value becomes equivalent to the fee simple value, not the other way around.
Thank you in advance for your quick follow up on our request.
Geez, for almost my entire 29+ year career I have had to deal with this error made by many appraisers. Thankfully, over the years, fewer and fewer appraisers think lease terms have anything to do with the property interest appraised. OCCUPANCY is essentially all that matters in this determination.
The quote the reviewer presents from the 13th Edition is 100% on target. In fact, it sounds exactly like my response over the past 20+ years….since I contribute to the each edition of The Appraisal of Real Estate and this is a pet peeve, the odds are those are words I wrote. Obviously, I like them:) lol
I have had exactly ONE existing apartment complex appraised as Fee Simple Estate. It was a 200-unit apartment project in Orlando in 2007 that had been vacated for condo conversion and the market crashed and that did not happen. In that case, the owner could immediately occupy all 200 units, if they so desired.
Another item the above fee appraiser assumed, that is likely in error, is that the subject contract rents were all at market. Once an existing apartment property is a few years old, it is near impossible that all of the contract rents are at market. My experience is actual income from contract rents is typically 5% to 25% (!) below the hypothetical market rent at 100% occupancy – this is often termed Economic Vacancy….and often not accounted for by many appraisers.
I encourage all appraisers to simply read the definitions of Fee Simple Estate and Leased Fee Interest. It is clear as day that lease terms are not mentioned. Also, note this nitpicky item – only Fee Simple is an ‘Estate’ – everything else is an ‘Interest.’ Why? I don’t know. I just had this pointed out to me while on The Dictionary of Real Estate Appraisal committee.
This is a long first post….but, I want to thank the Chief Appraiser who shared this item with me and allowed me to redact the emails and post the conversation above. I look forward to doing this on an ongoing basis. My hope is all of us can learn from these situations – fee appraisers, review appraisers, newbie fee and review appraisers, bank credit employees, et al.