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Woe is the market analyst who shoots from the hip. There is too much opportunity and rationale these days, or for that matter, at any time, for closer examination of the data, analysis, and conclusions set forth by appraisers reporting the decision-making processes of participants in the real estate market.

Who among us has not been subject to greater and closer scrutiny, or has scrutinized others in greater depth in the recent climate of market distress? How do valuation experts report the meeting of the minds of the buyers and sellers when those players are on the sidelines?

The market downturn has been more widespread, more inclusive of the spectrum and breadth of property sectors than at most times in the past several low points in business cycles. The sickly symptoms in pricing and demand during the relatively recent past have been more like those afflicting limited-market properties in normal times. Scarcity hasn’t been an issue in the availability of most product types. Transferability and effective purchasing power have been curtailed by the constraints on the flow of credit. And the resulting muting of demand, has effectively stepped on the brakes in the marketplace slowing the velocity in transaction activity.

Is anybody in the market really out there, in the market? Are appraisers the voices in the wilderness calling out for somebody, anybody, to tell them what’s going on out there?

What are we searching for? In the good old days, as recent as twenty-four months ago, it was difficult for investors to make a mistake in any market. The pipeline was flowing with a slurry of cash and credit. Buyers were buying, Sellers were selling. Some sectors were doing “land office” business. Does anybody remember this? The market was speaking loud and clear about their views regarding a clear and exuberant relationship between income and value. Hindsight is calling into question the rationality of those perceptions, but it was what it was—and the relationships of income and prices were defined by the overall capitalization rates associated with the deals. The players’ expectations were committed by virtue of securitization, for better or worse and in sickness or in health.

Looking back with an eye toward the deals taking place during the recent exuberance, and even just using a low level magnifier, the relationship that buyers and lenders had entered into was more fragile than anyone would want to admit, then or now.

But now we’ve got a problem. Not the bubble; not the bursting of the bubble ….market analysts are lacking market-based information with which to fully understand the future benefits of ownership for investors. Investors are also void of access to the information, mostly because there isn’t much.

One option for appraisers would be to make predictions of proper capitalization rates based on most recent bona fide transactions, whatever can be found. We can always defer to our infallible judgment and breadth of experience…but each of these data resources is vulnerable for lacking true emulation of the meeting of the minds in the marketplace.

If only we could use interviews with buyers that would identify their view of required cap rates needed to close a deal were the solution to the quest, we could stop this discussion here. Everybody’s got an opinion. We can’t fabricate capitalization rates, can we?

I suggest we don’t, at least not without reasonable basis from the market’s perspective… lest we get caught when it matters. Most of you who are reading this likely think it always matters. Cap rates can be constructed from the matter that comprises the deal, particularly from the investor’s perspective, and for the benefit of the appraiser, tested for reasonableness.

One of the fundamental weaknesses in understanding and projecting cap rates in transitional markets is the need to look in the rear view mirror at past transactions in order to try to make educated guesses about the next transaction. This is not as much of a challenge if stability characterizes the forecasted climate. We’re talking about capitalization rate forensics because market instability is diminishing our traditional levels of predictability.

Forensics

So let’s get forensic. But before we do, let’s digress. What does “credible appraisal” mean? Most agree that somewhere in the process of the credible appraisal report presentation, the reader is led from premises to conclusions and they are able to walk away from their reading with a market-based perspective.

Appraisal academia typically starts the lesson plan imploring the student to test their conclusions for reasonableness. As elementary as this teaching is, the absence of reasonableness is on the Top 10 List of most frequently observed appraisal deficiencies. I liken the concept to sitting on the curb, across the street from the subject property, when all the research is conducted, and the analysis nearly complete, and asking whether the conclusion and its components are truly market-based.

Forensics is relevant here. Mostly because as observers of the market, without a good supply of transactions to study, we need to dissect our overall cap rate conclusions, and in litigation, the conclusions of others, to get a closer look at the quantity, quality, durability and risk associated with collecting lease income anticipated from the investment.

It is appropriate to remember that value is created for investment real estate most often by a combination of debt and equity. The deal has got to work in terms of providing sufficient return to both the debt and equity participants. Lenders appreciate this concept especially.

Investors are also aiming to first pay the lender and then have sufficient funds left over to justify handing over the cash to own the illiquid asset and its attendant risks that often require management expertise, at of course, some cost. So in the process of dissection of the rate, we need to understand that the cash-on-cash return, the equity dividend component, is the analogous measuring stick with which to compare the vehicles in the investment spectrum, which range on the low risk end, from the mattress; to the greatest risk, demanding the highest return, venture capital.

In the mattress, liquidity and management are not typical negative factors. There is however, risk of erosion of effective purchasing power. In the next level, the high safety/low return vehicles are the time deposits, money market and “passbook” savings accounts. Most classes of investment property lie somewhere below the stock market, and somewhere above theses traditionally safe, low return vehicles. So in the forensic analysis of the rate components, one target variable to evaluate is the available cash dividend, and its proper relationship with its competitive investment vehicles.

Investors will most always say that they’d sacrifice some cash-on-cash return for some upside property appreciation that also contributes to their total return.

As of late, the closer scrutiny of the overall rate is most typically undertaken by an appraiser who is facing a thinner supply of market transactions, and is in need of using anecdotal supplemental insights. The appraiser is more often applying a test of reasonableness via a Band of Investments analysis. Similarly in any adversarial proceeding it is typical for the “opposing” party to dissect the components of their adversary to check for reasonableness. Most decisions handed down in disputed valuation cases evaluate the reasonableness of the respective parties’ assertions.

Debt

The debt portion of the analysis is often pretty straight forward. This component of the overall rate consists of the return to the lender, and is calculated based on probable loan to value ratio, amortization schedule, and likely interest rate applicable to the loan. The mortgage constant is calculated, and the weighted return to the lender represents one of the overall rate’s components. Not all lenders are shut down. Their credit criteria, is however, likely requiring greater equity contribution and more stringent pay back terms. Far too few appraisers are consistently up to date with their knowledge of available loan terms.

Equity

The equity position is a little more challenging to know well, in that the equity dividend rate has historically been extracted from market transactions. If we had these, this discussion would be moot. So the next best thing, a proxy for the extracted dividend rate, relates directly back to the equity dividend rate desired or anticipated, as it compares to alternative riskier, or less risky, investment vehicles. These alternative vehicles need also be evaluated with regard to their degree of liquidity and management burden.

Dissection

Most of the readers of this discussion are likely looking for a practical way to employ this analysis to their advantage in an adversarial proceeding. You should be so lucky that you’ve narrowed the differences in value estimates with the assessing jurisdiction down to net income and overall rate. This may represent a fantasy dispute, because many debates appear to center on whether the sun rises in the east, or west.

Nevertheless, let’s work the equation backwards solving for one of the debt or equity variables, with the intent of testing the reasonableness through dissection of the assessing jurisdiction’s cap rate.

The first and most obvious (and typically most effective) test is to evaluate the reasonableness of the equity dividend rate assuming both parties have narrowed their dispute on anticipated NOI, by subtracting the debt component from the overall rate. By definition, the remainder component is the equity position. With an atypically low overall rate asserted by the assessing jurisdiction, the equity dividend rate will be atypically (and unacceptably) low relative to that needed to entice an investor into this particular real estate investment. This evaluation is conducted on a comparative basis comparing the assessment jurisdiction’s implied equity dividend rate, with less risky, more liquid, and non-management required alternative vehicles, e.g., the CD, Bonds, Money Market or Passbook Savings.

By employing a working forensic knowledge of the theoretical components of the overall rate, you can test and solve for reasonableness of both your asserted overall rate, and that of the opposing party.

As a side note, user beware of the possibility of skewing the OAR downward through manipulation of the NOI in the analysis of the few transactions that may be available, where reliable income data is not readily available from a knowledgeable source. This behavior is found within the category of appraiser-based data as opposed to market-based data.

For example, with recent market conditions, a spike in vacancy rates has been generally commonplace. Many data services track vacancy and report it to subscribers. More than a few times assessment jurisdictions have been observed substituting current actual market vacancy rates for anticipated stabilized rates applicable to the property in their imputed income pro forma. Out the other end comes an appraiser-based, artificially skewed, lower-than-market overall rate purportedly derived from a market transaction. This has been observed more frequently when fewer transactions have occurred and fewer details are available from parties to those transactions for analysis.

Practical Forensics

This sort of dissection doesn’t require any sort of advanced scientific approach. To mix metaphors, no rocket science is needed. The overall rate is a simple conversion rate that expresses the relationship between a market-based perspective of net operating income, and the price an investor would reasonably be expected to pay for the future benefits associated with owning that income. The components of the rate represent a multitude of assumptions, but are simplified into adequate returns, sufficient for both the debt and the equity positions. Through a thorough understanding of the rate components and the reasonableness and market-based support for the components as they interact to form the overall capitalization rate, we have a better understanding of capitalization rates even without a prolific amount of market activity.

Now, it’s time to sit on the curb, and ponder the reasonableness of the rate.

TODD S. LIEBOW, MAI, is a commercial and industrial real estate appraiser and an Executive Shareholder in the firm of PGP Valuation Inc located in Portland, Oregon. Mr. Liebow’s professional appraisal experience includes five years as a commercial and industrial appraiser for the Clackamas County Assessor’s Office, in Oregon City, Oregon. Since 1983, Mr. Liebow has been in private practice with PGP Valuation Inc, specializing in valuation analysis for ad valorem tax assessment appeals and other forms of litigation. Mr. Liebow is a designated member of the Appraisal Institute and is a past president of the Greater Oregon Chapter of the Appraisal Institute and the Oregon/Southwest Washington Chapter of the International Association of Assessing Officers. He has chaired the Portland Building Owners and Managers’ (BOMA) taxation and legislation committee and has been a member of the Associated Oregon Industries’ committee on property taxation. Mr. Liebow is also a member of the Institute for Professionals in Taxation and was the Chair of IPT’s 1997 Property Tax Symposium as well as the Overall Chair of the 1999 Annual Conference. He has served as a member of both the IPT Annual Conference and the Property Tax Symposium committees several times over the past 15 years. Mr. Liebow has authored several articles on the ad valorem assessment system and has lectured frequently on tax and valuation issues. Mr. Liebow is a founding shareholder of Lewis and Clark Bank, a community bank in Oregon City, Oregon. He serves on their Board of Directors and is a member of their Loan and Corporate Governance Committees. In recent years, he has addressed Appraisal Institute Seminars on “Valuation of Environmentally Impaired Properties” and the American Bar Association/Institute for Professionals in Taxation’s Advanced Property Tax Seminars on “How to Create an Effective Appeal Team”, “Common Errors in the Appraisal Process,” “Selection and Evaluation of Attorneys,” “Hot Topics in Appraisals,” and “Valuation of Commercial and Industrial Property — Beyond the Cost Approach.” He is a graduate of Lewis and Clark College, with a BA in Philosophy with Honors, 1978.