Introduction

There is broad sweeping change in the mindset of the World economy caused by the credit crisis, economic downturn and long-term uncertainty, which is having a profound impact on the real estate market. Our job as appraisers is to interpret what is occurring in the economy including supply/demand conditions, unavailability of financing, rising unemployment and alternative investment vehicles in order to credibly estimate the value of real property. The following information provides an introduction to the commercial real estate appraisal process, and summary statements with regard to how we are adapting our analysis to the changing economic conditions.

Appraisal: (noun) the act or process of developing an opinion of value; an opinion of value.  (adjective) of or pertaining to appraising and related functions such as an appraisal practice or appraisal service.

Appraiser: one who is expected to perform valuation services competently and in a manner that is independent, impartial, and objective.

Appraisal Process

1) Define the problem

• Identify the real estate
• Identify the rights to be valued
• Establish the intended user of the appraisal
• Determine the definition of value
• Determine the effective date of the appraisal
• Identify the scope of the appraisal
• Establish any assumptions and limiting conditions

2) Preliminary Analysis and Data Collection

3) Highest and Best Use Analysis

4) Land Value Estimate

5) Apply the Appropriate Valuation Techniques (Cost, Income, and Sales)

6) Reconciliation of Value and Final Value Conclusion

7) Report the Defined Value

Scope of Work: the type and extent of research and analysis in an assignment.

The scope of work is defined by the appraiser and the client.  However, the appraiser can not limit the scope of work to such a degree that is jeopardizes the reliability of the value conclusion.

The most common value scenario requested is the As Is Market Value.  Market Value is defined below:

The most probable price which a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently, knowledgeably, and assuming that the price is not affected by undue stimulus. Implicit in this definition is the consummation of a sale as of a specified date and the passing of title from seller to buyer under conditions whereby:

1.     Buyer and seller are typically motivated;

2.     Both parties are well informed or well advised, and acting in what they consider their own best interests;

3.     A reasonable time is allowed for exposure in the open market;

4.     Payment is made in terms of cash in United States dollars or in terms of financial arrangements comparable thereto; and

5.     The price represents the normal consideration for the property sold unaffected by special or creative financing or sales concessions granted by anyone associated with the sale.

Office of Comptroller of the Currency (OCC), Title 12 of the Code of Federal Regulation, Part 34, Subpart C – Appraisals, 34.42 (g); Office of Thrift Supervision (OTS), 12 CFR 564.2 (g); This is also compatible with the RTC, FDIC, FRS and NCUA definitions of market value.

The scope of work may be defined by the appraiser, however, the scope of work must meet or exceed 1) the expectations of parties who are regularly intended users for similar assignments; and 2) what an appraiser’s peers’ actions would be in performing the same or similar assignment.

Appraisal Reporting Options

An appraiser has 3 options for written reports:

Self Contained

Summary

Restricted Use

Three Approaches to Value

• Cost Approach
• Income Approach
• Sales Comparison Approach

Cost Approach

The cost approach is based upon the principle that the value of the property is significantly related to its physical characteristics, and that no one would pay more for a facility than it would cost to build a like facility in today’s market on a comparable site. In this approach, the market value of the site is estimated and added to the estimated depreciated value of the improvements.

Or

Replace Cost of Improvements w/ profit – Depreciation + site value = Cost Approach Value

Replacement Cost New

All costs to construct

• -Direct Cost (materials, labor, contractor overhead)
• -Indirect Cost (perm. financing, marketing, professional reports)

Sources for Data: Developer’s Budget, Cost Comparables, Marshal Valuation, Bids

(+) Profit

Sufficient entrepreneurial incentive to compensate risk

• -Varies based on market sector

Developers (10-20%)

Users (5%)

Sources: Market survey, alternative investments

(-) Depreciation

Three Types

• -Physical (typical wear & tear)
• -Functional (obsolescence due to design)
• -Economical (surrounding influences)

(+) Land Value

Cost of equivalent substitute site

• -Valuation techniques

Sales comparison (most typical)

Residual analysis

= Cost Approach Value

Most Applicable for:

• New or proposed construction
• Owner/user properties
• Special purpose properties

Limited Application for:

• Investment properties

-mostly to test financial feasibility

• Older construction

-difficult to measure accrued depreciation

Cost Approach in a Declining Market

Many new projects are not financially feasible.  The lease-up or absorption/sell-out of a project becomes extended.  Many projects appraised 18 months ago that are nearing completion are no longer profitable due to extended marketing periods.

Replacement cost becomes a less reliable indicator of market value.

Land value assumptions change. In an active construction market, land is purchased for immediate development. If a development parcel is purchased now, the buyer’s assumption would be to hold until development is feasible.  Additional holding costs may require a downward adjustment to the land sales that sold in 2007.

Income Approach

In the Income Approach a property’s capacity to generate income is analyzed, which is in turn capitalized into an indication of present value. Two fundamental methods are used in this approach, Direct Capitalization and Yield Capitalization, which are described below:

• Direct Capitalization Method – The advantages of direct capitalization are that it is simple to use, easy to explain, often expresses market thinking, and provides strong market evidence of value when adequate sales are available. Direct capitalization is most commonly applied by applying an overall capitalization rate to relate value to the entire property income (i.e., net operating income).
• Yield Capitalization Method – This method is typically referred to as a Discounted Cash Flow Analysis. Market supported assumptions and projections are made for future changes in occupancy, rents, income, and expenses to arrive at periodic cash flow. The property’s eventual reversion is also estimated, incorporating anticipated changes in the property and market conditions. The resulting cash flows are discounted to a present value indication using an appropriate market supported yield rate.

Direct Capitalization – Most Commonly Used

The following steps create a basic outline of the income approach:

• Estimate income
• Estimate Vacancy and Expenses
• Derive an estimate of Net Operating Income (NOI)
• Derive a capitalization rate from a) market sales, b) band of investment analysis
• Divide the NOI by the Capitalization rate to estimate the value

The fundamental principle in this approach if anticipation.  The anticipated risk associated with the income stream is implicit in the cap rate.

A basic Income Approach is:

Potential Income – Vacancy = Effective Gross Income

Effective Gross Income – Expenses = NOI

NOI /Capitalization Rate = Value

Limitations - The limitations of this approach include:

• Lack of recent, directly comparable rental rates
• Lack of market transactions from which to derive a reliable capitalization rate

Common Mistakes - Common mistakes made by market participants include:

• Understanding the difference between current income and potential income and between fee simple and leased fee value
• Estimating appropriate expenses
• Understanding the structure of the leases in order to measure appropriate expense reimbursements when applicable
• Deriving an appropriate capitalization rate based upon the risk factors of the property

Income Approach in a Declining Market

The Income Capitalization Approach is the best measure of value for income-producing investment properties. One challenging task in the current economy is accurately estimating market rents, which requires the appraiser to measure the impacts that softer market conditions are having on rents.

Without a doubt, the most difficult and important modifications to our appraisals are occurring in the capitalization and discount rate analysis. Due to the drastic decline in investment sales over the past year, it takes a lot of creative analysis to reasonably estimate current capitalization rates. We look in the rearview mirror on past transactions, consider current listing and review national trends in order to provide the most reasonable estimate.

Sales Comparison Approach

The Sales Comparison (Market) Approach is based on the principle of substitution, which asserts that no one would pay more for a property than the value of similar property in the market. In this approach, the subject property is compared directly with other recent sales of similar properties in the marketplace. This comparison is typically accomplished by extracting “units of comparison,” for example, price per square foot, and then adjusting these units of comparison for the comparable sales for differences between the subject and each comparable.

The reliability of an indication found by this method depends on the quality and quantity of the comparable data found and the ability of the appraiser to make reasonable and supportable adjustments. In active markets with a large number of sales that are physically similar comparables, this approach is generally a good indicator of value.

Sources of Comparable Data

• Buyer
• Seller
• Brokers
• Public records
• Professional data companies
• Multiple listing services
• Other appraisers

Typical Units of Comparison

• Price/SF of gross building area
• Price/SF of net building area
• Price per unit (apartments, self storage, hotels, health care)
• Price per seat (restaurants and theaters)
• Price per door (truck terminals and distribution centers)
• Price per boat slip (marinas)
• Price per parking space (parking decks)
• Price per hole (golf courses)
• Price per lane (bowling alleys)
• Price per lot or pad (subdivisions, mobile home parks, RV parks)

Most Applicable for:

• Owner/user properties
• Special purpose properties
• Any property (retail, office, etc.) where sufficient data is available

Sales Comparison Approach in a Declining Market

Limited sales activity is making the sales approach more difficult. Investment sales are off 60% to 80%.  As much as 50% of those sales now include assumed debt.

The factors affecting value and pricing have changed. This includes buyer’s assumption on the future. For example, capitalization rates at 6% and investors IRR of 15% imply substantial increases in income over a holding period. With flat rents, higher vacancy costs to ownership, difficulty financing, the conditions in which sales took place in 2007 are much different that they are today.

Appraiser now need to do a better job interviewing brokers, analyzing active listings, and drawing a conclusion from possibly older sales prior to 2007.

W. Grant Norling & Jeff Grose, MAI presented the previous discussion with Perkins Coie LLP on Thursday March 19th of 2009. If you would like to meet with them to discuss anything further feel free to get in contact with W. Grant Norling at grant.norling@pgpinc.com

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Way back in November 1996, Oregon voters passed Measure 47. This was a constitutional amendment popularly referred to as the “cut and cap” tax reform act. The “cut” aspect of the legislation referred to a reduction in taxes for the 1997-98 tax year calculated as the lesser of the 1994-95 taxes or 90 percent of the 1995-96 taxes. Bonded debt would be exempt from the calculations. The “cap” aspect of the measure restricted growth in taxes to no greater than 3 percent annually after the 1997-98 tax year.
Exempt from the calculation were circumstances of new construction, significant renovations/rehabilitation, loss of exemption status, change in zoning, subdivision of the property, and omitted property.

When the legislative assembly convened in January 1997, it became evident that, as written, Measure 47 was impractical to implement on an equitable and feasible basis. Measure 50 was the revision of Measure 47 and is the product of a cooperative effort between industry, the petitioner for Measure 47, the Oregon Assessors, the Department of Revenue and the House Revenue Committee. Measure 50 limited the 1997-98 assessed value of each property to the lesser of real market value or the 1995-96 real market value, less 10 percent. Growth in assessed value was limited to 3 percent annually, thereafter. Thus, the 1998-99 maximum assessed value was the 1995-96 real market value, less 10 percent, plus 3 percent. The 1999-2000 maximum assessed value was the 1998-99 maximum assessed value plus 3%, and so on.

In addition to the cap on assessed value growth, tax growth was also effectively limited to a 3 percent annual growth rate, although exceptions are permitted under specially approved levies. Similar to Measure 47, assessed values can be increased due to new construction, subdivision, rezoning, omitted property and loss of exemption. When these events occur, the assessor will place the added value on the assessment roll at the maximum assessed value.

The maximum assessed value of added value will be determined by estimating the real market value of the change and multiplying it by the ratio of the maximum assessed values of like properties to the real market value of like properties.

For example, on December 31, 2007, a new fast serve restaurant was completed. Its real market value is $800,000. The average maximum assessed value for like properties in this class is $600,000 and the average real market value for like properties is $800,000. Therefore, the subject’s 2008-09 assessment (maximum assessed value) will be [($600,000/$800,000) x $800,000] $600,000.

The process is charted below:

The 2009-10 assessed value will be ($600,000 x 1.03) $618,000.

Measure 50 also provided for establishment of new levies outside the tax rate limits. One interesting aspect of the new levies clause was that the levy request required a 50 percent “turnout” of registered voters for approval. Voters overturned this supermajority requirement in 2008.

One significant implication of Measure 50 is the “disconnect” between assessed value and market value. Reliance on assessed value for market-based decision making and matters related to income tax is clearly a phenomenon of the past. There is reason to believe that there will be some level of predictability of future tax obligations based on the growth rate limits. Properties subject to exceptions, particularly new or significantly changed properties, should be monitored closely for their first year values on the tax roll, as these values will dictate the taxable values into the future.

Todd S. Liebow, MAI, is a Principal of PGP Valuation Inc, a National Real Estate Appraisal and Consulting Firm providing Property Tax Appeals/Consultations; Commercial, Industrial, and Special Use Property Appraisals; and Feasibility studies.

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Existing home sales were down consistently across all 4 counties in 2008 by 32 to 34%
New Detached sales followed a similar trend, with Clark, Washington & Multnomah down 29-33%, and Washington down 18%
Attached housing market faired the worse, down from 40 to 54% across all four counties.
Overall, the volume of home sales was down an average of 35% for the Portland Metro Area
Pending sales dropped 30%, and New Listings Dropped 8.7% for the year, and 20% compared to the same quarter last year
Foreclosure sales now approaching 10% of existing sales, with Clark County higher at 17%
Per the local RMLS service there is a 14.1 months of inventory based on current monthly sales rate, up from 8.5% in December 2007
Total Marketing Time for Homes Per MLS is up 13% to an average of 138 days

Median Sale Price Trends

Median Existing Home Price down from 2 to 6%, averaging 5%
Median New Home Price more static in Washington and Multnomah Counties, but down 13% in Clackamas and 19% in Clark County
Attached housing down average of 5%
Median Sale Prices Are Likely Skewed by Concessions and by the number and location of the sales

New Home Trends

Construction activity and starts are at all time low
Generally selling close to 1/4 of the new units as compared to the peak of the market
New home and lot inventories are declining, but slowing sales are still keeping the overall months of inventory high
Most plat in Clark County with new detached product have absorption from 0 to 2.50 sales per month, with average at about 1 per month
Attached townhome absorption similar to slightly lower at 0 to 2 closed sales per month
2009 Volume of New Home Sales Could Go Down Further 20% if Economy Does Not Improve
More builders will file bankruptcy in 2009 & we will see builders work together or consolidate to survive
Some production builders trying to get detached housing down to $180,000 for starter home
Affordability is improving with home prices continuing to decline & very low mortgage rates, but recession & tighter lending standards offset
Long term trend for production builders: goal to match of starter home pricing to median incomes, and conform to underwriting standards.
During the peak of the market, starter home prices far exceeded the affordability based on median incomes and traditional underwriting
Median Income are likely to drop given unemployment on the rise, and near term deflation is likely
Lot and land prices have to adjust further
Interest Rate Buy downs More Common as Incentive From Builders
Trend to continued increase in number of attached town-homes entering rental pools by builders.
Some discussion between building community and jurisdications to put a temporary freeze on increased impact fees

Banks & FDIC

Restructuring of the financial system & underwriting requirements likely in near future
Continued Bank Closures Likely in next two years
Bank closures typically result in frozen lines of credit and loans being called- ripple effect for the community
Opportunity for brokers to represent buyers & to inform them of inventory becoming available
Also recommend learning the process and establishing relationship with FDIC on selling side
Fed is injecting money (liquidity into banking system), but banks are stockpiling the liquidity and not passing it on.
Commercial Real Estate Problems will hurt already troubled banks in the coming year.

Lot Value Trends

25-40% value declines in many markets
Most transactions are individual retail sales or take down sales tied to home absorption to builders
Larger custom lots and acreage lots showing big declines, with the exception of very unique parcels in limited supply
Spec financing for smaller custom builders is extremely limited, so only buyers of larger lots are production builders or individuals
Most bulk discounts analyzed using Discounted Cash Flows range at 25-35% from retail, with some up to 50%
Increase in short sales for lots, will result in builders offering new below market product with competitive advantage
Some Recent Potential Buyer Comments on Liquidation Values for Land and Lots
Developer/Builder 50 cents on dollar because they can immediately react as a producer
Inventor buyer at 20-30 cents on the dollar for wait and hold scenario

Residential Land

Demand almost non existent in 2008, and will likely be limited to short sales, liquidation sales, or speculation in 2009
Reductions in land values have been magnified by the slower home sales, lack of demand for lots, and lack of financing
Land Valuation – Focus on supported finished product type, price it right, run conservative costs, and calculate residual on yields w/holding periods.
A&D Loans are essentially non-existent except for unique well positioned projects with high equity requirements of a limited scope.
Multi-Family Land – Few sales, developers have quoted likely range from 8,000 to 14,000 per door for land at 18-24/acre garden style.
Value of entitlement no what it used to be, and entitlements will expire for many projects
Developers will continue to obtain post decision reviews to phase larger projects, in attempt to extend length of entitlements
New Washington State Stormwater Rules Effective in April 2009 have caused a rush of new applications for subdivision to maintain lot yields

Overall Comments

Really in uncharted waters- Deep Recession, new administration, new stimulus plan, new direction for TARP
Demographic Trends also shifting to more conservative for savers in the future
Hard Money Lenders Coming into Play Now
My guess is that we will bottom in early 2010, with a signs of a recovery in later 2011.
Some national experts say housing crisis could last another 3-4 years.
Private parties need to start looking at housing as a long term investment, not a quick flip product
Future success in housing market will be dependent on bringing product to market that is supported by incomes and new underwriting requirements
Qualified buyers will have a great opportunity with declining values and low rates
If you are ready to pull the trigger on a home purchase & have a good deal you should do it as long as you are qualified and not heavily in debt.

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