Market conditions adjustments for residential development land in a declining market.This article outlines a protocol for analyzing rates of price decline for raw land--in this case potential residential subdivision land--in markets with few or no recent closed sales. Extracting time or market conditions adjustments in a distressed market is challenging, but with careful analysis it can be done through (1) Identification of the market peak and an estimate of value at that time; (2) Investigation of a wide range of transaction types; (3) quantitative analysis and reconciliation of the data; (4) use of compound monthly time adjustments; and (5) application of the concluded time adjustment to the estimated value at the peak of the market.
Real estate markets underwent a seismic shift during 2006-2009. Although the official beginning of the recent recession is identified as December 2007, participants in the real estate markets know that earlier in 2006 and 2007 warning signs were evident, and a pattern of static sale prices and declining sales volume had already emerged. Market resistance was papered over by complex financing instruments and loose underwriting standards that sustained effective demand, but the credit crisis of 2008 ended that last defense and laid bare and exacerbated the deteriorating fundamentals underlying the market. The difficulty this has presented to appraisers is in measuring the magnitude of the decline in values in an environment where everyone realizes that values have declined, but the kinds of market evidence usually available are insufficient due to the semifrozen status of the market.
This article outlines a protocol for analyzing rates of price decline for raw land--in this case potential residential subdivision land--in markets with a record of few or no recent closed sales. It does not deal with income-producing investment property, for which other techniques are available. The analysis is based on a case study involving valuation, for estate tax purposes, of a large tract of potential residential subdivision land in a second- or third-tier market in the Pacific Northwest. The assignment was unusual in having four potential dates of value. The two parties who owned the real property died a few months apart, which necessitated two dates of value associated with the respective dates of death; and the attorney representing the estate indicated that the IRS permitted using, for valuation purposes, either the date of death or a date six months after the date of death. Because there were two dates of death, there were potentially four dates of value.
The following paragraphs outline and discuss a procedure for estimating market value in a severely depressed market with a dearth of sales data. Briefly, the process involves (1) determining the market peak and estimating value as of that date; (2) developing negative time (market conditions) adjustments, using a wider variety of sources and methodologies than are typical; and (3) applying to the estimated peak market value a time adjustment for each date of value. An important part of the analysis is the use of compound monthly time adjustments.
Identification of the Market Peak
The first step in developing a negative time adjustment is the identification of the approximate market peak. The market peak usually corresponds with the last few meaningful sales, and after a crash there are often no closed sales suitable for analysis. After a market peak, the trepidation of market participants creates a stalemate in which buyers are reluctant to make offers, and sellers are reluctant to accept the offers they receive. The reasons for buyers' reluctance to make offers is reasonably well understood: a perceived lack of demand for the projected product, e.g., buildable lots; inability to obtain satisfactory financing; a fear of further declines in value; and a general adversity to risk. Sellers' reluctance may result from several factors, including a reluctance to accept a loss, a weighted analysis of the costs of holding versus the possibility of recovery, and (in the case of properties in or nearing foreclosure) a lack of cooperation from the lien holder, especially if a short sale is involved where the sale price is less than the mortgage balance. The implied equilibrium point of classical supply and demand curves is replaced by a kind of demilitarized zone: buyers unwilling to advance upward and sellers unwilling to retreat downward.
[FIGURE 1 OMITTED]
In the case study presented here, the market was small, and there were five sales in slightly more than two years. The graph in Figure 1 summarizes the sales data, based on price per square foot of land area. The data shows a pattern of slowly increasing unit sale prices from May 2004 to July 2005, and then a sharp increase between July 2005 and October 2005, followed by a slightly declining pattern thereafter. After June 2006, there were no sales of comparable properties suitable for analysis. After adjusting for other factors, such as location and topography and allowing for uncertainties, it was concluded that the peak of the market had been reached as of June 2006, and the available comparable sales were adjusted to arrive at an estimated market value of the subject property as of that date.
Developing Negative Time Adjustments
The next step in the case study valuation was to estimate the value of the subject property as of four dates in late 2007 and 2008, during and after a period of steep declines in demand and implied but with still unmeasured declines in value. It was a period in which no local sales were available to measure the decline.
The gold standard for developing time or market conditions adjustments is matched pair analysis of transactions of the same or similar properties. In its purest form, the recent sale of a property is compared with a prior sale of the same property, after verification to determine the effects of any changes in the property, such as physical condition, entitlements, or other factors. If the property has remained essentially unchanged in condition and amenities, then time or market conditions are imputed as the causal agent of price change.
For example, the widely followed Case-Shiller indices of housing prices use a matched pair sale methodology:
Home price data are gathered after that information becomes publicly available at local recording offices across the country.... For each home sale transaction, a search is conducted to find information regarding any previous sale for the same home. If an earlier transaction is found, the two transactions are paired and are considered a "repeat sale." Sales pairs are designed to yield the price change for the same house, while holding the quality and size of each house constant. (1)
The Moody's/REAL Commercial Property Price Index (CPPI) uses the same methodology for apartment, industrial, office, and retail properties. The CPPI, which is compiled in association with the Massachusetts Institute of Technology, is based on a repeat-sales regression (RSR) model, with conventional modifications and enhancements that are widely used in the real estate indices estimated in the academic community.
In an RSR index, the database on which the regression is estimated consists purely of properties that transact at least twice in the historical sample. The fundamental data on which the index is estimated consists of the price changes actually experienced by individual properties, the same type of price changes as direct property investors actually experience. (2)
In theory, appraisers have the same capability, but in smaller markets they may not have information and resources sufficient to survey, scrub, and analyze the data in the same way. Although appraisers in smaller markets typically have access to multiple listing service (MLS) records, and possibly one or more subscription services such as CoStar or LoopNet, those are not always adaptable to sound analysis in all market segments. The MLS services frequently develop and publish information on dollar and unit sales volume, average sale prices (less often median sales prices), and days-on-market information, but those indicators have flaws if one wants to estimate the rate of decline in values. For example, it is not clear whether a decline in average sale price represents the collapse of the high end of the market while leaving low- and middle-range properties comparatively untouched, or whether a decline in sales volume also indicates a corresponding loss in market value.
Although MLS and similar statistics are not sufficient to develop time (market conditions) adjustments, they do provide the context within which market conditions operate, and they can provide support and plausibility for time adjustments that will be extracted later in the valuation process. In developing a case for negative time adjustments, a sound market analysis is important preparation for the valuation that follows. A good market analysis for a property like the case study property should include most or all of the following elements:
* A summary of recent history in general terms
* A discussion of supply
* Sales history volume trends in dollars and units sold
* Days-on-market trends
* Ratio of supply to demand, i.e., the ratio of listings to actual sales
* The trend in sale-price-to-listed-price percentage
Most of this kind of data is easily available from multiple listing services. In the case study, narrative discussions of all of these elements were included and supplemented with charts and graphs that illustrated and supported the narrative.
It is important to note, however, that trends in improved property values are not a suitable proxy for values of raw land or unimproved sites. The value of land suitable for development or improvement is a function of its contribution to the improved property, and if the value of the improved property declines (or increases)--all else being equal, including cost of construction--the land value bears the burden or benefit of value loss or increase. Consider the following imaginary (but plausible) example.
Suppose a newly-constructed single-family residence in a normal market has a market value of $300,000, of which the land component is worth one-third, or $100,000; therefore, the value of the improvements, including all soft costs and entrepreneurial profit, is $200,000. After one year in a declining market, however, an identical newly constructed single-family residence has a market value of $250,000, a decline of 16.67%. All costs, including hard costs, soft costs, and entrepreneurial profit, remain the same; therefore, the land value component absorbs the loss in value, a reduction from $100,000 down to $50,000--a 50% decrease in value. The graph in Figure 2 illustrates this example. In other words there is a crack-the-whip effect on land value, and land is at the end of the whip. (3)
The mathematics of land value is similar to the mathematics of leverage in mortgage-equity analysis, where changes in overall property value are multiplied for the equity position. For example, an increase in overall property value of 50% will be equivalent to a 200% increase for the property owner with a one-fourth or 25% equity position, four times the overall increase. In the land value example, the original property had a one-third or 33% land-to-property value, and the decline in property value of 16.67% is multiplied by a factor of 5, or 3 times 16.67%, or 50%, i.e., land value has declined by half.
Proxies for Sale/Resale Analysis
In a severely depressed market, the availability of sales for sale/resale or matched pair analysis for extracting time adjustments is unlikely. There are, however, some alternatives for matched pair or sale/resale analysis, and in the case study, all of these were used:
* Offers to purchase and listings (offers to sell)
* Interviews with market participants
* Regional data beyond the usual boundaries of market research
Each of these alternatives will be discussed in the context of the case study, but first it is necessary to look critically at the topic of time adjustments, specifically the use of straight-line and compound time adjustments.
Straight-line vs. Compound Time Adjustments
Most appraisers make time (market conditions) adjustments using straight-line adjustments on a monthly basis, i.e., if the time adjustment is estimated to be +6% per year (or +0.5% per month), they will multiply the monthly percentage figure by the number of months between the date of closing of the comparable sale and the effective date of value for the subject property. The resulting percentage adjustment is applied to the comparable sale to provide a time-adjusted indication of value. For example, a sale that closed 18 months prior to the date of value would be adjusted by 0.5% per month times 18 months, or +9%.
There is, however, an alternative method--the use of compound monthly time adjustments. (4) Consider the following example: a property sells first for $500,000 and then resells, without major changes, 18 months later for $590,000. On a straight-line basis the percent change is 18% over 18 months, or 1.0% month, or 12% per year. However, it is also possible to extract the time adjustment on a compound monthly basis, most easily using a financial calculator, such as the Hewlett Packard HP-12c. For the HP-12c, the key strokes are as follows:
Step 1. Enter 0 in [PMT] (5) 0 [PMT] Step 2. Enter first sale price: $500,000 [PV] Step 3. Enter second sale price: $590,000 [CHS] (6) [FV] Step 4. Enter number of months, n 18 [n] Step 5. Solve for interest, i [I] 00.92(%)
After an iterative process similar to solutions for i (interest) in financial calculations, the answer will appear as 0.92 (percent). This may not seem like a significant difference from 1.0% straight-line, but over longer periods and with larger rates of change, the difference between straight-line and compound time adjustments is both conceptually and materially significant.
For example, in a declining market with double-digit percentage declines in value and a necessity to adjust from sales that are two or more years old, the difference between straight-line and compound time adjustments is very large indeed. Consider the following hypothetical example. A large tract of land sells for $2,000,000 and subsequently resells 18 months later in a declining market for $1,000,000. (Swings of this magnitude are known to many students of the market for residential development land during the period 2006 to 2008.) The indicated straight-line adjustment is -2.78% per month. However, the indicated compound adjustment is--3.78% per month. (7)
Now consider the difference when a straight-line adjustment and the equivalent compound time adjustment are applied to another comparable sale that is two years old and sold for $1,500,000. Straight-line adjustment will result in an adjusted price of $499,200, but compound monthly adjustment will result in an adjusted price of $594,922, nearly $100,000 and 20% higher.
Consider the Figure 3 graph, in which one line shows a decline in value over time with a negative straight-line adjustment of -2.78% per month, and the other shows the corresponding negative compound adjustment of -3.78% per month, each extracted from the described hypothetical sale/resale.
It can be seen that the two lines more or less agree for the first 18 months, the period from which the adjustment was extracted. After 18 months, however, the straight-line adjustment continues downward while the compound adjustment begins to level out. The latter appears more representative of market psychology: after a period of moving toward a new equilibrium point, the decline in value becomes less steep. In depressed markets, where adjustments are being extended significantly past the period from which the data was extracted, this is an important consideration. More importantly, the straight-line adjustment leads to an illogical conclusion: a negative value after 36 months! This would be comparable to a purchaser approaching the property owner and asking both for the deed and for some cash.
With these theoretical considerations in mind, let's examine their application to a real-world problem.
Typical Extraction Techniques in a Depressed Market
In the case study, the factors that led to a decline in the local market were also regional and national, so a much wider geographic net can be cast for market data to support the time adjustment. Briefly, the estimate of market value at the peak was derived from local sales, but the subsequent adjustment for market conditions was derived from analogous transactions, near-transactions, and other evidence from the greater region, in this case the Pacific Northwest The following are abbreviated descriptions of the kind of data used.
* A 37.6-acre parcel in another community was purchased by a major national developer for $15,000,000 in October 2005. However, after the market turned, the developer decided not to stay in the market and resold the property for $7,550,000 in June 2007. The decline in price represents a loss of 49.7%, or 3.4% per month on a compound basis over the 20-month period.
[FIGURE 3 OMITTED]
* A large site containing 3,337 acres in Idaho was originally negotiated for sale in September 2006 at $85,960,024. The agreement was subsequently amended in May 2007 as an option agreement to purchase the property for $30,800,000 due to market cooling and resulting renegotiation. In May 2008, the option was extended, additional earnest money was tendered, and the price was renegotiated to $33,200,000. This sale had not closed as of the date of the report, but the renegotiated price represents a decline in price of 61.4% over 20 months, or 4.6% per month on a compound basis.
* Phases 3 and 4 of a subdivision were subject to an option to purchase 167 lots for $6,095,500 in April 2007. In addition, there was an option down payment of $500,000. However, the option was never executed and the transaction never consummated. As of the date of the report, the property was in foreclosure and listed for sale for $6,360,000. There were two offers to purchase the property at a 50% discount, or $3,180,000. The indicated decline in price from the $6,095,000 option price in April 2007 to potential offers of $3,180,000 in August 2008 is 47.8% over 16 months, or 4.0% per month on a compound basis.
* A purchaser negotiated the purchase of 20 finished lots in an 84-lot subdivision in Northern California, for $1,660,000 in January 2007, but delayed the dosing and renegotiated a new price of $1,368,000. The indicated decline in price is 17.6% over 7 months, or 2.7% per month on a compound basis.
* Phase VI of a subdivision in Northern California, was sold for $126,000 per finished lot in 2005, and was resold for $38,000 per lot in December 2007. The precise month of the original sale is not available, but an intermediate date of mid-2005, or June 2005 is assumed. The indicated decline in price represents 69.8% over 30 months, or 3.9% per month on a compound basis.
* Seventy-two finished lots in Northern California, sold for $77,000 per lot in December 2005 and resold for $20,000 per lot in December 2007. The indicated decline in price represents 74.0% over 24 months, or 5.5% per month on a compound basis.
* The appraisers interviewed the chief appraiser of a large bank, who reported reappraisals in 2008 were coming in at values of 40% to 50% of 2007 values. The indicated reduction in value represents a range of 4.2% to 5.6% per month on a straight-line basis.
None of these instances was necessarily conclusive by itself, but considered together they provided compelling evidence and support for a decline in value and a negative time adjustment in the range of 3.5% to 4.0% on a monthly compound basis. Once there was a reasonable estimate of the negative time or market conditions adjustment, it was applied to the estimated market value of the subject as of the peak of the market, thus adjusting to the four dates of value requested by the client.
Extracting time or market conditions adjustments in a distressed market is a challenging exercise, but with careful analysis it can be done. It involves (1) identification of the market peak and an estimate of value at that time; (2) a willingness to investigate a wide range of transactions (including consideration of offers to purchase, listings, and anecdotal evidence from a wide range of market participants); (3) quantitative analysis and reconciliation of the data; (4) the use of compound monthly, not straight-line, time adjustments; and (5) application of the concluded time adjustment to the estimated value at the peak of the market in order to arrive at an estimate of value as of the date of value. Finally, although it has not been stressed in this discussion, there is no substitute for appraiser's judgment in the reconciliation of the hard data that has been collected and analyzed.
Internet resources suggested by the Y. T. and Louise Lee Lum Library
CCIM Institute: Land Valuation in the Raw
Lincoln Institute of Land Policy: Land and Property Values in the U.S.
National Council of Real Estate Investment Fiduciaries: Land Valuation
(1.) Standard and Poor's, S&P/Case-Shiller Home Price Indices: Index Methodology (November 2009), 6; available at http://www.standardandpoors.com/home/en/us.
(2.) http://web.mit.edu/ cre/research/credl/rca.html, referencing David Geltner and Henry Pollakowski, A Set of Indexes for Trading Commercial Real Estate Based on the Real Capital Analystics Transaction Prices Database (MIT Center for Real Estate: September 26, 2007), 5.
(3.) In the real world, there are additional points of accommodation that may soften the effect on land value. For example, in a declining market hard costs, i.e., materials and labor, tend to decline somewhat, and developers often accept a lower entrepreneurial profit, either or both of which mitigates a negative effect on land value. But the central fact remains: in a climate of changing property values, land has the potential to increase or decrease in value at a different rate from improved property.
(4.) An excellent discussion of straight-line and compound adjustments is contained in Julian Diaz, III, "Estimation of a Monthly Adjustment for Market Conditions," The Appraisal Journal (April 1994): 251-255. In his article, Diaz refers to straight-line adjustments as the arithmetic mean and compound adjustments as the geometric mean.
(5.) Or clear all registers or clear all financial registers, to ensure there are no leftover data in the financial calculator.
(6.) Although we are using the financial calculator to extract compound time adjustments and not yield rates or interest rates, the sign conventions of financial calculations must still be observed in order for the calculations to work. Therefore, the first sale should be entered as a positive number and the second entered as a negative number (or vice-versa).
(7.) Note that negative or downward compound monthly adjustments extracted from sale/resale analysis will show a higher percentage number than straight-line monthly adjustments, but they result in a smaller net adjustment over time. It is the mirror image of the situation in positive or upward adjustments. For example, a sum invested at a compound interest rate of 5.5% will grow larger over time than a similar sum invested at 6% simple (or straight-line) interest.
Robert M. Greene, PhD, MAI, SRA, is the director of Litigation Support Services for the Portland, Oregon, office of Integra Realty Resources. He has been appraising real estate since 1983; he previously operated his own office in Kalamazoo, Michigan; worked for MaRous and Company in Park Ridge, Illinois; and acted as director of the Real Estate Advisory Group for Stout, Risius, Ross, in Chicago. He has appraised real property in several states and in Europe. Greene is an adjunct professor, teaching real estate valuation courses in the real estate program of Portland State University. He currently serves on the Comprehensive Examinations Panel and the University Relations Panel of the Appraisal Institute and is the 2012 President of the Greater Oregon Chapter of the Appraisal Institute. Contact: email@example.com
Figure 2 Components of Value in a Declining Market Cost of Improvements Land Value Year 1 $200,000 $100,000 Year 2 $200,000 50,000 Note: Table made from bar graph.