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A question of value.

A major topic of discussion in and out of the real estate industry today is the issue of value. This article will explore value issues, outline trends and present a perspective on how value is looked at today.

Is true that all industries, at times, have problems. Back in the mid-1970s, properties that experienced downturns in income could be financially restructured. Mortgage rates could be reduced to the level of net income, participation features added, and, as the market recovered, lost interest could be repaid, participation received, and the mortgage could be paid off through refinancing. The basics of the real estate industry had remained fundamentally unchanged for decades, and there wasn't any need to "teach an old dog new tricks." Over time, the majority of the mid-1970s workouts became successful ventures. Then the market turned, and we entered the 1980s.

The 1980s: a period of transition

Beginning in the late 1970s and going into the next decade, changes occurred that have had a major impact on today's real estate markets.

One such change was the deregulation in the 1980s, which allowed the nation's thrifts to "go public" and raise vast sums to be loaned on real estate. Also, depreciation schedules were dramatically changed with the 1981 tax act, and liberalized write-off schedules remained in place until 1986, allowing depreciation periods of 15 to 19 years. It is well known that commercial property value is measured by the present worth of future benefits. With the tax change, a new benefit developed in the form of the value of depreciation, or alternatively, the syndication proceeds that could result.

On the technology front, computer programs popularized discounted cash flow studies. The availability of computers to most developers, lenders appraisers and others led to many misuses and abuses by those real estate analysts who were inexperienced with the techniques.

Real estate holdings became increasingly national, giving rise to problems such as faulty analysis of variations in local markets and their driving forces and differing valuation techniques applied to various property types and locations. Problems such as these were addressed by the formation of appraisal network organizations to answer to need for national appraisal services offering a combination of local market expertise, consistent appraisal techniques used by each local expert and sound judgment in analyzing data.

Finally, with demand for real estate space rising to levels not seen in 50 years, the real estate development community, funded by public pension funds and others, created hundreds of millions of square feet of space.

What was forgotten in the midst of all the building and buying frenzy was that employment is the principal driving force behind the demand cycle. With a decline in employment, markets can quickly crash when they become overbuilt. This happened first in Houston, where signs were evidents in the early 1980s when 100,000 jobs were lost, and there was an excess supply of roughly 45 million square feet of space.

Real estate markets in other areas of the country also crashed as employment growth declined and then actually shifted to a negative number. For example, by mid-1986, it was obvious that overbuilding was occurring in the Boston area. But it was impossible to predict at that time the depth and severity of what has since occurred there.

Analysis of a market crash: Boston

In mid-1986, I published an article (Appraisal Views, July 1986) titled "Even in Boston, Lights Turn to Caution." At that time, downton Boston had been among the nation's strongest downtown office markets for a decade. During the period of 1976 to 1986, the downtown office market had more than doubled its size, with vacancies averaging less than 5 percent and rentals tripling from approximately $11 per square foot to nearly $35 per square foot for first-class space. The market was still very strong when the article was written, however, it expressed reservations about the future.

What sparked my initial concern then was not extra sensory perception. I had been subscribing for some time to regional employment trends and tracking employment growth. I also had been writing market studies on the Boston office market since 1978 and knew that 250 square feet of space for each employee was realistic. It was evident to me that the city's new construction was far out-stripping the ability indicated by employment growth to absorb the space. This information was available for anyone to read and study. It was solid, careful analysis and correlation of existing market data that had flashed those early warning lights to me.

The fundamental reason for Boston's growth was a change in regional economics. Boston threw off its mill and manufacturing image, and replace it with what was then a new term: "high-tech business." Demand for space began to substantially exceed supply in the early-to mid 1980s. In downton alone, for several years, demand exceeded supply by more than 2,000,000 square feet per year.

From 1976 to 1985, research for my article showed that 236,000 new office jobs were created; much of the growth within the financial, insurance, real estate and service sectors was downtown. However, new high-rise office buildings require a long incubation period for their construction. When the crop of new buildings finally started to come on the market in the mid-1980s, the historically low vacancy rate more than doubled to 10.3 percent.

By sounding a warning, I had hoped that new construction would be discouraged and actually stop. Needless to say this did not occur. Instead, the developers "blasted" through early warning signs in the late 1980s with more new construction, which ultimately resulted in a free fall in Boston in 1991.

In the mid-1980s, there were definite signs that Boston's high-tech market was beginning to slow. Economic studies in 1985 indicated that for the next five years, the rate of growth for overall, office-oriented employment was expected to decline approximately 10 percent compared to the prior 10-year growth cycle. Given the continused new building, it was almost inevitable that space would exceed demand by the end of the five-year period in 1990.

Based on employment projections, it was estimated that approximately 9 million square feet of office space would be absorbed between 1986 and 1990; 9.2 million square feet of space was actually absorbed. Against this, more than 13.2 million square feet of new office space was expected to come to market in this period. The projected oversupply of more than 4.2 million square feet, with a predicted decline in absorption, equated to two and a half of three year's supply to office space.

Further throwing a monkey wrench into this market was the sizzling real estate investment climate of the period 1985 to 1989, with fierce, competitive bidding for prime and trophy properties in downton Boston, as well as in the markets of New York, Los Angeles, San Francisco and Washington, D.C.

From my experience, when demand exceeds supply, values rise at a far greater rate than can be justified by normal rates of inflation. In Boston, from 1978 to 1986, we saw a tripling or, in some instances, a quadrupling of value. Conversely, when the supply of space outstrips demand, values may decline at a similarly steep pace.

The office market slowdown in 1989 was sharp and sudden; driven by a decline in employment growth. In one year's time--from the end of 1989 to the end of 1990--effective rental rates dropped from the mid-$30 range per square foot to the low, $20-per-square-foot level for prime space. Downtown vacancy rates rose to 16 percent with trend signaling the rate would move still higher. The suburban office market, industrial market and research and development space were equally hit with vacancy rates in excess of 20 percent.

In 1991, the real issue facing the Boston real estate market is the loss of credit. Banks are not lending. Insurance companies have low allocations. Evaporating credit has had a large impact on property values.

Owners of office buildings are caught between a rock (cash flow) and a hard place (the lender). Most lenders value property based on discounted cash flow with provisions for declining rents over time, as above-market leases expire. This is just the opposite of what occurred in the mid-1980s.

Compounding this factor, discount and capitalization rates have risen in Boston in the first half of 1991, moving appraised values even lower. Conventional lenders have been reluctant to lend maney against even these reduced values. Yet, landlords need cash flow.

Until credit and capital stability return, landlords, their tenants and lenders are likely to continue to feel the pinch. In the meantime, with many commrcial markets in the midst of this tumult, it remains the job of people in the appraisal profession to try to accurately assess property value. How can this be done with any degree of accuracy, given what we have seen transpire in the last year or so, and particularly against the backdrop of the last decade?

A case study in value

Under original appraisal concepts, gaps in value were typically very narrow. A 5- to 10-percent range in value between appraisals was thought reasonable. Today, this is not the case.

The concept that property will sell, or even that it should sell, is problematic today. There are huge gaps between buyers and sellers in the marketplace. For example, in Boston, a 50,000-square-foot, unrehabilitated office building was acquired in 1986 at a price of $6.2 million. The property was gutted and rehabilitated at an additional cost of close to $5 million for a total of $11 million.

The owner is an experienced real estate developer who looked at the property from a long-term perspective and who acquired the preperty because of its value as an asset.

The property, upon completion, was 100-percent leased. The returns were typical for downtown Boston buildings at the time, in the 9-percent range, and the perspective of the developer was that, over a period of time, income would increase.

In the marketplace today, this same building is viewed completely differently. To begin with, although 100-percent leased, there are just no buyers in the marketplace. Potential investors see downtown vacancies pushing 20 percent; they require higher rates of return.

The Japanese purchaser was one type of buyer in the market in the 1980s who looked at initial returns in the 5-tp 6-percent range. These rates of return, in terms of expectation, have now increased 300 basis points due to changes in Japan's own markets. The British investor feels more comfortable at home at sees the European Economic Community (EEC) at the new market opprotunity in 1992.

With changes in investor attitude and behavior, market activity virtually stopped by early 1990. To the experienced appraiser looking at this type of situation, multiple values developed.

Using the same 50,000 square-foot building as an example, at a 10-percent return, the cash flow produced from the property would indicate a value of not more than $7 million on a property that actually cost $11 million. Under various cash-flow scenarios, the property's value would move into the low $8 million range if positive leasing assumptions occurred in the mid-1990s.

Under the concept of underlying intrinsic value based on normal market sales, the property most certainly would justify its cost. Buildings were selling for more than $200 per square foot when there was an active market.

Values can move upward or downward over time, with the only significant date being the actual sale date, when all forces come together and the property transfers. In this example, the property is not for sale, and the owner's perspective is that of the long-term hold. To the owner, value is not defined as rigidly as that required by an appraiser. Owners have been known to use such terms as "braindead appraisers" when they receive reports that the property is worth less than it cost. Building owners are disappointed, to say the least, that the property is not worth what they paid for it. Thus, the gap widens.

In the 1980s, the "market" in the phrase, "market value," was considered a short-term concept. Great increases in value were occurring and could be captured by immediate sale. It is evident now that this line of thinking is nature. The "market" in market value is a long-term concept. Value must be viewed as if on a curve, with the valuation date being but one point in time on that curve.

The issue here is one of expectations. There is no expectation at this time that a transaction can be completed. Investor confidence must return and overall employment growth must be rejuvenated in order for the market to fully move back into balance. This will take years, and probably the rest of this decade for Boston, to see this accomplished.

Boston is still looking for signs of market stabilization. This is most likely to occur in the downtown area sooner than in the suburbs because of the strong institutional ownership of tower buildings. These institutions, in certain instances, have made the decision to hold space off the market rather than lease it at rates that would result in a guaranteed loss.

A second sign that must be watched closely is the turnaround of employment. This can only be generated when there is a positive political plan in place to foster growth. This now is in the development stage in Massachusetts.

The final issue for stabilization is that new, non-owner-occupied, real estate development must stop. An excess supply of space in all cateroties exists and must be absorbed over time. This, in turn, will level real estate rental rates, which would m,ean that by the mid-1990s, we will be well through the adjustment period and back to a more normal real estate market pace. This is expected to be followed by a phase of acquisition, recovery/development, maturity and, in the 21st century, the inevitable new cycly of overbuilding.

Conditions of the type we currently see in Boston, or in markets overall, place great requirements for judgment on appraisers. As I hope

I have shown, no longer is the term "final estimate of value" really meaningful. What is developing now is the need for various valuation scenarios under several alternative conditions. This creates a high demand for the appraiser of long experience, who has the expertise and respect of clients to advise on alternative issues as they impact property.

Pershaps the biggest issue today is whether or not to foreclose. This requires a careful analysis of whether a lender is better off keeping the owernship in place and adding incentives where the lender can "earn back" losses and where the original ownership also has an incentive to perform. Tight controls and legal documentation are necessary for this approach to work.

Divide and conquer

Perhaps the most serious issue that has arisen from the underlying decline in real estate values is the virtual bankrupting of lending institutions with a heavy orientation otward real estate. Banks typically have loan/real estate portfolios of 35 percent or more. The typical capital base for banks is between 7 and 8 percent of assets. With declines in real estate value of one-third, the entire banking system has been placed at risk. Forced write-downs and the failure to recognize the long-term nature of real estate value only exacerbate the situation.

In the last several years, poor management has fundamentally been swept out ot the banking system. Those banks left are basically good institutions; yet, they face the FDIC gavel of forced, continued write-downs, which can wipe out even good institutions. Particularly in the thrift industry, this hurts the public sector, because there is a real demand for consumer banking services for the small, individual customer.

What is happening is that government regulators are actually saying things such as, "You might have to sell property to prevent loss." Acted upon, this advice does not pervent loss, it guarantees loss and places lenders at risk.

A partial solution to this problem, which could help to address the problems of the banking industry, is the bifurcation of loans. The "good part" that can carryb itself at normal interest is separated, and the "bad part" that cannot carryb itself is then classified. The most far-thinking aspect of loan bifurcation involves adding participation clauses held by the lender to the clauses held by the lender to recapture lost interest. Thus, by such an approach, we can see the cycle of the mid-1970s returning.


Among the lessons learned in the past decade is that value is not a mechanical calculation. A definition of value and the application of value requires wisdom and judgment. What is becoming increasingly evident today is that there are a number of other consideratins that cannot be overlooked in the valuation equation. They include:

* the factor of employment trends;

* supply and demand;

* the price of money itself;

* the fact that an estimate of value is never "final."

These factors all have an overriding influence, and they will directly impact the pace at which this country's real estate markets will return to stability. A by-the-numbers approach to real estate provides a disservice to owners and lenders alike. Appraisers must take an extra step beyond relying on the results of these traditional methods and impart their own good judgment on the properties they evaluate.

Webster A. Collins is president of Valuation Network, Inc., a national real estate valuation and consulting services company and is executive vice president of Whittier Partners, a commercial real estate services firm based in Boston.
COPYRIGHT 1991 Mortgage Bankers Association of America
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Copyright 1991 Gale, Cengage Learning. All rights reserved.

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Title Annotation:valuation of real estate in the current crisis situation
Author:Collins, Webster A.
Publication:Mortgage Banking
Article Type:Cover Story
Date:Jul 1, 1991
Previous Article:Managing through the crisis.
Next Article:Apartment lending after the boom.

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