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Appraisal considerations in distressed markets.

The collapse of real estate markets in the "oil patch states" was the harbinger of the current severe distress occurring in real estate markets across the United States. Appraising real property under such market conditions involves emphasis on somewhat different factors than those used during more active markets. Some practical considerations pertinent to appraisal under distressed conditions are discussed in this article, with a focus on investment properties.

During the 1980s we witnessed the collapse of real estate markets in the "oil patch states," followed by the collapse of real estate markets in Arizona. Now at the beginning of the 1990s severe distress is appearing in markets across the United States, perhaps even extending worldwide. Appraising real property under current market conditions can and should involve emphasis on somewhat different factors than those employed during more active markets. Appraisers need to carefully reconsider the basic or elementary rationale underlying the valuation process. The purpose of this article is to discuss some practical considerations pertinent to appraisal of real property under "distressed" conditions as compared with "normal" market conditions. The emphasis is on investment properties, which include all types of real property typically purchased (primarily) for a return on investment, including land investments as well as income-producing properties.

WHAT IS A DISTRESSED MARKET?

A good starting point is to describe what appraisers typically consider to be normal market conditions. Although historically real property appraisers have experienced upward trends in property prices, a downward trend is not conceptually different. Declining price levels, by themselves, do not distinguish distressed markets from normal markets. For most investment property categories, an appraiser is generally comfortable with a significant volume of sales activity over a given period of time. One facet of a distressed market is a steep decline in sales activity, often as a result of declining price levels. This facet by itself is often referred to as a "depressed" market.

In a normal market income-producing properties tend to be sold only when they are operating at or near optimum levels, or when typical prospective purchasers anticipate that properties can be readily "leased up" at little cost in time or money. During normal markets, appraisers tend to avoid sales of properties that occur at levels that are not optimum, particularly when such sales are a decided minority of transactions for a given property type. Typical thinking is that such sales are distressed. In a distressed market, however, many or most sales are properties operating far below optimum economic levels, or that have not been physically completed.

In this regard, it is instructive to consider the role of a developer under normal market conditions. At such times, a developer combines an appropriate site with his or her ability to select an appropriate improvement design to meet the user or tenant market demand, to obtain financing for development, to oversee construction, and to successfully lease or sell the finished product. This is similar to the role of a manufacturer, who purchases tools to transform raw materials or parts into a finished product that is in demand by prospective purchasers or (in some cases) renters. In both cases, sales are as necessary to the process as design or manufacture. In a distressed market, the sales do not occur and an appraiser is asked to value the unfinished product, which may vary from a site selected for a specific development, to some "parts" (e.g., a shell building), to a finished product with little or no market demand.

In this depiction of real estate markets, the "boom" and "bust" periods are not normal. Every market has problems with the boom portion of the cycle, when buyers exceed sellers and prices are bid up rapidly, tenants fight for a limited amount of available space, lenders tend to lend to any warm body investing in real property, and comparables are plentiful.

It is the bust phase of the cycle that appraisers (and others) tend to regard as distressed. Owners are reluctant to sell at reduced prices as prospective sellers far exceed prospective buyers; sale prices tend to decline; tenants find an excess of available space and are fought over by landlords; loans enter default and lenders are reluctant to lend when the security is real property; and comparables are increasingly rare and difficult to analyze.

The demand for appraisal services continues in distressed markets, often fueled by foreclosures, deficiency claims, bankruptcy, and other lawsuits. Owners typically do not offer their property for sale as a result of depressed price levels, and lease transactions become less frequent as more tenants have adequate space, reducing the market information available. In addition, there is the question of whether transactions under these circumstances meet the typical market value definition that refers to a "willing seller," which applies to the typical definitions of market rental value. This question was discussed at length in "Appraisals Under Fire--Again," by Lloyd D. Hanford, Jr.(1) The bottom line for appraisers is that during a distressed period, these transactions are often the only market from which to derive data for market value appraisals.

This article discusses the effect of a distressed market on the following factors that affect an appraisal:

* What is to be appraised

* Highest and best use analysis, including absorption analysis

* Particular problems with the cost approach

* Particular problems with the income approach

* Particular problems with the sales comparison approach

* Excess land and parking adequacy

* Applicability of discounting over time

* Types of buyers

* "True" market value

* Reconciliation analysis

The comments in this article are based on objective observations of distressed market conditions in Arizona since approximately 1986, rather than on armchair speculation. The real estate markets in Arizona have had a pretty wild ride in recent years. There is considerable disagreement among local appraisers as to what constitutes "good" comparables, and a wide range of market value opinions is found among appraisers as compared with the range found during mire normal market conditions.

WHAT IS TO BE APPRAISED?

Every appraisal assignment requires a description of the property to be appraised, a definition of the type of value, and usually has a separate Scope of the Appraisal and Report section to discuss the particular appraisal problem and how it is handled (while the scope section is required by the Uniform Standards of Professional Appraisal Practice [USPAP], it need not be in a separate section). Under distressed market conditions, these items can take on additional importance.

While a legal description provides the location and physical site dimensions (at least by reference to a recorded map), it does not describe the property to be appraised. Leases and zoning, both existing and potential, are two readily recognized property attributes that are not contained in the legal description, but that are nevertheless part of the real proerty. On a broader scale, while a vacant site and a high-rise office building have the same legal description, they are substantially different properties.

The estate to be appraised should be clearly and consistently defined. In many legal jurisdictions, there is no distinction made between real estate and real property, although this is an important distinction to appraisers. Consider a neighborhood shopping center as an example. The fee simple estate in the real estate implies a vacant property, or at least a disregard for existing leases. It can be argued that this requires valuing the property as if vacant and available for lease, which could require many months of leasing activity in a distressed market, or appraising it as if leased at current market levels and terms. The leased fee interest in the real property implies valuation subject to existing leases, "as is." There is often no practical difference between fee simple and leased fee in an active rental market in which all of the subject leases reflect current market terms and tenancies. There are major differences, however, if some subject property rental rates differ substantially from current market levels. The terms fee simple and leased fee are legal terms, adopted by appraisers, and can cause difficulties when a property is only partly leased, or the remaining lease terms are short. These situations should be discussed with a client, and the chosen property should be described clearly and consistently in an appraisal report.

Under normal market conditions, sales of real estate are rare. Real property is usually sold. The Appraisal of Real Estate, tenth edition,(2) contains a clear description of the difference between these concepts. In a distressed market, it is not unusual to find sales of investment property that closely approach real estate (e.g., empty office buildings, empty retail centers) consisting of the physical land and structures only. Technically, even these properties are real property rather than real estate because they include zoning, real estate taxes and assessments (often in arrears), and other government restrictions; however, they are as close to real estate sales as are likely to be found. The point here is that, in a distressed market, leased fee real property typically sells for a much higher price than fee simple real property (which more closely approaches pure real estate), primarily because of the reduced demand by tenants.

As most investment property appraisers extensively use word processing, it should be possible to describe the property rights being appraised consistently throughout the report. All too often, a "canned" Letter of Transmittal or Certificate of Appraisal refers to fee simple when the property is at least partially leased fee.

Sometimes a question arises regarding how to deal with existing leases that are above current market rent levels. Few clients really want an appraisal of the fee simple real estate, but a literal leased-fee valuation may not meet a client's needs either. The consideration of what is to be appraised can help in these situations. If a client wants an estimate of the market value of the property as is, then the leased fee should be valued. Conversely, what if the major tenant is an affiliate of the property owner, and the client is a lender foreclosing on the property? Perhaps the tenants are not paying rent in accordance with the leases or there could be a landlord default unless certain repairs are made in a timely manner. These questions should be discussed with a client, and the results of the discussion clearly described in the appraisal report.

Suppose, however, that a multitenant property with valid third-party leases is being appraised, but that some or all of the leases are older and above current (depressed) market rent levels. The way to treat this situation is derived from the market for the property (assuming market valuation). A study of the market might indicate that a higher overall rate would be applied to current net operating income (NOI) to reflect higher risk of tenant default, or short-term leases with renewals likely to be at lower rent levels. Alternatively, if these are particularly creditworthy tenants on longer term leases, the market may indicate no risk premium in the overall capitalization rate (OAR) or discounted cash flow (DCF). Again, this is assuming market valuation of real property. A third situation might be a master lease of the property, perhaps to a prior owner; once again, guidance on market valuation should be sought in the market.

Only rarely should an appraiser substitute current market rents and expense levels for actual leases and operating levels in the market valuation of a leased property. If required to do so by the circumstances of the assignment, great care should be taken in the appraisal report. One possible circumstance in which this could occur would be under foreclosure, when a lender might have the legal right to cancel existing leases in effect. There is, of course, one broad area of assignments in which this type of analysis is typically required--under eminent domain proceedings when the entire property is being appraised rather than just the leased fee. Even in eminent domain, leases above current market rent levels are usually required to be compensated for, and a division of the fee simple estate between the leased fee and leasehold estates must be made when below-market level leases are involved.

"As is" valuation is required by many clients, particularly the Resolution Trust Corporation (RTC) and the Federal Deposit Insurance Corporation (FDIC). An appraiser should not, however, so restrict his or her view of a property as to violate the USPAP or clear indications from the market. The USPAP require consideration of likely, reasonably probable rezoning, and this should also be reflected in an as is appraisal. Typically, a prospective purchaser would pay less for a property with rezoning potential than as if actually rezoned, but more than for a property without such potential. For example, assume a vacant parcel is zoned residential in a major artery location, is abutted by commercially zoned parcels, is under a municipal "master plan" for commercial zoning, and is located where the local planning department personnel report the likelihood of rezoning to commercial on appropriate application. The as is situation is residential zoning with reasonable probability of rezoning to commercial, not just residential zoning.

Similarly, if the market data indicate that a property should be valued as if repaired, or as if leased, appropriate adjustments for current as is condition should be made. The basic criteria for an appraiser are derived from the market. For example if a subject lacks heating, ventilating, and air-conditioning equipment (HVAC), and all of the comparable data are from properties with HVAC, perhaps the subject property should be appraised "as if," then adjusted (e.g., cost plus incentive) to arrive at "as is." This is usually a clearer method to a reader than attempting to adjust each comparable for HVAC, and may be necessary if market evidence of demand for properties that lack HVAC does not exist.

HIGHEST AND BEST USE

Under normal market conditions, the highest and best use, or most probable use, can often be dealt with easily and concisely. A newer apartment complex in an appropriate location, operating at 95% occupancy at market rents sufficient to provide a healthy NOI, requires little analysis to determine that it is an appropriate improvement, particularly if there are no clear indications of a near future overbuilt situation. The same property operating at 30% occupancy, with operating expenses at or exceeding income, can require a detailed analysis.

For an apartment property under such circumstances, detailed analyses of population trends, renter profiles, income levels, unit sizes, floor plan desirability, maintenance characteristics, and a variety of other factors may be required. It is not unusual to find that management may be a problem, indicated by similar nearby properties (or even another phase of the same project) operating at significantly different economic levels.

For retail, office, or industrial properties, such factors as sight lines, bay depths, rear delivery access, and parking ratios may need to be carefully analyzed. In some cases, a local architect familiar with the appropriate design for this type of property can be helpful. Market valuation is market derived, however, and the particular property should be carefully discussed with local leasing agents and sales agents. An older property that lacks a number of current "state of the art" criteria may still be viable in the local rental market, though perhaps only at reduced rental levels relative to newer properties.

An appropriate rent level and marketderived absorption rates are also considerations in highest and best use. If a partially occupied property is appraised for market value as is, the future absorption rate for the vacant space should be based on typical prospective purchaser expectations. A thorough study of the potential demand for the vacant space and an absorption period estimate are of no use in estimating the market value of the property as is unless prospective purchasers of the property would base their purchase decisions on a similar study.

In this regard, it is also important to recognize that not all retail, office, or apartment properties are created equal. The local retail market may have a 20% vacancy level, currently absorbing space at a rate sufficient to reduce the vacancy rate by 2% per year. It would not be appropriate for an appraiser to use only this information to estimate an absorption period for the subject property. Such overly broad measures of the rental market provide little guidance. There are differences in tenant demand among freestanding, strip retail, and anchored center retail as well as between anchor space and shop space. Perhaps grocery anchors have closed in certain neighborhood centers and shop tenants in those centers are moving to anchored centers as their leases expire. Perhaps there was a recent surge in development of poorly designed or poorly located retail properties, and vacancy levels in more appropriate facilities are much lower than overall market statistics show. Perhaps rents in appropriate anchored centers have declined, and retail shop tenants are moving up from older strip space to take advantage of this situation.

One of the most important, and most overlooked, factors in absorption analysis is rent levels. High-visibility, premium rent space may be in strong demand at the same time that marginal, low-visibility retail space is begging for tenants, or vice versa. The particular attributes of the property being appraised should be analyzed in terms of tenant market demand for those particular attributes.(3)

It is not uncommon to find that certain market segments are distressed at the same time that other segments in the same geographical market are normal. We recently experienced this in Tucson (metro area population 700,000), where major portions of the industrial, multitenant office, apartment, and multitenant retail markets entered distressed conditions at about the same time, but demand for prime, one-acre, single-user retail sites on major arteries, and for medical clinic buildings and sites, continued to drive up prices for these properties for years thereafter.

There is a particular ethical danger in distressed markets. As prices decline for many property types, clients tend to perceive that "the sky is falling," and expect every appraisal report to reflect a declining market. At the same time, appraisals are often ordered by clients when no wealth is being generated by the property to be appraised and there is downward pressure on appraisal fees. That is, the lender is not booking a new loan and points, the borrower is either in default or is likely to obtain no additional funding, or a government agency (e.g., FDIC, RTC) is anticipating liquidation of the loan or REO property at a fraction of "book value." Because sale prices are indeed falling for many property types, an appraiser may also fall into the error of automatically anticipating that every property is declining. Unfortunately, one of the first practical lessons every appraiser learns is that a "low-ball" (or conservative) appraisal is much less likely to generate criticism than one perceived as high. An intentionally low-ball appraisal report, however, violates Standards Rule 2--3 as much as an intentionally aggressive appraisal report.

U.S. Representative Doug Barnard admonished appraisers, at the American Institute of Real Estate Appraisers (AIREA) convention in Dallas a few years ago, to be on guard against "low appraisals" that could result in diminishing assets acquired by government agencies such as FDIC and RTC. At that time, the majority of appraisers were more concerned with whether prior appraisals had been inappropriately high. Just because major property market segments are declining in market value, an appraiser should not approach every assignment with the prejudgment that the property being appraised has a lower market value than was evidenced by an earlier sale or appraisal of that property. Specific properties tend to trade within a particular submarket, as described earlier. Generalized market conditions should not be allowed to inappropriately influence the analysis of a specific property. In distressed markets, this may mean contravening conventional wisdom and risking criticism.

A particularly difficult phenomenon for most appraisers is a property that lacks absorption potential. During boom periods it is not uncommon for high levels of optimism to lead to the development of such poorly designed or poorly located properties that effective tenant demand (at least at the time of appraisal) is below the level necessary to achieve an economic return consistent with the development cost. In some cases, even very low rents will not attract tenants, resulting in massive functional or locational obsolescence. In one case in Tucson, an older neighborhood center was refurbished and expanded, placing a second anchor space directly behind a frontage parcel improved with a donut shop. This portion of the center has been vacant for almost four years, despite a "make me an offer" rental rate. Simiarly, in a neighborhood center next to a large high school, vandalism and rowdyism became such a problem that the national chain grocer closed the anchor within a year of development. The center was enclosed by a chain link fence with barbed wire, losing virtually all of the tenants (except a police substation) in the process.

With most properties, however, the primary criterion for estimating stabilized operating levels and absorption rates is the opinions of potential purchasers. If sales of appropriately designed and located rental properties are occurring based on existing low occupancy, the market is relaying the message that absorption and stabilized operating levels are not a significant factor in market valuation. This can only be discovered through careful and thorough analysis of comparable sales, although the opinions of prominent sales agents regarding purchaser expectations in general can be a guide. If the market is telling us, through recent sales, that the subject multitenant office building at 40% occupancy can only be sold based on current NOI, an absorption study with a stabilized market value estimate and discounting to present economic levels is probably pointless. In such circumstances, the market is saying that it has no confidence in being able to accurately predict the future potential of the property, and will only purchase based on historical or current annualized economic performance.

With the rare exception of such properties as gravel pits or waste dumps, potential purchasers typically expect that the property will be worth more in the future than they are presently paying for it. In some cases, typical purchasers have a clear conception of how they expect their property, and the market affecting it, to perform in the future. In such cases, similar properties can be valued by estimating future performance using this market-derived criterion. In numerous examples in Arizona, however, purchasers indicate through market decisions that the future is unclear and they will only buy based on current economic performance.

There may be an important exception in a distressed market. At existing rent levels and occupancy, the income valuation may be so far below reproduction or replacement cost, after physical depreciation, that purchasers will typically pay a higher price. We have had numerous sales that reflect a 2% or 3% overall capitalization rate on existing NOI with no clear prospects of a near-term substantial increase in NOI. According to the parties involved, these purchasers basically concluded that a price of 30% to 60% of replacement cost was satisfactory, despite a lower income approach indication.(4)

COST APPROACH

This can be the most difficult approach to use in a distressed market but, almost perversely, may also be a very important approach, as indicated in the preceding paragraph.

If there is no current development of the subject property type, the valuation of a site can be particularly difficult. Similar sites, with the same zoning or development potential options as the subject site, may be selling. The end use, however, may be a drastically different use (e.g., multitenant office sites may be selling for apartment development). Thus, site value as if vacant and available for development may be found, but questions are raised regarding the contributory market value of the site for the present use of the property.

External obsolescence is a major difficulty. In a distressed market, rents may have fallen (or expenses may have increased, or both) to such an extent that the market value of the property is substantially lower than reproduction cost less physical depreciation. This raises some significant issues.

First, one cannot estimate external obsolescence in the cost approach by deducting the market value conclusion derived from the income or market approach from the replacement cost less physical depreciation plus land value. This is circular reasoning, and invalidates a separate market value estimate from the cost approach. External obsolescence should be derived independently from the conclusions reached in other approaches.

While there are several techniques that can be used to independently derive external obsolescence, an appraiser must not also use the economic age/life method. The economic age/life method divides the effective age of the improvements by the economic life estimate to derive a percentage of total depreciation. The physical age/life method can (and should) be used, in which effective physical age is divided by estimated physical life to derive the percentage of physical depreciation only. The problem, of course, is that the physical life of any structure can be difficult to estimate. There is a good discussion of accured depreciation in The Appraisal of Real Estate, tenth edition,(5) which explains these techniques.

Finally, external obsolescence resulting from distressed market conditions may be fundamentally different from locational obsolescence or other forms of depreciation in that it is usually temporary.(6) Therefore, it may not be appropriate to capitalize a rent loss resulting from current market conditions in perpetuity. Economic obsolescence resulting from current market conditions should be differentiated from locational obsolescence because of other factors. As in other aspects of a market value appraisal, guidance should be sought from market participants.

The cost approach, although difficult to use under distressed markets, can still be useful as a check on the other approaches. Merely estimating reproduction cost less physical depreciation can be helpful if only to establish that the indications from the other approaches reflect substantial, if unspecified, economic obsolescence. If this is done, however, an appraiser should be careful to state in the report that only two approaches were used to derive market value estimates.(7)

INCOME APPROACH

Comparable rents, comparable expenses, and market-derived rates of return or overall rates take on new complexity and importance during distressed market conditions.

Consider comparable rents. Assume that a four-year-old multitenant office building is being appraised, with a reported cost of $100 per square foot to develop, which is currently 30% occupied at 30% of potential gross income (note that physical and economic occupancy may not be the same). Similar three- to six-year-old office buildings in the same submarket as well as the subject have lowered their effective rents significantly, to $14 per square foot, full service, with occupancy levels that typically range from 20% to 50%. One of the similar properties, an empty building, recently sold to an investor who dropped rents to $10 per square foot full service and achieved 95% occupancy in three months. What is the comparable rent? Assume that there are not enough tenants at present to fill all of the buildings in this submarket even though the overall vacancy rate may be slowly declining. If all of the buildings reduce rents to $10 there is no benefit to any of the property owners. The next building, however, to reduce rents to $10 may substantially raise its occupancy at the expense of slower moving property owners by capturing tenants in other buildings whose leases are expiring. In this situation, rents could decline to $0 with no net economic advantage, and knowledgeable owners would likely recognize this and resist wholesale rent declines.

Alternatively, consider what the appraisal situation would be if the other properties (and the local submarket) are at 80% to 90% occupancy, or a rent reduction in the subject attracts tenants from another area. Absorption of vacant space in the subject might take years at $14, but only months at $10. This can have a profound effect on the market value indication derived from a DCF analysis. On the other hand, the first building to drop rents may capture most of the available tenants in the market, and the second building to drop rents could encounter a depleted tenant market.

Expenses are another problem. A property requires $X to operate if vacant and $X + $Y if occupied and the landlord pays the $Y portion (i.e., full service). Alternatively, in a triple-net rental property, an empty property costs the landlord $X + $Y, while a fully occupied property costs the landlord only $X, if the tenant pays $Y. When a subject is operating at only partial occupancy, historical operating expense levels may be distorted. In obtaining operating expenses from comparables, an appraiser should be sure that the expense levels in the comparables reflect occupancy levels consistent with his or her analysis of the subject (in addition to consideration of replacement reserves). For example, if comparable office buildings have 60% to 80% occupancy and are full service, expenses per square foot will reflect these occupancy levels. Care must be taken in applying these to the subject, whether at 40% current occupancy or at 90% stabilized occupancy. Of course, in distressed markets distressed owners are often found who may not adequately maintain their properties, or lender-owned properties may be mismanaged.

A favorite income approach technique has always been direct capitalization. Clients often request specifically that this technique be used, even when a DCF analysis may be more appropriate. In distressed markets, the hidden assumptions in the direct capitalization technique become especially important.(8)

Typically, direct capitalization is applied to a stabilized financial projection. If stabilized finances are used for the subject, the overall rate is derived from the market, either directly from comparable sales or built up using equity and loan components or some similar technique. That procedure is adequate when the comparables are selling at stabilized economic levels, but can be disastrous when the comparables are distressed.

In normal markets, non-distress sales of improved properties typically occur after an owner has brought a property up to stabilized levels. Under such market conditions, most of the comparable sales will have 85% to 100% economic occupancy and will be fully finished properties. In distressed markets, however, great variations can occur in economic occupancy and degree of finish between the comparables and the subject.

For example, assume a 30% leased apartment property sells for $1,000,000 and is reasonably comparable to the subject in all respects except occupancy levels, with the subject at 70%, and both are at similar market rent levels. Analysis of the comparable sale indicates a current NOI of $32,000 per year, annualized. Discussions with participants to the sale establish that the parties agreed that stabilized NOI would be $135,000 per year, at current rent levels. The OAR from the sale is 3.2% on current NOI and 13.5% on stabilized NOI. Neither OAR could be directly applied to the subject's NOI at 70% occupancy. Similarly, applying the 13.5% OAR from a 30%-occupied property to a 70%-occupied property is irrational, because any reasonably knowledgeable purchaser would recognize the longer time period typically required for absorption.

Even greater complications arise in industrial, office, and retail properties. Perhaps the office comparable is 30% occupied with 40% tenant finish, 10% requiring reconfiguration for new tenants. Perhaps the retail comparable had special tenant improvements for one or more of the tenants. These are factors to be considered under all market circumstances when analyzing comparables, but the sale data often become more diverse and complex under distress conditions.

Figure 1 details a sale of a high-quality multitenant office building in a prestigious location in Tucson. The property was in financial difficulty at the time of the sale. The pro forma reflects a continuation of the existing average rental rate in the property--this was a dubious assumption because the building had achieved only 60% occupancy at this rental rate in three years--but reflects the analysis of the purchaser. As shown, it is possible to derive several differing indications from this sale. If one is fortunate enough to be appraising a high-quality, well-located building at 60% occupancy, 40% shell, this might be a good comparable. It is less likely to be a good comparable, at least directly, for a building of average quality and average location operating at 30% occupancy.

FIGURE 1 Improved Comparable No. 1
Property type: Multitenant office building
Location: Tucson
Tax code: 128-10-056
Recording information: 8724/1894
Date of Closing: February 13, 1990
Date of sale: N/A
Buyer: Investment
Seller: Mortgage & Int'l Realty
 Corp.
Sales price: $3,200,000 (plus $475,000 in
 estimated remaining T.I.'s)
Terms of sale: All cash sale
Sale price per NRA of $50.26 as is ($57.72 as if finished)
 improvements:
Description of improvements: This three-story, two-elevator,
 multitenant office building is of
 concrete block
 and stucco construction. There are
 183 open spaces and 58 covered
 asphalt paved parking spaces
 (1/264 s.f.). All improvements are
 in
 excellent condition, approx. 40%
 unfinished shell.
 PRO FORMA ACTUAL
Gross annual income: $924,308 $554,585
Vac.: $ 92,431
Annaul expenses: $396,132 $381,000
 ($6.22/s.f.) ($5.98/s.f.)
Net annual income: $435,745 $173,585
Gross rent multiplier: 3.46 (3.98 including remaining
 T.I.'s) pro forma: 5.77 actual
Overall rate: 13.6% (11.9% including remaining
 T.I.'s) pro forma; 5.4% actual
Zoning: Williams Centre Specific
 Plan--office
Age & condition: 3 years old
Comments: Unique design, in prestigious rear
 location. No sale in prior 3 years.
Size of improvements: 66,020 s.f. gross; 63,670 s.f. net
Confirmed with: Grubb & Ellis


NOTE: Confidential information has been removed.

The low parking ratio affecting this property should also be noted. This reflects the location in a proposed mixed-use development that was to include residential development, and which would presumably have attracted office tenants who biked or walked to work. The typical parking ratio in Tucson for larger suburban offices is about 1 space per 200 square feet of building area. After approximately five years of development, the park had four large office buildings, a retail center, and a number of vacant sites, with no signs of bike usage or alternate transportation.

Figure 2 is another suburban office building that was 67% occupied at time of sale but fully finished. It should be noted that stabilized expenses (per purchaser) are 14% higher than actual. This requires some investigation and consideration before indicators are applied from this sale to the subject property. In Figure 1, the difference between pro forma and actual was only 4%, which likely reflects only inflation expectations. As the property in Figure 1 was only 60% finished, however, this also raises a question regarding the reasonableness of the purchaser's pro forma.

FIGURE 2 Improved Comparable No. 5
Property type: Multitenant office building
Location: Tucson
Tax code: 122-12-330A, B, 331A, 337, 338, 340
 & 341A
Recording information: 8832/200
Date of Closing: December 11, 1990
Date of sale: October, 1990
Buyer: Property Investment
Seller: Real Estate Corp. (
 Bank of Arizona)
Sales price: $1,600,000
Terms of sale: All cash sale
Sale price per NRA of $39.72
 improvements:
Description of improvements: Two- and three-story elevator office
 building, phone system, 179 spaces
 (1/
 225 s.f.) with 43 covered.
 PRO FORMA ACTUAL
Gross annual income: $503,550 $325,000
Vac.: $ 50,355
Annual expenses: $251,775 $221,500
 ($6.25/s.f.) ($5.50/s.f.)
Net annual income: $201,420 $103,500
Gross rent multiplier: 3.18 pro forma; 4.92 actual
Overall rate: 12.6% pro forma; 6.5% actual
Zoning: R-2, R-4 & B-1
Age & condition: 3 year old, average
Comments: 67% occupied, sale by REO lender. No
 sale in prior 3 years.
Size of improvements: 40,905 s.f. gross; 40,284 s.f. net
Confirmed with: selling agent


NOTE: Confidential information has been removed.

Figure 3 is a multitenant office-warehouse building. This can be a treacherous type of property for an appraiser because it is a building type designed to be flexible for tenancy. The building usually has a rear roll-up door for each tenant (with adequate truck access room) and a storefront for access to an air-conditioned office portion. In a purely industrial location, the office finish can be 5% or less, while in a mixed retail/office/industrial location the particular tenant spaces can range up to 100% office finish. The problem for an appraiser (and a typical prospective purchaser) is how to make a judgment as to the likely long-term percentages of office and warehouse, and how to treat an existing subject property that markedly differs from that conclusion.

FIGURE 3 Improved Comparable No. 2
Property type: Multi-tenant industrial
Location: Tucson
Tax code: 123-04-205L & M
Recording information: 9212/1549 & 53
Date of Closing: January, 1992
Date of sale: November, 1991
Buyer: Investment
Seller: Mortgage
Sales price: $1,500,000
Terms of sale: All cash sale
Sale price per NRA of $28.17
 improvements:
Description of improvements: One-story tilt-up office/warehouse,
 16' to 18' clear height, 242 parking
 spaces, 53% air conditioned office
 at time of sale.
 ACTUAL
 PRO FORMA (1991) (1990)
Gross annual income: $345,672 $240,483 $202,010
Vac.: $ 51,851 -- --
Annual expenses: $ 73,263 $ 48,214 $ 73,078
Net annual income: $220,558 $192,269 $128,932
Gross rent multiplier: 6.24 on 1991, 7.43 on 1990; 4.34 on
 pro forma
Overall rate: 12.8% on 1991, 8.6% on 1990; 14.7%
 on pro forma
Zoning: Cl-2
Age & condition: 1986, very good
Comments: Sold prior to full 1991 income and
 expenses being known, with
 Peroxidation
 lease (19.4% of building) about to
 expire. Purchaser negotiated new
 leases
 and achieved 100% leasing by
 April, 1992, including extensions
 of existing
 leases nearing expiration. No sale
 in prior 3 years.
Size of improvements: 53,240 square feet
Confirmed with: buyer and seller
Vacancy: 27% at time of sale; 7.6% shell
 space.
Coverage: 26% on 4.774 acre lot, plus leased
 parking area (0.634 acres, rent
 included
 in expenses)


NOTE: Confidential information has been removed.

In this sale, only the full-year 1990 income and expenses were known with certainty. The purchaser advised that the sale was primarily based on these 1990 figures. However, the seller advised that both parties knew the building was economically improving, and 1991 annualized figures, based on 10 months, were used in the negotiations. Both parties agreed that substantial uncertainty existed because a major tenant's lease was about to expire, and there was 27% vacant space (i.e., shell) with unpredictable future finish cost. The purchaser prepared the pro forma prior to the close of the sale based on successful leasing efforts by the seller and purchaser during escrow. The purchaser succeeded in leasing the remaining space by April 1992, achieving 100% occupancy with an average of 55.1% air-conditioned office space two months from closing in a market with approximately 38% speculative industrial space vacancy. Other office/warehouse properties in Tucson often have 10% to 20% air-conditioned office space. Obviously, rents vary substantially based on percentage of office finish, which typically costs three or four times as much to finish as warehouse space. Therefore, the indicators from this sale are not directly comparable to some other office/warehouse properties. The purchaser in this transaction prepared detailed 10-year DCF projections. The seller (and original developer) was under pressure from the lender to effect a cash sale, for reasons other than the performance of this property.

How an appraiser actually uses sales such as these in an appraisal is beyond the scope of this overview. The point is that sales of somewhat similar properties, in a distressed market, can be different from the typical sales in a normal market, which reflect stabilized or near-stabilized income and expenses. The discussion on the limitations of the sales comparison approach in The Appraisal of Real Estate, tenth edition,(9) takes on even greater meaning when sales in a distressed market are dealt with. A market with these types of sales often produces large divergences in valuation conclusions among different appraisers.

Techniques of deriving overall capitalization rates through mortgage-equity components or debt coverage ratios are also severely affected during distressed market conditions. These are particularly difficult techniques in a normal market as a result of the diversity of terms and interest rates generally available to particular property types. In a distressed market, lenders may largely withdraw, resulting in virtually no available financing. In Arizona by mid-1992 there was a single healthy local S&L with assets of $72 million. Three years earlier there were eleven local S&Ls with $23 billion in assets, indicating a decline of about 99.7% in this lender segment. Commercial banks in Arizona are now primarily out-of-state owned and operating in Arizona as depository institutions, making only car, boat, and house loans to all but their most favored customers. In this climate, mortgage terms are very difficult to obtain, especially for distressed properties.

As discussed earlier, a stituation can develop in which purchasers are buying based solely on current NOI. If this can be clearly established in an appraisal and appraisal report, an appraiser should still be concerned that the future potential of a subject property is adequately and accurately considered. While prospective purchasers may use existing NOI on 60%-to 70%-occupied properties, different factors may affect 10%- or 20%-occupied properties.

These different factors are of two basic types. For some purchasers, the opportunity to purchase a well-located, well-designed, but drastically under-utilized property at 40% or 50% of physically depreciated replacement cost may entirely offset economic factors.

Another type of purchaser is a user, as compared with an investor. Even multitenant investment properties may become attractive to users if the prices are right. This raises particular problems for the income approach. An appraiser should try to apply some common sense to the income approach when market transactions indicate a potential for conversion to a wholly or partly user-occupied property.

To properly analyze comparable improved sales and listings, much more information is required about each transaction than would typically be the case in normal markets. Unfortunately, some of the pertinent information may not be available to an appraiser. This is a common situation in all markets, under all market conditions. Appraisers must rely on data they can obtain and proceed to a valuation conclusion. The difference in distressed markets is that thorough analysis requires more information, and each sale should be investigated as thoroughly as possible. In addition, the fact that the absence of complete information regarding a comparable can drastically affect reliance on that comparable should be recognized.

SALES COMPARISON APPROACH

The same factors that affect the income approach may affect the sales comparison approach. If a 30% leased apartment complex sells for $25 per square foot of net rentable area, this may not be directly comparable with a similar property at 70% occupancy.

The amount of finish in an office building may be of particular concern when this approach is used for market valuation of multitenant office properties. If a comparable sells with 30% finish and 70% shell space, care is required when this sale is compared with a subject at 60% finish, 40% shell space, even if both are 30% leased. A particularly egregious error is to use comparable sales at partial finish and occupancy to directly indicate market value for a subject at 90% stabilized occupancy, 100% finish, then to compound the error by deducting the cost of leasing and finishing the subject.

For retail properties, appraisers must consider and adjust for differences in the actual or potential performance between the subject and the comparables. The price per square foot for a well-designed and well-located comparable, at 50% occupancy, should not be directly used for a poorly designed or poorly located subject at 50% occupancy. Future potential is a factor under all market conditions, and can even be accentuated in distressed markets.

A major problem in distressed markets is adjusting for cash equivalency. When third-party institutional lending is rare or even nonexistent for distressed properties, it is virtually impossible to judge what market terms (at the time of sale) should have been. With the wide variety of conventional loan terms available in normal markets this is a diffiuclt task. Often the best guidance is from the participants to the sale (as to whether the financing was cash equivalent), rather than mechanical adjustments with little foundation. The poorest method may be to use quoted terms by a lender who is, as a practical matter, out of the market. Precise cash equivalent prices (e.g., $2,337,218) may be particularly inappropriate, even misleading, if derived from a mathematical formula.

EXCESS LAND AND INADEQUATE PARKING

Real property typically is bought, sold, financed, or appraised as a single economic unit. Mixed-use developments are typically analyzed in terms of their separate components, although there may be a synergism factor. A mixed-use project may be approved by local authorities, however, and developed as a self-contained project. Under these typical circumstances, a site is selected, or apportioned, of adequate size for each portion of the proposed project.

In distressed markets, however, the occurrence of noneconomic units becomes more prevalent. Excess land(10) often results from noncompletion of a proposed multiphase project. Conversely, local authorities may approve a multiphase development plan in which a specific phase may not meet zoning or other requirements, although the entire development would. These situations create special problems for an appraiser.

The classic example of excess land is taken from the single-family residential field of appraisal, and illustrates both the concept of excess land and the potential complexity of the appraisal problems.(11)

Assume that a home purchaser acquires two adjoining lots within a large subdivision designed for single-family detached residences. Each lot is 50 feet wide by 120 feet deep, under development by a tract homebuilder. If this purchaser has the builder/developer construct a standard model residence on one of the lots following typical lot setbacks, the purchaser subsequently owns a residence on one lot and an additional undeveloped lot. This is depicted in Figure 4. In this case, the market value of this purchaser's property consists of the market value of the residence on one lot plus the market value of the adjacent lot, as this lot could be sold to another party for subseqent residential development. If there are examples of such resales in this subdivision or a similar one as well as separate lot and house sales, there is good and appropriate data for an appraisal, and also for determining (from the market) if any discounts apply.

[CHART OMITTED]

In contrast, suppose that this purchaser of two adjacent lots has the builder/developer construct a standard model residence in the middle of the combined lots. This is shown in Figure 5. If a typical residence requires 50 feet of frontage, this development arrangement leaves 25 feet of excess land on each side of the completed residence. In this case, the excess land may not be developable separately because of zoning restrictions, convenants, or subdivision homogeneity. If this is the case, the appriser has land value as if vacant based on the highest and best use for two residences, while land value as developed is as a single lot. There is an appraisal consideration regarding the market value for a residence with excess undevelopable land to be analyzed from appropriate data, but there is not a consideration that involves a separate, developable parcel. Similar situations affecting investment property often are found in a distressed market, in which development projects have been halted prior to completion.

[CHART OMITTED]

In normal markets, a principal example of an investment property type that often contains excess land is the neighborhood shopping center. This type of property is typically planned as a group of stores, often anchored by a grocery and drugstore, plus frontage "pads." The individual pad market values may or may not be discounted for sale over time, depending on several factors, as discussed in the next section.

Consider an existing neighborhood shopping center in a small city near Tucson. The center was built in late 1986, with completion of all three phases of shop space at the same time. By late 1991, all three anchors had changed, and the shop space was 45% leased. Of the two pads on the highway frontage, the central pad had been sold and developed and contributed only a common area maintenance (CAM) percentage to the center. The easterly pad was still vacant and available for sale or lease.

In the income approach, only the developed portions of the center were used. The vacant pad was separately assessed, so its real estate tax burden was distinguishable. If both pad sites had been sold, the income and expenses would have been substantially unchanged (the CAM percentage from the pads was relatively insignificant). Assuming that income is processed into a value indication appropriately (i.e., based on rates of return applicable to fully improved shopping centers, or from sales adjusted for excess land), the remaining pad is considered a separate asset. Thus, the market value indication from the income approach is the capitalized value of the income-producing portion plus the market value of the pad site, and the two should be summed to provide an indication of market value for the entire property. The appropriate market value for the pad is open to discussion and consideration. Comparable sales of pads in other neighborhood shopping centers to such users as fast-food franchises or gasoline service stations may or may not reflect the market value of the subject pad for sale to a typical prospective purchaser of the entire shopping center, including the pad. This question can sometimes be resolved through analysis of sales of centers with vacant pads or discussions with market participants.

It should be noted that this particular neighborhood shopping center has an unusual design. All three anchor tenants are grouped together at one end of the center, with all of the satellite space located at the other end. One result of this design is that the typical corner pad is missing. Such corner pads at a major, traffic-lighted intersection are usually highly desirable in the market to typical users. In this case, the anchor tenants required full sight lines and their leases prohibited development of the corner pad. As noted previously, all three anchor tenants had changed since the center was originally developed (in this case, all three chains went bankrupt and were supplanted by other tenants). The appraiser should review the new leases to ascertain whether the prohibition on a corner pad was retained. If not, and as the provided parking significantly exceeds the required parking, there may be a third pad included in the real property to be appraised. If review of the leases opens this possibility, the appraiser should probably seek assistance from an architect in ascertaining the possible size of such a third pad, with access and other characteristics. Excess land can sometimes exist even if not shown on the development plan.

The same concept would apply if the property to be appraised included property in addition to the shopping center. The property discussed avove has vacant land to the south and east. It is not uncommon, especially in distressed markets, to find that an adjoining parcel was originally owned by the developer of the center, and that the lender required the entire property be encumbered with the loan made to develop the center (or a later modification to include additional security). The appraiser now is asked to appraise the entire property, including the adjacent undeveloped parcel. If the appraiser concludes, based on an appropriate market investigation and analysis, that the shopping center (including pad) has a market value of, say, $1,000,000 to a typical investor in shopping centers, and the adjacent vacant parcel has a market value of $200,000 to a speculator, it is likely that the market value of the property being appraised is the sum of these two, at $1,200,000.

The same principles apply in the market valuation of other property types with excess land, perhaps planned for future development. A complicating factor in other property types, however, is that the excess land may have been originally designed for future development as part of a single, integrated project, and there may be legal or practical constraints on sale to another entity, such as rear location or common access.

Inadequate parking or other zoning noncompliance can often arise in conjunction with excess land. The first phase may have been approved for development on the basis that additional parking or a parking structure would be developed in a later phase, and this may not have been developed as of the valuation date. Similarly, a Phase I building may have been approved and developed, then separately financed and foreclosed, resulting in a separate land parcel on which the building may have inappropriate or inadequate setbacks, parking, or in some cases even lack legal access.

A distinction should be drawn between zoning requirements and market requirements. A reduced setback of a building adjacent to an adjoining property that is likely to be used as open space or parking may be a technical violation of zoning, but have little practical effect on the market value of a property. Some zoning ordinances have no parking requirements for buildings, only for the building uses. For example, an ordinance typically requires 1 space per 200 gross square feet for large multitenant office or typical retail use and 1 space per 50 square feet of dining area for restaurant use; this can affect the conversion potential of a property. The local market typically looks for 1 space per 200 square feet for office use; a property with 1 space per 300 square feet, perhaps as a result of planned parking in a future phase, may have functional obsolescence. If there is excess or adjacent land, this inadequacy may be curable by acquisition and parking development of such land. An appraiser should not simply value the developed Phase I property and then add the excess land without also checking the adequacy of the developed site. Conversely, the developed portion could have excess parking designed to facilitate future development of the excess or adjacent land. These are factors to be considered even if the adjacent land is not part of the property to be appraised, especially if cross-easements for parking exist.

DISCOUNTING FOR SALES OVER TIME

As discussed, the property to be appraised may consist of multiple parcels. If market value is sought, then the considerations of market participants in pricing such properties in actual or proposed transactions should be investigated.

When the separate parcels are similar in existing or potential use and would typically sell to similar prospective purchasers, discounting for sales over time would be appropriate. The usual example is lots in a residential subdivision; the lots are each suitable for a single residence and generally sell to separate purchasers for home development. Although there may be differences in size, location, and terrain among the individual lots, the subdivision analysis technique is based on the assumption that the individual sale parcels are similar in potential use, and the prospective purchasers basically compete with each other for sites with similar development potential. The subdivision analysis technique also applies to industrial or commercial subdivisions, provided the separate lots are essentially similar in highest and best use and would be sold to the same class of potential purchasers.

The basic rational of the subdivision analysis technique applies primarily to relatively large groupings of lots. When an appraiser is valuing only two (or even five) lots, questions of applicability can arise. The ideal solution would be to find evidence that a typical prospective purchaser would use a subdivision analysis technique in pricing the purchase of such a property. This would include an analysis of the market value of each lot, a sales period, income and expense projections, and the calculation of a discount rate to present worth. For example, if five pad sites are included and they are each attractive to typical prospective purchasers, a subdivision analysis technique may be applicable to a neighborhood shopping center to obtain an indication of market value for the five pad sites for a single sale to a single purchaser. No additional discount would typically be appropriate, however, when this market value is added to the market value of the improved portion of the center (from the income approach) to obtain the market value of the entire property.

When only two or three pad sites are involved, or when the pads have unique characteristics that cause them not to compete with each other for the same prospective purchasers, the subdivision analysis technique or even an overall discount may not be applicable. In this connection, some clarification of terminology may be appropriate. Some readers of appraisal reports on multiple parcel (e.g., subdivision) properties are confused by the terms "retail value" and "wholesale value." In a typical subdivision analysis technique, an appraiser estimates the market value of each individual subdivision lot (or the typical market value if they are similar). This is the market value of each lot for sale in a separate transaction to a separate purchaser and is often termed retail value. Typically, selling a group of lots to different purchasers involves time, marketing expense, and overhead expense, among other things. Therefore, some discounting is required (in the market) if the entire group of lots (subdivision) is sold at one time to a single purchaser. This results in the market value of the entire subdivision for sale at one time to a single purchaser, often termed "bulk value" or "wholesale value." To avoid confusion, it is recommended that the report clearly identify that retail value or retail prices are actually market value conclusions, but for individual sale, and that a bulk value or wholesale value actually refers to a market value conclusion for a single transaction. This technique (without this terminology) is described in detail in The Appraisal of Real Estate, tenth edition.(12)

A clearer situation arises if a property that consists of components with different highest and best uses is examined. Hypothetically, a mixed-use property consisting of an apartment complex, an apartment site, an office site, and a site suitable for single-family detached development would typically sell to different classes of potential purchasers, and such purchasers would not typically compete with each other. That is, a potential buyer for the office site would not normally also be a buyer for the apartment complex.

This example actually raises two issues. First, assuming there is a separate market for each property type, it is not necessarily correct that one parcel would sell before another. Therefore, a discount for sales over time would likely be inappropriate. Second, there is a difference between appraising a specific property and appraising a portfolio of properties. An easily recognizable example of portfolio appraising is an estate--which might consist of a house, an apartment complex, and an industrial building where a decedent operated a business. The estate might require a total, but there is a question of whether an appraiser should include a discount for multiple parcels. This is a question that should be answered by the market. If each of the properties could be sold simultaneously at the appraised market value, or if a typical prospective single purchaser would sum the market values of the separate components, then the reporting of a total would be appropriate.

In addition, sale commissions and other sale expenses are not an issue if the market would not recognize such expenses. Appraisers do not typically provide market value net of sale expenses on individual properties. Such expenses should not be deducted from separate components unless the market would deduct such expenses.

TYPES OF BUYERS

The nature of the active buyers in a local market can sometimes affect an appraisal. A typical example under normal market conditions is a national chain retail site user. A representative of a national chain user, such as fast food or major oil company, may enter a local market, investigate parcels offered for sale, then select and purchase a given number of sites and move on to another market. Over time, successive "waves" of such purchasers create a continuing market for somewhat similar sites. At times, no participants are active in the local market. As a result of the large number of separate entities with similar requirements, however, the next wave is usually not long in coming, and the valuation of such sites causes no particular problem.

In distressed markets, however, the sale data may reflect participants who have since left the market. In the early stages, these could be developers who have ceased acquisition activity, and the prices paid by this (no longer active) group may not reflect the prices current purchaser participants would pay. Further, distressed lenders sometimes decide to "dump" properties to clean up their portfolios, and the prices accepted for these properties may not reflect prices other owners would accept (alternatively, these sales may "set" the market). In the later stages, bargain-hunting purchasers may be priced out of the market by investors who recognize a potential upturn and are willing to pay somewhat higher prices than historical sales reflect.

This type of market situation is best recognized through frequent discussions with active sales agents for the type of property involved about the characteristics of purchasers presently active in the market. Appraisers are interested in the market at the time a sale occurs (when there is a bona fide offer and acceptance establishing a fixed price), which is not necessarily when title is conveyed.

"TRUE" OR "ACTUAL" MARKET VALUE

Some believe that any property has a "true" market value at a particular point in time, and it is the job of an appraiser to find this true market value. The experience of appraising in distressed markets leads to the conclusion, however, that this may not be the case.

There are at least two major factors that affect the sale price of a particular property. First, most sales tend to be between a seller who is trying to sell a single property (as compared with liquidating a portfolio) and a purchaser who is trying to acquire a single property (not a portfolio). After any transaction, those two participants (i.e., buyer and seller) typically leave the market, at least temporarily. Most real property sales in a normal market involve several offers to purchase, with the sale occurring when the highest offer is accepted. When the particular purchaser who offered the highest price and successfully bought the property leaves the market, the remaining purchasers are those who offered lower prices. In a normal, active market some of these remaining purchasers may raise their price level (based on the sale that has just occurred that they were unsuccessful in purchasing) for a similar property currently available for sale. If there are numerous sellers and buyers of similar properties in a submarket, the negotiated prices within a reasonably stable period tend to establish a market--price range, which is called market value. Although price levels may tend to rise over time (for similar properties in the same market), appraisers can discern a level or range of market value. With price levels on an upward trend, there is a tendency for additional buyers and sellers to emerge in the marketplace.

The second major factor involves the negotiating power and ability of the parties involved in a transaction. This always depends on the particular individuals involved in each specific transaction. Some individuals have greater ability to persuade or greater financial resources than others. In any market there are transactions to be avoided for market comparison, such as those subject to distress, ignorance of a buyer or seller, or particular motivation of the buyer. In a distressed market, however, these transfers are more difficult to avoid, and sometimes must be used because the marketplace regards them as indicators of market value.

The problem in distressed markets is that the number of transactions often declines drastically for any given property type and market, and both buyers and sellers leave the market as a result of declining price levels. It is difficult to make a profit in real estate by "selling short." This situation produces a limited amount of data, and one or two flawed transactions can exert undue influence on an appraiser or on the market.

In addition, a point can be reached at which the majority of transactions involve financial institution real estate owned (REO) sellers and speculative purchasers. While the negotiating ability of any particular institutional seller depends on the ability of the person representing it and can vary from abysmal to excellent, the motivation is basically different than a seller's motivation under normal market conditions.

A market dominated by institutional sellers on one side and speculators on the other can raise some questions in relation to certain specific definitions of market value. If the officer of an institutional seller obtains particular credit or even bonuses for "moving" a large quantity of REO, then the emphasis has shifted from the desire to maximize sale price, which is the typical motivation of a seller in a normal market. Similarly, if the prospective purchasers are interested in buying almost any property provided the price is right, some questions can be raised concerning their motivations and knowledgeability. In a normal market, with no undue pressure, a seller is trying to obtain the highest price possible, and a purchaser is trying to obtain the lowest price possible.

Figure 6 is an example of a listing under distressed market conditions, in a smaller city near Tucson. This is an REO property being marketed through a major national real estate brokerage firm. Notable points are

* Excess land

* Half of "original development cost" asking price

* Close of escrow in 30 days

* The "10% cap rate" includes the excess land

FIGURE 6 REO Property Listing
 of Arizona, Inc.
Phoenix, Arizona 85004
Tel:
Fax:
August 28, 1992
Mr. Alfred M. Benson, MAI
Alfred M. Benson Company
Old Farm Executive Park
6115 East Grant Road
Tucson, AZ 85712
Dear Alfred:
 has received the disposition assignment of a 51,000
 square foot mixed use [office; office/warehouse;
and warehouse] development in Sierra Vista, Arizona.
 Bank, the owner, is committed to doing whatever is
 necessary to sell this fine property and close
escrow prior to September 30, 1992. ALL OFFERS ARE ENCOURAGED.
You should be aware of the following features of this excellent
offering:
 * There are 4.5 extra acres of land involved in the offering.
 This well located land is ideal for building apartments
 and/or mini warehouses.
 * The asking price is less than 1/2 of the original development
 cost.
At its current occupancy [65%] the $1 million asking price equates
to a 10% cap rate.
We believe this is an excellent opportunity for the knowledgeable
investor who is familiar with Sierra Vista, Arizona.
Excellent Property Management is also available. Should you have
any questions whatsoever, or desire further
information please phone me.
Very truly yours,


NOTE: Confidential information has been removed.

Further inquiry revealed that the lender had decided to sell the property as quickly as possible, offering it at the lender's book value, but was likely to accept less to facilitate a quick sale. The future sale of this property will appear as a comparable for any appraiser valuing a similar property in the area in the future. It is likely that this will be the only sale of such a mixed-use property in the local market for at least three years. How an appraiser should deal with the unusual seller motivation is a major question, although disregarding the sale would not be a practical alternative.

In a distressed market, a practicing appraiser faced with the assignment to appraise a particular property can often obtain only one, two, or three recent transactions of similar properties in the same or similar markets. In such a case, an appraiser cannot be choosy about the motivations or negotiating abilities of the participants in the sales, although he or she should always try to be knowledgeable on these matters and adjust the sale prices accordingly, even if reduced to using common sense as well as listings and offers, if they exist.

The bottom line in a distressed market is that a particular property may not have a specific market value, only a range within which it is likely to sell. There may be philosophical questions of whether the market is incapable of establishing a specific value (for a particular property as of some relatively specific time), or whether insufficient evidence exists for an appraiser to reach a specific dollar conclusion. Under either circumstance, a market value range may be more appropriate than a specific dollar amount.

RECONCILIATION ANALYSIS

Under distressed market conditions, the indications of market value derived from the three approaches may be much farther apart than are found typically under normal market conditions.

If a cost approach is used, an estimate of external obsolescence, site value, or even replacement or reproduction cost may be difficult to support from the market. Typically, this approach serves only as a check on the other approaches under these conditions.

The indications from the sales comparison and income approaches may be quite far apart. This could be a sign that a property is more desirable to users than to investors, which can be ascertained by careful investigation and analysis of the comparables. As in normal markets, a striking difference may simply indicate that one approach or the other should be reconsidered.

Appraising for market value in distressed markets is not conceptually or technically different from appraising in normal markets. The difference arises in the degree of investigation and analysis of the market that is required. The comparable data are at once more diverse and scarcer.

Under most market value definitions, an appraiser is required to reach a specific dollar conclusion. In a distressed market, either the indicators of likely market value or the nature of the market itself may provide an appraiser with a wide range of market value indications for the subject property. The concept of providing a likely range instead of a specific estimate was debated in the pages of The Appraisal Journal in several articles in the 1970s and 1980s, although the vast majority of appraisal assignments still require a specific dollar conclusion.

A case could be made that when market data are insufficient to provide a clear, specific indication of a subject property's market value, as is often the case in a distressed market, an appraiser should provide a likely range of market value (in addition to a specific dollar conclusion, if required) in order not to mislead a client. If a thorough and competent appraisal results in the conclusion that the market value of the subject property is $1,000,000 to $1,300,000, perhaps an appraiser should prominently disclose this and state that the final conclusion (e.g., $1,100,000) is the best (or most probable) specific figure that can be reached within this range.

This is somewhat different from a typical reconciliation analysis, in which an appraiser carefully weighs the separate indications from each approach and reaches a logically supported conclusion. In such a situation, an appraiser may want to point out that, for example, while the greatest weight was placed on the income approach, a likely range rather than a conclusive single value was indicated, and that while the indications derived from the other approaches provided some narrowing of this range, they still left an area of uncertainty.

CONCLUSION

The Great Depression is credited by some with creating the real estate appraisal profession. It at least led to the formalization of appraisal approaches and techniques and generated thoughtful articles in early issues of The Appraisal Journal. For example, there was considerable debate over whether real estate (or real property) had "intrinsic value" or merely "market value," subject to the whims of market participants.

In some respects, we are now going through what may be the most significant collapse of real estate markets since the Great Depression. It is still too early to know if the collapse is restricted to such areas as Texas and Arizona or is spreading nationally and worldwide. Even the localized declines, however, may produce significant changes in appraisal theory and techniques as appraisers reflect on the experience of their local markets.

For most appraisal assignments, however, some deeper analysis and investigation of the market can provide better support for an appraisal. To some extent, this has always been true, yet a practicing appraiser rarely can take the time and effort to produce a "demonstration report." The difficulty of analyzing the distressed market compels appraisers to more closely approach this ideal in their everyday work.

(1.)Lloyd D. Hanford, Jr., "Appraisals Under Fire--Again," The Appraisal Journal (October 1991): 447--453.

(2.)Appraisal Institute, The Appraisal of Real Estate, 10th ed. (Chicago: Appraisal Institute, 1992), 6--8.

(3.)A detailed discussion of these factors for shopping centers can be found in a new book to be published by the Appraisal Institute written by James D. Vernor and Joseph Rabianski, and titled Shopping Center Appraisal and Analysis. These factors, however, apply to all rental property types.

(4.)The discussion of market analysis in The Appraisal of Real Estate, 10th ed., provides a sound basis for an appraisal practitioner, whether in a normal or distressed market. An excellent article on the subject is Stephen F. Fanning and Jody Winslow, "Guidelines for Defining the Scope of the Market Analysis in Appraisals," The Appraisal Journal (October 1988): 466--476.

(5.)The Appraisal of Real Estate, 10th ed., 344--359.

(6.)Ibid., 358.

(7.)Good articles on using the cost approach in distressed market conditions are MacKenzie S. Bottum, "Estimating Economic Obsolescence in Supply-Saturated Office Markets," The Appraisal Journal (October 1988): 451--455; Romain L. Klaasen, "Fickle Obsolescence," The Appraisal Journal (July 1989): 327--337; and Mark Galleshaw, "Market-Wide External Obsolescence," The Appraisal Journal (October 1991): 519--525.

(8.)The Appraisal of Real Estate, 10th ed., 467.

(9.)Ibid., 369.

(10.)Ibid., 212.

(11.)Ibid., 212 and 294.

(12.)Ibid., 305--307. Also, an excellent article on this topic, which stresses correct terminology and recommends that an appraiser seek guidance in the market, is Douglas D. Lovell, "Condominium and Subdivision Discounting," The Appraisal Journal (October 1983): 524--539.
COPYRIGHT 1993 The Appraisal Institute
No portion of this article can be reproduced without the express written permission from the copyright holder.
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Author:Benson, Alfred M.
Publication:Appraisal Journal
Date:Apr 1, 1993
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