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Comments on "Price versus Fundamentals--from Bubbles to Distressed Markets".

In my previous letter to the editor (Fall 2011) about "Price versus Fundamentals--From Bubbles to Distressed Markets" (Spring 2011) by Stephen F. Fanning, MAI, John A. Blazejack, MAI, and George R. Mann, MAI, I did not address directly the article's larger issue--the distortion of the role of fundamental market analysis in the valuation process. The implication in the article, and reaffirmed in the letter to the editor by Mr. Jorgensen (Winter 2012), is that fundamental market analysis can be used to override direct market evidence. This is a dangerous expansion of the profession's responsibility. In addition, failure to acknowledge the integrated function that market analysis has to an appraisal may serve to undermine the credibility of real estate valuation. The problem posed in the authors' response to Mr. Jorgensen's letter, "which one is market value: transaction prices or fundamental value," reinforces these distortions.

Mr. Jorgensen's letter contends that fundamental market analysis is necessary to identify "lagging perception of market participants" Even if his description of this relationship were accurate (and I don't believe it is), the issue is not what the market ought to know but what the market does know. A market value assignment is not what the appraiser thinks the property is worth; the assignment is what the market thinks it's worth (and why).

Count me as one of Mr. Jorgensen's "traditionalists," since I believe value is a market concept and the market is best understood through transactions. Furthermore, thinking outside the "traditional box" when it comes to the definition of market value can be dangerous because the box, while defined by well-informed market participants, is also defined by "reasonable exposure time." This means that the subject property is assumed to have already been offered (exposed) on the open market, possibly under the same forces of supply and demand as the comparables. However, if those forces have changed since the comparable transactions, a market conditions adjustment is the simple solution. The problem in Mr. Jorgensen's example, which contrasted recent sales that indicated $100/SF with a discounted cash flow value of $85/SF, is that only the latter sale incorporated fundamental market analysis. A similar error occurred in the article's Case Study 1. If there is a valid difference in values in both illustrations, it must be due to a change in market conditions ignored in one of the approaches. In Mr. Jorgensen's example, applying the proper market conditions adjustment to the sales would produce a lower value, possibly $85/SF; but if this adjustment is not appropriate, the market value of the property is unquestionably $100/SF.

Both of the Appraisal Institute's Market Analysis and Highest & Best Use courses stress the importance of market analysis to the entire valuation process-not just in determining a property's highest and best use but in applying each of the three approaches to value, including demonstrating how to use fundamental market analysis to derive a market conditions adjustment when transactions are insufficient. Consequently, the authors' proposed question of "which one is market value: transaction prices or fundamental value" can be easily resolved by the consistent application of the results of fundamental market analysis.

Market analysis--inferred or fundamental--is not a fourth approach; it is integral to and supports all three approaches. Its consistent application will produce consistent results from the various methods and approaches without favoring one method (such as discounted cash flow) over another (such as direct capitalization). In fact, it doesn't favor one approach (such as income) over another (such as sales comparison). It is simply the research necessary to apply all properly.

Furthermore, it may be a questionable assertion that fundamental market analysis can be used to outsmart the market in light of the fact that it is not a proprietary appraisal procedure but a process developed by market participants. Appraisers adapted the process to better model and better understand market behavior. The fact the market relies on the process should challenge the notion that market participants are not well informed. The appraiser's task is determining if new, relevant information has become available since the occurrence of the most recent market activity. Market activity can only be expected to reflect available information.

Finally, market analysis is not an additional consulting component of an appraisal. I am a strong proponent of consulting. But, consulting assignments are distinctly different from valuation assignments--as different as an appraiser is from market participants. One of the reasons appraisers remain unchallenged as the primary providers of real estate valuation services is that the profession separates valuation from consultation services. It is a mistake to encourage appraisers to blur the distinction by implying fundamental market analysis is a virtual crystal ball that gives appraisers magical powers.

Richard L. Parli, MAI

Fairfax, Virginia

Responses to Letter to the Editor

My letter to the editor certainly does not suggest we should cease providing clients with traditional market value opinions tied to current transactions. Obviously, it is vitally important in most assignments for the client to know what a property would currently sell for. I only suggested that sometimes what a property should sell for and what it would sell for are two different things. In a bubble market or in a market collapse, the price being paid for properties can be out of line with the fundamentals. Even in ordinary cycles, market perceptions tend to lag behind changing market conditions. Mr. Parli has great faith in the unseen hand of the market and in the sophistication of the buyers and sellers, and doubts such a situation could exist. My own view is that the events of recent years have clearly shown that irrational exuberance (and its opposite) is not confined to the stock market. Mr. Parli worries that appraisers should not be led to believe that they have magical powers to outguess the market. My own view is that a well-trained appraiser, skilled in market analysis, can often predict changes in market conditions ahead of general market perceptions or changes in transaction prices. It's intriguing to talk about another value, not market value as we have traditionally thought about it but one that truly reflects any predictable changes in market conditions. Actually developing that other value opinion may be beyond the scope of a typical bank appraisal assignment. Still, the appraiser has the responsibility to report to the client, in some way, when there is disconnect between current prices and market fundamentals (like many markets in 2006 and 2009). That was my point; and I continue to believe it is vitally important if we are to eliminate some of the criticism of appraisers and remain a growing and vibrant profession.

Although we differ in our opinions on this subject, I continue to appreciate and hold in high regard Mr. Parli's contributions to our understanding of market analysis. As I said before, it is good we are having this discussion.

Kerry M. Jorgensen, MAI

Sandy, Utah

We thank all of the people who have taken time to respond to our article; stimulating interest in the application of market analysis will help our profession.

Mr. Parli states the article distorts the role of fundamental market analysis in the valuation process. However, we believe and continue to state fundamental market analysis must be applied to estimate highest and best use that includes a forecast of rents and occupancy over the holding period. The valuation of investment-grade property should always include this type of market analysis.

Mr. Parli believes the article implies fundamental market analysis can override market evidence. We contend, however, that fundamental data is market evidence just like sales are market evidence. The article clearly notes no one data or analysis method should be controlling, and an appraisal is an analysis and reconciliation of all the market data. So, if Mr. Parli means that only sales transactions are market evidence, then we plead guilty as charged. If a new sale or new development satisfies demand, then the next sale or development may be left without current demand. The experience of the past five years in the real estate market clearly proves that without fundamental demand for houses you can get the wrong value from transactions. The market had artificially induced low interest rates and CMBS-induced poor underwriting of mortgage loans. The results were speculative purchases of single-family homes and overstated values.

Mr. Parli states, "It is a mistake to encourage appraisers to blur the distinction by implying fundamental market analysis is a virtual crystal ball that gives appraisers magical powers" We do not think this is a mistake. Fundamental data is what it is, just like sales are what they are. We believe not only is there room for both in appraisal, but also both should be in appraisals.

The technique of adjusting old sales by using fundamental data for a market conditions adjustment can be helpful in a market with few current sales. We agree this is a good method; the article only points out that with this procedure the two methods (sales and fundamental data) have been blended together, which then makes the sales comparison method equivalent to the fundamental market data. The article simply suggests that sometimes it might be useful to separate this data. Note the article strongly recommends that even if the three approaches are kept independent, the appraisal should by all means include a sales comparison approach. The reconciliation then becomes a key analysis section.

Stephen E Fanning, MAI

Denton, Texas

John A. Blazejack, MAI

Miami, Florida

As my coauthors have reiterated since our article was published, the continued discussion of this topic was the original goal, and this should benefit the industry as a whole. Thanks to all who have added to the dialogue.

I wanted to provide my own reply that does not speak for my coauthors.

The most significant statement by Mr. Parli that I disagree with is, "A market value assignment is not what the appraiser thinks the property is worth; the assignment is what the market thinks it's worth (and why)." This belief has contributed to the continued decline of the worth of our profession. Users of our services do not need an appraiser to determine the price of a property as transactions are readily available public information. For 80 years, appraisers have simply been following prices up and down through the economic cycles. Appraisers are needed to provide an independent estimate of value that may or may- not coincide with market transactions. As I will discuss, rarely are market transactions and value in sync.

Mr. Parli states it is a dangerous expansion of the profession's responsibility to use fundamental market analysis to override direct market evidence. However, fundamental market analysis is direct market evidence. Yes, it is safer to maintain the status quo and write appraisals that simply go up and down with prices, but what is needed in our profession is a significant increase in responsibility and the willingness to let the market know when it is wrong.

Mr. Parli contends market value is defined by well-informed market participants. The market, however, has proven consistently over the decades that it is not well informed, and it can be way off in its estimate of value. The latest housing bubble clearly proves the market is not very sophisticated. Studies have also shown that institutional investors (supposedly the most sophisticated buyers and sellers) have been consistently- wrong about the real estate market. Sole reliance on the market is a dangerous activity that undermines the credibility of real estate valuation.

Lastly, Mr. Parli contends that any difference between fundamental demand analysis conclusions and market transactions can be explained by a market conditions adjustment. Yes, that is useful for comparing older comparable sales with current market conditions. However, this misses the point that fundamental market analysis and market transactions can provide substantially different indications of value at the same time. There is no market condition adjustment for this situation.

So as not to speak for my coauthors, I personally contend that the discussion of fundamental market analysis and market transactions comes down to the interaction of price and value. I believe appraisers should recognize the following logic:

* Price only equals value when a market is in equilibrium.

* Real estate markets are rarely in equilibrium.

* Therefore, price rarely equals value.

As such, market transactions should only be given consideration when a market is at or very near equilibrium. At all other times, fundamental market analysis is going to provide a better indication of value than market transactions. The real estate valuation industry will become more useful when it gets away from writing price confirmation reports and starts providing opinions of value based on solid supply and demand analysis.

George R. Mann, MAI

Cincinnati, Ohio
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Author:Parli, Richard L.
Publication:Appraisal Journal
Article Type:Letter to the editor
Date:Jun 22, 2012
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