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Market value: does one size really fit all?

Among the more frustrating challenges of communicating valuation analyses are the multiple perspectives of what constitutes value. One definition of value should not be relied on to serve all needs. Inherent in any value definition, such as "market value," is a compromise of different perspectives of what constitutes value. For example, a property owner under no pressure to sell property in a currently weak resale market may need an opinion of value to report net worth to an unsecured lender. On the other hand, a seller marketing to a specified buyer profile may need a value estimate that assumes a sale to that group of buyers.

Many real estate investment decisions depend on meaningful conclusions of value. This article's goal is to stimulate dialogue and thought concerning the appropriateness of estimating value using alternative definitions of value.

A client's expected use of a certain value conclusion should drive a professional appraiser's application of one or more value definition. Specific definitions of value must be carefully constructed and explained. No attempt is made here to solve the difficult problem of creating and employing different value definitions, except to exemplify their usefulness to clients.

MARKET VALUE: A CASE STUDY

Under Title XI of the Federal Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA), real estate-related financial transactions entered into by federally regulated institutions must rely on a "written statement independently and impartially prepared by a qualified appraiser setting forth an opinion as to the market value of an adequately described property as of a specific date(s), supported by the presentation and analysis of relevant market information."(1) (Emphasis added.)

This definition of market value often serves as a compass to direct an appraiser's course of inquiry. Therefore it would seem that appraisers and their clients have settled on, once and for all, the meaning and usefulness of the value estimate. From an appraisal consumer's perspective, however, market value as currently defined and interpreted may be less meaningful than ever. This confusion stems from a client's need for the appraiser to articulate the specific conditions under which market value is an indication of transaction price.

The significance of the role played by the definition of market value is apparent in that it underpins value estimation of trillions of dollars of wealth in the United States. The market value definition presented below encompasses many complex concepts, each of which deserves separate analysis and comment when communicating the value estimate.

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

1. Buyer and seller are typically motivated;

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

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

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

5. The price represents the normal consideration for the property sold unaffected by special or creative financing or sales concessions granted by anyone associated with the sale.(2) (Emphasis added.)

This definition encapsulates a market perspective not necessarily consistent with a literal interpretation of commercial property markets during 1992. To support this contention, plausible interpretations of two of the concepts embedded in this market value definition are discussed next.

COMPETITIVE AND OPEN MARKET

Competitive market conditions typically exist when two or more parties act independently to secure the business of a third party by offering the most favorable terms. An open market may be defined as accessible and free from hampering restraints. Finally, a market refers to the people gathered for the purpose of buying and selling.

A competitive and open market, therefore, is one characterized by many people acting independently of each other to secure the business of a third party, with the caveat that the market is free from hampering restraints. Reference to historical transactions of commercial property supports the conclusion that without ample credit, a competitive and open market cannot exist. Instead, a monopolistic advantage accrues to those persons able to dominate a market by virtue of their preferential access to capital. A shortage of equity capital can also lead to monopolistic conditions within a market.

As seen in fall 1992 markets, lenders' unwillingness to lend on real estate created a shortage of capital that affected the realizable price of a property. The appraisal problem may be exacerbated if these conditions, which are more monopolistic in character, are confused with truly open and competitive conditions.

The preceding analysis suggests that recent and current market conditions as of the effective date of appraisal may bear little relationship to conditions assumed by the market valuation problem. An appraiser faces an apparent dichotomy between assumptions that underpin market value and the current market realities. A professional appraiser is expected to avoid misleading the client and the public while solving the valuation problem for which he or she was engaged. The hypothetical market value definition referenced here constrains an appraiser's perspective, while a client may not realize the open and competitive market assumption embedded in the baseline assumption of market value.

An appraiser's goal in presenting such an analysis should be to ensure that the appraisal process is consistent with the basic assumptions contained in the value definition, in this case market value.

APPLYING VALUE DEFINITIONS

A misconception held by appraisal users is that an appraiser makes value. Instead, an appraiser synthesizes appropriate evidence based on a defined problem. This synthesis should exclude using a valuation approach or technique that the appraiser's research proves is irrelevant to the buyer's and seller's investment calculus. Alternatively, when specific benchmarks and valuation tools are prevalent in a defined market, they should be included in the report and used to support indications of value.

The basis on which to include or exclude an identified valuation method must be founded on whether that method is used by buyers and sellers within the context of the value definition. In solving for market value, for example, an appraiser develops a ten-year cash flow forecast for an existing, fully leased office building, discounted at a certain yield. The resulting value estimate may not equal market value. Rather, the cash flow model may be one of many tools used by prudent and knowledgeable market participants in open and competitive markets.

If office buildings were valued by typical buyers and sellers based on after-tax benefits, exclusion of this after-tax calculus would be inappropriate. Those valuation methods that prevail within the context of the market studied and that are consistent with the value premise should form the basis for solving for value. If a property market is temporarily weak but the assignment is to estimate market value, the resulting appraisal process might reflect on current buyer and seller calculus, but the value estimate should rely on valuation methods consistent with the actions of knowledgeable and prudent participants, given open and competitive conditions.

ALTERNATIVE USES OF APPRAISED VALUES

A list of possible consumers of appraisals and their specific uses of value estimates is shown in Table 1. In light of the fact that a single consumer may have two or more divergent value needs, multiple definitions of value may be required to solve the range of client valuation problems.
TABLE 1 Client Uses of Appraised Value Estimates

Client Profile Alternative Use of Value Estimates

Pension fund Comply with ERISA (accounting role)
advisor Purchase a property
 Sell a property

Federally Determine asset values (accounting
regulated role)
financial Reclassify a mortgage loan
institution Accept an offer on owned real
 estate

 Determine how much credit should
 be extended, based on collateral
 value but assuming a seven-year
 loan term
 Comply with FIRREA

Individual Determine the financial rewards of
 selling under current market
 conditions
 Value equity position for financial
 disclosure statement

Attorney Estimate damages in the context of
 a deficiency judgment


BUYER AND SELLER EACH ACTING PRUDENTLY AND KNOWLEDGEABLY

This definition of market value also includes a condition that both the buyer and seller act prudently and knowledgeably. Under certain conditions, a prudent seller's perspective of a property's value may differ greatly from a prudent buyer's perspective. For example, a pension fund with $1 billion to invest in commercial property during the next year may find itself the only institutional participant on the buy side for office property in a particular area. On the other hand, assume this same institution also owns an office property in the same market. Under these conditions, while prudent managers may consider purchase of office property, they would not be likely to consider sale of their existing office investment in this area. Generally, if prudent sellers would avoid participating under current market conditions, market valuation becomes hypothetical. While oversimplified, this example is intended to reflect the impact on the appraisal process from assuming both buyers and sellers act prudently and knowledgeably.

Under the constraints of market value, before simulating a transaction an appraiser should identify what a knowledgeable party to a transaction would know, and how a prudent party would act. In practice, this would entail identifying motivations that underlie the buy and sell decision, typically including an analysis of financial matters and recognition of unquantifiable factors that may be material to the valuation. An example of quantifiable purchase or sale criteria is a specific required rate of return on invested capital. A less easily quantified factor is the value to a purchaser of an owner-occupied industrial property, wherein a purchaser will pay a premium for control over both future occupancy cost and business location. The following investment criteria are not easily quantified, but nonetheless affect the degree of knowledge and prudence exercised by buyers and sellers.

* Portfolio diversification objectives

* Income tax considerations

* Risk tolerance levels

* Assessment of alternative investment opportunities and their unique return characteristics

Although a client may think a market value estimate is needed, the client may be better served if an appraiser initially screens that client as to the use and purpose of the valuation. This may affect the appraiser's selection of an underlying valuation premise or definition of value.

For example, a lender subject to FIRREA is considering making a loan on a 500,000-square-foot, nearly fully leased, CBD office building, as of summer 1992. An appraiser might assume that the lender's need for an appraisal is FIRREA-based, and that the only meaningful definition of value is market value. While a web of contractual obligations may underpin a commercial property loan, the lender's ultimate recourse is to the security interest in the commercial property. When a lender forecloses and takes possession of a property to satisfy a mortgage, does the lender's ownership stigmatize the property, resulting in a lower realizable sale price? In this case, before the loan is made the lender would be well served by a value estimate based on a definition that captures a lender's motivation under these circumstances. The current market value definition cannot be interpreted to solve this problem.

In a similar lending situation, assuming that existing market conditions are either highly speculative or weak, a value estimate that captures the existing market conditions is meaningful to the decision to underwrite the current risk. If a borrower is purchasing commercial property in an oversupplied market facing a shortage of mortgage capital, the lender may be willing to extend more credit than under healthier market conditions. This business decision made by the lender would be based on the conclusion that over the life of the loan, conditions in both the office-leasing and capital markets would probably improve. This underwriting analysis would rely on the relationship between market value and value under current market conditions. One might refer to the value under current market conditions as "liquidation price."

While not formulated as a precise definition, liquidation price would refer to the proceeds from selling a property, given current conditions affecting the sale. One could compare this value with the value of a share of common stock or the price of a junk bond. Instead of contacting a licensed securities broker, however, an appraiser would examine recent sales as well as the balance between current demand and the supply of comparable properties to determine liquidation price.

BRIDGING THE DEFINITION GAP

The implication of the preceding examples is that the reporting of value must be improved. To respond to a client's various needs and uses of appraised value, an appraiser should identify appropriate definitions of value, communicate their precise meaning, and discuss how the meaning affects the appraisal process. In this way, an appraiser will apply the definitions of value consistently across all appraisal assignments. For instance, regardless of the reason a client requested a market value estimate, the process employed to reach the conclusion of value should not change. If a lender is updating its internal valuation of owned real estate, a market value estimate would likely be appropriate. However, what if a client wants the value estimate to form the basis for setting an acceptable offer for the asset? If current market conditions are highly speculative, should this affect the market value estimate? The market value estimate should be compared with a liquidation price to provide the client with meaningful information.

This example suggests that appraisers should consistently apply the definition of market value. If the purpose and use of an appraisal are inconsistent with the definition, however, an alternative value definition should be included.

Having identified a client's use of the appraisal and having provided an interpretation of the printed definition of value, a professional appraiser is well positioned to articulate a series of responsive and creative solutions to the client's problem. Principal among these solutions is to present more than one value conclusion based on alternate definitions. Embodied in this approach is a well-reasoned and thoughtful explanation of valuation theory within the written or spoken communication of the value estimates.

BENEFITS OF JUXTAPOSING MULTIPLE VALUES

An example of how an appraiser might juxtapose market value and liquidation price is presented next. This might begin with a statement in a report that market value is based on the following stated conditions:

* Ample liquidity is present in the market.

* Sellers and buyers are prudent, which means that the value estimated is not solely based on the actions of "bottom fishers" or speculators.

* Both buyer and seller are well informed; this means that both parties have retained the consulting services of a qualified appraiser to help them decide on the reasonableness of the proposed transaction.

* A competitive and open market is defined to include the spectrum of participants normally observed in real estate markets. Absence or overabundance of certain segments of this defined spectrum would be evidence of current speculative or troubled conditions that would fall outside the conditions proximate to the market value definition.

An appraiser's interpretation of the meaning of liquidation price would be similarly outlined. Focusing on current realizable cash proceeds from a sale is a different valuation process than estimating market value. For example, estimating liquidation price may rely much more on current sale activity, regardless of sellers' or buyers' motivations. A liquidation price versus market value perspective might demonstrate to a client that a purchase or sale in the current market is not advantageous and may be an outright mistake.

Under either speculative or troubled market conditions, the liquidation price estimate may differ from the market value estimate. As of September 1992, liquidation value estimates for most types of commercial property are likely to be significantly lower than market value estimates. The point of this comparative analysis is that clients are provided relevant inputs through which to sort and effect solutions to their problems.

CONCLUSION

A single value definition can neither capture the range of perspectives nor meet the range of needs of real estate market participants and appraisal consumers. By incorporating multiple value definitions to underpin valuation of real estate, a professional appraiser can help crystalize in his or her own mind how that definition relates to the client's needs.

An appraisal that contains five definitions of value and five conclusions of value could be viewed as excessive and possibly misleading. Yet a well-documented report would reference the different definitions, discuss their applicability to identified appraisal problems, juxtapose their meanings, and provide the context within which each value estimate is relevant to a client.

In complex institutional environments where a matrix of client perspectives exists, providing value estimates guided by alternative definitions is appropriate and would offer a decision-making dimension that is missing from a single estimate of market value.

1. Comptroller of the Currency, Treasury, 12 CFR 34.42 (a), (January 1, 1992): 383.

2. Federal Register, v. 53, no. 165 (August 24, 1990): 34696.

Peter N. Thomson, MAI, is a vice president at Citicorp Real Estate, Inc., in Chicago. He received a BA in political science from the University of Chicago, an MS in real estate appraisal and investment analysis from the University of Wisconsin-Madison, and an MBA in corporate finance from the University of Wisconsin.
COPYRIGHT 1993 The Appraisal Institute
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Copyright 1993 Gale, Cengage Learning. All rights reserved.

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Author:Thomson, Peter N.
Publication:Appraisal Journal
Date:Oct 1, 1993
Words:2877
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