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What is real estate worth? A debate over the meaning of market value.

As the dispute rages over whether market or investment value is "real" value, the answer may be, "It depends who you ask."

In a true market economy, a product is worth what a buyer will pay for it. In real estate terms, this translated into the concept of market value - a time-honored pillar of appraisal.

The Appraisal of Real Estate, 8th edition (published by the Appraisal institute) defines market value as "the most probable price . . . for which the appraised property will sell in a competitive market under all conditions requisite for a fair sale. . ."

The text goes on to explain that the fundamental assumptions of this definition are willing and prudent buyers and sellers motivated by self-interest, and a reasonable amount of time for the property to be offered on the open market.

Yet today, this definition, which has served the real estate industry for decades, is under fire. Owners, investment advisors, managers, pension funds, and banks are beginning to question whether the market value represents "real" value today.

Faced with falling real estate prices, some investment managers and owners contend that properties held in long-term portfolios should be appraised at an "investment" value, rather than at the current, low market value.

Seeds of controversy

The roots of this debate spring from the credit crunch facing real estate. Frank Liantonio, executive managing director of national appraisal services for Cushman and Wakefield, summarizes the source of the problem.

"Currently, there is such an aberration in the capital markets that only a very small universe of potential purchasers exists. As a result, there is a paucity of activity in the market, and it is difficult to assess where the market really is."

Vincent Martin, managing partner with TCW Realty Advisors, Inc., concurs. "The controversy over market versus investment value has arisen because people do not understand the realities of the market," he says.

"Values in real estate are really a function of negotiation and transactions, not of running the numbers. In a depressed marketplace, the traditional definition of market value is inoperative because it requires two parties acting without duress. What you are really seeing is liquidation values rather than market value."

The market's illiquidity further dictates lower values because of fair value appraisal requirements promulgated by the Comptroller of the Currency. These provisions require that if in the opinion of the appraiser, a property could not be sold within 12 months, the value must be discounted to reflect the time value of money.

This requirement harkens back to the market value definition that property be offered for a reasonable period of time." Yet, according to Liantonio, a reasonable period today may be 18 months, rather than the three to six months needed to sell in a good market. As a result, many properties are being discounted.

Appraisers are also raising residual cap rates on properties, further depressing values. Vince Martin estimates that cap rates have risen by as much as two percentage points on comparable properties over the last year.

A search for bar"s

Another "hit" to current market prices is the desire of the few buyers with money to get bargains at the expense of sellers. So little money is available that those with cash can negotiate extremely low, "liquidation value" prices from those who must sell.

However, the question remains, are sellers in these transactions "willing," as the definition requires? Many experts say "no."

"The sales that we do find in the market are more truly reflective of the actions of a distressed seller than a willing one" says Liantonio. "With prices this low and financing this hard to secure, no one is likely to sell unless he or she needs the money."

Martin echoes this thought. "In the market today, you do not have many owners willing to sell at these lower prices, so in effect, you do not have two parties to the assumed transaction. As a result you have liquidation values being presented by appraisers in the guise of market value."

Pressure on appraisers, bloodied by the S&L bailout and under pressure from bank regulators to take conservative positions on value, may be further undercutting value estimates.

"The review appraiser at the institution wants to make the regulators comfortable," contends Liantonio. "Since real estate is anathema anyway, why not take the path of least resistance and be more conservative."

Placing the blame

There is no doubt that recent market volatility has had a negative impact on values. A March 5, 1991 Wall Street Journal article cited two appraisals of the Marriott Hotel at La Guardia, one commissioned by the investment manager and the other by the pension fund owner. The investment manager's appraisal valued the property at $71 million; the fund's appraisal came in at only $39 million.

While this may be an extreme case, many investment managers will be forced to take significant write downs when properties receive their yearly valuation as required under ERISA. The results of the Frank Russell Company/NCRIEF index for the fourth quarter of 1990 show overall growth in value of only 1.25 percent for 1990.

Some feel that managers' concern over this evidence of poor property performance plays a role in the debate over value.

"The controversy is not so much about the appraisal process as the results," contends Jeff Lewis, manager of the Roulac Group of Deloitte and Touche. "There has been bad news, and there is bad news coming. Some people may be trying to tweak the values to make their performances look better."

Other interviewees agree that investment managers' concern of performance evaluations and fees do play a part in the debate, but feel that its influence has been overplayed.

"Part of the motivation is fees," says Liantonio, "but the pension funds are moving away from using increases in appraised value as the sole method of compensating advisors."

Martin also believes that the reluctance of managers to write down assets has been overstated. "In my experience, most major players are not going to let this influence their decisions," says.

However, Martin does have concerns about the lack of uniformity among the liquidity discounts used. "Investment managers are concerned that if they use a 30-percent discount and another manager uses a 10-percent discount, they may suffer," he explains.

Martin revealed that the National Association of Real Estate Investment Trusts (NAREIT) is currently studying how liquidity discounts can be made more uniform. TCW and other investment advisory firms are also working to develop a performance evaluation framework that will incorporate risk adjustments into a more fully developed assessment of property return.

A desire for regularity

If the reasons behind the market versus investment value controversy seem complex, the answers to "real" value seem even more elusive.

For some, such as Jeff Lewis, the answer seems to be that if market value seems erratic, it is only mirroring market realities.

"The market can be volatile," says Lewis, and values can change dramatically. Performance ought to reflect that volatility rather than trying to smooth the numbers out to a more desirable figure."

Others, such as Frank Liantonio, believe the answer lies in refining the accuracy of the data used to make the income projections that underpin value.

"At Cushman and Wakefield, we believe that the market is made up of its participants," says Liantonio. "We, and some of our competitors, make regular surveys of financial institutions, pension funds, and so forth, to determine the yield criteria they expect from different property types. In that way, we attempt to anticipate future thinking among buyers, not just past sales."

Liantonio also believes that the appraisal industry needs to become more sophisticated in its use of demographic projections rather than relying on historical rates of absorption. "To the extent that we become better at that," he predicts, "the better we will be able to forecast when markets are reaching equilibrium."

Perhaps the best answer to the controversy over what constitutes real value is Martin's belief that there is not just one value for a property - there are several.

"People are focusing on the definition, when they should be focusing on what the number will be used for," states Martin. "If a pension fund is using an appraisal to plan for future funding liabilities, a liquidation value is appropriate. On the other hand, if a fund is trying to make a hold/sell decision, an investment value gives a much more precise picture of the true potential for return."

Even a computation of investment value may differ depending on the assumptions, continues Martin. "There are so many variables in the model," he says, "projections of future income stream, residual cap rates, inventory estimates, that several reasonable ranges of value could be assigned. To assess an appraisal, the client needs to understand the assumptions used to make the calculations."

Yet the final word belongs to an anonymous attendee at a Pension Real Estate Association session on the market value versus investment value controversy. "Do you think," he asked, "that we would be having this session if market values were going up?"

Jeffrey D. Lewis is a manager of the Roulac Group of Deloitte & Touche in San Francisco. Mr Lewis manages performance measurement reporting for major pension fund accounts and provides litigation support in cases involving real estate valuation.

Frank R Liantonio is executive managing director of national appraisal services for Cushman and Wakefield, Inc. The firm provides a wide range of real estate services nationwide, including sales, leasing, management, and appraisal.

Vincent F. Martin, Jr., is one of the founding partners of Los-Angeles-based TCW Realty Advisors, Inc., which was formed to provide real estate investment management services to employee benefit plans, endowments, and foundations. Prior to forming TCW, Mr. Martin was the general manager of Coldwell Banker's Capital Management Services Division.
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Title Annotation:Asset Management
Author:Evans, Mariwyn
Publication:Journal of Property Management
Date:May 1, 1991
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