One Step Further
Practical Implementation of Guide Note 12
• Equilibrium - The theoretical balance where demand and supply for a property, good or service are equal. Over the long run, most markets move toward equilibrium, but a balance is seldom achieved for any period of time.
The Problem
• Real estate markets characterized by cycles (gradual or boom-and-bust)
• An appraisal can quickly become outdated
The Problem
The Appraiser’s Role:• The appraiser’s perspective• The client’s perspective
Point of Agreement:• Value at a single point in time may not be
adequate for some intended uses
The Problem
• Two risks in use of an appraisal:– Value opinion is unreliable due to lack of quality
data (or analysis)
– Value might not be sustainable over time
The Solution – Guide Note 12
• Factors of change vs. symptoms of change• Capital markets and fundamental markets
each cause markets to change• Market analysis (6 steps) allows the appraisal
to be forward looking• Unforeseen events can invalidate conclusions
of market analysis
The Solution – Guide Note 12
• As appropriate, reconciliation should discuss the likelihood the value might not be sustainable into the foreseeable future
The Solution – Guide Note 12
• Predictions are not meaningful• Risk of a lawsuit• Clients will not like it• More work with no additional
compensation
Concerns about Guide Note 12
Real Estate Market Cycles
Expansion
Recession
Contraction
Recovery
Market Trough
Equilibrium
Market Peak
Equilibrium
• Capital markets– Equity capital (investors)
– Debt capital (lenders)
• Fundamental markets– Space users
Real Estate Market Cycles
• Entrepreneurial Incentive– Minimum necessary to justify construction
– Not potential profit at a given point in time
– Concept of positive external obsolescence
– Challenges to application
Tools for Analyzing Cycles
Frictional Vacancy – vacancy unrelated to disequilibria in supply and demand… a typical vacancy rate in a given market operating in equilibrium.
Tools for Analyzing Cycles
Feasibility Rent – the rent necessary to justify new construction.
• When the market is at equilibrium, the rental rate for new, fully functional space is equal to feasibility rent.
Tools for Analyzing Cycles
Feasibility Rent Example
Replacement cost new (per square foot or per unit) for fully functional space, including land and entrepreneurial incentive $100.00Multiply by the overall capitalization rate x 0.085Feasibility net operating income per square foot or per unit $8.50Add fixed expenses per square foot or per unit + $1.50Subtotal $10.00Divide by (1 – variable expense ratio) ÷ 0.80Feasibility effective gross income per square foot or per unit $12.50Divide by (1 – frictional vacancy) ÷ 0.92Feasibility rent per square foot or per unit $13.59
Tools for Analyzing Cycles
Equilibrium Rent – what market rent should be for a subject property, assuming the market is at equilibrium (hypothetical)
Tools for Analyzing Cycles
Subject Equilibrium Rent Example
Subject replacement cost new (10,000 SF @ $70) $700,000Entrepreneurial incentive (Minimum necessary to justify new construction when the market is at equilibrium)
$70,000
Depreciation (excluding external obsolescence due to market conditions) ($170,000)
Subject depreciated improvements cost $600,000
Land value $200,000
Subject depreciated replacement cost including land $800,000
Multiply by the overall capitalization rate x 0.0875
Subject equilibrium net operating income $70,000
Add fixed expenses + $17,000
Subtotal $77,000
Divide by (1 – variable expense ratio) ÷ 0.80
Subject equilibrium effective gross income $96,250
Divide by (1 – vacancy rate estimate for subject when the market is at equilibrium) ÷ 0.90
Subject equilibrium potential gross income $106,944
Divide by rentable SF or units ÷ 10,000 SF
Subject equilibrium rent estimate $10.69/SF
Affordability Analysis
Affordability Index – a measure that indicates potential buyers’ ability to purchase a home
Tools for Analyzing Cycles
Residential Affordability Analysis (Owner Occupied)
Affordability Loan Terms
Down payment ratio (at sustainable ratio) 10%
Mortgage interest rate (at sustainable rate) 5.00%
Mortgage term in years 30
Ratio of income available for mortgage payments (at sustainable ratio) 25%
Analysis of Affordable Median Home Price
Median household income in competitive market $67,750
Ratio available for mortgage payments 25%
Annual income available for mortgage payments $16,937.50
÷ 12 months
Monthly income available for mortgage payments $1,411.46
Monthly loan constant (by financial calculator or spreadsheet) ÷ 0.0053682
Affordable mortgage amount $262,929
Mortgage ratio (loan-to-value ratio) ÷ 0.90
Affordable median home price $292,143
Actual current median home price $312,000
Affordability index (affordable ÷ actual current) 0.936
Residential Affordability Analysis (Renter Occupied)
Affordability Rent Limit
Ratio of income available for rent (at sustainable ratio) 25%
Analysis of Affordable Median Home Price
Median household income in competitive market $52,500
Ratio available for rent 25%
Annual income available for rent $13,125.00
÷ 12 months
Affordable median rent $1,094
Actual current median rent $1,025
Affordability index (affordable ÷ actual current) 1.067
Tools for Analyzing Cycles
Retail Affordability Analysis
Gross rent indicated by comparables $30.00
Affordability rent ratio for subject type space 7.0%
Indicated square foot sales required $428.57
National median sales per square foot $300.00
Percentage over national median sales 43%
Tools for Analyzing Cycles
Retail Affordability Rent Estimate
Current or forecasted subject sales per square foot $250.00
Affordability rent ratio for subject type space 7.0%
Indicated affordability rent for subject $17.50
Tools for Analyzing Cycles
Market Area for Class A Apartments
Year
Rental Rate perSquare Foot
(Current Dollars) % Increase
4 years ago $0.80 --
3 years ago $0.85 6.3%
2 years ago $0.90 5.9%
1 year ago $0.95 5.5%
Current $0.98 3.2%
Tools for Analyzing Cycles
• Market Analysis (6 step process)– Property productivity analysis
– Market delineation
– Demand analysis
– Supply analysis
– Marginal demand analysis (comparison of supply & demand)
– Projection/forecast of subject capture
Tools for Analyzing Cycles
Fundamental Analysis of Supply and Demand
CurrentForecast+5 Years
Forecast+10 Years
Current and forecasted demand (occupied sq. ft.)
1,377,000 1,593,000 1,791,000
Adjustment for frictional vacancy (10%) ÷ 0.90 ÷ 0.90 ÷ 0.90
Supportable space (sq. ft.) 1,530,000 1,770,000 1,990,000
Current supply (sq. ft.) 1,800,000 1,800,000 1,800,000
Net new construction* - - -
Forecasted supply (sq. ft.) 1,800,000 1,800,000 1,800,000
Marginal demand – (excess)/shortage of supply
(270,000) (30,000) 190,000
Current and forecasted occupancy rate (demand ÷ supply)
76.5% 88.5% -*
* New competition is left at "0" for the initial look at the market, and then adjusted in the next study phase, if warranted.
Tools for Analyzing Cycles
Market Rent(For New Const)
MarketVacancy
ConstructionVolume
DevelopmentProfit
Expansion Above feasibility rent and increasing
Below frictional vacancy and decreasing
Less than growth in demand
Above entrepreneurial incentive
Contraction Above feasibility rent, but flat or decreasing
Below frictional vacancy, but increasing
More than growth in demand
Above entrepreneurial incentive
Recession Below feasibility rent and flat or decreasing
Above frictional vacancy and increasing
More than growth in demand
Below entrepreneurial incentive
Recovery Below feasibility rent and flat to increasing
Above frictional vacancy, but decreasing
Less than growth in demand
Below entrepreneurial incentive
Determining Current Market Stage
Reporting Conclusions
Midvale Office Market
Expansion
Recession
Contraction
Recovery
Equilibrium
Equilibrium
Midvale Office Market
Reporting Conclusions
• Equity market– Capitalization rates and yield rates– R = Y - CR
• Debt Market– Interest rate and terms– Underwriting criteria (LTV, – Marginal demand analysis (comparison of supply &
demand– Projection/forecast of subject capture
Analyzing Capital Markets
One step further called for by Guide Note 12 means:
• Appraisal becomes more valuable tool• Future of appraisal profession is brighter
Conclusions
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