The Appraiser is a Storyteller

Value is the present worth of future benefits of ownership.

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For example, the value of your car is the benefit you get from using the car.

The value of jewelry is the benefit you get from wearing it and how it makes you feel.

The value of a single-family home can be created by a combination of utility and pride of ownership.

 

A single-family home purchase may also be motivated by a general belief that the property will appreciate.

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It is important to remember that there are many different types and definitions of value, i.e., market value, investment value, value-in-use, intrinsic value, sentimental value, among countless others.

In real estate, one must keep in mind that different properties, regardless of their market segment,

will inevitably have different values to different users, since each unique user has different motivations driving their purchase decisions.

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In my experience, the value of commercial property – while being generated by similar economic factors as residential value in some cases – typically stems from

1) utility to owners or users, or

2) required yield or economic return as a passive investment when leased to third parties.

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Simply put, you either use real estate, or you rent it.

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"Ironically, it is rare that any one sale fits the definition of market value as all buyers have different investment or use criteria."

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For a property leased to third-parties, the preferred purchase price may deviate significantly among investors based on their required return on investment. [1] In the same vein, owner-users are willing to offer significantly different prices for commercial property based on their specific use requirements.

 

What is being described are concepts known as “investment value” and “value-in-use”, respectively. Otherwise, this could be understood as the price a buyer is willing to pay based on their specific purchase criteria.

 

Conversely, as appraisers, we are typically tasked with reporting on “market value” which is most commonly defined as:

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The most probable price that 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:

 

• Buyer and seller are typically motivated;

• Both parties are well informed or well advised, and acting in what they consider their best interests;

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

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

• 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]

 

The fact is, there are two major themes in real estate transactions:

 

1. Most sales occur under some sort of undue stimulus, and

2. People buy when the real estate value derived from their personal investment or use criteria results in a number equal to or greater than asking price

 

Therefore, ironically, it is rare that any one sale fits the definition of market value in the absolute sense of the definition as all buyers have different investment or use criteria.

Rather, it is a combination of sales that constitute the theory of market value.

 

As the personal criteria specific to a particular transaction approaches the “markets” overall criteria – developed from analysis of buyer/seller interviews and sales – the need to adjust for violations in the definition of market value are less essential to yield a credible appraisal. Appraisers might refer to these violations as differences in conditions of sale and/or market conditions – each of which are difficult to quantitatively support.

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"Essentially, in residential appraisal, the data often speaks for itself; in commercial, we need to speak for the data."

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In residential appraisal, data is more prevalent as comparable sales occur on a much more frequent basis. We would refer to the residential market as being more efficient than its commercial counterpart. A more efficient market breeds more reliable data which translates to more accurate predictions of future outcomes.

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For many commercial property types, appraisers are not typically granted the same benefit of robust data. In this way, it is imperative that commercial appraisers be excellent storytellers.

 

This should not suggest that commercial appraisers have a license to develop incredulous results or inputs to determine market value; rather, it should suggest that with a relatively limited amount of data from which to derive an opinion, we must be very good at narrating the thought-process and observed market activity which led us to each conclusion. Essentially, in residential appraisal, the data often speaks for itself; in commercial, we need to speak for the data.

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One of the best examples is vacant professional office space. I observe similar offices selling for vastly different prices and it is often difficult to make sense of the deviations.

How can that be?

 

They have the same size, similar condition, and are in the same office park.

They sold a few years apart, but Central PA is not an overly dynamic office market.

It is because they have different stories.

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To this end, I recently acquired the philosophy that motivation, or timing, has more to do with purchase price than almost any other factor. As previously noted, the value of commercial real estate stems from two primary functions:

 

1. housing a business or economic need to owner-users, or

2. providing a return on investment to passive investors

 

Businesses are constantly growing or contracting – thus influencing their real estate needs.

Interest rates and other external factors are also dynamic which influences investor requirements for passive investments. It follows then that it is incredibly difficult to quantify:

 

1. the ever-changing fundamental demand for commercial space of any kind, or

2. the required yield for passive investors

 

For example, an owner-occupant buyer of a 50,000 SF office paid $5,000,000 one day ago. Unless supply and demand are perfectly balanced, in theory, an adjacent and identical office building is worth something greater or less than $5,000,000 today. However, there are factors that preclude an ability to perfectly quantify supply and demand, and as the best point of reference, an appraiser would typically be inclined to conclude that the identical and adjacent building is worth $5,000,000 today.

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Similarly, for passive investments, news from the Federal Reserve, interest rate fluctuations, and prospective changes to the federal tax code – among many other external factors – can influence required return on investment.

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"Real estate values fluctuate similarly [to the stock market] based on factors relevant to users and investors; the ability – or lack thereof – to discern these changes lies in the quantity and quality of available data."

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With the above in mind, real estate demand factors are changing daily, and without a significant number of comparable commercial transactions, it is impossible to prove that constant changes in demand translate into a constant change in commercial property value. However, although unobservable in real time, based on the dynamic demand for commercial property from users and investors alike, this economic phenomenon actually suggests that market value of most properties is also incredibly dynamic and changes daily as well (possibly referred to as unobservable micro-fluctuations).

 

While it is nearly impossible to determine changes in market value on a daily basis, this underlying principle may shed some light on why there are deviations in price between two seemingly identical properties. [3]

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Consider the stock market.

It is probably safe to say most people are aware that stock prices can and do fluctuate – sometimes quite drastically – on a daily, hourly, or even second-by-second basis.

 

Theoretically, real estate values fluctuate similarly based on factors relevant to users and investors; the ability – or lack thereof – to discern these changes lies in the quantity and quality of available data.

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"As a seller’s preferred disposition price approaches a buyer’s preferred acquisition price, there is increasing likelihood that a sale will commence."

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It is important to bear in mind that the emotions and motivations of property owners and buyers factor into this equation. A property whose owner believes its value – be it any combination of real estate and/or non-realty factors which influence their perspective – to be greater than that which buyers in the market are willing to pay will not often result in a sale.

 

Likewise, a buyer who is unwilling to meet the price expectations of sellers in a given market is unlikely to be successful in acquiring the property they seek. Either or both parties to a particular transaction can exhibit a broad spectrum of motivations, desires, and preferences, which can result in a wide range of preferred outcomes. As a seller’s preferred disposition price approaches a buyer’s preferred acquisition price, there is increasing likelihood that a sale will commence.

 

It is the appraiser's job to research and analyze sufficient information to conclude which “puzzle pieces” are relevant to derive such equilibrium, as of a specified date, and report a corresponding price of the hypothetical transaction. This is the essence of a market value appraisal.

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It is entirely possible – or rather probable – that many properties could command higher (or lower) sale prices than credible and well-supported market values concluded by appraisers, depending on the specific motivations and desires of the parties to a particular sale, as well as the quantity and quality of data available to the appraiser at the time of the appraisal assignment. This is not a flaw in an appraiser's conclusions; it is simply a reflection of the imperfections and inefficiencies inherent in real estate markets.

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"In less efficient markets such as many commercial real estate segments, the scarcity of data is such that a much wider range of value opinions can often be credibly supported."

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While such variance should not be confused with a "margin of error", the range of value opinions which can be credibly supported for a given property typically narrows as relevant and reliable data becomes more readily available.

 

As previously discussed, this can be illustrated by the example of stocks, where transactions are plentiful and up-to-the-second data is readily available. Thus, pricing can be updated frequently, and there is no disagreement as to what the price of a given stock is at any particular time.

 

Conversely, in less efficient markets such as many commercial real estate segments, the scarcity of data is such that a much wider range of value opinions can often be credibly supported.

In this way, appraisal is often referred to as a combination of art and science.

 

The probability of any one scenario occurring needs to be considered in a process known as reconciliation – which speaks to the art component of an appraisal and is paramount in developing a credible value opinion. [4] Reconciliation is the best tool in the "appraiser arsenal" to explain why the purchase price, for instance, is different than market value due to undue stimulus on behalf of the buyer or seller.

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Considering these factors, my philosophy of what constitutes a “good” appraisal continues to evolve.

 

While I will always strive to procure a substantial amount of relevant data, a sound approach also puts significant emphasis on how a subject property fits into the ever-shifting narrative of the market, i.e., the story.

 

Since market value is ultimately an appraiser’s opinion, it is particularly important that a commercial appraisal thoroughly explain those opinions with extensive narrative support. I believe this approach adds the most value to clients and other intended users of commercial appraisal reports, and authorizes appraisers to develop value opinions, even – or especially – when faced with sparse and/or disparate data, as is often the case in the realm of commercial real estate appraisal.

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Ultimately, while they are professional opinions, it is important to remember that appraisals are just that – opinions. And like any other opinion – or building – they are only as good as the foundations upon which they are built.