One Step Further

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• An appraisal can quickly become outdated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


• As appropriate, reconciliation should discuss the likelihood the value might not be sustainable into the foreseeable future


• 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.


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.


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


Equilibrium Rent – what market rent should be for a subject property, assuming the market is at equilibrium (hypothetical)


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


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

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%


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


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%


• 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


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.


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

One Step Further

Documents

Transcript of One Step Further