One Step Further
Practical Implementation of Guide
Note 12
The Problem
• 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• An appraisal can quickly become outdated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 Solution – Guide Note 12
• 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
Concerns about Guide Note 12
• Predictions are not meaningful
• Risk of a lawsuit
• Clients will not like it
• More work with no additional
compensation
Real Estate Market Cycles
Market Peak
Contraction
Expansion
Equilibrium
Equilibrium
Recovery
Recession
Market Trough
Real Estate Market Cycles
• Capital markets
– Equity capital (investors)
– Debt capital (lenders)
• Fundamental markets
– Space users
Tools for Analyzing 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
Multiply by the overall capitalization rate
Feasibility net operating income per square foot or per unit
Add fixed expenses per square foot or per unit
Subtotal
Divide by (1 – variable expense ratio)
Feasibility effective gross income per square foot or per unit
Divide by (1 – frictional vacancy)
Feasibility rent per square foot or per unit
$100.00
x 0.085
$8.50
+ $1.50
$10.00
÷ 0.80
$12.50
÷ 0.92
$13.59
Tools for Analyzing Cycles
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)
Entrepreneurial incentive (Minimum necessary to justify new construction when the
market is at equilibrium)
Depreciation (excluding external obsolescence due to market conditions)
$700,000
$70,000
($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
Divide by rentable SF or units
Subject equilibrium rent estimate
$106,944
÷ 10,000 SF
$10.69/SF
Tools for Analyzing Cycles
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)
Mortgage interest rate (at sustainable rate)
Mortgage term in years
10%
5.00%
30
Ratio of income available for mortgage payments (at sustainable ratio)
25%
Analysis of Affordable Median Home Price
Median household income in competitive market
Ratio available for mortgage payments
Annual income available for mortgage payments
$67,750
25%
$16,937.50
÷ 12 months
Monthly income available for mortgage payments
Monthly loan constant (by financial calculator or spreadsheet)
Affordable mortgage amount
Mortgage ratio (loan-to-value ratio)
$1,411.46
÷ 0.0053682
$262,929
÷ 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
Ratio available for rent
Annual income available for rent
$52,500
25%
$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
130
120
110
100
90
80
Affordability Index
16-Yr Average
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
70
1997
← Less Affordable | More Affordable →
Affordability Index - Midvale Apartment Rents
Tools for Analyzing Cycles
Retail Affordability Analysis
Gross rent indicated by comparables
Affordability rent ratio for subject type space
$30.00
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
Affordability rent ratio for subject type space
Indicated affordability rent for subject
$250.00
7.0%
$17.50
Tools for Analyzing Cycles
Year
Market Area for Class A Apartments
Rental Rate per
Square 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
Forecast
+5 Years
Current
Current and forecasted demand
(occupied sq. ft.)
Forecast
+10 Years
1,377,000
1,593,000
1,791,000
÷ 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
76.5%
88.5%
-*
Adjustment for frictional vacancy (10%)
Current and forecasted occupancy rate
(demand ÷ supply)
* New competition is left at "0" for the initial look at the market, and then adjusted in the next study phase, if
warranted.
Determining Current Market Stage
Market Rent
(For New Const)
Market
Vacancy
Construction
Volume
Development
Profit
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
Reporting Conclusions
Contraction
Expansion
Equilibrium
Equilibrium
Recession
Midvale
Market
MidvaleOffice
Office
Market
Recovery
Reporting Conclusions
Expansion
Recovery
Contraction
Recession
Analyzing Capital Markets
• 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
Conclusions
One step further called for by Guide Note 12
means:
• Appraisal becomes more valuable tool
• Future of appraisal profession is brighter