A Professional Courtesy of:
Mark T. Kenney, MAI, SRPA, MBA
American Valuation Group, Inc.
207 Abbey Lane
Lansdale, Pennsylvania 19446
5201 Ocean Avenue #2007
Wildwood, New Jersey 08260
Specializing in Real Estate Appraisal and Property Tax Consulting


In This Issue:

  • Key Valuation Principles
  • Capital Markets and Real Estate
  • Appraisal Review
  • Hotel Valuation

  • Key Valuation Principles

    The real estate valuation body of knowledge includes several principles that effectively form the foundation of appraisal theory. Valuation professionals are well trained to understand and apply such principles, including those described below.

    The agents of production in real estate are land, labor, capital and entrepreneurial coordination. Each agent is essential to the development of real estate, and each must be accorded an adequate return in order for the investment in the project to be financially feasible. Returns take the form of annual net income/cash flow, as well as incremental property value. Entrepreneurial coordination has the last claim on returns from investment. Nonetheless, a return on this element is crucial to successful development.

    Supply and demand have as profound an effect on real estate as on other goods and services. Property values typically vary inversely with supply (i.e., greater supply equates to lower values, all other factors being equal). Values typically vary directly with changes in demand. Many real estate analysts give inordinate consideration to changes in supply as predictors of price/value. However, contractions in demand can obviously place downward pressure on properties in which equilibrium had recently existed. This occurred in 2001 as sharp declines in demand from technology firms negatively affected the prices of office properties, despite relative stasis in supply.

    Competition is a subprinciple of supply and demand. Buyers, sellers, lessors and lessees actively compete for real estate. Developers also compete for development opportunities.

    In all cases, profit tends to breed competition, and excess profit breeds ruinous competition.

    The principle of substitution is the most important element in real estate valuation. Simply put, a buyer will not pay an amount greater than the cost of acquiring or building an equally desirable substitute property. This principle underlies all three approaches to value (i.e., income capitalization, sales comparison and cost). It also extends to lessees who will not pay a lease rate greater than that for otherwise similar space. In certain situations, however, buyers and lessees may choose to pay more for a property they consider to have unique characteristics relative to their needs.

    The principles of balance, contribution, surplus productivity and conformity are interrelated. Balance is the principle that "value is created and sustained when contrasting, opposing, or interacting elements are in a state of equilibrium" (The Appraisal of Real Estate, 13th edition). Balance dictates the need for optimization of land and improvements in order to achieve optimal value/returns. As an example, the amount of onsite parking for an office building should be in balance with the amount of square footage of leasable area. A surplus or deficiency of parking would thus be out of balance, as the term is defined above.

    Contribution is generally applied to individual components of real estate. Specifically, the value of an individual component is measured by its contribution, if any, to the value of the whole property. The provision of exotic hardwood flooring throughout the common areas of an office building may not contribute proportionately to the value of the property.

    The laws of increasing/decreasing returns are interwoven with the principle of contribution, stating that "additional expenditures beyond a certain point will/will not yield a return commensurate with the additional investment" (ibid).

    Surplus productivity is "the net income remaining after the costs of the other agents of production have been paid" (ibid). This principle underlies highest and best use analyses, which attribute surplus net income (that remaining after the return on improvements) to land. This residual technique is often used by appraisers, particularly in the valuation of proposed developments.

    The principle of conformity is that "real property value is created and sustained when the characteristics of a property conform to the demands of its market" (ibid).

    The principle of externalities states that "factors external to a property can have either a positive or negative effect on its value" (ibid). Such externalities may be either physical attributes or economic forces. The proximity of linkages and supportive facilities is an example of the former. The availability of capital is an example of the latter.

    Finally, the principle of consistent use dictates that land may not be valued for one use while improvements are valued for another use. An example may be a single-family residence on a site zoned for commercial usage. One cannot properly value the site for commercial usage and the improvements for residential use. Nonetheless, the improvements may add value as an interim use to the site as if vacant. In all cases, the site is valued first. The value, if any, of the improvements is measured by their contribution to the value of the site, as vacant.

    The foregoing principles are not abstract concepts, but rather serve to underpin all valuations of real estate.

    Capital Markets and Real Estate

    Income-producing real estate is obviously capital intensive, given the magnitude of investment. Therefore, the availability and cost of capital clearly has broad implications in the pricing of such property.

    Capital is derived from both debt and equity sources. These sources may be further divided into public markets and private markets.

    Public market real estate debt has heretofore taken the form of securitization. From the early 1990s through 2007, investment banks provided long-term debt through commercial mortgage-backed securities and collateralized debt obligations. However, concerns over asset pricing and underwriting brought a virtual halt to this financing vehicle. Equity from public markets comes from publicly traded real estate investment trusts (REITs) and real estate operating companies.

    Private debt sources include commercial banks, thrifts and life insurance companies. Commercial banks provide both interim and construction financing, as well as term (intermediate and long-term) loans. Life insurance companies typically are sources of long-term financing.

    Private equity comes from individual, institutional, international and corporate investors. In addition, they come from private REITs and pension funds (generally through their advisers).

    In terms of pricing and returns, public debt and equity compete with other non-real estate investments. Investors in public real estate capital markets enjoy the benefits of liquidity.

    The impact of the cost of capital is reflected in all three approaches to value. The cost approach includes interim interest during presumed construction and lease-up as an indirect ("soft") cost. The interest rate for such debt is most likely variable and thus subject to volatility.

    Capital costs also affect the price and value of properties used as comparable sales in the sales comparison approach. Similarly, such costs directly affect the velocity of sales.

    The impact of capital costs in the income capitalization approach is manifest in both the overall capitalization rate and the yield (discount) rate. Both tend to vary directly with such costs, although other factors influence both rates as well.

    Mortgage rates are generally tied to the rates of other credit instruments, such as Treasury notes and bills, as well as LIBOR (London Interbank Offered Rate). Other mortgage terms are just as important as rate and include the loan-to-value ratio, term to maturity and debt coverage ratio. Mortgage and equity returns vary directly with leverage (i.e., higher leverage requires higher returns because risk to both positions is greater).

    The relative relationship between the cost of debt and equity returns is significant. The use of debt is appropriate when the mortgage constant is less than the required equity capitalization (dividend) rate. Such a relationship results in positive leverage. The reverse (negative leverage) indicates that the use of debt capital is disadvantageous.

    From the foregoing it should be clear that the cost and availability of debt and equity have important consequences for real estate pricing and value. During periods of expensive and scarce capital, real estate values decline.

    Appraisal Review

    The Uniform Standards of Professional Appraisal Practice (USPAP) defines appraisal review as "the act or process of developing and communicating an opinion about the quality of another appraiser's work that was performed as part of an appraisal, appraisal review, or appraisal consulting assignment.

    Professional appraisers are frequently engaged by a variety of client types to perform appraisal reviews for a variety of purposes. Examples of users include lenders, loan servicers and litigating attorneys. Lenders utilize reviews as a part of the overall underwriting process. Such reviews are prepared by both staff appraisers and third-party appraisers. Loan servicers are responsible for default resolution and foreclosure of properties. Because asset value is obviously of crucial importance, reviewers are thus engaged to assist in obtaining accurate valuations. Attorneys frequently hire reviewers as both consulting experts and testifying experts in the course of litigation in which real estate value is an issue.

    As with appraisals, appraisal reviews involve a specified scope of work, which might include the following (adapted from The Appraisal of Real Estate, 13th edition):

    • Verifying that the problem statement is complete, accurate and appropriate for the intended user and use.
    • Determining if the highest and best use is properly analyzed and supported.
    • Verifying that mathematical calculations are accurate.
    • Determining if the appraiser's methodology is appropriate.
    • Verifying that the data used are appropriate, adequate and internally consistent.
    • Determining if the appraisal was completed in accordance with the client's guidelines, appraisal policy requirements, regulatory requirements and the USPAP.
    • Inspecting the exteriors of comparable properties and, when appropriate, the interiors.
    • Performing a limited or full verification of market data and field inspections of comparable properties and areas of market influence.
    • Performing independent research to gather additional market data.
    • Verifying results obtained with electronic spreadsheet software or software used in the lease-by-lease analysis.
    The determination of the scope of the review involves interaction between the appraiser and the client. The review may be a desk review (without inspection) or a field review (with inspection). The reviewer may also be asked to opine upon the reasonableness of the conclusions in the appraisal. If the appraiser believes that the conclusions are unreasonable, he or she may be asked to provide his or her own opinion of value. The reviewer then is presumed to be providing an appraisal and must therefore abide by the appropriate portions of the USPAP dealing with the performance of an appraisal and the reporting of the results of the appraisal.

    Hotel Valuation

    The characteristics of hotels are different from those of other property types. The valuation of hospitality properties requires specialized expertise on the part of the professional valuer.

    Hotels - a term intended to include motels - may be generally categorized as follows:

    • full-service hotels;
    • limited-service hotels;
    • extended-stay hotels;
    • convention hotels;
    • resort hotels; and
    • all-suite hotels.
    Such properties may also be defined by their locations (e.g., highways, center cities, business parks) and their predominant clientele (e.g., business, group, convention, tourist and leisure).

    Unlike other types of property, a standard set of revenue and expense accounts is widely used. This arranges revenues and expenses by department to the extent possible. For example, revenue and expense from rooms is a department, as are food and beverage, and telephone revenues and expenses.

    It is widely accepted that the revenue from hotels constitutes more than that generated by the real estate. Hotels are best viewed as business enterprises that include real estate. The methodology for quantifying non-real estate income and value, particularly that which is intangible, is a source of considerable controversy.

    Under the USPAP (Uniform Standards of Professional Appraisal Practice), appraisers are required to identify and quantify value components of their value opinions that are not attributable to real estate. Such components may include furniture, fixtures and equipment, inventory and working capital.

    The existence or lack of a major franchise agreement is often significant. Franchisors offer franchisees a reservation system, marketing and brand-name recognition. Obviously, some franchises are more valuable than others. As a broad generalization, franchise hotels have higher revenues per room and higher occupancy rates. In return for franchise agreements, franchisors require minimum levels of property maintenance. Franchise hotels are periodically inspected by franchisors for compliance with these minimum standards. If such standards are not maintained, the properties risk losing the franchise and the benefits that accrue therefrom.

    Next Issue:

  • Discounted cash flow analysis
  • Valuation in distressed markets
  • Entrepreneurial profit
  • Indirect costs

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