Property Valuation In An Upward Trending Market

PROPERTY VALUATION IN AN UPWARD TRENDING MARKET

When comps are scarce, use these strategies to determine accurate values.

by Frank Desloge & Alex Samsonov

In an upward trending market driven by rapidly changing supply and demand dynamics, comparable sales (comps) that reflect the current market may be lacking. How does one arrive at a reasonable property valuation in such a situation?

As a starting point, if selected comps do not support pricing, it is time to take a step back and question whether pricing and value are in alignment. Price reflects the amount asked, offered, or paid for real property, and may or may not reflect value (The Dictionary of Real Estate Appraisal, 6th ed., Appraisal Institute). If pricing always reflected value, there would be no need to go through the valuation exercise, and valuation professionals would be out of business. Here are some techniques for estimating value when comparable sales are scarce.

PRIORITIZE RECENT COMPARABLE SALES DATA

In an ideal world, when performing sales comparisons, one would be able to select comps that have been sold recently and are similar in physical and location characteristics. Keep in mind, the word “recent” is a relative term because one can source comps from three to six months, or longer, before the date of valuation, depending on the transaction velocity in a submarket or the uniqueness of the property.

If such comps aren’t readily available, one option would be to expand the search criteria for comparable sales to include older, but highly similar, comparable sales. An adjustment on market conditions could then be applied to the older comps by examining pricing changes in the overall market, ideally through repeat sales or a repeat sales index. Changes in submarket conditions are highly correlated with changes in overall market conditions, even if the repeat sales or index might not be specific to a submarket.

However, in an upward trending market, more weight should be given to recent comparable sales. That approach better reflects rising prices for comparable properties, even if it means expanding the geographical scope of the search area. More emphasis should be placed on current or relatively recent comps as they can be more relevant than a property located closer to the one being valued.

PHYSICAL CHARACTERISTICS MATCH

A different option appraisers commonly use to round out comps when performing a valuation analysis with limited comparable sales is a physical characteristics match. In this approach, listed properties that match the physical characteristics of the subject property in that submarket are considered. Typically, a downward adjustment of 10%-15% is given from the list price to account for the comparable being listed above market value; however, in an upward trending market, this adjustment can be minimized.

It is important to note that listed comps are not as reliable as sold comps and should be used as a data reference point only when sold comps are limited or not available. This can also be said of properties that were listed for a period but never sold. If a property is similar to the subject property in location, physical characteristics, and unit mix (among other factors), the old list price of this comp may be used to bracket the comparable sales of the subject property relative to a superior comp.

LOCATION CHARACTERISTICS MATCH

Another option that can be useful in the sales comparison approach is paired sales analysis. With this technique, you might select recent sales similar in location characteristics, but less than ideal in terms of physical characteristics. Adjustments for physical differences could be estimated through the analysis of paired sales.

Paired sales analysis is premised on the idea that when two properties are equivalent in all respects but one, the value of a single difference can be measured by the difference in price between the two properties (The Appraisal of Real Estate, 15th ed., Appraisal Institute, 2020). Such an analysis is a challenging and time-consuming pursuit, but with diligence and effort, it can be done effectively.

INCOME-PRODUCING INVESTMENT PROPERTIES

If the subject property is an income-producing investment property, the income approach may be the most appropriate method to estimate value. Income-producing real estate is typically purchased as an investment. From an investor’s point of view, earnings and cash flow are the critical elements affecting property value.

A basic investment premise holds that with all else being equal, the higher the earning potential or cash flow of an income property, the higher the value. An investor purchasing income-producing property is essentially trading present dollars for the expectation of receiving future dollars.

The income capitalization approach to value consists of methods, techniques, and mathematical procedures that valuation professionals use to analyze a property’s capacity to generate benefits (i.e., usually the monetary benefits of periodic income and reversion from a future sale) and convert these benefits into an indication of present value (Appraisal Institute, 2020).

The most widely used income approach method is called direct capitalization. Using this method, the valuation profession converts a single year’s income expectancy into an estimate of value by dividing the projected net operating income estimate by an appropriate capitalization rate (or cap rate). Direct capitalization is most applicable for properties operating on a stabilized basis or being valued under the assumption they are stabilized. The approach can also be used for forward projections of value if rents are expected to increase, or to value a new construction income property project (Appraisal Institute, 2020).

The direct capitalization method can run into issues, however, if the capitalization rate is unknown due to a lack of comparable sales or reliable information on those sales. For example, if one reviews recent market sales of similar income properties to determine the cap rate, but does not account for certain listings that have minimized the operating expenses the property is incurring, then it would problematically increase the net operating income and cap rate.

Since owners and listing agents generally want to increase the marketability of their properties, they are prone to exaggerate the cash flow capabilities of their assets, thereby increasing the cap rate at which that property was sold. This means one’s valuation analysis may be skewed at these higher cap rates if one were to just reference those listings without assuming the cap rates have been inflated. One way to combat this inflation is to assume the operating expense ratio as a constant. Here’s an example: A newly constructed four-plex may have operating expenses of 25%, whereas a more dated four-plex may have operating expenses of 30%. This can also be projected onto multifamily buildings—a 30% expense ratio may be used for new construction, and a 35%-40% expense ratio may be used for a more dated property. By assuming the same expense ratio for all comparable sales, you can nullify the variability of the expense ratios being used to determine cap rates and reach a more accurate submarket cap rate.

Once a direct capitalization rate is determined for that submarket or geographical area, it can be applied to the subject property, or adjusted accordingly in an upward trending market without a surplus of comparable sales. Since income properties are valued for their cash flow potential, an income approach can be weighed more heavily than a sales comparison approach as a possible solution to limited sales comps.

Although it may be challenging in an upward trending market to value a property, there are many creative solutions available to compensate for a lack of comparable sales. Ultimately, one can use good judgment to weigh trade-offs for each technique to develop a reliable value estimate.

ABOUT THE AUTHOR

FRANK DESLOGE

Frank Desloge is a commercial real estate underwriter at Arixa Capital Advisors. His responsibilities include due diligence, underwriting, and valuation analysis. He has experience leading investment analysis, valuation, and acquisition/ disposition decision support for multifamily, retail, industrial, office, hotel, and other commercial real estate. He holds a CFA designation, as well as MBA and MSRE degrees from Cornell University.

ALEX SAMSONOV

Alex Samsonov is director of underwriting at Arixa Capital, where he has personally underwritten more than $1 billion of loan volume. He evaluates loan structure and credit risk, and he leverages his experience and technical expertise in property valuation, corporate structures, and title work to develop strategies with the Investment Committee to mitigate the risk of Arixa’s credit files.

Before joining Arixa Capital in 2014, Samsonov was a paralegal at a boutique law firm specializing in nursing home medical malpractice cases. He graduated UCLA with a bachelor’s degree in political science and holds a CA DRE salesperson license.