Why this article is important: Conducting an analysis of residential or commercial market conditions is one step of the process to conducting a broker price opinion (BPO). Learn how a market condition report is drafted and included in a price analysis.
The broker’s BPO duty to inform
It is never an appraiser’s role to project or forecast what home prices will be in the future. Thus, the role of a BPO for an evaluation is merely to reflect the fair market value (FMV) of the subject property on the date the BPO is issued.
Even when the broker preparing a BPO is aware a bubble is forming, their job isn’t to report what they believe prices might be, say, one year from now. Their BPO states what they believe the value of the property in question is today.
However, as an agent with fiduciary duties, their BPO also needs to inform their client of any market distortions known to the agent that signal property prices are out of control and unsustainable — or on a downward spiral. Observable trends in market conditions are material to a client’s decisions made based on a BPO evaluation because trends disclosed alert the client to consider likely forward expectations which might alter their decisions today.
A lesson from recent history
Agents preparing a BPO or representing a buyer who ignore price trends can end up over- or under-valuing the subject property — which can result in damaging consequences.
In the second half of the Millennium Boom, circa 2005, real estate participants viewed the housing market with a profound level of irrational exuberance. The commonly shared belief was that the only way housing prices go is up — indefinitely. Of course, history teaches otherwise.
When property prices are on an upward trend, real estate participants on both sides of a transaction can expect to earn (and spend) more money. The seller earns more by taking profits on a sale at a higher price. The buyer pays more to purchase a property. The mortgage lender lends more and charges more to take on greater risks. It is a time when money abundantly and more frequently circulates through the economy.
But when housing prices are on a downward trend, owners and sellers lose net worth as the real estate on their balance sheet is worth less than it was in the peak market of the business cycle just ended.
When property values are increasing quickly, BPO price valuations tend to lag behind the current sales pricing as buyers pile into the market. A comparable property analysis actually reflects yesterday’s pricing of homes sold rather than the present market value, a higher price than even a few weeks earlier.
Brokers preparing a BPO try to keep up with price movement by including pending sales or market conditions adjustments, but it’s easy to fall behind. Thus, under-valued reporting tends to cause the most immediate harm to buyers and sellers in a rising market, a fact well-known by real estate agents and brokers in sales at any point in the early 2010’s.
On the other hand, over-valued reporting causes less-immediate, but longer-lasting harm for buyers. A buyer who purchases a property mortgaged (read, leveraged) at a price higher than sales of nearby comparable properties may well find themselves underwater in the following recession. Once strapped with the negative equity solvency issue, they are unable to sell without losing money, ownership and possession.
Local job performance
For a forward look into their community’s economic future, prudent brokers representing owners and buyers of residential or commercial property look first to local job performance. Jobs are a strong indicator of local economic performance, which has a direct influence on property values.
The reason? Without jobs, wage earners have insufficient financial ability to make rent or mortgage payments, requiring unemployed or underemployed workers to relocate. The result is the unemployed move in with relatives or friends, negatively impacting the economics of the housing market. Further, employers as business operators need less space for fewer employees, unused equipment and reduced inventory.
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The trend in the number of individuals employed in a region sets the direction for:
- the volume of rentals and sales of property during the following 12-to-18 months; and
- the price movement of rents and prices paid for the use and occupancy of real estate, residential or commercial, during the following 24-to-30 months.
Job issues which affect the level of rents and prices paid for property include:
- the quantity and percentage of individuals employed locally;
- the type of jobs existing and evolving in the local market;
- the sustainability of existing jobs;
- education, training, skills of the workforce; and
- the level of wages paid.
Of all the factors affecting California real estate, employment has the most impact. This is true in good economic times, and times of economic recession and financial crisis. Without a paycheck for the household or earnings for a business operator, rent and mortgage payments for shelter as home or office cannot be paid.
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Residential market conditions
For both residential and commercial properties, the BPO includes an objective assessment of the market direction — the trend in prices — in the neighborhood within which the subject property is located. For a BPO, consider factors like:
- recent price changes;
- average days-on-market of for-sale and for-lease inventory; and
- the supply in the inventory of similar property for sale.
The BPO also needs to adjust pricing from recent sales which include excessive seller concessions, i.e., absorbing expenses the buyer normally incurs in mortgage-funded closings. The price of these properties is higher than their actual fair market value (FMV) due to kickbacks to the buyer’s account on closing. [HUD Mortgagee Letter 2007-11]
Further, a BPO prepared during a declining market needs to:
- include at least three completed sales of comparable size, quality and location;
- include at least two active listings or pending sales of comparable size, quality and location, which are “market tested,” meaning they have been listed for a typical amount of time for the neighborhood, ensuring these are not outliers;
- adjust active listings for the neighborhood’s sale-to-asking price ratio, substituting the contract price for pending homes whenever possible;
- evaluate the total days on market for each comparable home and that of the subject property, including an evaluation for each home that does not meet normal expectations for days-on-market; and
- include an absorption rate analysis to inform the BPO’s market condition conclusion. [HUD Mortgagee Letter 2009-09]
The equation for calculating the absorption rate is:
number of homes sold / total number of homes available
For example, over the course of a month there are 40 homes available for sale — inventory — in the selected neighborhood. Six of those homes are sold during the month. This equals an absorption rate of 0.15, or 15% (6 divided by 40). Related, the availability of homes for sale is a six-to-seven-month supply (a reciprocal analysis), both representing the monthly sales rate.
A typical absorption rate varies by location, and an experienced broker knows what sort of absorption rate is standard for a given neighborhood. Generally, an absorption rate of around 20%, a 5-month supply at the current sales rate of property available for sale, is considered a balanced market.
The lower the absorption rate, the tighter the inventory, and the more the market favors seller pricing and terms, as in an accelerating market. When the absorption rate is higher than 25% monthly, say a 4-month supply for sale or lower, this means homes are likely selling quickly, favoring sellers. When homes trend to a longer period on the market, sales conditions are indicative of a declining market — unless asking prices are dropped to allow buyers to return.
Commercial market conditions
The commercial market is more complex. Users of commercial property, investors and tenants, expect any valuation to include a thorough analysis of local market conditions.
Along with comparable sales and leases, the BPO for commercial property reviews local statistics on like-type property, including:
- absorption rates, on both for-sale and for-lease inventories;
- vacancy rates;
- rents;
- construction activity; and
- job levels.
This is true for properties evaluated using any of the valuation approaches (cost method, income method, gross rent multiplier (GRM) and replacement method).
For example, consider two office units located in the same neighborhood, of similar square footage and with similar features and amenities. However, one is located in an office building with an average 15% vacancy rate, and the other is in a building with a 5% vacancy rate.
The unit in the building with the higher vacancy rate commands a lower price than the unit in the building with a lower 5% vacancy rate. Some conditions not patent on the property — behavior of management, ownership, pricing, adjacent properties, etc. – may be factors influencing occupancy.
While no formula includes the effect of local economics in an evaluation, their influence is reflected in the valuation set in the BPO— and the price agreed to by the buyer, tenant or owner.
Further, consider a retail parcel for sale located in a neighborhood with a low vacancy rate of 4%. Absorption rates are also rather high at 40% monthly, an eight-week supply. Asking rents sought by owners increased at a steady pace over the past 12 months.
The broker uses the income method — specifically, the capitalization (not a GRM figure) method — to determine the property’s value. The broker includes the scheduled annual gross rents the subject property most likely commands in the local market, as determined by a survey of similar properties that recently sold.
However, the broker knows a large, Class A retail development is currently under construction in the same neighborhood. When this development is completed, the monthly absorption rate of space for rent is likely to decline and vacancy numbers increase in existing properties, particularly older class B or C parcels — like the subject property.
Thus, the astute broker adjusts their BPO by anticipating the probability of:
- a higher vacancy rate for setting rental income; and
- rent increases limited to maintaining the pace of the consumer inflation component in the capitalization rate appropriate for the property.
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Cap rate, trailing or forward NOI, pricing
The capitalization (cap) rate is the annual rate of return — a present-value (PV) yield — represented by, or applied to, the net operating income (NOI) generated by the subject income property. Thus, the cap rate for a property is produced differently and used for different purposes by seller brokers and buyer brokers.
For example, a buyer agent assists their client to establish a price for an income property the buyer is considering for acquisition.
To proscribe a price their buyer may consider for an offer, the buyer agent prepares an operating data sheet (APOD) on the subject property. The rents and expenses are initially based on data the seller agent provides as experienced by the property owner over the previous 12 months. On analysis of the operating data, the buyer broker determines the trailing net operating income (NOI) for the property.
Based on the NOI worked up, the buyer broker now selects a capitalization rate suitable for the particular property, and sufficient to make the investment worthwhile. Using the capitalization rate selected and the trailing NOI for the property, the buyer broker calculates the price for consideration in an offer. The formula used to set the price is: NOI / cap rate = purchase price.
On the other hand, the seller broker marketing the same income property may or may not be using the same objective trailing data for a NOI they use to market the property. The seller broker’s marketing approach may instead use forward data for the NOI, a subjective projection of rents and expenses to arrive at a capitalization rate for the property.
Either way, the seller broker uses a different formula for a different purpose than the buyer broker: NOI / asking price = cap rate.
Here, the cap rate is the result of the forward projected NOI divided by the asking price to set the cap rate. The seller broker includes the cap rate they calculate based on the asking price in their marketing package for the property.
In contrast, a buyer broker uses the NOI to establish a price for negotiations to acquire the property. However, the buyer agent is not limited to using only the objective trailing data garnered from the previous 12 months of operations for arriving at a price the buyer might consider for an offer.
The buyer broker often prepares a subjective forward projection of the property’s income and expenses to produce an NOI for valuing the property. This forward NOI projection is based on the buyer agent’s knowledge of rent and expense trends for similar properties.
Thus, the buyer-client is given an alternative approach to pricing based on a forward projection.
Editor’s note — The cap rate for pricing real estate is the reciprocal of the price-to-earnings (P/E) ratio for stocks. The P/E ratio is calculated using the formula: price / earnings-per-share. For example, the trailing P/E ratio for one stock index in Q3 2025 is 27.9, equivalent to a cap rate of just 3.6% (1 / 27.9) based on the prior 12 months of earnings. The P/E ratio for a stock is equivalent to the net income multiplier (NIM) as a ratio for the asking price of an income producing property.
Again, the seller broker determines the cap rate for marketing an income property by dividing the property’s NOI by the asking price for the property.
For example, consider a property with an annual NOI of $75,000. The seller’s asking price for marketing the property for sale is $1.3 million. The property’s cap rate is 5.8% (75,000 / 1,300,000). The reciprocal price-to-earnings ratio (P/E) in stock market lingo is a NIM real estate multiplier figure of 17.3 (1,300,000 / 75,000).
In complete contrast, buyers — and brokers preparing a BPO valuation — set the cap rate for evaluating a property based on the NOI they expect from the property’s likely future economic performance, whether that is trailing NOI data or numbers worked up for a forward projection NOI.
For BPO consideration, the cap rate set by prices paid by buyers of comparable property is most relevant. Often as an alternative, the client seeks a valuation based on rent and expenses currently experienced by comparable properties.
Further, each separate parcel of real estate considered for acquisition is given its own cap rate, as we explain.
A cap rate appropriate for pricing a property
A cap rate formulated by a prudent buyer to determine a property’s value for acquisition is comprised of expected future annual returns for:
- a real rate of return on monies invested, say 3% or 4%, and patterned solely on the 10-year Treasury Note rate as free of any risk of loss and management;
- a rate of consumer inflation anticipated, say 2% or 3% since income property is a 30-year outlook, not 10 years;
- a rate of recovery of invested funds allocated to improvements, commonly called depreciation, of say 2% to 3.5%, dependent on the aging of the property; and
- a risk premium rate appropriate for the ABC classification of the subject property, say 2% to 6%.
For example, when the future trend for long-term interest rates is rising — except for periodic recessions — higher cap rates may be needed to ensure yields remain sufficient for future expectations from an investment.
Thus, the price of real estate generally is slower to increase during the decades of rising long-term interest rates, such as took place between 1953 and 1983. In contrast, during the past decades of declining interest rates (1983 to 2012), investors relied primarily on asset inflation to generate earnings taken as profit on a resale or refinance rather than on annual NOI for earnings.
As the general trend for interest rates continues to rise, owners for some three decades after 2012 need to rely on earnings from the net rent generated from operations (the NOI), as took place in the 1960s and 1970s.
Thus, a rise in long-term interest and cap rates translates into a corresponding drop in prices investors and homebuyers pay to acquire real estate, unless:
- the rise in long-term rates is offset by a concurrent equal rise in rents — which is unlikely; and
- local annual rent increases — an appreciation factor — are equal to or greater than the level of consumer inflation permitted by the Federal Reserve Bank.
Investors also need to weigh the risk of other property owners defaulting on mortgages in the future or rents dropping on nearby properties. These conditions tend to drag down the value they might prudently pay to acquire a property.
Without a higher cap rate set to weather into the 2030s, ARM-mortgaged commercial property owners will be stressed to cover needed maintenance and component replacements to remain competitive. Thus, investors need to consider higher cap rates when pricing property for acquisition in anticipation of waning profits due to higher trending rates of return and rising mortgage rates.
Conversely, lower cap rates become acceptable to investors when:
- vacancies are low;
- NOI growth is likely to equal or exceed consumer inflation; and
- greater profits on resale are anticipated.
But these results need a forward economic environment of downward-trending long-term interest rates. When long-term rates decline continuously — as took place between 1982 and 2012 — the pricing of real estate tends to rise rapidly, unrestricted by the rate of consumer inflation as are rents.
In each business cycle of price movements, it takes 9-12 months for the impact of a change in the direction of 10-year T-note and FRM rates to trigger a change in pricing. Of course, the direction of prices depends on whether rates are declining or rising. As FRM mortgage rates rise, sales volume tends to decrease. The reverse is also true: as FRM mortgage rates decline, sales volume begins to increase.
Consider also that after sales volume decreases for 9-12 months, only then do prices begin their decline. The delay in prices to drop to match buyer demand and ability to pay is due to the seller sticky price syndrome, present only when prices are falling.
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