This article explains how local economic conditions influence the pricing of a property and discusses different valuation methods.
Evaluating property in a declining market
Broker price opinions (BPOs) rely on various static factors, like the type, size, components, and age of a property, the quality of its amenities, and its current rental income and operating expenses.
In times of a recessionary environment, demographics in the location of a property are not static, as they are altered. This causes a property’s market value — and in turn a BPO for the property — to change rapidly over several months.
For example, during times when home values are increasing quickly — most recently during 2021 — BPO valuations tend to fall behind. As a result, an evaluation based on sales data from comparable properties reflects yesterday’s property sales rather than the present market value, which is higher than it was even a few weeks earlier.
By the end of the decade leading into 2022, the pricing trends real estate agents came to expect and promote began to reverse course. California home prices rapidly declined following their mid-2022 peak.
When prices take a dive, brokers — who embraced the rising market of prior years of economic recovery — need to pivot from past approaches rendering services and adjust to the market reversal in pricing.
Understandably, the wisdom of the crowd approach to valuing property embraced as inherent in a comparable market analysis causes a property’s price to shift constantly. Thus, a broker’s knowledge of economic forces currently working their magic is crucial to achieving a more accurate BPO.
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The damage of high BPOs in a declining price environment
Agents active in sales are kept aware of shifts in pricing by their constant exposure to pending sales of MLS inventory. The more diligent among them with peripheral vision consider general market conditions which induce the shifts in pricing. Influential market conditions include:
- home sales volume;
- inventory available for sale;
- mortgage rates; and
- homebuyer purchasing power.
But it’s easy to fall behind.
Thus, in a rising market dependent on mortgage financing, under-valued BPOs tend to cause possibly over-priced homes to fail to close escrow, a fact well-known to real estate agents and brokers practicing at any point in the decade ending in mid-2022.
However, over-valued BPOs running with the comparable market pricing trend do cause financial harm to buyers acquiring property in the last years of a recovery cycle, as well as the concurrent origination of government guaranteed mortgages. Buyers and lenders are quickly saddled with negative equity property in the immediately following years of declining prices — a recessionary environment.
Experienced by a debilitating third of California’s owner-occupant population in the first years after the 2008 Millennium Boom, negative equity is universally feared by homeowners, lenders and policymakers alike. Consistent with this awareness, negative equity is often blamed — not erroneous creditworthiness reporting or low-to-no down payment housing policies — as the primary cause for the rise in foreclosures that invariably precipitate from busts in real estate pricing. While encouraged by government homeownership policy, negative equity typically is the result of the price paid by FOMO buyers and the fervor of brokerage office to keep sales volume rising at ever increasing prices… until they don’t.
The last time prices declined over a sustained period — a recession by definition — was during the post-Millennium Boom crash, concentrated during 2007-2009, often called the Great Recession. Until 2010, appraisers were not yet intended to be shielded from lender pricing pressures by appraisal management companies (AMCs). Thus, they worked more closely with financially invested parties (e.g. lenders and brokers) to help achieve greater production of mortgage origination and fee levels with BPOs matching the price agreed to by the buyers.
In 2007, Fannie Mae issued directives to appraisers on how to handle a declining market. While AMCs are now said to handle much of the oversight addressed in the notice, the advice remains true for both appraisers and brokers evaluating properties. For example, during a declining market, Fannie Mae suggests evaluation opinions include:
- an objective assessment of the market direction — the trend in prices — in the neighborhood within which the subject property is located, considering factors like:
- recent price changes;
- average days-on-market of for-sale inventory; and
- the supply in the inventory of homes for sale; and
- adjust pricing from recent sales which include excessive seller concessions, i.e., absorbing expenses the buyer normally incurs in mortgage funded closings, as those home prices are higher than their actual FMV due to kickbacks to the buyer’s account.
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The term “fair market value” has meaning
Fair market value (FMV) is the price agreed to by a buyer and seller, who are knowledgeable of relevant facts, for the purchase of a parcel of real estate for sale on the open market. Of course, the word knowledgeable is the keystone holding this definition together.
A broker’s BPO is their best estimate of the property’s FMV at the moment the BPO is prepared. Again, the BPO is all about the broker’s knowledge about pricing in the local economy.
To arrive at the FMV, the broker initially uses one of three approaches:
- The market comparison approach, also known as the sales comparison approach, and commonly known as a comparable market analysis (CMA) for evaluation of a property;
- The cost approach, an evaluation derived under the replacement and reproduction method; and
- The income approach, an evaluation derived under the gross rent multiplier or capitalization of net operating income (NOI) method.
The market comparison approach is the most commonly used approach to establish the FMV value of all types of real estate.
Applying the market comparison approach, the broker looks at the current selling prices of similar properties to help establish the comparable value of the property being evaluated. This refers to the price like-type property was actually sold for — not the propitious price sellers ask when listing a property.
Dollar adjustments are made for the value of any differences in the similar properties, such as location, obsolescence, lot size, amenities, and physical condition.
For example, consider a property owner’s neighbor who recently sold their residence for $745,000.
The neighbor’s house is of a similar age, size and condition as the owner’s house, except it has a patio improvement worth $15,000 and the owner’s does not. Adjusting for the difference in the improvements — the patio — between the owner’s and neighbor’s house establishes the value of the owner’s house at approximately $730,000.
To produce the most reliable BPO report, the broker gathers data on numerous comparable sales, frequently called comps.
The broker then compares the most similar properties against the subject property for their differences.
Sales information is most commonly obtained from the multiple listing service (MLS), but it is also obtained through tax records and title insurance companies.
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Calculating market value of properties: cost approach
Brokers setting value using the cost approach calculate the current construction cost to replace the improvements. From the replacement cost, brokers subtract their estimate of the accrued depreciation of the existing improvements due to accumulation of obsolescence and deterioration to establish the current depreciated replacement value of the improvements.
Added to the replacement cost of improvements is the value of the land as though vacant. Thus, the market value under the cost approach is the result of totaling the value of the lot plus the cost to replace the improvements minus a depreciation factor for structural and component obsolescence and physical deterioration.
The cost approach is best used when valuing new buildings and special or unique structures, even single purpose structures, such as churches, factories and theaters.
Further, a broker places more emphasis on the cost approach when recent sales data for comparable properties are not available or the property has no income.
Estimating the cost of improvements incurred today to construct the improvements as they exist on the property involves the calculation of direct and indirect costs.
Direct costs include labor and materials used to construct the improvements.
Indirect costs include expenditures other than labor and materials, including permits and other governmental fees, insurance, taxes, administrative costs, litigation. and financing charges.
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Calculating replacement cost
Replacement cost is the present cost to replace a structure with one having the functional equivalent of the structure evaluated, but constructed with modern materials and methods.
A related term is reproduction cost. The reproduction cost is the cost to rebuild a structure as close to the original as possible under existing ordinances and codes.
The estimated replacement cost of the existing improvements is determined using one of four methods:
- comparative-unit method. This estimates the cost in terms of dollars per square foot or per cubic foot based on known costs of similar structures, adjusted for physical differences.
- unit-in-place method. This estimates the unit costs for building components such as foundations, floors, walls, windows and roofs, as well as labor and overhead.
- quantity survey method. This is the most comprehensive and accurate method for estimating the cost of the labor and materials a general contractor might use to build an identical structure, such as lumber, concrete, walling, plumbing, electrical, roofing, and labor. The list goes on. You’ll notice the similarity to the unit-in-place method.
- index method. This method determines building costs by multiplying the original cost of the property by a percentage factor to adjust for current construction costs. It is most frequently used when updating historic costs or backdating current costs.
The method used is determined by who is intended to use the information.
After the broker estimates the replacement costs, the next step is to estimate and deduct depreciation. Depreciation reflects any value-related loss in the property due to use, decay and improvements that are now outdated.
There are three types of depreciation:
- Physical deterioration is the loss in the property’s value due to wear and tear. Physical deterioration is either curable or incurable. Examples include damage from termites or damage resulting from deferred maintenance and negligent care. Alternatively, the deterioration is incurable wear and tear on components. A water heater that is five years old has that much less useful life.
- Functional obsolescence is any loss in the property’s value due to outdated style or non-usable space. Examples include a one-car garage or an outdated kitchen, or a swimming pool in a market that does not absorb the cost, as discussed earlier.
- Economic obsolescence is the loss in property value due to changes in the property’s neighborhood. Economic obsolescence is external to the property. For example, a property’s value may decrease due to increased noise and traffic when a transportation route exists next to it.
Calculating market value of rental properties: the income approach
Under the income approach, an agent uses a property’s rental income to set its value.
Property evaluated using the income approach includes:
- apartments;
- offices;
- industrial buildings;
- commercial units; and
- other income-producing property.
There are two methods of calculating the property’s value under the income approach:
- the gross rent multiplier (GRM) method; and
- the capitalization method.
The GRM method uses the amount of total annual gross rents the subject property presently commands in the local market, as determined by a survey of similar properties. The GRM factor as the multiplier for the subject property is established by a buyer or BPO broker before multiplying the gross rents to set value. The GRM figure is determined by comparing the subject property to similar properties that recently sold.
Thus, the GRM is a buyer’s multiplication tool used to preliminarily arrive at an inarticulate value when considering whether to further investigate the subject property. The buyer multiplies the gross annual rent amount by a GRM multiplier appropriate for the classification of the subject property. For owners, sellers agents produce a GRM figure for marketing purposes, not for buying. To arrive at the seller’s GRM, they divide the seller’s asking price by the annual gross rent amount without further analysis.
As more instructive, the capitalization approach determines a property’s value based on the property’s verified or prospective Net Operating Income (NOI) — its future income and operating expenses. While the GRM method can use either monthly or annual income, the capitalization method is only calculated using annual income and operating expenses.
The first step to establish value using the capitalization approach is to determine the property’s effective gross income. A property’s effective gross income is its gross scheduled income minus a vacancy and collection factor.
Next, deduct operating expenses from the effective gross income to determine the property’s net operating income (NOI). [See RPI Form 352]
Operating expenses include such items as:
- property taxes;
- insurance;
- security;
- management fees;
- utilities; and
- maintenance.
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Some operating expenses are variable, such as utilities and maintenance. Others are fixed, such as property taxes and insurance premiums. Operating expenses also include reserves set aside for large expenses infrequently incurred, such as the replacement of the roof or short-lived components.
Recall that we’ve arrived at the property’s net operating income by deducting the operating expenses from the effective gross income.
The third step is to mathematically divide the property’s NOI by the appropriate capitalization rate (cap rate).
The cap rate is comprised of a prudent investor’s expected future annual real rate of return on monies invested, plus the rate of anticipated future consumer inflation and a risk premium for an ABC classification of the subject property, plus a rate of recovery of their invested funds allocated to the improvements, also called depreciation.
Thus, the fair market value of the property is determined by dividing the NOI by the cap rate. Here too, again, sellers agents reverse the process to divine a cap rate based on the seller’s asking price by dividing the property’s NOI by the asking price.
For example, consider a property with an NOI of $100,000 annually. A buyer applying a cap rate of 10% values the property under the income approach at $1,000,000.
Since the NOI is divided by a percentage figure, the resulting fair market valuation is always greater than the NOI, typically 8-to-12 times greater. For the purposes of valuing a property under the income approach, the property is viewed as being free of any monetary encumbrances.
However, the rate of interest paid on mortgages and the amount or terms of mortgage debt on a property do affect financial decisions for sellers and those buyers considering purchase-assist financing or the assumption of an existing mortgage. Otherwise, existing mortgages have no bearing on a property’s market value.
Stay tuned for Part 2 in next week’s newsletter, which will cover alternative valuation methods for BPOs. Subscribe to firsttuesday’s free weekly newsletter, Quilix.