Mr. President, running the Country is very different from running the Trump organization because when you made poor decisions only you or your investors suffered the consequences.  But, when, as POTUS you make poor decisions they can, directly have negative impact on the populations of entire Countries.

You are probably not the “genius” of a business man you think you are. This is because of your “listening to your gut” instead of studying and listening to advisors. Unquestionably, you are a supremely persuasive and successful promoter of your own interests but managing a Country requires a “thinker” not a brazen Barnum like promoter.

When your Casinos went bankrupt the only ones to suffer the result of your folly were the lenders, junk bond holders and the people forced into unemployment.  But, those effects didn’t range far and wide. When you made losing investments in a major New York hotel and an airline, again the suffering was confined to a very few.  But, when you pull out of the Paris Climate Accord based on the flawed belief that climate change is a hoax denying the science behind climate change, your decision potentially impacts the entire world population now and in the future.  A decision like that mandates much more study and consultation with other world leaders than you gave it. There was no “showing” as to how that decision “made America Great Again” and seemed to be based on nothing more than a desire to reward the fossil fuel industry while maliciously trying to destroy any Obama legacy.

Pulling out of the Iran nuclear deal similarly not only impacts Iran but threatens the near term security of the region and possibly the security long term. You never disclosed the basis of your withdrawal other than to condemn it as a “bad deal”.  Why was it bad? And, why if it was so bad did other major countries so vigorously support the agreement. Was your rejection of the agreement based on just wanting to undo another Obama accomplishment? Please disclose which of your advisors convinced you that “pulling out” was good for the USA? And, tell us why engaging in a war of words with the leader of Iran is a good thing and more than just a diversion from your other failures.

Your reputation as a negotiator may be entirely contrived because you don’t exhibit the patience, preparation and style of a good negotiator.  Your penchant for name calling and denigrating others suggests that you are a negotiation bully.  Negotiating by “bullying” may get a deal occasionally but if the person on the other side is skilled you will walk away empty handed.

Why do you persist in continuing to attack the investigation of Russian interference in our elections as a “witch hunt” even after indictments and guilty pleas have resulted (even though so far nothing yet disclosed has pointed to any wrong doing by you)? Is it because you already know of things that, if they come out, would clearly point to your complicity? An innocent person, who has not been formally accused of wrongdoing would not go to such lengths to discredit an investigation. Your actions cry out GUILTY!.

Your zero tolerance policy was a clear blunder and looks like a knee jerk policy lacking a thorough prior study as to both probable effectiveness and possible unintended consequences.  Obviously, there was no PLAN in place before the policy was implemented. Despite the policy, most Americans are very decent, empathetic people who view the policy as contra to who Americans are.

You mistakenly announced that you had solved the nuclear crisis represented by North Korea only to later learn that you solved nothing.  Your announcement of success was designed by you to bolster your image. Your ego and self interest took over when a more measured announcement would have been appropriate.

There is nothing wrong with trying to engage other leaders in productive dialog even if those leaders are nasty dictators and thugs.  But, there is something very wrong with trusting them absent some act (not words) proving that trust is not misplaced. There is something very wrong with praising and trusting dictators while “blasting” allies and friends. Presidents just shouldn’t do that. Presidents who are statesmen would take up disagreements with other leaders through diplomatic channels rather than tweets and press comments If they really want to solve a perceived problem.

Playing the bully in the area of trade doesn’t stimulate cooperation from trading partners. Articulating a punch list of items needing to be improved through skilled trade negotiators is the way to accomplish the task. Threats of “pulling out” or imposing tariffs are just bullying strategies that will ultimately come back to hurt our economy. That fact has already been demonstrated by the harm done to certain U S producers. Promoting financial relief for certain sectors of the economy negatively impacted by your trade policies puts an unnecessary burden on taxpayers and could have been avoided by a coherent trade policy instead of knew jerk actions trying to pass as constructive policy.

Constantly attacking the media and calling every story you don’t like “FAKE NEWS” just demonstrates that you don’t know the difference between news reporting and the editorial page of a newspaper. The clear majority of print journalism scrumptiously vets news stories for accuracy before going to print and thus do not purposely print fake news. What appears on the editorial pages is intended to be opinion and is not, in any case, presented as NEWS. If your base believes your taunts, then they don’t understand either. Apparently, you never considered the unanticipated consequences of wrongly confronting the media on a constant basis.  You just provoke them into doing a better job of documenting your faults, mistakes, lies and dictator like reactions in ignoring or wishing to ignore rules of law

A President with a low regard for the truth would make a very poor witness on his own behalf in a court of law. Over 2,000 documented lies or distortions of the truth would convince any thinking jury that, as a witness, you were not believable.

You promised to drain the swamp but it is getting filled up with incompetent appointees who seem to toe the line of loyalty instead of providing what you really need – unadulterated, objective and truthful advice.

Keep it up and you will win the unchallenged title of the WORST PRESIDENT IN HISTORY.  That will be your legacy.

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President Donald Trump has touted his proposed tax bill as a benefit to all taxpayers, particularly the middle income class.  He has also unequivocally stated that his taxes will increase as a result of the new tax bill.


Taking the latter statement first, since Donald Trump has not released his tax returns there is no way of knowing if that claim is true or just more of his usual bluster.  But, based on his penchant for deviation from truth, why should the public believe him unless and until he releases his tax returns and proves the point. The simple answer is the public shouldn’t believe him.


What Donald Trump doesn’t tell the public is that one of the biggest gifts to large real estate owners (and small ones too) but excluding homeowners,  is the ability to depreciate the cost of their physical asset (the building but not the land) This is a “phantom” loss as no out of pocket cash is involved like in the case of real cash expenses and the amount of depreciation charged in a given year is a direct deduction from income in arriving at taxable income.


Depreciation is a myth in the vast majority of instances because it is very rare that, at the end of a building’s “useful life” (the number of years over which tax code allows for depreciation) the building is demolished. What is more common is that at the end of the “useful life” under the tax code or in reality a building is renovated and/or its use is changed or both and it goes on.  On the down side, when buildings are demolished because they have passed their usefulness, the value of the underlying land has often risen by a sufficient amount to offset any loss in value for the demolished improvements.


Depreciation is a gigantic gift to the real estate industry and serves to provide a chunk of tax free income to the property owner. One of the arguments in favor of depreciation was that it induced greater investment and created jobs.  That may have been true once but in an expanding and/or inflating economy, such as the economy today, it is probably not true. And, to make things worse it appears that the Senate version would shorten the depreciable life of improvements which will just increase the benefit to the real estate owners.


To argue that the economy needs the incentive of “quick write off” to stimulate investment (development) and employment doesn’t make sense at a time when the U S is at almost full employment.  As long as there is demand for the end product developers will build and would do so without the incentive of tax free cash from depreciation. However, if “stimulus” is the raison d’être for the depreciation allowance then it might be confined to only new construction not to be passed on to subsequent buyers.  An offset could be the allowance of a 100% write off, in the year incurred, for any tenant improvements and a depreciation allowance for the cost of major renovations or changes of use.


Depreciation of buildings is not like depletion allowances in the natural resource industries.  When oil is pumped out of the ground it is gone and the amount in the well is “depleted”.


There is nothing in the proposed tax bill that even hints at considering eliminating the bonanza of depreciation and, under his tax bill, Donald Trump’s income will still be greatly enhanced by the depreciation tax shelter he and his company receives. Eliminating charging depreciation in real estate as an income deduction in arriving at taxable income should be considered for elimination under the proposed code. The reason it is not proposed is most probably that, outside of the  special  interest groups, the subject is not on the public radar no is it likely to be on the radar of less affluent lawmakers.


It would be interesting to see a study as to the total amount of income tax collected on 100% of the net income before depreciation and the tax collected on the revenue after the deduction of depreciation. The amount would probably be more than enough to make some of the other eliminated tax deductions unnecessary.


Now to the first point, the proposed tax bill does not appear to be a huge WIN for the middle class.  In fact, for a large part of the middle class, it appears, they will pay more taxes. The elimination of medical cost deductions will hit the elderly very hard and will be negative for many real people who will have an increased problem trying to afford their medical bills, even after the more expensive insurance pays its part. The average homeowner could be disadvantaged by possible limitations on mortgage interest and property taxes. Meanwhile real estate developers and investors would potentially receive greater gifts than currently enjoyed. There are other problems but they are minor in terms of public impact assuming that the proposed elimination of State income and property taxes do not survive.


The elected officials should move cautiously and avoid quickly enacting legislation just to prove to the public that they did something that achieved a campaign promise. The elected officials, to protect the public, should insist that each provision of the new tax code does, on balance, accomplish a beneficial result and that all arguments in favor of the legislation are proven out by facts as opposed to rhetoric. As things now stand, the proposed tax bills do not appear to bring any major benefits to the middle income taxpayers that are commensurate with the benefits to the wealthy. The lawmakers they should be diligent in understanding all of the possible, unintended consequences of their legislation.

Posted in Property Developemnt, Property Ownership, Real Estate Economy, Real Estate Investment, Real Estate Lending, REITs, The Real Estate Economy | Leave a comment


When I wrote this several months ago the Trump tax bill had not been written or passed. But, now it is a fait accompli.  To my great surprise the Congress wrote a tax bill that rewarded the rich and particularly real estate owners. Instead of removing the depreciation provisions that provided big time tax benefits, which should have been revisited, the Congress actually increased the benefit. So, until the next round don’t worry about that aspect of the Trump effect. However, since Trump’s inauguration more has changed.

Real estate prices, particular homes, residential properties, industrials and office buildings have continued to rise in many markets.  This is good news and bad news. The rise in residential prices has hit many economic segments with serious affordability problems. Where this will end up no one really knows but in Cities like San Francisco the working class is literally forced out of the market and will have to live further and further from their employment.  At some point business dependent on support staffs will find their pool of potential employees to be far less than needed and will either be forced to raise salaries, provide housing subsidies or move out to lower cost areas where their staff’s can find affordable housing. In Cities like San Francisco,  rigid zoning and building codes raise the cost of construction and the lack of building sites is very limited making it difficult to produce affordable housing. This set of problems will hit many cities.

A danger point is approaching in the retail sector where competition from on-line merchants are eating into once healthy store sales.  Many retailers, like department stores (except apparently Macy’s) are struggling and may become dinosaurs. In the major cities traffic and unreliable public transit are inducing people to use on-line purchasing rather than going to the store.  This is not good for retail.

So far, interest rates have not made a material jump but that is probably temporary.  If and when interest rates rise there should be downward pressure on values. Further rising costs of doing business in major cities could cause cracks to appear in the rental markets as the number of willing and ready renters diminishes.

Add to the foregoing the possibility that Donald Trump’s trade policies could prove very disastrous for business in the U S..  This could result in lower demand for all types of real estate.  Sailing looks smooth but there are many potential bumps on the road. The problem is that when a major bump is hit it will be too late to run for the doors as it was in 2007 with the financial meltdown.

Commercial real estate prices seem to be inflating and rates of return appear to be at all time lows. Could this suggest that real estate is in a “bubble”?


There are two factors circling around that could spell a meltdown in real estate values in the not too far distant future. The first is what might be called the Trump Effect which should lead to an overhaul of the tax laws while the second is the probability that interest rates will rise..


THE TRUMP EFFECT: The brouhaha over Trump’s tax returns and the apparent agreement between Trump and Clinton that the tax laws need overhaul are one reason that tax code changes may be in the offing under a new administration.  But another reason is the fact that Donald Trump has probably not paid any significant federal income taxes for several years at least.  He has gamed the system and bragged about it with statements like “I love depreciation” coupled by remarks of surrogates that the ability to avoid paying taxes shows how “smart” he is. Every real estate professional knows that the tax laws are very favorable to real estate but, until now, the general public did not realize how really favorable they were. Until the campaign induced focus on the Trump tax returns the general public may have thought the tax laws were unfair but now they are convinced of it. This sets the stage for probable, strong public support for a major overhaul of the tax laws to remove that favorability and create a more balanced system. This not to say that Donald Trump did anything that was remotely illegal because he absolutely did not do anything that was against any law.  He used the convoluted tax codes to his advantage.  That’s all.


Most people without real estate experience don’t realize how the tax codes help  investment real estate owner and developers.  There are many ways but, most importantly the depreciation allowance and the tax deferred exchange provisions are major “tax shelters”.  Looking at depreciation first, real estate owners can deduct, from taxable income annually, over the “useful life” of the building only (land is theoretically not depreciable) an amount that will “recapture” 100% over that “useful life”.  Useful life for commercial buildings is generally codified as 39 years but there are methods for accelerating that recapture. Theoretically, this depreciation schedule simulates the gradual loss in value as a building deteriorates. However, the notion that buildings depreciate in value by 100% over 39 years due to deterioration is just not supported by the facts. The theory completely ignores that, over a 39 year period the odds are that a building will increase in value. Just in case that happens there is a recapture provision in the tax code that claws back any charged depreciation in excess of that actually incurred at the time of sale.


Now the tax deferred exchange comes into play.  A property owner can “postpone” any taxable gain by just exchanging the property for another one of like kind with a greater value.  Theoretically, the tax on the gain is deferred until the new property is sold and may be further postponed by another exchange. When the owner dies and leaves the property to heirs the property gets a “stepped up” basis and this avoids any capital gains tax on the asset.


The foregoing is an over simplification as the tax code is full of twists and turns.  For example, property repairs are deductible in the year incurred but if the extent of repair is considered as a renovation for tax purposes, the cost may be required to be “capitalized” (added to the cost basis and depreciated over time).


Most people only experience real estate ownership through their homes.  Homes may not be depreciated which is one major difference from investment property. Accordingly, depreciation write-offs have not been a popular focus. For the individual homeowner, the only tax benefit is the ability to deduct local real estate taxes (ad valorem taxes) and the ability to deduct mortgage interest (with some limitations).


There are transaction structures that greatly improve the ability to shelter income from taxes.  And, it can’t be overlooked that investor/developers only invest a small percentage of the cost of an asset as they borrow the lions share from lenders.  Thus, they depreciate the borrowed funds as well. That may be OK because they must repay the loan and pay the lender interest (also deductible) over the life of the loan.


To make tings more complicated there are “loss carry forward” provisions in the tax code that permit any loss (like Trumps almost $1 billion) to be carried forward for multiple years, to the extent they are not already charged. There is no basis for assuming that the loss carry forward provisions will remained unchanged in the next round of income tax legislation.


Years ago, syndicators tied up properties and sold them to investors who became limited partners in the property. Many of these transactions were so cleverly structured that no tax was incurred by the partnership with an excess “write off” available to the limited partners to apply to other otherwise taxable income for years to come. Many of these Master Limited Partnerships failed and the investors lost everything plus getting added tax problems. They were sold as “tax shelters” and were not always great investments.


INTEREST RATES:  It is not a matter of whether interest rates begin an upward climb.  It is only a matter of WHEN. When they do move upwards the spendable income from a property will diminish unless there is a corresponding rise in rents to offset interest cost.  However, rents in many urban areas are already at unaffordable and unsustainable levels particularly when one considers the potential cost of doing business add-on of an increase in the minimum wage.


CONCLUSION:  Donald Trump may think he knows more about our tax laws than anyone else and, thus is best equipped to fix them.  But, that is an unsubstantiated boast.  Real estate could be very vulnerable to a Trump Effect when the tax laws are redone as the overhaul will be designed to close all of the glaring loopholes which can only be a big problem for the very rich. Any material rise in interest rates should be expected to depress real estate values as such will increase the rates of return (capitalization rates) expected by investors unless there is a corresponding increase in rents to offset the effect of higher rates.  In many parts of the country, rents appear to be reaching unsustainable levels, particularly in multi-family residential, in view of economic change. Retail rents may come under pressure as retail stores face continuing heavy competition from alternative retailers selling on the internet without the need for a retail store (think Amazon) or big box retailers located outside the CBD (think Costco and Wal Mart). Escalating office rents in central business districts coupled with technological advances via computers may result in causing less need and demand for offices as tele-commuting (working from home via computer) increases. Accordingly, increasing rents is not necessarily something that can be depended on.  The bottom line is that there are reasons to worry about the current levels of value and price of investment real estate in the long term future.

Posted in Property Ownership, Real Estate Economy, Real Estate Appraisal, Real Estate Investment, REITs, The Real Estate Economy | Leave a comment


The Wall Street Journal issue of March 25, 2015 had an article describing the reduction of returns and plight facing private REITs (REITs that are not publicly traded).  This article prompted the question as to whether or not private REITs were or are a good idea  as an alternative real estate investment alternative.


Starting at the end, it is suggested that for various and sundry reasons, private REITs probably were not and are not a good idea.


One of the major disadvantages of owning real estate is its relative lack of liquidity.  Investing in the traditional publically traded REIT security had and has investment attractiveness because the investor is able to sell his or her position, in the public market, in a matter of minutes, at a market driven price, with the cash proceeds delivered within days. This is not true of investments in private REITs.  Thus, the private REIT becomes somewhat similar to the old master limited partnerships but, without the MLP advantage of being able to pass through depreciation (tax shelter) directly to the investor on an annual basis.


As the article noted, there was a risk that private REITs overpaid for the portfolios that they acquired.  That risk is somewhat universal wherever the acquiring entity is essentially a money manager acting for a group of investors or stockholders. Two factors probably “drive that boat”.  First, there is a pressure to invest followed by a “herd mentality”.  Whenever attractive properties hit the market a competitive buying frenzy usually results when conditions are as they now are where there is substantially more demand (money) competing for very few qualified properties. The investing environment is very different than competition between individual buyers investing their own money. In the case of individual buyers there is a tendency to worry about the risks leading to a more conservative approach. As an individual investor once remarked “even when I lie to myself with the numbers they just don’t work. Aggressive purchasing is validated if, and only if, values rise over time but there is no certainty of that happening.


The article also pointed out that investors in private REITs were disappointed by the slow pace of selling off property. Where the portfolio is in the hands of someone who is essentially a money manager, selling off assets is tantamount to “selling yourself out of a job”.  Unless the money manager is a very major investor in the REIT his or her goals may not be the same as the investor’s goals. Because of this there is a potential conflict of interest risk between the investor and manager.


While the general conclusion is that investing in private REITs may not be the best idea there are transaction structures that could eliminate or ameliorate the observed negatives. As with any investment, there is no substitute for a thorough investigation and analysis as well as asking questions before becoming committed.

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An article in the Wall Street Journal this week suggested an increase in foreign investment in U S real estate.  While much of the investment reportedly comes in the forms of financing for U S projects rather than direct ownership or development, the move may suggest hitting the “warning gong”.  There is an old saying that goes something like “he who doesn’t read history is doomed to repeat it”. Those readers old enough to remember the 20th century will be reminded of the debacle of Investors Overseas Service (IOS) and the later invasion of Japanese investments in the U S real estate market.  Both of these investment moves preceded recessions in U S real estate values. Was this a freaky coincidence or was there a structural reason?  Are there parallels as to what might be expected in the foreseeable future? The short answer is that there are most probably parallels that should lead to caution but the opposite may be the case.


The current crop of foreign investors appears to be “institutionally” rather than individually driven.  The individual investor is not the real player. Thus, the investment decisions are in the hands of “money managers”. These foreign investors are reportedly using more liberal loan underwriting criteria than the U S financial institutions that were burned by the 2008 financial meltdown. That, in and of itself, translates into a gigantic risk factor for the lender and their pool of investors. Secondly, this increase in money from abroad comes at a time when the real estate market has undergone explosive value increases coming after the 2008 market collapse. So, there is a market timing risk. Some may say that it doesn’t make any difference if these foreign investors are wrong.  However, it may not be that simple.


If the foreign investors are financing high profile properties using liberal underwriting standards, then there is a market risk that failed projects individually or in the aggregate may induce a down trend in U S values.


Next, the currently low U S interest rates have contributed to the rising real estate prices.  If, as expected, domestic rates rise, the rise may dampen the U S values.


But, the most worrisome problem may be a lack of understanding real estate development and ownership risks by the investors.


In the second half of the 20th Century (1955) a gentleman named Bernie Cornfeld  started Investors Overseas Services (IOS) headquartered in Geneva (the money was held in Canada) with 25,000 salesmen covering Europe selling their real estate fund investments to ordinary people. In the 1960’s IOS started the Fund of Funds (which held the other funds previously marketed) and raised $2.5 billion with dividends guaranteed. To make a long story short, a “blip” in the market left the Fund without income sufficient to cover the dividends so capital (newly raised funds) had to be used.  This step made the Fund a Ponzi scheme (the funds from other investors used to pay dividends to current investors). The bottom line was that the investors lost all of their money.  Bernie Cornfeld probably never intended this result and started off with good intentions. However, the seeds of failure may have been the ease of raising money which put pressure on management of put the money out in the market resulting in chasing higher and higher prices as the pressure of their money met competition from domestic investors. In other words, IOS was paying premium prices to acquire assets. If they had not been able to buy assets the ability to raise more money would have been seriously constrained. Also, in this period, public syndication of real estate was underway making purchasing more competitive. If the pool of money had belonged to an experienced individual investor it is very doubtful that the prices paid for many of the assets would never have been paid. Along with their counterparts (the syndicators) IOS was under pressure to invest and a “herd mentality” may have taken over.


The Japanese investments in U S real estate during the 1980’s also demonstrated a competitive investment mentality.  The investors sought only prime assets at the start but later dipped into quality secondary assets.  Borrowing rates in Japan were lower than rates of return from U S real estate so it looked easy to borrow money in Japan and invest in the U S. The catch was that the Yen to Dollar exchange rate was very favorable at the time of asset purchase but, when it became necessary to liquidate that relationship had been completely reversed.  So, not only were U S real estate prices declining but the cost of converting sales dollars back into yen was steeply rising casing a loss of money not only on the sale but also on the exchange rates. The common denominator of IOS (& other syndicators) and the Japanese investors may well have been the role of the money managers making investment decisions rather than the end investor making the decisions.


In the period 2001-2008 the loose lending practices in the single family market ultimately led to the collapse of the entire domestic real estate market.  The common denominator was the fact that nobody in the transaction chain had any money at risk.  The real estate broker collected the sale commission; the mortgage arranger collected a commission; the lending institution collected a fee for originating the loan; the Wall Street investment banks saw a payday through the sale of loan product through mortgage backed securities; and the rating agencies had a substantial fee interest in rating the mortgage backed securities.  The only people at risk were those who purchased the securities. The originating lenders had come up with a foolproof method of transferring all of the risk of the transaction to the investor. Nice work if you can get it. 


The dominant real estate market makers (Institutions, Investment Banks, Banks, REIT’s, Fund Managers and related entities) all share a common element.  They are all using mostly OPM (Other Peoples Money) in the implementation of their investment strategies. They are all competing in the same markets and share the concern of being labeled “underperformers”. Leading up to 2008 prominent investment bankers, financial institutions, pension funds and others like themselves made some unbelievably ill timed, poorly analyzed, very costly investment decisions.

Included in the list of losers were the likes of State of California employee pension funds that lost $500 million in land investments, Morgan Stanley and other investment banks who lost billions in flawed real estate deals.  What happened then demonstrated that people investing other people’s money did not, necessarily make the same kind of wise decisions as they might have made if they had been investing their own money. 


In the 1990’s, easy money led to a commercial real estate collapse.  Savings and Loan Banks took in billions of dollars using “brokered deposits”. Investors desirous of diversifying to obtain optimum FDIC/FLIC insurance covering their wealth were easy clients for account brokers to land.  They earned a fee for leading a client to a financial institution.  The banks (mainly S & L’s) became over weighted with cash deposits that had to be invested in order to pay interest to the depositors.  Conveniently, the banks earned fees on the loans originated with the gathered funds. The weight of money to lend forced a serious compromise of lending criteria and standards as the loans became riskier and riskier as the loan frenzy progressed until it collapsed.  To say that the involved lenders made some terrible, high risk loans as well as falling prey to fraudsters gaming the system would be a great understatement. Again, a common denominator of lending other peoples money was at the root of the problem.


Real estate is very different from the other most favored investment vehicle of listed stocks.  Stocks traded on major exchanges are generally very liquid.  That is to say that they can be quickly sold on the exchange at a very low transaction cost. So, if an investor wakes up fearing that an investment was a mistake it takes only a moment to get out.  Further, a defensive strategy of using “stop loss” orders can be employed to limit loss exposure. Neither quick sale nor “stop loss” are available to real estate owners (as differentiated from investors in real estate securities). It can take 6 months or more from listing to sale closure on a major property. And, the real estate transaction costs can run 2% to 6% of the total sale price depending on a number of factors. When product and service companies operate under adverse circumstances they can substantially reduce their operating costs to offset the adversities. When real estate runs into trouble by virtue of vacancies some costs can be cut but the major costs keep on going.  A 100% vacant building still must pay debt service charges, property taxes and insurance as well maintaining equipment to avoid premature breakdown. Then when new tenants are signed a large leasing commission is paid to the leasing broker and the owner usually must pay for substantial tenant improvements.  Tenant turnover is expensive. All of this and more contributes to the reason behind a “liquidity premium” The fact that real estate is difficult to sell compared to securities is the reason behind the notion of a “liquidity” premium attached to real estate (for example, if stocks pay a dividend of, say 4% how much higher would the return on real estate need to be to offset the lack of liquidity? The answer is not the same for all properties. However, the greatest risk of all is the interest rate risk and most current investors don’t remember the days of 10% and higher mortgage rates.  The real estate rates of return are at current lows resulting in money being cheap.  But, if there is a progressive increase in money rates such could well trigger a recession.


The bottom line is that seeing major foreign money move into domestic real estate finance at what may be a cycle top creates an environment where another real estate recession could be triggered. What the trigger will be is impossible to predict just as it was impossible to predict the action of the Fed in 1979 in a surprise raising the discount rate that resulted in mortgage lending rates going to the stratosphere and causing a major real estate recession.




Stay tuned!

Posted in Property Ownership, Real Estate Economy, Real Estate Investment, Real Estate Lending, REITs, The Real Estate Economy | Leave a comment


In recent weeks there have been several unrelated news articles that, taken in the aggregate, paint a picture of what might be expected in the future. These stories are discussed below and are not in any order of reporting date or importance.

The City of San Francisco is experiencing a crisis of growing shortages of residential rentals and rapidly escalating apartment rents.  Not only is there a serious shortage of affordable housing but a shortage of housing period.  There are many contributors to this problem.  One major contributor is the failure, years ago, of planners to adequately anticipate and accommodate growth in their planning codes. Instead, the planners and politicians followed the cries of anti-high rise activists and neighborhood preservationists resulting in more stringent land use codes which, among other thing, massively reducing allowable densities at a time when builders and developers were anxious to develop. The code changes resulted in disrupting new supply at a time when the best thing for the renters would have been the creation of a substantial over-supply of housing as that would have forced rents downward.  Couple the code changes with residential rent control which, while benefiting existing tenants greatly reduced normal levels of turnover. Those with “affordable” rents were economically dis-incentivised from moving unless absolutely necessary.

 There was a legal decision, many years ago, involving a zoning issue. The judge opined something along t following lines “Zoning is a tool to be used in planning for the future.  It should not be used to deny the future”.  However, restrictive land use codes and policies do just that – they deny the future.  As if the problems are not big enough, San Francisco has an entitlement process that uses up valuable time (12-18 months or more) and substantial money in going through the process. These factors cause a dramatic increase in rent as rent is related to project cost. One potential  solution might be to change codes to permit higher densities, streamlining the entitlement process to stimulate timely commencement of construction resulting in more rapid delivery of supply. This would apply to office buildings as well as apartments. The annual limitation of entitlements for offices is a classic example of governmental interference with the economic forces of supply and demand and result in artificially driving rental costs upwards at the point where shortages develop.

 The barriers to new construction help drive the prices of property upwards as investors adopt the notion that the downside risks of ownership in San Francisco are minimal.

 Single family home prices have risen to a point where the middle class is being driven out of the market and, coupled with runaway residential rents threatens to drive all classes of service and labor workers out of the City.  This is not good for the long term economic future of the City and the sustaining of growth in property values.

 Calpers (The California Public Employees Retirement System)) announced a new commitment to real estate investments by boosting its $26 billion in real estate investments by 27%.  This decision follows a loss of $10 billion or about 50% of the value of its real estate portfolio during the downturn in the market following the 2008 market meltdown as well as following an indicated increase in the value o high quality properties of over 80% in the past 5 years. Calpers will reportedly concentrate on fully leased office buildings and apartments. This type of investing is not opportunistic because it depends on increasing rents for long term growth rather than depending on value added management that can come from repositioning properties. One should question whether “buying in” after a 5 year period of explosive increases in prices is a sound investment decision.

 Nationwide, the prices of residential rentals and single family homes appear to be increasing, particularly in those markets where the excess supply has been worked off.

 Interest rates on mortgages remain relatively low.  However, the behavior of REIT stocks has recently underscored the sensitivity of values to borrowing rates.  The prices of REIT stocks declined in reaction to fears that the Fed would increase rates.

 These observations lead to the question of whether or not low borrowing rates may be a major contributor to the demand for and current increases in value of real estate?  Is the current real estate market a “bubble market” that could collapse if interest rates increase measurably? If interest rates increase, will business investment and growth decline?  If the answer is yes would it impact offices and residential rents? The answer would be yes.

 To some observers, there are more forward risks inherent in real estate ownership than are being built in to current offering and buying prices. Volume and price activity, in many sectors and many regional markets appear to some as exhibiting patterns like those in 2008 when a frothy market and cheap money drove frenzied activity


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Much has been written recently about the decline in REIT share prices with most of the blame attributed to rising interest rates or the fear of rising interest rates. Some pundits see rising interest rates as a problem while some do not. Most of the analyses reviewed focus on whether or not rising interest rates are a problem for REITs but, that type of analysis may fall very short of identifying the real risks faced by REITs.

Most analysts would probably agree that the great advantage of REITs is liquidity followed by shelter from income taxation (the REIT pays no income tax if it distributes the statutory amount to shareholders). Neither of these advantages is impacted by interest rates and will survive regardless of whether rates are high or low. But, an analysis of the effect of rising interest rates must go further.

The very low interest rates in the last few years have caused capitalization rates to fall to a historically low level.  The capitalization rate (cap rate) is the rate of return that is used to convert net income into value by dividing that net income by the rate. Historically, as rates fall values rise and conversely as rates rise values rise.  Hence, rising interest rates can trigger a reduction of individual and portfolio property values. This, in turn can impact share prices. This effect can be immediate.

Rising interest rates will force debt service to increase at the time of re-finance which, in turn, may reduce the cash flow available for distribution? This is not an immediate problem and is often postponed until refinancing is necessary.

However, interest rates are not the only REIT problem and the lack of analytical research on other potential problems for REIT investors may result on causing the focus to be limited to a simple issue rather than seeing the range of potential issues.

Management:  One analyst observed the contribution of management as “acquisitions, dispositions and development” as well as “effective capital allocation”. There is no doubt of the importance of these skills.  However, much more important and rarely discussed is the “operating management” skill of the management team.  Properly managing the day to day operations of each individual property includes; effective tenant retention, effective leasing and rental programs, minimizing vacancy risk, strong preventive maintenance programs and rigid control over operating expenses to name a few. Most analysts fail to offer any analysis of these important functions as contributors to dividends and value. Unfortunately most REIT investors have no means for evaluating management and, thus face a risk that management shortcomings could negatively impact performance.

Portfolio Diversification: Many REITs are sector REITs (investing in one type of property like offices, apartments etc) rather than being diversified into different property types.  There are good arguments pro and con on this subject. However, the fact is that not all property types can be expected to perform in the same manner in all types of economic circumstances. For example, Power Centers (“big box” retailers) face consolidation problems like the merger of Office Max and Office Depot or failure. The preferred means of achieving diversification is to own REIT shares in the various sectors.

Local Nature: Individual real estate is locked into its location.  It can’t be moved to another part of town or to another city. Many REITs are geographically concentrated and not all geographic areas can be expected to perform in the same manner. REIT investors need to consider the potential positives or negatives of ny geographic concentration.

Vacancy Exposure: One of the greatest risks of real estate ownership is the constant exposure to vacancy by virtue of lease expiration, tenant bankruptcy or tenant failure. Many REIT report their lease expiration schedule but few, if any, disclose the renewal probabilities for specific large tenants until the tenant has made some form of public announcement.

All of the foregoing problems, in addition to the interest rate problem are things that should be of concern to REIT investors and the need for information may be an opportunity for some analysts to find an unfilled niche.

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In the last couple of weeks there were four different, yet related, public discussions (TV or print media), on the current real estate market that were very interesting. The first discussion covered the re-emergence of the “competitive buying” phenomena that was prevalent before the “bubble burst” in 2008 when brokers were getting multiple offers on their listings. The thesis of the discussion was that improvements in the residential real estate market, suggesting a recovery, were bringing buyers back into the market.  However, the discussion pointed out that the competitive nature of this market favored the “all cash” buyer (buyer’s not purchasing contingent on receiving a loan). The discussion also pointed out that the buyer’s were not, for the most part, “end users” (people buying the home to live in it). Rather, the buyers were “operators” purchasing multiple properties in the anticipation of continued market improvement and being able to re-position the homes in the market for a turnaround sale at a much higher price. This type of activity does not necessarily spell out the actuality of a long term improved market.  The ultimate test will come when the properties are placed back on the market and “end users” step up to buy them.  That may not be as easy as it seems.  The ultimate homeowner is most probably dependent on conventional mortgage financing, which itself requires a good credit score and an income level satisfactory to service debt. This also raises the question of whether or not the economy has improved sufficiently to restore confidence in the mind of the home consumer. That has yet to be proven.


For most homebuyers, becoming involved in a “competitive” buying situation should be avoided because it can only lead to paying more for a property than it is worth. To avoid unwittingly being drawn into a competitive situation buyers should consider retaining their own agent, under contract, to act as the buyer’s exclusive agent charging that agent with responsibility for preventing being drawn into a competition.  Offers to purchase should be very short term and should contain a provision that, if the offer is being submitted to the seller along with competing offers it is deemed immediately withdrawn. A buyer’s exclusive agent can help manage this process while dealing with only the seller’s agent offers little protection because the seller’s agent has a primary obligation to the seller and not the buyer. No potential buyer wants to have their offer become the “stalking horse for another offer from a competing buyer. Agents like long term exclusive buyer representations because they have an assurance that when the right situation is found the agent will get a pay day and, because of that the agent will work hard to find the right situation.


The next discussion reported a shortage of “mega mansions” (multi-million dollar homes) in many markets. This phenomena pops up in places like the San Francisco Bay Area where each new IPO involving a high tech company in Silicon Valley disgorges an army of new multi-millionaires into the market.  This is an example of too much money chasing too few properties. The newly minted millionaires would be well advised to read a history of the local real estate market to learn what may have happened during previous market melt-downs. At the time of the dot.com bust many mega mansions suffered a substantial price decline. This could happen again. The shortage of mega mansions obviously creates an environment for competitive buying. Owning a mega mansion also requires the ability to remain super-rich. Forgetting the cost of debt service, the owner of a mega mansion in California, with a price of $15,000,000 would pay an annual real estate tax of $150,000+ on top of which would be high costs of maintenance, insurance, utilities etc. A buyer would need to be very comfortable that a sufficient fortune was possessed that there was no dependence on a job and an ever inflating value to the corporate stock held.


The third interesting discussion involved a discussion that the U S governments give home buyers a subsidy.  That is a very interesting notion that completely overlooks the fact that there is already a substantial subsidy given in terms of very low mortgage interest (because of the monetary policy in place), coupled with a tax saving via the deductibility of mortgage interest and property taxes. Government policy that is designed to stimulate homeownership proved to be a total failure that, in part, brought about the 2008 meltdown. The development of new initiative to stimulate homeownership would, most likely, lead to another meltdown in the future. If government policies do anything, they should responsible ownership by precluding assuming more debt than can be serviced and encouraging higher equity so that a short term downturn in prices does not cause wholesale collapse.


Finally, this week REIT shares came under downward pressure because of concerns that interest rates would rise causing a potential future decline in income available for distribution. There is little question that the easy money policies of the government have subsidized growth in the REIT industry and it is natural to feel that a change in the interest rate environment will change things for the worst. There is every good reason for believing that interest rates will increase over time if the economy continues to improve.  In terms of commercial real estate, rising interest rates may not only decrease net cash flow but will also decrease value because of the impact of interest rates on capitalization rates (the rate used to measure value).


At the present, despite published optimism, there is no certainty that the apparent improvement in the real estate markets will prove sustainable or of long term benefit to all segment of the market.  The behavior of the stock market in the week of June 17, 2013 suggests that there is an overhang of uncertainty leading to increased volatility. While it is very easy to sell securities to quickly take profits or minimize loss, it is not so easy to sell real estate and that suggests avoiding aggressive acquisitions except under unusual circumstances.

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The New York Times Business Section of October 13, 2012 contained an article by Shalia Dewan entitled “Which House is Worth More?” The article is timely and interesting in that it highlights perceived problems of home sales facing the real estate appraisal process. The general complaint is that failure of a home to appraise at or close to its sale price will “torpedo” the deal. The article suggests that the “problem is so widespread” that the National Association of Realtors blamed faulty appraisals for holding back the housing recovery.

An example cited was one of a seller receiving multiple offers against an asking price of $197,500 and accepting one at $210,000 only to be faced with an appraisal of $195,000 causing a compromise price of $205,000. The seller commented “The part that blew me away – the appraisal can be such an arbitrary personal decision and there is no appeal process”. Further, adding to his indignation, according to the article, was the fact that a similar home two doors away sold for $225,000.

An analysis of this example suggests that the complaints may arise out of a lack of understanding what the appraisal is and what it isn’t and how appraisers work. First and most importantly licensed appraisers (appraisers of residential property for loan purposes are required to be State licensed) are bound by the Uniform Standards of Professional Appraisal Practice (USPAP) and those standards prohibit basing value on “arbitrary personal decisions”. USPAP recognizes that the final value conclusion is an “opinion” but an “opinion” arbitrarily reached or one based on a personal decision unsupported by facts and data would fail to be within required USPAP compliance. This doesn’t mean that no appraiser has ever been arbitrary or lacked proper evidence before concluding value. It just means that such would be the exception and not the rule.  If an appraisal fails to comply with USPAP a complaint can be filed against the appraiser with the State licensing board, which if sustained could lead to a loss of license. It may not resurrect the transaction but would provide satisfaction. Also, if fault is found with an appraisal based on data or process errors, most lenders will take another look.  It is foolish to believe that the lender doesn’t want to make the loan and lenders may reopen a file if convinced that an error was made.

The complaint that a home two doors away from the subject sold for $225,000 (while the subject was appraised for only $195,000) may or may not b a valid complaint. It is indicated that the home two doors away had $30,000 worth of upgrades that were not present in the subject house.  Assuming that the appraiser included the $225,000 sale in the comparable sales used and adjusted the comparable price downward to $195,000 to reflect the value of the upgrades, any complaint would be unfounded. However, if the appraiser did not include a similar home sale two doors away in the list of comparables, such omission might justify a valid complaint.

The National Association of Realtors in blaming “faulty appraisals” for holding back the recovery of the housing market cited unidentified member reports that more than a third of all deals were cancelled, delayed or renegotiated at a lower price because of a “low appraisal”.  The National Association of Realtors (NAR) is a Trade Association with a primary interest in promoting the real estate brokerage business (the business of a majority of its members). Their comments and criticisms are for the most part biased rather than objective and should be treated with suspicion absent supporting empirical evidence. There comments need to be carefully examined:

What do the complaints of “low appraisals” really mean?  Are they appraisals that fall short of objective market value measures? Or, is a “low appraisal” just an appraisal that did not report a value equal to or greater than the sale price.  It is most probably the latter.

The NAR report (the report) indicates that appraisers use previous sales of comparable houses to “help” value a home and if prices are just starting to climb, with sales taking two to three months to close, there can be a lag before the change in prices can be observed.  This statement is partially correct.  Appraisers do use sales to “help” value a home and it can take two to three months before a sale closes.  But, that causes a lag in closed sales prices but not a lag in the observation of sales.  Part of the appraisal process includes studying the market and being aware of shifts in demand for homes vs. the supply of homes available for sale. Part of the process also includes maintaining relationships with brokers (market makers) from whom the appraiser can learn whether or not asking prices are rising, demand is increasing and the spread between ask price and selling price is diminishing.  The multiple listing services report sales under contract so even though a lag time to close can be protracted, the data is there to be used. Using these kinds of information the appraiser can and usually does adjust older sales for change in market conditions rather than depending on the old sales as the entire basis for the value conclusion.

The report suggests that appraisers were improperly using foreclosures and neglected properties as comparable homes as well as failing to account for market conditions like scarce inventory and bidding wars. Using foreclosures and neglected properties of similar homes as “comparable” properties is not, in and of itself, wrong.  What would be wrong would be the failure of the appraiser to make proper adjustments to those comparables to reflect, if such is the case, the superior condition of the home being appraised and/or the negative impact of a foreclosure on value.  In the case of “neglected properties” the appraiser should adjust for the cost of putting the property in equal condition to the home being appraised. And, if market conditions have improved and/or there are bidding wars, that kind of information would also call for an adjustment in the comparable property. Further, the report faulted banks for using “inexperienced appraisers” and for creating unrealistic requirements like “six comparable sales instead of three” as well as criticizing lenders for using appraisers lacking local expertise.

USPAP contains a competency requirement.  If an appraiser, knowingly lacks the experience necessary to appraise a property because of unfamiliarity with the city, neighborhood or specific subdivision, then the appraiser risks being charged with a USPAP violation that could cause a loss of license. What is not said is that lenders usually require competitive bids or use appraisal management firms to select the appraiser and this process risks failing to retain the best appraiser for a property in favor of the cheapest one.

It is foolish to complain about a lender requiring six sales versus three.  The residential form appraisals appear to “require” three comparables and that has caused furnishing only three to be the norm.  However, if there are six or eight truly comparable properties, there is no prohibition against analyzing all of them and reporting based on all rather than three. A competent appraiser would look at all of the data in estimating value. One of the problems is that supplying only three sales became the norm and it is easy visualize how an appraiser might “cherry pick” the sales to select the easiest ones for use rather than sales requiring substantial work to analyze.  Instead of lenders requiring three or six sales, they should require appraisers to report sales data in whatever depth is necessary to accurately portray the market.

The report quotes the NAR Director of Research as saying “It’s (the appraisers being hired) holding sellers off the marker” and “Sales volume could probably be an additional 10 to 15 percent higher if we had normal lending practices and if we had normal appraisal practices”. These comments are totally self serving as the goal of NAR is to create more business for the Realtors who are their members and making loans easier to get would certainly do that. But, otherwise, the comments do not make any sense when logically analyzed.  First, what does the word “normal” mean in the context used above? Does it mean a return to the pre 2008 financing market that caused the financial meltdown? One would certainly hope not but, there is no recollection of NAR sounding any warnings, pre 2008 that what was going on in the market might well lead to destabilization in the market. Many professionals recognized as early as 2006 that prevailing market practices (speculative purchasing and lending without standard documentation) would lead to problems.  They just didn’t know when the problems would surface.

The notions that appraisal practices would hold sellers off of the market or that a “normalized” market could increase sales volume by 10 to 15 percent are speculative at best and completely lacking any kind of empirical evidence or proof.  At worst, they are misleading and delusional notions perhaps designed to involve the political process in the perceived problems. It is more probable that sellers under no particular compulsion to sell would, in their own self-interest, hold their property off of the market if they truly believed that market conditions were improving leading to a potentially higher price in the immediately foreseeable future. On the other side of the coin, sales volume would increase dramatically if buyers became convinced that prices were beginning to rise and that, by waiting too long to buy an opportunity would be missed. Whatever appraisers may or may not do has absolutely no impact on the law of supply and demand.  If supply is shrinking and demand is increasing, prices will rise.  If the converse is true, prices will fall. If sales volume is not at the level needed to push prices up, it is because buyers are unconvinced that the market is rising and they prefer to wait.  That decision may be wrong but it is what moves the market.

Are lenders more cautious?  Certainly.  Any lender that survived 2008 wants to be satisfied that newly originated loans are sound and not at risk of failing. It should be realized that, back in the dark ages, when 25% down payments were required and lenders retained loans in their own investment portfolio, there were few appraisal problems. However, when loans of 90% to 95% of sales price are involved, over estimating value can result in a loan being “under water” the day the deal closes with particular risk to the lender because the borrower has a very small stake in the property.

To the degree that the lending problems cited by NAR might be realistic, good agents (not all agents/brokers are good) can take steps to avoid the problems. Once a transaction is agreed the agent can put together a detailed description of the house including all special and distinguishing features as well as detailed information on all sales of similar property that have sold recently.  In addition, the agent can provide a listing of similar homes that are currently on the market or under contract as well as an overview of the current market. This process removes guess work from the appraisal process as it makes sure that the appraiser has all of the relevant information necessary to analyze value. Agents belonging to a multiple listing service have easy access to all of this information while appraisers may not have that access. There is no prohibition against making the job of the appraiser easier by eliminating the expenditure of time searching for otherwise readily available data and information. Real estate sales commissions are very high in relation to the service provided and laziness by an agent should not be acceptable by a client.

Finally, in some instances an agent will represent both seller and buyer.  Under the laws of many states, in these instances the agent is obligated to represent the interests of the seller while the buyer signs off on this relationship. If the agent is a “dual agent” it is doubtful that they would advise a potential buyer that the asking price was too high and that value was probably around $X. For this reason, buyers should select an agent to represent them as buyers.  That agent would have the obligation of advising the buyer as to price and terms without worrying about the best interests of the seller which can be left to the sellers agent.

What is most interesting is that whenever there is market “dislocation” the appraiser is blamed for market problems. The Appraisal Journal (Published by the Appraisal Institute) published an article by me in October of 1991 entitled “Appraisers Under Fire – Again”. Re-reading it suggests that nothing ever changes. If any reader is interested in that article a copy can be requested via a comment to this article.

(c) 2012 by Lloyd D. Hanford, Jr., MAI

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(c) 2009 by Lloyd D. Hanford, Jr., MAI

Since the collapse of the real estate markets following the financial failures of 2007-08, it has become increasingly difficult to develop any reliable insights via the sales comparison approach to value. Thus, at least as far as commercial properties are concerned, one of the pillars of valuation theory has crumbled. However, despite this, appraisers still search for sales data and spend time trying to analyze whatever may be available. A critical look at the sales comparison approach suggests that, even before the markets turned, the approach was poorly understood by both appraisers and users of appraisal. The purpose here is to examine the approach in an attempt to provide a better understanding as to what it can and can not provide in the way of reliable guides to value.

The sales comparison approach to value is a “significant and essential part of the valuation process.”(The Appraisal of Real Estate published by the Appraisal Institute) Substantial time is devoted to it in the education and the learning process as one gains appraisal experience. The profession has done such a good job of promulgating the approach that many users of appraisals (such as courts, lenders etc) have come to rely too heavily on the results of the approach. However, the approach is not adequately or universally understood by users and appraisers and has become both highly used and abused.

The textbook The Appraisal of Real Estate (published by the Appraisal Institute) states the following: “The sales comparison approach is applicable to all types of real property interests when there are sufficient, recent, reliable transactions to indicate value patterns or trends in the market. For property types that are bought and sold regularly, the sales comparison approach often provides a supportable indication of market value.”(Emphasis added) This primary qualification will be discussed in more detail further on in this paper. The textbook goes on to say: “Generally the sales comparison approach has broad applicability and is persuasive when sufficient data are available. It usually provides the primary indication of market value in appraisal of properties such as houses which are not purchased for their income-producing characteristics. (Emphasis added). More, later about this also.

In addition to the foregoing quotes the textbook has the following to say:

“When the market is weak and the number of market transactions is insufficient, the applicability of the sales comparison approach may be limited.”

“Buyers of income-producing properties usually concentrate on a property’s economic characteristics, most often focusing on the rate of return for an investment made in anticipation of future cash flows.”

Thoroughly analyzing comparable sales of large, complex income producing properties is difficult because information on the economic factors influencing buyers’ decisions is not readily available from public records or interviews with buyers and sellers. Without complete information it will be difficult to arrive at a reliable indication of value for the subject property.” (Emphasis added)

“Rapidly changing economic conditions and legislation can also limit the reliability of the sales comparison approach. Perhaps the single greatest criticism of sales comparison is that the approach lags behind the market, resulting in appraisals that are based on dated information.” (Emphasis added)

The foregoing caveats appear to be completely disregarded by a large number of appraisers, and users of appraisal services such as the courts and investors as well as lenders

An essential criterion of the sales comparison approach is that there are “sufficient, recent, reliable” transactions to indicate value patterns or trends in the market. What does the term “sufficient” mean? The answer to that question appears to be left to the judgment of the appraiser. The term “sufficient” was probably intended to mean an adequate number of sales to provide a reliable conclusion. Many form, single family appraisals “require” three sales. Are three an adequate number? In the context of an active market three sales are probably inadequate. This will be probed later in this paper. But, in the field of major properties, three sales may the most one can get. The question of “reliability” of the approach should be foremost in the mind of the appraiser and user of the appraisal. It would seem to be axiomatic that the greater the degree of homogeneity within the sales sample (for example single family tract homes) the fewer the number of transactions needed to provide a comfort level (reliability). Thus, three recent sales of similar sized tract homes within the same sub-division may provide very strong evidence of value although there is no persuasive reason to confine the study sample to three sales if more, truly comparable sales are available for study. However, it would seem equally axiomatic that the more complex the property, the greater the number of variables that would impact value (a lack of homogeneity). Hence, a larger sales sample would be necessary for analysis to provide reliability. But, in the case of the single family home there is most likely a far larger sample available for study, where there is adequate homogeneity, to provide a reliable result, which begs the question as to why some lenders require only three sales. Conversely, in the case of complex properties, where a larger sample of sales would be necessary to provide reliable results, there are most likely far fewer sales available for study. Accordingly, regardless of analysis of those sales, it is most probable that the sample is of insufficient size to provide a reliable result. Returning to residential sales, a major argument against limiting the sample size to a few sales when there are many available to study is the potential for abuse by using only those sales which, on their face, support the selling price of the property being appraised rather than providing a broader view of the market by an analysis of a greater number of sales.

Why are “recent’ sales important? First, the further back in time that one goes, the greater the risk that there have been significant changes in the market. The sales would require adjustment for market changes but, as will be discussed further on in this paper, it is not always possible to make objective adjustments that are supported by empirical evidence causing any support to be based on subjective judgments or anecdotal evidence. Such adjustments may render any result unreliable. Next, what is “recent”? Is “recent” one day, one week, one month, six months, one year, two years etc? Except where otherwise required, defining “recent” appears to be left to the appraiser’s judgment. In single family appraisals, sales more than three months old are usually too old to be useful, particularly when there is a high volume of sales activity within a three month period. However, sales of complex properties such as major office buildings, shopping centers, hotels and large multi-family projects do not usually reflect any significant transaction volume within a one or even two year period. This factor often redefines the term “recent” for appraisal purposes. However, here there is a very substantial risk that the economic conditions surrounding a sale in the past were so significantly different that there can be no logical, supportable explanation for any adjustments.

What is meant by the term “reliable” transaction? Most probably the term, as used in this context, means that the sale has been verified as to all of the significant details of the transaction through completely reliable sources. In the case of the single family home, verification is easier than in the case of the more complex properties. Typically, homes are marketed thorough a local multiple listing service that tracks the important details of the sale. The same is not the case with larger, more complex properties. Most often, sales data on these properties comes from third party sources and participants in the transaction, for whatever reason, are reticent to provide all of the important details and are often under a confidentiality agreement preventing disclosure. Partial verification is not adequate to produce reliability. But, most importantly, the appraiser should not completely rely on third party sources as independent verification has demonstrated, too often, that there are inaccuracies in the third party data despite the fact that the source has ostensibly verified the data.

The criticism that the sales comparison approach “lags behind” the market is a very real concern. The approach is a backwards looking approach and the results of a sales comparison study may not adequately portray the market as it is on the value date. Economic conditions do change over time and imperceptible changes like, for example, a relatively consistent, 3% rate of inflation, while potentially influencing values upwards would not invalidate the results of a sales analysis because that inflation assumption may be inherently built into the minds of buyers and sellers in the market. However, a major event or events causing a radical change in the economy or parts of the economy may eliminate any reliability of a sales comparison study because that event or those events result in a complete economic disconnect between the past and present. Possibly, the easiest example to envision is the change that must have occurred on Sunday, December 7, 1941, the day that the Japanese bombed Pearl Harbor and signaled the entrance into World War II. Obviously, the United States was so completely different on Monday December 8th than it was on Friday December 5th that any indicators from December 5th and before would become “false indicators” because everything was different on December 8th. Similar, less obvious events were the date in 1979 when, at mid-night on a Saturday night, the Federal Reserve initiated a significant raise in the discount rate as a means of slowing run-away inflation. The timing was chosen because at mid-night on Saturday all financial markets in the world were closed, thus all participants received the news at the same time as far as doing business was concerned. That step changed all of the rules as to how real estate was financed and rendered all prior value indicators useless. In Northern California, in 2000, the high tech and dot.com sectors of the local economy began to implode. The implosion, over a few months, induced major changes in office real estate occupancy rates and rents with a ripple effect into other sectors. This event, coupled with the September 11, 2001 attack on the World Trade Center caused an economic disconnect between the period pre 9/11 and post 9/11 making it difficult to rely on sales or rental data prior to 9/11. Finally, the collapse, in 2008 of the sub-prime mortgage market with its spill over impact on the financial institutions and changing mortgage conditions caused an economic disconnect between the market pre collapse and post collapse. This impact especially affected the single family market at the outset but spilled over in to other sectors like retail and office. Even though sales of residential properties appeared to continue to close, the sales data became unreliable because prices continued to drop as foreclosures rose and demand faltered.

The next problem with the sales comparison approach arises because of the adjustments that are made to sales. A distinction must be made here between single family sales and the sales of more complex properties. Very often there is adequate single family sales evidence to permit somewhat objective adjustments but, in the more complex properties, the number of sales is usually insufficient to permit any objectivity in the adjustment process. This leads to a substantial risk that the appraiser will end up “manipulating” the adjustments to make the results appear reasonable. In the absence of empirical evidence supporting any adjustment, the adjustment factors become completely subjective and prone to manipulation. Observation of cross examination in litigated matters would lead a trained observer to conclude that the appraiser on the witness stand is most often unable to provide any factual data or persuasive support for adjustment factors used.

With the exception of rare circumstances the sales comparison approach will not prove to be reliable in the case of complex properties. First and foremost, the number of truly comparable, contemporary sales available for study is usually quite limited. In other words, the sample is too small to provide a reliable result. Secondly, the more complex the property, the greater the number of value variables. A value variable is an element that would have an influence on value such as location, leasing structure (length of leases, rents at, above or below market, specific lease terms), condition, amount of deferred maintenance, services, expense pass through items, tenant improvements, tenant improvement allowances, occupancy and other factors that may be observed. From a statistical standpoint, as the number of variables increase the requisite sample size for reliability also increases. This problem does not arise if there is substantial homogeneity in the sales sample (as in the case of single family tract homes where the majority of product is the same). In the more complex income properties, as stated, the available sample is most often too small or limited to produce reliable results but, in the final analysis, the net income from the property is usually the culmination of the interaction of all of the value variables. Thus, the income approach narrows the variables down to net income and capitalization rate and should provide a more reliable result than an analysis and subjective adjustment of limited sales data. .

Regardless of sample size, the sales comparison approach measures certain “units of value” such as value per square foot, value per rentable square foot, value per square foot of GLA, value per realizable square foot or number of units of improvements (new construction) value per unit, value per room or a gross rent (income) multiplier. Each one of these “units” has some limitations. In operating properties, the square foot values reflect the impact of income, which may not be uniform from comparable to comparable. In apartments, the value per unit may not properly adjust for the unit mix (number of 1 bedroom units in relationship to 2 bedroom units etc). And, the gross rent (income) multiplier is limited by the fact that the income characteristics (rents at market, below market, above market & occupancy) are not uniform and, accordingly, the result only provides a range rather than a free standing, self supporting multiplier.

In the appraisal world there is always a question of “form over substance”. Many things find themselves in an appraisal because they have “traditionally” been there. So it is with sales data. This is not intended to imply that sales be omitted from the complex appraisal altogether or that the residential appraiser must reflect all sales, whether needed or not. Instead, what is intended it to create a mind set that starts with the question of relevance. If there are twelve residential sales of which five are very relevant and seven are just of interest, it would be important to detail the five relevant sales and analyze them. In the complex income properties, it is suggested that the available sales data be provided with focus on extracting the capitalization rate. A detailed analysis of an insufficient sample is, by definition, a wasted exercise since any result is, at best, unreliable. ”

A sales search, in an of itself, is valuable to the appraiser as it should result in an understanding of the condition of the market even if the identified sales do not lead to a reliable, stand alone, conclusion of value. The search should indicate whether the market is active or inactive, whether there is current demand or whether the number of properties on the market exceeds the number of buyers active in the market. The search should indicate the length of time listings are on the market before selling as another indicator of activity. The appraiser must always be aware of the fact that when the market is weak the number of transactions is reduced and when the market is strong the number of transactions is increased. In periods of fierce activity prices appear to move upwards very rapidly with the probable result that price moves out ahead of value. Similarly, in a declining market, the probable result is that price drops below value. In each case this phenomena should be expected to last until the market stabilizes – that is prices stop rising or falling as the case may be. This awareness should assist the appraiser in rendering credible appraisals to the client and should help the client assess the reliability of the appraisal and risks inherent in the property.

In order to render credible appraisals, appraisers must process a substantial amount of information and data that, in the end, should provide a firm basis for judging the characteristics of the market including the behavior patterns of buyers and sellers. Whether sales data is useful in leading to a stand alone conclusion of value or not is not the most important question to be answered. The most important question is one of what the sales indicate about the market. All kinds of good information can be obtained from a study of sales even if the sales comparison approach does not provide a value answer in and of itself. Useful information from sales may include buyer identification (what is the profile of the typical buyer?), length of time on the market, number of similar, competing properties being offered at the same time, market participants perception of the market at that time, and financing environment, to name some information types. Even though the sales comparison approach may not yield a stand alone value conclusion, the approach is very important in understanding the market.

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