SALES COMPARISON APPROACH IN REAL ESTATE VALUATION

REAL ESTATE APPRAISAL ISSUES
**
THE SALES COMPARISON APPROACH
TO
VALUE

Well, another seven years have passed and still there have been no comments, pro or con, instructive or destructive forwarded for consideration and response. The Sales Comparison Approach has been a cornerstone of  of valuation study since the profession began. Yet, out of the thousands who have read this no one has yet  raised any challenge to any of the notions or conclusions expressed. Since the original reason for writin the article in the first place was to begin a professional dialog with an eye to improving the analytical portions of an appraisal. To my chagrin and disappointment it appears that no appraiser anywhere has bothered to raise a question. Does that mean that everytnhing set forth in the article is so correct that there is no challenge? Well, that outcome is doubtful. Does it measn that no one agrees or disagrees with the analysis? That outcome too would be doubtful. Does it mean that the institutions having control over appraisal theory and practice are uninterested?  That notion would be a stretch. Does this lead to a conclusion that those in charge of appraisal education have too much invested in in the current methodology to think about change?  That is certainly very possible because “once the gemie is out of the bottle” putting it back in would be impossible and would unleash much time consuming and expensive study.

What should be very obvious to anyone in the valuation field is the fact that there has been absolutely no new valuation theory introduced to the profession in over 60 years. There have been many improvements in analytical  tools and in appraisal methodology but the profession is still adhering to the original three approaches to value (Cost, Sales and Income) even though each has some identifiable flaws which reduce the reliability of the approach.  If the profession hopes to remain relevant for the next 100 years it would seem that efforts to expand and improve the theory need to be undertaken. The last decades have seen giant strides in Uniform Standards and it is time for the same efforts to be aplied to valuation teory

SINCE THIS ARTICLE WAS POSTED IN 2009 IT HAS RECEIVED MORE “HITS” THAN ANY OTHER POST.  WHAT IS A BIT SURPRISING IS THE FACT THAT THERE HAVE NOT BEEN ANY COMMENTS, EITHER PRO OR CON NOR ANY SUGGESTIONS FOR IMPROVING THE CONTENT. THE REASON FOR EXPRESSING SURPRISE IS THE RECOGNITION THAT THE SALES COMPARISON APPROACH CONTINUES TO BE SO FUNDAMENTAL TO THE APPRAISAL PROCESS.

IN 2009 THE REAL ESTATE ECONOMY WAS IN A STATE OF COLLAPSE AND THE LACK OF RELEVANT SALES DATA, IN TERMS OF MARKET TIMING, IF FOR NO OTHER REASON, RENDERED THE SALES COMPARISON APPROACH RELATIVELY UNRELIABLE, MOST PARTICULARLY IN TERMS OF COMMERCIAL PROPERTY.

HAS ANYTHING CHANGED? ON ANALYSIS, PROBABLY NOT. EVEN THOUGH THERE ARE INDICATIONS THAT THE MARKET FOR COMMERCIAL PROPERTIES IS IMPROVING, THE VERY FACT OF IMPROVEMENT RENDERS PRIOR SALES OUTDATED EVEN IF USEFUL FOR OTHER REASONS. SALES, AT BEST, PORTRAY THE MARKET AS IT WAS AND NOT NECESSARILY AS IT IS. SALES ARE A LAGGING INDICATOR.

DESPITE THE APPARENT LOGICAL LIMITATIONS OF THE SALES COMPARISON APPROACH IN TERMS OF COMMERCIAL PROPERTY, MOST APPRAISERS HAVE CONTINUED THE LABORIOUS ANALYSIS OF WHATEVER LIMITED DATA IS AVAILABLE EVEN THOUGH THE RESULTS OF THE ANALYSIS PROVIDE A VERY UNRELIABLE VALUE INDICATION AT BEST.

ONE MIGHT QUESTION WHY THIS IS. THE ANSWER IS PROBABLY THE FACT THAT THE APPROACH IS “TRADITIONAL” AND THUS  FEAR MAY EXIST THAT ANY APPRAISAL LACKING THE DETAILED APPROACH IS SOMETHING LESS THAN A “CREDIBLE” OR “COMPLETE” APPRAISAL.  THIS FEAR MAY GO BACK TO A TIME IN THE DISTANT PAST WHEN APPRAISALS WERE “REQUIRED” TO INCLUDE ALL THREE APPROACHES WITH A  CORRELLATED CONCLUSION.

INVESTORS IN COMMERCIAL PROPERTIES STILL FOCUS PRIMARILY ON THE QUALITY OF INCOME AND CAPITALIZATION RATE IN MAKING DECISIONS AND NOT THE RESULTS OF A SALES COMPARISON GRID. TO THE INVESTOR, THE MOST PERSUASIVE, NON INCOME RELATED DATA, IS WHETHER OR NOT THE VALUE/PRICE IS BELOW REPLACEMENT COST.

(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.