Real estate appraisal users have a variety of informational needs and intended uses for appraisal products. As a result, a user must communicate effectively when ordering an appraisal to ensure that objectives for the assignment are understood and met.

Most importantly, the appraiser must learn what type of value opinion the user is seeking. Appraisers can estimate a variety of values including, but not limited to, market value, liquidation value and net realizable value. The methodology for arriving at each of these values is quite different — thus the importance of establishing a requirement before work begins.

Although the value estimate of a real estate appraisal is based on information obtained from an analysis of market conditions and activity, as well as input from market participants, the stated value is an opinion and can only truly be tested if the subject property is sold.

Three Types of Value — Market, Liquidation and Net Realizable

Users order appraisals for a specific requirement and, therefore, the value estimate must reflect the requirement. For example, a lender may order a valuation and use it as the basis for providing financing on a property, or an investment company may use it as the basis for pricing an acquisition offer.

Appraisals are often completed to estimate the market value of a property. The Uniform Standards of Professional Appraisal Practice of the Appraisal Foundation defines market value as “The most probable price, which a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus.” Implicit in this definition is the consummation of a sale by a specified date and the passing of title from seller to buyer under conditions whereby:

• the buyer and seller are typically motivated;

• both parties are well-informed or well-advised, and acting in what they consider to be their own best interest;

• a reasonable time is allowed for exposure in the open market;

• payment is made in cash (U.S. dollars) or in terms of financial arrangements comparable thereto; and

• the price represents the normal consideration for the property. This price is unaffected by special financing or sales concessions granted by anyone associated with the sale.

Liquidation value is similar to market value except that the consummation of a sale occurs within a limited future marketing period specified by the client. When assigning this value, an appraiser also considers that, for the most part, only the buyer is acting prudently and knowledgeably and is typically motivated, and only a limited marketing effort is possible for the completion of a sale.

For example, a client wants to sell a property in 6 months that would typically require an 18-month marketing period to reach its full market value of $10 million. As a result, the appraiser estimates a maximum liquidation value of only $8 million under the constraints of a shorter timeframe. Typically, liquidation value is lower than market value as the result of the seller being compelled to sell the property with a partial marketing effort.

Finally, the net realizable value is an indication of the net proceeds from the sale of a property. The key difference between net realizable value and either market value or liquidation value is the cost of disposition. Depending on the definition of disposition cost, or the user of the appraisal report, the net realizable value can reflect deductions for selling/brokerage fees; operating expenses such as taxes, insurance, maintenance and utilities during the marketing period; and/or rent or financing costs during the marketing period. Lenders and investors are the most frequent users of net realizable value.

Appraisal Methodology Determines the Type of Value Estimate

To complete an appraisal, appraisers typically use one method, or a combination of methods, including the cost approach, the sales comparison approach and the income capitalization approach. The cost approach is based on the principle that the value of the property is significantly related to its physical characteristics. This valuation method assumes that no one would pay more for the facility than it would cost to build a comparable facility on a comparable site in today’s market.

In the cost approach, the market value of the subject site is added to the depreciated cost of the improvements. This methodology is most applicable when a property is new and is developed to its highest and best use. The reliability of the approach is weakened when a property is older or suffers from significant accrued depreciation. Depreciation can exist even in new properties, particularly when there is limited demand for the property beyond the current user or when property characteristics limit the property’s functionality to a very narrow set of users.

The sales comparison approach, a widely used methodology, is based on the principle of substitution, which states that no one would pay more for the subject property than the value of a similar property in the market. In active markets, with a large number of properties with physical similarities, this approach is generally considered to be a good indicator of value. However, many properties have unique characteristics that cannot be accounted for in any form of adjustment process.

Unique characteristics or the lack of local comparable properties may reduce the validity of this approach unless the appraiser has close ties with a national real estate disposition company. Through this association, the appraiser can often solicit an opinion of value from disposition professionals who base their information on recent orderly and forced liquidation sales involving comparable properties in a cross-section of markets.

Finally, the income capitalization approach is based on the premise that properties are income producing and are purchased based on this ability. This approach is most relevant when adequate rental rate information from an active rental market exists and when investors are actively seeking to acquire similar properties for rental income and anticipated appreciation.

The income capitalization approach is best suited for properties developed principally to produce income. These include apartment complexes, public warehouses and distribution centers, retail centers and multi-tenant office buildings. This approach is not appropriate for single-tenant manufacturing facilities, which are typically not developed for the purpose of generating a rental income stream.

W. Todd Haney is president of Northbrook, Illinois-based Hilco Real Estate’s Valuation Services Group.

RETAIL PROPERTIES AND CENTRAL BUSINESS DISTRICT OFFICES TOP INVESTOR LISTS With the real estate market experiencing tough economic times, buyers and sellers are making an extra effort to secure the right properties at the right prices for their business. Milwaukee-based American Appraisal Associates provides valuation services, including financial advisory and other financial services, to companies searching for the right investment. So far in 2003, the company has seen mixed results in dollar volume transactions for the main property types, with retail properties and central business district offices showing gains, and suburban offices and flex space performing the weakest. Capitalization and discount rates have fallen sharply on retail properties in the past year. Investor appetite for stabilized and anchored retail centers, especially Class A properties with national credit tenants, has grown considerably because of the availability of low-cost debt. The Second Quarter 2003 Korpacz Investor Survey reports that capitalization rates for both regional malls and strip shopping centers have fallen nearly 50 basis points in the past year. According to Retail Capital Trends July 2003, published by Real Capital Analytics, the average capitalization rate for all retail properties in the Midwest region is 9.4 percent, a decrease of 43 basis points from 1 year ago. In the same time period, the average price fell approximately 10 percent to $91 per square foot. Even though the current office market has weak fundamentals, investor demand is intense for Class A assets that are fully leased for at least 4 years. Investors believe that the 4-year period will carry them through the current market and into a market with stronger fundamentals. There is less demand for buildings with low occupancy or with significant near-term leasing exposure. The demand for well-leased, Class A assets is being driven by several factors including the bearish equity markets, which have caused institutional investors to seek real estate as a suitable and stable alternative. The amount of cash on hand for acquisitions, coupled with the limited number of assets available for sale, has resulted in low rates of return and premium pricing. Some clients are questioning these low rates of return for several reasons. For example, investors are concerned about their exit strategies, the near-term rise in interest rates and any improvement in the equity markets that may pull cash away from potential real estate investments. The national hospitality market began 2003 with mixed signals that were skewed by the threat of imminent war in Iraq and the continued threat of domestic terrorism. In addition, interest rate decreases by the Federal Reserve Bank have not stimulated the economy as expected. Sellers realize that stabilization is years away and, although bid spreads have narrowed, transactions continue to be difficult to complete due to the lack of confidence in financial modeling. Capitalization and discount rates for hospitality properties have fluctuated approximately between 80 and 110 basis points, during the last 28 months. During the last quarter, average discount rates for full-service hotels moved lower as investors became more comfortable with their cash flow projections. After the hospitality market stabilizes, discount rates for full-service hotels are expected to settle at an average of 12.5 percent to 13.5 percent. Meanwhile, capitalization rates, currently averaging 11 percent, will settle near 10 percent. The national multifamily market has also suffered from the stagnant U.S. economy. Job loss has created vacancy and credit loss for apartment complexes. Additionally, low interest rates have adversely affected the top revenue line as people become first-time homebuyers. On the other hand, low interest rates have allowed owners and buyers alike to lower their debt service and improve their cash flow. Investor interest in apartments has been strong because investors believe that apartments provide the best long-term returns. Competition for multifamily investment opportunities has been intense because prices have been increasing and capitalization rates have been decreasing. In the Midwest, capitalization rates for some Class B properties have fallen between 7 percent and 8 percent. — Ken Kapecki, managing principal in the Chicago office of Milwaukee-based American Appraisal Associates; Doug Needham, managing principal in the firm’s Irvine, California office; Frank Fehribach, managing principal in the firm’s Dallas office; and Brian Johnson, managing principal in the firm’s New York office.

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