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Quantitative vs. Qualitative Adjustments
Since two properties are usually not identical, especially in commercial real estate, it is essential for an appraiser to make adjustments within the Sales Comparison Approach. The adjustments made by the appraiser should imitate the market. For example, adjustments could include location, size, and topography for a property, if these are characteristics that the average buyer in the market would consider when making a purchase. Appraisers can use either quantitative or qualitative adjustments (or a combination of both). Generally, quantitative adjustments consist of making either percentage or dollar adjustments to account for the differences between the subject and the comparable sales. Qualitative adjustments require the appraiser to rank the comparable sales in terms of inferiority/superiority to the subject. Each of these techniques has its own weaknesses and strengths.
Quantitative adjustments are considered useful because they provide an actual quantifiable and measurable adjustment. Since the adjustment is quantified, it is more objective in nature than a qualitative adjustment. The result is a more scientific and precise analysis of the comparable data. However, the major weakness of the quantifiable adjustment is that it is rare to find the data to support quantitative adjustments. For example, the most common way to find a quantitative adjustment is to use a paired data analysis. In this analysis, two properties are compared two each other that are similar in all their attributes besides the one difference being analyzed. An example would be two lots that are identical except that one lot is a corner lot while the other is an interior lot. If the corner lot is $10,000 and the interior lot is $8,000, the appraiser could conclude a corner lot adjustment of $2,000, or 25%. The problem is that there is not typically enough data to provide paired sales for all the required adjustments for the subject property.
On the other hand, the biggest weakness of qualitative adjustments is that they are more subjective in nature because they do not include direct quantification. However, their biggest strength is that they match the typical behavior of most market participants. It is often more common for the typical buyer to compare property attributes on a scale of superior or inferior than to calculate market-derived adjustment factors. Both types of adjustments have their own strengths and weaknesses and when determining the applicability of using quantitative or qualitative adjustments the appraiser needs to consider the dependability of the market data in support of an adjustment and how market participants would make similar adjustments. Due to the imperfect nature of the real estate market, the judgment and experience of the appraiser is always a factor in determining what type of adjustments to use.
The Unfinished Office Park
Almost every larger town has one - the unfinished development project that was put to a halt during the economic recession. As the bottom fell out of the market, developers were caught with half-finished projects and a falling demand for commercial space. The result was a distressed property and an unusual appraisal project. Today’s post will take a look at an example of one way to approach the appraisal of a partially finished development project. The example focuses on using a retail sellout analysis to find the value of a partially completed office park development that includes two completed office buildings, two “shell” office buildings, and four pad sites for new construction.
The retail sellout analysis is a type of discounted cash flow where the retail values are determined through market research, and then discounted over an appropriate period, at a market-extracted discount rate. This process is crucial because of the time value of money, which is based on the premise that money currently in hand is more valuable than money in the future. The first step of the analysis is to determine the retail values of the subject property’s individual components. For the office park development example this step would include completing Sales Comparison and Income Approaches for each of the office buildings on an individual basis. In our example, this step may require the use of different comparables for the completed office buildings and the “shell” office buildings. (We will assume all the buildings are of similar size and construction) Additionally, the pad site’s retail values would need to be estimated using the Sales Comparison Approach. Since it would be difficult to determine which pad site would sell first, it is common to find the average price per pad site and use the average in the discounted sellout.
The next and often most difficult step, is to determine the most likely absorption of each of the developments components. This step requires a study of the subject’s market and research into the sellout of similar projects. In the office park example, we could conclude that either one pad site or one office building would sell per quarter indicating a sellout period of two years. After the absorption rate is determined, it is necessary to estimate the appropriate deductions for expenses such as sales costs, commissions, title insurance, D.O.C stamps, marketing/advertising, real estate taxes, etc. during the sellout period. The quarterly expenses would be deducted from the quarterly income.
Next, a discount (yield) rate would be extracted from the market. The final two steps would include discounting the net income stream for each period and adding the present values of the income stream for a total present value of the project. To complete our example, the present value of the eight quarters of the sellout period would be totaled to find the present market value of the subject office park.