How to Use Less-Than-Perfect Comps to Estimate Value
In today's volatile real estate market, it can be difficult to obtain a meaningful estimate of what a parcel of commercial real estate is currently worth. In many areas, such as Alaska, West Virginia, North Dakota and Wyoming, the market is in an official recession, while the markets in Louisiana, New Mexico and Oklahoma are at risk. Such information is essential to help you make strategic decisions about buying, selling, financing, developing and improving properties.
Relying on Comparables
Appraisers often use the sales comparison approach to reach a market value for a subject property, because it's intuitive and objective. It assumes that the subject property will sell for a comparable price (or price per square foot) as similar properties (known as "comps"). When valuing a property under the sales comparison approach, appraisers must consider all relevant transactions in the area and then determine which should be used in the analysis to produce a credible value. The best comps are those most similar to the subject property in terms of land use (type of property), timing, location and size.
Ideally, each comp also was sold under the same conditions as the subject property currently is. For example, the buyer and seller should have been typically motivated (that is, not under any compulsion), and the marketing effort and exposure time should have been typical for that property type in that market.
Dealing with Distressed Sales
When the search for comps includes foreclosures and short sales, appraisers need to consider whether these "distressed" sales are still relevant in today's market. In some circumstances, the answer may be "yes." But using them usually requires extra legwork, especially if local market conditions are now more favorable than when the distressed sales occurred.
It's true that the differences between the conditions of sale and those of the subject property can make a distressed sale transaction unsuitable as a comp, but certain adjustments can be made to account for some deficiencies. An adjustment might be made, for example, if the transaction involved sales concessions, or the transaction involved atypical motivations (for example, the seller might be highly motivated in a short sale), or the property's physical condition was poor.
Note that physical condition and the conditions of sale are distinct factors that must be considered separately. In other words, an appraiser shouldn't assume that a property sold under foreclosure conditions was in inferior condition. Using distressed comps may require greater investigation and analysis than relying on comps that occurred under more comparable market conditions.
Expanding the Search
At times, an appraiser might be confronted with a market experiencing limited sales activity of any kind, distressed or otherwise. In such situations, the appraiser will need to modify his or her selection criteria when searching for comps. For example, the appraiser might expand the geographic area (and make appropriate adjustments for location) or rely on less recent sales (with appropriate adjustments for market conditions).
Adjustments can be supported using paired sales, market participant surveys, analysis of rent or net income differentials, and cost analysis.
Counting on Qualified Appraisers
It's critical to ensure your valuations are built on solid ground. But you can't do it alone. A qualified real estate appraiser who has been through multiple cycles knows how to deal with comparable sales and use them to arrive at a meaningful estimate of value.
For more information on comparables and other real estate matters, contact Doug Collins, CPA at (973) 328-1825.