OSPAR Consulting Ltd.

Why Market Value Isn't...

QUESTION:  At a conference shortly after a large "correction" in the value of commercial real estate the senior investment officer of a large financial institution asked "Why is it we had appraisals for real estate assets that didn't reflect the huge drop in values that was coming? Why did the appraisers give us those inflated values?"

ANSWER:  When the Fund commissioned the valuation, the appraiser was asked to provide the estimate of current "Market Value".

"Market Value" reflects the value the asset would fetch on the open market under voluntary sale conditions. There is always a market (even during the worst period of a "down cycle" or the headiest period of an "up cycle" and effecting a sale is typically only a question of price.

"Market Value" appraisals must reflect the most probable price for which a property would sell at the appraisal date. This concept presupposes that each property has a range of possible values at which it might sell, and the range depends on assumptions such as Highest and Best Use, the objectives of the potential purchasers, availability of financing, etc.. However, as the final estimate of value must represent the most probable price at the appraisal date, the assumptions must reflect typical or widely-held current market beliefs and perceptions, as opposed to those which are not widely held but still possible. For example, if empirical research could show that vacancy for a particular market property type will be 15%, but the widely-held belief is that vacancy will be 10%, then the proper assumption to use would be the latter. The appraisal date of "Market Value" appraisals can be retrospective, current, or prospective, but in each case, the assumptions must represent typical perceptions and beliefs.

This is all quite well understood in the industry and should be quite clear. After all, a lot has been written about "Market Value". But this leads us back to the lead-in at the top of this page "Why Market Value Isn't".

The problem is that the intent of "Market Vale" has been tragically twisted with long-standing and always referred to requirements in the definition.

The commonly used definition in North America is well known. It refers to "a competitive and open market under all conditions requisite to a fair sale" and buyers and sellers who are "acting prudently and knowledgeably", and "assuming the price is not affected by undue stimulus".

The very fact that real estate markets continuosly go through "bubbles" and "crashes" points to the need for a new definition of Market Value. After all, if investors were knowledgeable and prudent we would not have "bubbles".

So we propose a new definition of Market Value

"Market Value is the estimated amount for which an asset should exchange at the date of valuation between a buyer and a seller in an arm's length transaction after typical marketing wherein the parties each act with common knowledge and typical prudence and without compulsion."

"The estimated amount..." refers to a price expressed in terms of cash payable for the asset. This estimate specifically excludes a price affected by special terms or circumstances such as financing, sale and leaseback arrangements, special consideration or concessions granted by anyone associated with the sale.

"...for which an asset should exchange..." refers to the fact Market Value is an estimate of the most probable price out of a whole range of possible prices.

"... at the date of valuation..." refers to the fact the Market Value estimate is only valid as at the date of valuation. The expectation by some investors and regulators that the valuation be valid for a period of time is not reasonable, any more so than expecting a valuation of a stock portfolio to remain valid for a period of time. It is possible the value may hold for a while, but that is only so long as the asset and market conditions do not change.

"... in an arm's length transaction..." requires the parties to be acting independently and establishes that the price has not been affected by any relationship between the buyer and/or seller.

"...after typical marketing..." means that the asset would be exposed to the market in the most appropriate manner to effect its disposal at the most probable price. The length of exposure time and the number of potential purchasers to whom the asset is exposed may vary with market conditions. The exposure period occurs prior to the valuation date.

"...wherein the parties each act with common knowledge and typical prudence..." allows for a margin of human fallibility and presumes that both the buyer and the seller are typically informed about the nature and characteristics of the asset, its actual and potential uses, and the state of the market as of the date of valuation. The buyer and seller will act in accordance with commonly known market information available at the time.

"...and without compulsion..." establishes that the price has not been affected by any duress on the buyer and/or seller. It does not refer to the motivation of either party, as parties who have been motivated to sell or buy under duress may still transact at market prices.

Until the definition is changed to something like what is suggested above THAT'S Why "Market Value" Isn't .

Well, that was FUN. But, seriously, although the currently promulgated definition is a bit twisted, Market Value always exists, and is represented by the range in value which reflects the overlap between the lowest price at which sellers will part with a property and the highest price at which buyers will acquire it. This is explained in the section "Market Value in a Bust Cycle".

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