There are two broad philosophies of value that I have discerned in my discussions with practicing consultant/appraisers. For purposes of simplification I will categorize these two philosophies as Objective (outer) and Subjective (inner). The concept of value that a particular consultant/appraiser holds will affect the type of value derived and the data analyzed and included in the report prepared for a client.
Those who hold to the Objective concept of value believe that value can be measured, estimated, or calculated from evidence in the marketplace. The appraiser/consultant will seek evidence of sales and/or income/expense data to derive the market value of the subject property. This value conclusion is then presented to the client (who engaged the appraiser) as a single number or a range of numbers. The client (let’s assume a lender) will then use this value conclusion as the basis for a decision about the size of loan to be funded on this property. The client/lender often refers to this issue as the loan to value decision. To determine the market value of an income producing property, the consultant/appraiser will often use a methodology like the DCF (discounted cash flow) model, the Band of Investment methodology, or the Direct Capitalization methodology. For those who hold to the Objective concept of value, the purpose and function of every assignment is usually to estimate some aspect of value, usually market value. Market value is presumed to be an Objective reality which is “out there” in the marketplace to estimate, according to those who hold this philosophy. Value under this philosophy could be defined as: a reality that is determined from specific data (called facts) that are available to everyone who searches for this evidence.
The other philosophy of value, is generally referred to as the Subjective (inner) concept of value. Those who hold to this philosophy, believe that value is derived by the subjective assumptions of individuals in the marketplace and then quantified in a currency of the realm (dollars for most USA transactions). Value is not “out there” as the Objective school maintains, but is derived from human mental processes (which are subjective and personal). Therefore, a given property could have many different derived values. Each value derived would vary depending on the underlying subjective assumptions adopted. Under this philosophy, value could be defined as: a result based on assumptions. Value is not “out there” to discover, find, or determine; but is merely a mental concept used as a name to specify a result derived by specific human beings or decision-makers. Human beings and their mental assumptions would be central to the derivation of any value conclusion. Clients who engage consultant/appraisers under this concept of value recognize that any value conclusion is only valid if all the underlying assumptions are understood and accepted. Value is viewed, therefore, as a potential monetary outcome. And the process of report writing would need to focus on the client’s problem and questions (e.g., the supportable loan amount for the property under evaluation if the report is being prepared for a lender/client).
Another mindset that can help to explain this difference in the understanding of value would be the concept of Inner and Outer realities. Outer realities, for consultant/appraisers, would be the building(s) and site under evaluation (say an office building in a suburban location). The building and all the fixtures and personal property within this building are physical things that exist in space and time. We can, thus, call these realities Outer (they exist). However, the value of this building and site, is in the mind of human beings (say the consultant/appraiser and/or the client/decision-maker). Value would be viewed as a non-physical (inner) concept or notion that has no Outer reality. So value, under this mindset would be subjective and personal to the person doing the derivation. Value would not be viewed as some thing which exists or which can be discovered by analyzing historical data such as sales transactions. All such data would be viewed as derived phenomena which had its basis in the minds of people in the marketplace.
Now, what is the significance of these philosophies on the practice of consulting/appraisal assignments in the marketplace? I would maintain that the significance is substantial. If value (let’s assume market value) is not “out there” to determine, then the focus and function of a particular assignment changes. In lieu of estimating the market value of the subject property, I would focus on the particular decisions that my client (let’s assume a lender) is concerned about. For example: If a lender/client calls me and requests a report on a particular property (let’s assume a proposed office building), I would need to ask a whole new set of questions to get to the crux of the problem. Valuation would be viewed strictly as a “tool” to help with the decision-making issues when appropriate. Following is a hypothetical dialogue between a lender/client and a consultant/appraiser given a particular situation. Keep in mind that every assignment between a client and a consultant/appraiser would involve a different set of questions and problems. Dialogue with the client becomes paramount in this process.
Assumption: Let’s assume that a developer/borrower has submitted an application for a first mortgage loan of $8 million on a proposed 100,000 s.f. office building.
A typical dialogue between the client and consultant/appraiser might be as follows:
Client: This is xyz lender calling with regard to your interest in a consulting/appraisal assignment on a project in your area. I have received an application for an $8 million loan on a proposed office building.
Consultant/Appraiser: Can I ask you a few questions about this assignment? Where do I get all the details about this project? What would be the terms of this proposed loan? Who will be reading and making decisions from this report? What questions are you concerned about?
Client: You can obtain all the information about this project from the developers at their office location. The current terms for this type of loan would be 7% with 30 year amortization. Generally, we require a debt coverage ratio of 1.33 on this type of property. The reason for the report is to make a decision about the maximum supportable loan that we can fund upon completion and rent-up. Our Board is concerned about the quality of this project, the rent structure proposed, the lease conditions and clauses, the marketing time necessary for rent-up, the net operating income (NOI) which this property will generate upon reaching stabilized occupancy, and the supportable first mortgage loan given all your assumptions. We plan to fund the loan after completion and occupancy.
Consultant/Appraiser: Do you need a value conclusion for this assignment or would you prefer to derive your own investment value after determining the maximum supportable loan for this project? Since there will be no transfer of ownership involved with this loan application, I presume that you do not need a market value opinion? Is this correct?
Client: My concern is the maximum supportable loan for this project over the longer term. My Board of Directors will review your report and assumptions and decide the maximum loan to fund. Once we determine the stabilized NOI for this property, we then divide this amount by the debt coverage ratio of 1.33 to derive the annual debt service amount which this property will support. We then divide this amount by the mortgage constant to obtain the maximum supportable loan. We then capitalize the cash flow at a 10% equity dividend rate to derive the value of the equity position. The addition of the maximum supportable loan amount and the equity position results in our investment value for lending purposes. You can derive your conclusion of investment value also, if you like, using your assumptions which you deem appropriate. Since market value assumes a transfer of ownership (which is not involved in this situation) we do not need your opinion of market value. Our intention is to encumber the property with a loan to the existing borrowers. And our desire is to fund a prudent loan amount given the risks involved with this property. Your estimate of NOI will be crucial in this process. If a foreclosure event were to occur in the future, then we would request an opinion of the most likely selling price (market value) at that time. But that is not the problem, nor our concern, at this time.
Consultant/Appraiser: According to the Uniform Standards of Professional Appraisal Practice (USPAP), I will call this assignment a consulting/appraisal report. The primary objective of this report is to assist you with your decision-making questions and issues regarding a proposed first mortgage loan. This is the problem at hand and my scope of work will reflect this problem situation. I look forward to your letter of engagement, after which I will provide you with my scope of work and the estimated date for delivery of my report. Please keep me informed about any changes or new terms that you might negotiate with the developer/borrowers. We can derive different numbers and conclusions depending on the assumptions we adopt and the scenarios that seem appropriate.
Client: I look forward to your report. Please keep me updated on your progress.
The above dialogue illustrates the dynamics between a typical client and a consultant/appraiser given a particular problem situation. As you can discern, the focus of the dialogue is upon the decision-making issues of the client not the market value of this property. Deriving the market value of this property is not viewed as an objective reality and is thus not the crux of the problem to be evaluated. The crux of the problem, in this situation, is the loan amount to be funded on this property in the future. So the dialogue assumed a subjective concept of value that would be derived after the maximum loan amount had been determined by the consultant/appraiser.
I might conclude by saying that under the subjective (inner) concept of value, the consultant/appraiser looks at the problem with a different mindset. This mindset assumes that value is subjective and strictly an inner reality. This results in a different set of questions to be answered and a different report for the client. The typical report that would be prepared under the objective (outer) view of value, would ignore the lender’s decision-making questions and issues and proceed directly to the process of estimating the unique market value for this property. This report would include all sorts of data that may not be relevant for the particular problem at hand. And the viewpoint of the client would not be considered as the primary focus. Also, the definition of value would more then likely be the definition of market value used by most appraisers which assumes a transfer of ownership as the central tenet in the definition. Hypothetical buyers and sellers would also be assumed. The decision-making issues of the client/lender would be ignored as irrelevant since the objective of the assignment would be discovering the market value of the subject property.
So the philosophy of the consultant/appraiser and the client does have a major impact on the type of report that is generated. Is the concept of value objective (outer) or is this concept a subjective (inner) reality? Personally, I would suggest that the following eight principles (expressed as questions) be followed prior to writing any report for a client:
1. What is the problem at hand?
2. Whose viewpoint should be adopted?
3. What judgments and questions need to be explored?
4. What assumptions seem appropriate for this problem situation?
5. What premise results from the above steps?
6. What derivation process seems appropriate for this assignment?
7. What conclusion results from this process?
8. What alternative scenarios and assumptions could be adopted in this situation?
If all the above information were given more serious consideration by consultant/appraisers in the field, then I would wager that the reports prepared would be more meaningful and relevant for all clients who engage us. Also, the public trust in our profession would improve substantially as our reports would be meaningful for the decisions that the client must make. I would also suggest that an inner (subjective) concept of value is more realistic in today’s world. As consultant/appraisers we deal with both outer realities (the physical property) as well as inner assumptions that determine our loan amount and our value conclusion.
Author / Contact: Don Swenson M.A.I., S.R.P.A.
email swenson@wisc.edu
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