Chapter: Adjusting for Conditions, concessions❓, and Market Shifts

This chapter delves into the critical adjustments appraisers make to comparable sales data in the Sales Comparison Approach. We’ll examine adjustments for atypical conditions of sale, concessions offered during transactions, and fluctuations in market conditions over time. Understanding and appropriately applying these adjustments is crucial for deriving a reliable and credible indication of value.

1. Adjusting for Conditions of Sale

1.1. Identifying Atypical Conditions of Sale

The ideal comparable sale is an arm’s-length transaction occurring under typical market conditions. However, various factors can influence a sale, leading to a price that deviates from market value. These non-market conditions require careful consideration and, if possible, adjustment.

• Definition: Conditions of sale encompass any unusual circumstances that may have influenced the agreed-upon price.

• Examples:

  • Related Parties: Sales between family members or affiliated businesses may not reflect market realities due to non-economic considerations.
  • Distress Sales: Sellers facing foreclosure, bankruptcy, or other urgent financial needs may accept lower offers to expedite the sale.
  • Like-Kind Exchanges (1031 Exchanges): As detailed in Section 1031 of the Internal Revenue Code, these exchanges allow deferral of capital gains taxes. Buyers in these exchanges may be willing to pay a premium, requiring a cash-equivalency adjustment.
  • Forced Sales: Eminent domain proceedings or other legal mandates can create urgency and pressure on the seller, affecting the price.
  • Unusual Tax Considerations: Special tax situations may motivate a buyer or seller to act in a way that affects price, distinct from general market value.
  • Lack of Market Exposure: Sales not adequately marketed can miss potential buyers, resulting in a suboptimal price.

1.2. The Science Behind the Adjustment

The theoretical foundation for adjusting for conditions of sale lies in the principle of substitution. Buyers make rational decisions, and the price they are willing to pay is theoretically equal to the lowest price for which a comparable property can be obtained. Atypical conditions distort this rational decision-making process. By adjusting, we attempt to normalize the comparable sale to reflect a true arm’s-length transaction.

• Market Efficiency & Information Asymmetry: A perfectly efficient market assumes complete information available to all participants. Conditions of sale often introduce information asymmetry, where one party has more information or faces constraints that distort the price.

• Game Theory Perspective: Negotiations can be modeled using game theory. Factors like a seller’s urgency (distress sale) shift the power dynamic and the Nash equilibrium point, leading to a price that wouldn’t occur under normal circumstances.

1.3. Practical Application & Experimentation

Determining the magnitude of the adjustment for conditions of sale requires careful investigation and market analysis.

• Verification is Key: Interview buyers, sellers, brokers, and other parties involved in the transaction. Scrutinize sales contracts and other documentation.

• Paired Sales Analysis: Search for paired sales – similar properties that sold under typical and atypical conditions. The price difference can provide an indication of the necessary adjustment.

  • Example: Two identical houses are sold. House A is a standard sale for $500,000. House B is a distress sale, selling for $450,000. The difference of $50,000 (10%) suggests a potential adjustment for distress sale conditions.

• Regression Analysis: If sufficient data exists, statistical techniques like regression analysis can quantify the impact of various conditions of sale on property prices. The model can be expressed as:

  • Sale Price = β₀ + β₁*Characteristic₁ + β₂*Characteristic₂ + ... + βₙ*ConditionOfSale₁ + ... + ε

    • Where:
      • Sale Price is the dependent variable.
      • β₀ is the intercept.
      • β₁, β₂,... βₙ are coefficients for property characteristics.
      • ConditionOfSale₁ represents a dummy variable indicating the presence (1) or absence (0) of a specific condition of sale.
      • ε is the error term.

• Sensitivity Analysis: Explore the impact of different adjustment amounts. Determine a reasonable range for the adjustment and assess how the final value opinion❓ changes within that range.

• Experiment: In a simulated market environment, present different negotiation scenarios with and without distressed sellers. Observe the resulting transaction prices and calculate the average price difference. This provides a controlled environment to isolate the impact of distress conditions.

1.4. Disclosure and Support

Transparency is paramount. Any adjustments for conditions of sale must be clearly explained and supported in the appraisal report. If adequate data is unavailable, the sale may need to be discarded, or its limitations explicitly acknowledged.

2. Adjusting for Concessions

2.1. Defining Concessions

Concessions are incentives offered by the seller to the buyer that are not directly related to the property’s inherent physical characteristics. These incentives effectively lower the buyer’s net cost❓, potentially inflating the nominal sale price.

• Definition: A concession is a financial payment, special benefit, arrangement, or non-realty item included in a sale contract or rental agreement as an incentive to the sale or lease.

• Examples:

  • Seller-Paid Closing Costs: The seller contributes to the buyer’s expenses at closing.
  • Personal Property Inclusion: Items like furniture, appliances, or vehicles are included in the sale.
  • Seller-Financed Below-Market Interest Rates (Buydowns): The seller provides financing with a reduced interest rate.
  • Points Paid by Seller: Seller pays points to reduce buyer’s interest rate.
  • Repairs/Improvements Paid by Seller Post-Sale: Seller commits to making improvements to the property after closing.
  • “Inflated” Personal Property Purchase: Seller buys a buyer’s used item for an artificially high price.

2.2. The Economic Impact of Concessions

Concessions distort the true price of the property. The observed sale price includes the value of the concession, which isn’t inherent to the real estate itself. Failing to adjust for concessions leads to overvaluation.

• Time Value of Money: Seller-financed buydowns affect the present value of the future cash flows. A simple dollar-for-dollar adjustment might not be sufficient; a present value calculation is often necessary.

  • PV = Σ (CFₜ / (1 + r)ᵗ)
    • Where:
      • PV = Present Value of the concession
      • CFₜ = Cash flow (savings on interest payments) in period t
      • r = Discount rate (prevailing market interest rate)
      • t = Time period

• Opportunity Cost: The buyer benefits from the concession, but the seller incurs a cost (either directly or through a reduced net price). This cost represents the opportunity cost of the concession, which should ideally be quantified.

2.3. Quantifying Concession Adjustments

• Direct Valuation: The most straightforward approach is to directly value the concession (e.g., the market value of the included furniture). This value is then subtracted from the sale price.

• Cash Equivalency Adjustment: This method focuses on converting all aspects of the sale into cash terms. For seller-financed loans, calculate the present value of the interest rate differential compared to a market-rate loan.

  • Example: A seller offers a 4% interest rate when market rate is 6%. Calculate the present value of the savings on the loan payments and deduct that amount from the sale price.

• Paired Sales Analysis (Again): Compare sales with and without similar concessions to estimate the market’s reaction to such incentives.

2.4. Avoiding Double-Counting

Carefully consider how the concession affects other aspects of the analysis. For example, adjusting for a seller-paid buydown might implicitly account for a lower capitalization rate in an income-producing property. Avoid adjusting for the concession and separately adjusting the capitalization rate to reflect the lower effective interest rate.

3. Adjusting for Market Shifts (Market Conditions)

3.1. Understanding Market Dynamics

Real estate markets are dynamic, constantly shifting due to various economic forces. Adjustments for market conditions account for changes in property values between the date of the comparable sale and the appraisal’s effective date.

• Definition: An adjustment for market conditions is made if general property values have increased or decreased since the transaction dates.

• Key Drivers:

  • Supply and Demand: Changes in the availability of properties and the number of buyers directly affect prices.
  • Interest Rates: Lower interest rates increase affordability and boost demand.
  • Economic Growth: Strong economic conditions lead to higher incomes and increased demand for housing and commercial space.
  • Inflation: General price increases erode purchasing power and can drive up real estate values.
  • Employment: Job growth attracts new residents and boosts demand.
  • Government Regulations: Changes in zoning laws, building codes, or tax policies can impact property values.

3.2. Measuring Market Changes

• Repeat Sales Analysis: Analyzing the sale prices of the same properties over time is the most direct method.

  • Percentage Change = ((Sale Price₂ - Sale Price₁) / Sale Price₁) * 100%
    • Where:
      • Sale Price₁ = Original Sale Price
      • Sale Price₂ = Subsequent Sale Price

• Market Surveys & Indices: Consult real estate market reports, surveys, and price indices published by reputable sources. Be cautious about using broad indices, as they may not accurately reflect the specific subject property’s submarket.

• Regression Analysis (Time as a Variable): Include the sale date as an independent variable in a regression model to estimate the market’s appreciation or depreciation rate.

  • Sale Price = β₀ + β₁*Characteristic₁ + β₂*Characteristic₂ + β₃*Time + ε
    • Where Time is measured in months or years from a base date. The coefficient β₃ represents the estimated change in price per unit of time.

3.3. Applying Market Condition Adjustments

• Percentage Adjustment: Multiply the comparable sale price by the percentage change in market value over the relevant time period.

  • Adjusted Sale Price = Original Sale Price * (1 + Market Change Rate)
    • Where Market Change Rate is expressed as a decimal (e.g., 5% = 0.05).

• Dollar Adjustment: Convert the percentage change into a dollar amount and add or subtract it from the original sale price.

3.4. Important Considerations

• Lag Effects: Real estate market reactions often lag behind economic events. Don’t assume an immediate and proportionate response to changes in interest rates or employment.

• Submarket Segmentation: Market conditions can vary significantly within different submarkets (e.g., different neighborhoods or property types).

• Contract vs. Closing Date: The effective date of the sale is the contract date, not necessarily the closing date. Adjustments should reflect market changes occurring between the contract date and the appraisal’s effective date.

• Retrospective and Prospective Appraisals: Appraisals requiring retrospective (past) or prospective (future) value opinions heavily rely on accurate market condition analysis and forecasting.

4. Expenditures Made Immediately After Purchase

4.1 Definition

These are costs a buyer anticipates incurring immediately after purchasing a property to bring it to its full utility or to address existing deficiencies.

4.2 Examples

• Costs to cure deferred maintenance
• Costs to demolish and remove a portion of the improvements
• Costs for additions or improvements to the property
• Costs to petition for a zoning change
• Costs to remediate environmental contamination
• Cost of obtaining entitlements (permissions)
• Demolition and removal costs
• Environmental remediation costs
• Large capital improvements needed at the time of sale

4.3 Adjustment Methods

• Identification and Quantification: Interview buyers and sellers to determine the expenditures they considered at the time of sale.
• Adjust the Comparable Sale Price: Add the anticipated expenditure to the sale price of the comparable to reflect its condition relative to a property not requiring such expenditures. The relevant amount is what the buyer expected to spend, not necessarily what they actually spent.

4.4 Example

A comparable warehouse sold for $850,000. The buyer anticipated spending $65,000 on a loading dock. The adjusted sale price is $850,000 + $65,000 = $915,000. If the subject property already has a loading dock, this adjustment is necessary to bring the comparable sale in line with the subject.

Conclusion

Adjusting for conditions of sale, concessions, and market shifts is a crucial aspect of the Sales Comparison Approach. These adjustments require thorough investigation, sound judgment, and clear documentation. By understanding the underlying principles and applying appropriate methodologies, appraisers can derive reliable and credible value opinions that reflect true market realities.