Methodology Muddle: Reconciling Income and Sales Approaches
You are reviewing an appraisal of a mixed-use property (retail on the ground floor, two apartments above). The original appraiser developed both the income approach and the sales comparison approach. The income approach yielded $850,000, based on market rent for the retail space and the apartments, a vacancy rate of 5%, and a capitalization rate of 7.5%. The sales comparison approach yielded $920,000, based on three comparable sales, but the appraiser made a large negative adjustment (-15%) to one comparable for location and a positive adjustment (+10%) to another for condition. The appraiser reconciled to $900,000, giving more weight to the sales comparison approach because 'it reflects actual market transactions.' The review must assess the reasonableness of the reconciliation. You have market data showing that mixed-use properties in this area typically sell for capitalization rates between 7.0% and 8.0%, and that the subject’s retail space is currently leased at below-market rent with a lease expiring in two years. The apartments are above-market rent and month-to-month.
1. What are the key methodological issues in the original appraisal’s reconciliation?
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Key issues:
Income approach inputs: The appraiser used market rent for the retail space, but the subject has a below-market lease for two years. The appraiser should have considered the contract rent and the lease terms, perhaps using a discounted cash flow or adjusting for the lease. Using market rent ignores the actual income stream and may overstate value. Similarly, the apartments are above-market and month-to-month; the appraiser should consider the likelihood of rent reduction. The vacancy rate of 5% may be reasonable, but the cap rate of 7.5% is within the market range (7.0-8.0%), so that seems okay.
Sales comparison adjustments: The large adjustments (-15% for location, +10% for condition) suggest the comparables are not very similar. The appraiser should have explained the basis for these adjustments and considered whether they are supported by market data. Large adjustments can indicate unreliable comparables.
Reconciliation rationale: The appraiser gave more weight to the sales comparison approach because it reflects actual transactions. However, for an income-producing property, the income approach is often more reliable, especially when the property is leased. The appraiser did not explain why the income approach was less reliable. The reconciliation should consider the quantity and quality of data, the applicability of each approach, and the property’s characteristics. The income approach may be more credible if the leases are typical and the market data is strong.
Consistency: The appraiser’s value of $900,000 is between the two approaches, but the rationale for weighting is weak. The reviewer should assess whether the reconciliation is logical and supported.
Market data: The reviewer’s market data on cap rates supports the income approach’s cap rate, but the lease issues may mean the income approach value is overstated. The reviewer should consider whether the sales comparables reflect similar lease situations.
2. How should the reviewer analyze the income approach given the lease situations?
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The reviewer should analyze the income approach as follows:
Retail lease: The below-market lease has two years remaining. The contract rent is below market. The appraiser used market rent, which assumes the lease is at market. The reviewer should consider the present value of the lease differential. One method is to use the contract rent for the remaining lease term and market rent thereafter, discounting to present value. Alternatively, the appraiser could have used a blended rent or made an adjustment. The reviewer should determine whether the appraiser’s use of market rent is a material error. If the below-market lease is significant, the income approach value may be overstated.
Apartment leases: The apartments are above-market and month-to-month. The appraiser used market rent, which is lower than contract rent. This may understate income in the short term but is conservative because the rents will likely adjust to market quickly. However, the appraiser should have explained the treatment. The reviewer should assess whether the use of market rent is reasonable given the month-to-month nature.
Vacancy and collection loss: 5% may be reasonable, but the reviewer should check market data.
Cap rate: 7.5% is within the market range, so acceptable.
Overall: The reviewer should consider whether the income approach value is reliable. If the lease situations are not properly handled, the reviewer may conclude the income approach is less credible and the sales comparison approach may be more reliable, or the reviewer may adjust the income approach. The reviewer should also consider whether the sales comparables have similar lease situations; if not, adjustments may be needed.
In the review, the reviewer should state whether the original appraiser’s handling of the leases was adequate and how it affects the credibility of the value.