Reconciling the Reconciliation

1. Reconciling the Reconciliation Presented by: Mark Pomykacz, MAI Federal Appraisal & Consulting LLC Phone: (908) 823-0607 E-mail: mark@federalappraisal.com Presented to: IAAO Councils & Sections Public Utility Section Thursday May 11, 2006Charleston, SC

2. Mark Pomykacz, MAI • Managing Partner, Federal Appraisal & Consulting LLC Real estate and business appraisal and advisory services • Specialize in complex issues and properties, • IRS, SEC and other financial reporting • Utilities, power plants and telecommunications assets • Member of Appraisal Institute (“MAI”) • Member of the National Board of Directors of the Appraisal Institute • Teach Income Capitalization, USPAP and Various Seminars for the Appraisal Institute, IAAO, Baruch (CUNY) and New York University, and others • State certified general real estate appraiser in multiple states • Published several articles on appraisal and property taxes

3. The Reconciling Issue • Theory and Practice leaves many unprepared for complex reconciliation issues. • The major appraisal treatises and journals: • Provide limited coverage. • Often imply reconciliation is required. • Often imply if a reconciliation is not completed, then it is due to appraiser incompetence, or worse. • Usually a reconciliation is so obvious, that little thought is required, and even poorly written reconciliations are rarely challenged.

4. Limited Coverage in the Major Treatises and Journals The Appraisal of Real Estate, 12th Edition 7 pages of 759 pages (0.9%) The Appraisal Journal and Other Journals 3 Articles Valuing a Business, 4th Edition, Shannon Pratt 12 pages of 923 pages (1.3%)

5. Articles on Reconciliation Proper Reconciliation in Narrative Reports Favors Substance Over Form By Ralph H. Emerson, III, MAI Notes and Issues, pg 94 Real Reconciliation By R.H. Holstein, III, A.R.A 2003 JOURNAL OF THE ASFMRA, pg 37 The Myth about Appraisal By Joe Roberts & Eric Roberts The Appraisal Journal, April 1991, pg 212

6. Definition* - Reconciliation • The last phase of any valuation assignment in which two or more value indications derived from market data are resolved into a final value opinion, which may be either a final range of value or a single point estimate. • In the sales comparison approach, reconciliation may involve two levels of analysis: 1) derivation of a value indication from the adjusted prices of two or more comparable sales expressed in the same unit of comparison and 2) derivation of a value indication from the adjusted prices of two or more comparables expressed in different units of comparison. * The Dictionary of Real Estate Appraisal, 4th Edition

7. Definition* - Reconciliation Criteria The criteria that enable an appraiser to form a meaningful, defensible conclusion about the final value opinion. Value indications are tested for the appropriateness of the approaches and adjustments applied, the accuracy of the data, and the quantity of evidence analyzed. * The Dictionary of Real Estate Appraisal, 4th Edition

8. USPAP & Reconciliation • Standards Rule 1-6 • (This Standards Rule contains binding requirements from which departure is not permitted.) • In developing a real property appraisal, an appraiser must: • reconcile the quality and quantity of data available and analyzed within the approaches used; and • reconcile the applicability or suitability of the approaches used to arrive at the value conclusion(s). • Comment: See the Comments to Standards Rules 2-2(a)(ix), 2-2(b)(ix), and 2-2(c)(ix) for corresponding reporting requirements.

9. USPAP & Reconciliation, 2 • Departure is not permitted (AO-15) • A reconciliation must be adequate for the report’s purpose and use. (10-2) • Sales history must be reconciled with other indications of value. (AO-22) • USPAP reconciliation requirements apply to: • Real • Personal • Consulting • Mass Appraisal • Business and Intangibles • Assistants who can conduct most other aspects of the appraisal, may need help from a principle to reconcile. The report should disclose which parts were done by whom. (AO-5) • Self Contained • Summary • Restricted Use

10. The Appraisal of Real Estate* • Diverse indications are common. • Reconciliation is not just for final indications of value • Also for reconciling adjusted sales comparables • And for reconciling various appraisal aspects. • The purpose and use of the appraisal will impact the scope of the reconciliation. • A reconciliation requires judgment. It is not an averaging process. • A reconciliation must be supported and explained. • Data may be best available, may not yield appropriate value. • Reconciliation involves setting a rounding policy 12th Edition

11. Common Reconciliation Mistakes • Completing a reconciliation by rote.Conversely, failing to complete an approach/analysis because in otherwise similar circumstances, it is commonly not done.

12. Common Reconciliation Mistakes, 2 • Mixing indications that assume a different highest and best use. • Failing to account for needed, but incomplete, adjustments in deriving the indications. • Expecting all completed approaches to be reconcilable. • With out good reason, and/or in an inconsistent matter, simply changing various analysis assumptions in order to get the various indications to be the same.

13. The Criteria • Appraisal Parameters – Consistency with appraisal purpose, use and scope, and with highest and best use. • Theory – What does appraisal theory say you should do? • Data Quality and Quantity – Regardless of theory, what does the quality and quantity of the data allow you to do?

14. The Theory Criteria Question: What does appraisal theory say you should do? Answer: Whatever your peers would do. Question: But what should my peers do? Answer: Whatever buyers and sellers do. Question: But what do buyers and sellers do? Answer: It depends on the property, and the market. But whatever they do, we assume it will follow rational laws of economics concerning value, i.e. appraisal theory .

15. The Theory Criteria, 2 • Examples • SFH – use sales, maybe cost, if new enough, but not income.Reconcile with all or nearly all weight to the sales. • An apprentice appraiser, in their first month on the job, learns that both his peers and the market do this. • Apartment Building - primarily use income, maybe sales (if data is good), and maybe cost, if new enough and if market is near equilibrium. • An apprentice appraiser, in their first year on the job, learns that both his peers and the market do this. • Thereafter its rote. • But what are the economic principles that explain the actions.

16. The Economic Theory - SFH • Buyers do not buy for the income. They buy for their own use. • They sometimes build for their own use. • Buyers comparison shop. • They even compare the cost to build versus the price of existing homes. • Overwhelmingly, they do not consider the income potential. • Principles of substitution, not principles of economic anticipation, apply. • So use sales, sometimes use cost, do not need income. • If client’s purpose and use is limited, then use sales only. • If client’s purpose and use is expansive, then use sales and cost, but still not income, unless subject and/or market has an income potential.

17. The Economic Theory - Apartments • Buyers buy apartment homes for the income. They do not buy for their own use. • They sometimes build for income potential. • Buyers comparison shop. • They even compare the cost to build versus the price of existing. • They emphasize the income potential. • Principles of economic anticipation apply, but principles ofsubstitution are used to measure the value of the anticipated income. • So use sales, sometimes use cost, but emphasize income. • Sales must have similar income potentials, and highest & best uses. • Cost must reflect all economic obsolescence, along with functional and physical obsolescences.

18. Market CyclesU.S. Office Market Cycle Positions Source: Pricewaterhouse Coopers

19. Market CyclesU.S. Multifamily Market Cycle Positions Source: Pricewaterhouse Coopers

20. Cost vs. Value Probably Excess Profit Probably Economic Obsolescence

21. Cost vs. Value Probably Excess Profit Probably Economic Obsolescence

22. The Appraiser as Mimic Appraisers should do what the market does!

23. Appraisers in Action Survey of Assessors, Owners, Appraisers and Representatives

24. Question 1a

25. Question 1b

26. Question 1c

27. Question 2a

28. Question2b

29. Question 2c

30. Question 3a

31. Question 3b

32. Question 3c

33. Question 4a

34. Question 4b

35. Question 4c

36. Question 5

37. Question 6a

38. Question 6b

39. Question 7a

40. Question 7b

41. Question 8

42. Question 10

43. Cost, Income, Sales RegulatedMarket DeregulatedMarket Minimal Most Minimal Some Minimal Most

44. Cash is King All businesses produce the same thing: CASH! AKA: Income or Cash Flow Thus, The Income Approach is King Not “Capitalist”. Rather: “Cash Flowist” “Cash Flowite” “Cash Flowian”

45. Practical Considerations • Size of absolute adjustments • Typical data quality and quantity

46. Conclusions • Avoid the usual mistakes. • Not all completed approaches can be reconciled. • Use appraisal theory to the extent possible to reconcile • Mimic the market • Use economic theory • Use practical considerations • Size of absolute adjustments • Typical data quality and quantity

47. Questions? Questions?