Valuation procedure and cycles: an emphasis on down markets
| Published date | 12 July 2011 |
| DOI | https://doi.org/10.1108/14635781111150312 |
| Date | 12 July 2011 |
| Pages | 384-427 |
| Author | James DeLisle,Terry Grissom |
| Subject Matter | Property management & built environment |
Valuation procedure and cycles:
an emphasis on down markets
James DeLisle and Terry Grissom
Department of Urban Planning and Design, College of Built Environments,
University of Washington, Seattle, Washington, USA
Abstract
Purpose – Current economic conditions have identified a complication if not conflict in the
application of valuation analysis assumptions with the free fall in asset prices observed since 2007.
Discrepancies in debt obligations (from prior periods) with underlying collateral value have been
opined to be an unforeseen anomaly. This investigation aims to observe an alternative perspective
using data from 1900 to the present.
Design/methodology/approach – This 110-year period of observation shows that return (value)
volatility is the characteristic norm of the market system. Showing volatility as a fundamental
characteristic of economic and property performance supports conjecture by definition, observation
and rationality that valuation analysis had to be successfully employed in prior down cycles and
across divergent economic regimes. A systematic literature search was conducted to identify the
application of specific value theory, premises and concepts with appropriate valuation techniques in
given economic regimes. The variables derived from the literature and practices observed and
designated as operating across time emphasizing recorded recessions are then tested for statistically
significant associations using
x
2
tests.
Findings – The findings show that traditional value techniques are successfully applied in stabilized
and even accelerated growth periods, but weaken and even break down during down markets.
Alternative approaches and techniques are emphasized and developed during these periods that
address specific problems but are befitting more general issues. The alternative perspectives are then
observed to operate, generating much debate for extended periods. They are then incorporated as
orthodox or disappear as issues. This study identifies a statistical link between the economic and
valuation concerns of the Great Depression of the 1930s and the current Great Recession of 2007-2009.
The more relevant finding, however, is that the period following the depression of the 1930s, which
shows a period characterized as using innovation and alternative valuation techniques, was continued
into a period that ran from the 1950s into the mid-1990s. This was a period of stabilization, at least into
the early 1980s. The deregulation of the 1980s generated a period of fewer cycles but major magnitude
shifts in the less frequent measures of volatility. Unfortunately, the sophistication in debate concerning
valuation procedure and valuation premises, as statistically measured, declined from the 1990s into the
present period. The present economy reflects statistical measures similar to those observed from
1900-1930.
Originality/value – Given the 110 years considered in the study, the findings should not be
considered original with regard to assisting the general welfare or professional decision making.
However, given that the market shifted from being a useful institution to assist in the allocation and
distribution of property to being a religious caveat that could only result in perfect solutions to solve
all social needs, wants and ills, the findings emphasizing valuation techniques based on rational value
premises that can operate to assist inference of future events subject to divergent and cyclical
operations might be calmed to offer very useful assistance with procedure based on fundamentals and
expression of behaviour that has long been vilified. The uses of the patterns identified in this study
need to be incorporated into causal analysis.
Keywords Valuetheory, Valuation theory,Chi-square (
x
2
) tests,Hierarchy of techniques,Cycle phases,
Regimes, Recession,Asset valuation, Financial markets
Paper type Research paper
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1463-578X.htm
JPIF
29,4/5
384
Received December 2010
Accepted March 2011
Journal of Property Investment &
Finance
Vol. 29 No. 4/5, 2011
pp. 384-427
qEmerald Group Publishing Limited
1463-578X
DOI 10.1108/14635781111150312
Valuation procedure and cycles
The collapse of the commercial real estate market in the USA began in 2007 and came
on the heels of the worst financial crisis observed since the Great Depression according
to Reinhart and Rogoff (2009). Indeed, developers, investors, lenders, policy-makers
and regulators seemed totally unprepared for the downturn, claiming it was
unprecedented and thus unpredictable. Once the bubble began to burst and the depth
of the problem started to sink in, the market panicked. As a result, capital flows to the
asset class froze and market activity came to a screeching halt. The disruption led to
record levels of distressed assets and bid-ask spreads that were so wide that
transaction activity almost completely dried up. Some observers noted that this
correction differed from prior downturns, which typically were associated with
overbuilding. Alternatively, this downturn was related more to over-pricing and the
failure to consider the risk side of the equation. Regardless of the factors that led up to
the downturn, the end result was a market environment in which the value of
commercial real estate was difficult to establish.
The turmoil in the commercial market led to a lot of finger pointing including criticism
of the appraisal process. Many observers called into question the process of appraising
properties suggesting that valuation policies and practices were a major contributing
factor behind the collapse. This criticism of appraisal is not new and has emerged in a
number of situations in which the market is out of balance either at the bottom of the cycle
where a floor in value is hard to establish or at the peak of the cycle where a series of
record prices suggest the sky is the limit. In such situations, the emphasis on recent
transaction prices as an anchor for real estate value becomes problematic. This is
especially true when such analysis ignores the externalities that may create a distortion
between current prices of individual properties and the underlying market value of the
broader set of properties and when transaction volume abruptly changes. In such
situations it could be argued that emphasis should shift to longer-term trend indications
of economic activity needed for asset and durable good decisions. These issues are at the
crux of the on-going debate in the literature differentiating price and value, which
becomes more heated during certain stages of the market cycle.
Despite historical experience with economic cy cles, major market players,
institutions and regulators often seem to be caught off guard when abrupt changes
in market behaviour are triggered. The importance of these behavioural responses and
the nature of their cause-and-effect relationship to economic conditions have not been
adequately addressed in the literature. Indeed, the recent risk of an outright economic
collapse suggests a failing of the financial and economic orthodoxy based on
assumptions of efficient and stable markets rather than one based in part on changes in
market behaviour. Such behavioural responses are often ignored in the regulation and
operation of financial institutions and government agencies, which are often based on
the assumption of stable behaviour. The alternative perspective offered by Minsky
(1992) that financial markets and practice are inherently instable (financial instability
hypothesis) offers some insights into such behaviour. His explanation notes that as
asset values are inflated, financial underwriting constrains seeking gains and profits
become relaxed and rational risk aversion is modified if not suspended so that
“surprises” become more probable. Recognition of this instability and research into the
underlying forces may assist in altering expectations and in turn reduce the tendency
towards and the acceptance of “surprise.”
Valuation
procedure and
cycles
385
Real estate valuation policies and practices are based on many of the same
assumptions as economic theory. In particular, valuation practices assume transaction
prices are set by fully informed and knowledgeable participants acting under no duress
and can be used in estimating market value. The recent collapse of the commercial
market, which created record volumes of distressed assets and disrupted the normal
market flow, suggests some of the underlying economic assumptions may not hold up
over the complete market cycle. This is evidenced by the record number of distressed
assets that quickly accumulated as the market effectively shut down in a panic mode.
In this environment, appraisers where left with a dearth of transactions for which
prices could be extracted and extended to other properties to estimate value. This
suggests that reliance on the assumption that prices equal value is unreliable over
certain stages of the real estate cycle. While some might argue that the recent situation
was an anomaly and will not repeat itself, history suggests this may not be the case.
For example, during the collapse of the real estate market in the latter-1980s the
market also shut down with prices of few assets that did sell spiralling downward and
leaving the market struggling with the question of what is the true value of real estate.
The fundamental question of whether the value equals price assumption holds up
over time has received little attention in contemporary appraisal literature. The
absence of a debate may be philosophical and relate to the position that values should
be positive and focus on “what it is” rather than on normative or “what it should be.” It
is also possible that some of the resistance to debating the issue is based on the belief
that it is not possible to determine when the assumption breaks down and should be
ignored to prevent valuation from becoming speculative. Interestingly, the argument
that price does not equal value (price –value) can be traced back to the Great
Depression of the 1930s when appraisal organizations first emerged in the United
States in response to the need for formal policies and practices to guide the process of
estimating real estate value after the market has broken down. The primary objective
of this study is to explore whether the fundamental assumption of whether real estate
“value equals price” is valid or whether it becomes unreliable during certain phases of
the market cycle. Of particular interest is the question of whether abrupt changes in
market cycles can trigger changes in market behaviour that in turn creates a
divergence between observed transaction prices and alternative choices of estimating
value. A secondary objective is to determine whether future real estate cycles and
changes in market behaviour should continue to “surprise” the market or whether they
are related to the economic cycles which could signal when valuation based on the
status quo is likely to break down and alternative premises of value and valuation
technique needs to be considered.
I. Methodology and data development
The methodology for this study is based on a two-stage design. In the first stage, the
inquiry applies quantitative analysis of economic cycles to delineate clear regimes or
time periods during which the real estate market may have been subject to similar
market forces. The analysis integrates economic cycles and real estate performance to
determine breakpoints between one period or regime and the next. This analysis helps
ensure that the delineated time periods are meaningful and likely to represent temporal
frames during which the real estate market exhibited similar behaviour that affected
the price versus value proposition in a consistent manner. In the second stage,
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