Reconciling the ReconciliationReconciling the Reconciliation

Presented by:

Mark Pomykacz, MAIFederal Appraisal & Consulting LLCPhone: (908) 823-0607

E-mail: mark@federalappraisal.com

Presented to:

IAAO Councils & SectionsPublic Utility Section

Thursday May 11, 2006Charleston, SC

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

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.

The Reconciling Issue

Limited Coverage in the Major Treatises and Journals

The Appraisal of Real Estate, 12th Edition7 pages of 759 pages (0.9%)

Valuing a Business, 4th Edition, Shannon Pratt12 pages of 923 pages (1.3%)

The Appraisal Journal and Other Journals3 Articles

Articles on Reconciliation

Proper Reconciliation in Narrative ReportsFavors Substance Over FormBy Ralph H. Emerson, III, MAINotes and Issues, pg 94

Real Reconciliation By R.H. Holstein, III, A.R.A2003 JOURNAL OF THE ASFMRA, pg 37

The Myth about AppraisalBy Joe Roberts & Eric RobertsThe Appraisal Journal, April 1991, pg 212

Definition* - Reconciliation

1. 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.

2. 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

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

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:

 (a) reconcile the quality and quantity of data available and analyzed

within the approaches used; and

(b) 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.

USPAP & Reconciliation, 2

1. Departure is not permitted (AO-15)2. A reconciliation must be adequate for the report’s purpose and use.

(10-2)3. Sales history must be reconciled with other indications of value. (AO-

22)4. USPAP reconciliation requirements apply to:

• Real• Personal• Consulting• Mass Appraisal• Business and Intangibles

5. 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

The Appraisal of Real Estate*

1. Diverse indications are common.

2. Reconciliation is not just for final indications of value1. Also for reconciling adjusted sales comparables

2. And for reconciling various appraisal aspects.

3. The purpose and use of the appraisal will impact the scope of the reconciliation.

4. A reconciliation requires judgment. It is not an averaging process.

5. A reconciliation must be supported and explained.

6. Data may be best available, may not yield appropriate value.

7. Reconciliation involves setting a rounding policy

12th Edition

Common Reconciliation Mistakes

1. Completing a reconciliation by rote.

Conversely, failing to complete an approach/analysis because in otherwise similar circumstances, it is commonly not done.

Scope of Appraisal

Reconciliation

Purpose and Use

Common Reconciliation Mistakes, 2

2. Mixing indications that assume a different highest and best use.

3. Failing to account for needed, but incomplete, adjustments in deriving the indications.

4. Expecting all completed approaches to be reconcilable.

5. 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.

The Criteria

1. Appraisal Parameters – Consistency with appraisal purpose, use and scope, and with highest and best use.

2. Theory – What does appraisal theory say you should do?

3. Data Quality and Quantity – Regardless of theory, what does the quality and quantity of the data allow you to do?

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 .

The Theory Criteria, 2

Examples

1. 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.

2. 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.

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.

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 of substitution 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.

Market CyclesU.S. Office Market Cycle Positions

Source: Pricewaterhouse Coopers

Market CyclesU.S. Multifamily Market Cycle Positions

Source: Pricewaterhouse Coopers

Cost vs. Value

Residential Apartment

-0.4

0

0.4

0.8

1.2

1.6

2

2.4

1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

BLS Cost Index (20% EI) BLS Cost Index

NCREIF Value BLS Cost Index (20% loss)

Probably Economic Obsolescence

Probably Excess Profit

Cost vs. Value

Office Space

-4

-3

-2

-1

0

1

2

3

4

5

1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

BLS Cost Index NCREIF Value BLS Cost Index (20% EI) BLS Cost Index (20% loss)

Probably Economic Obsolescence

Probably Excess Profit

The Appraiser as Mimic

Appraisers should do what the market does!

Appraisers in Action

Survey of Assessors, Owners,

Appraisers and Representatives

Question 1a

0

2

4

6

8

10

12

14

16

NoWeight

MinimalWeight

EqualWeight

MostWeght

AllWeight

Regulated Acqusition/Disposition Cost Approach

Other

Both

Owner

Assessor

Question 1b

0

2

4

6

8

10

12

NoWeight

MinimalWeight

EqualWeight

MostWeght

AllWeight

Regulated Acquisition/Disposition Income Approach

Other

Both

Owner

Assessor

Question 1c

02468

1012141618

NoWeight

MinimalWeight

EqualWeight

MostWeght

AllWeight

Regulated Acquistion/Disposition Sales Approach

Other

Both

Owner

Assessor

Question 2a

0

5

10

15

20

NoWeight

MinimalWeight

EqualWeight

MostWeght

AllWeight

Deregulated Acquisition/Disposition Cost Approach

Other

Both

Owner

Assessor

Question 2b

0

5

10

15

20

NoWeight

MinimalWeight

EqualWeight

MostWeght

AllWeight

Deregulated Acquisition/Disposition Income Approach

Other

Both

Owner

Assessor

Question 2c

0

2

4

6

8

10

12

14

NoWeight

MinimalWeight

EqualWeight

MostWeght

AllWeight

Deregulated Acquisition/Disposition Sales Approach

Other

Both

Owner

Assessor

Question 3a

0

5

10

15

20

NoWeight

MinimalWeight

EqualWeight

MostWeght

AllWeight

Regulated Property Tax Cost Approach

Other

Both

Owner

Assessor

Question 3b

0

2

4

6

8

10

12

NoWeight

MinimalWeight

EqualWeight

MostWeght

AllWeight

Regulated Property Tax Income Approach

Other

Both

Owner

Assessor

Question 3c

0

5

10

15

20

NoWeight

MinimalWeight

EqualWeight

MostWeght

AllWeight

Regulated Property Tax Sales Approach

Other

Both

Owner

Assessor

Question 4a

0

2

4

6

8

10

12

14

16

NoWeight

MinimalWeight

EqualWeight

MostWeght

AllWeight

Deregulated Property Tax Cost Approach

Other

Both

Owner

Assessor

Question 4b

0

5

10

15

20

25

NoWeight

MinimalWeight

EqualWeight

MostWeght

AllWeight

Deregulated Property Tax Income Approach

Other

Both

Owner

Assessor

Question 4c

0

2

4

6

8

10

12

14

16

NoWeight

MinimalWeight

EqualWeight

MostWeght

AllWeight

Deregulated Property Tax Sales Approach

Other

Both

Owner

Assessor

Question 5

0 5 10 15 20 25

1

Different Approaches for Different Power Plants

Always

Frequently

Occasionally

Never

Question 6a

02468

1012141618

NoWeight

MinimalWeight

EqualWeight

MostWeght

AllWeight

Market Value via Income Approach Direct Cap

Other

Both

Owner

Assessor

Question 6b

0

5

10

15

20

25

NoWeight

MinimalWeight

EqualWeight

MostWeght

AllWeight

Market Value via Income ApproachDiscounted Cashflow

Other

Both

Owner

Assessor

Question 7a

0

2

4

6

8

10

12

NoWeight

MinimalWeight

EqualWeight

MostWeght

AllWeight

Market Value via Cost Approach Replacement Cost

Other

Both

Owner

Assessor

Question 7b

0

2

4

6

8

10

12

14

NoWeight

MinimalWeight

EqualWeight

MostWeght

AllWeight

Market Value via Cost Approach Reproduction Cost

Other

Both

Owner

Assessor

Question 8

0 1 2 3 4 5 6 7 8 9

Acquisition

SEC Reporting

Property Tax Assessment (ow ner)

Property Tax Assessment (taxer)

Federal Tax Reporting

State/Local Tax Reporting

Insurance

Financial modeling

Other

Purpose of Appraisal

Other

Both

Owner

Assessor

Question 10

0 2 4 6 8 10 12 14

All of U.S.

CAISO

MISO

NYISO

ISD-NE

PJM

SPP

Other, Please Specify

Regions Practiced In

Assessor

Owner

Both

Other

Cost, Income, Sales

Sales Cost Income

Direct Capitization Yield Capitalizaton

Appraisal

RegulatedMarket

DeregulatedMarket

Minimal Most Minimal

Some Minimal Most

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”

Practical Considerations

1. Size of absolute adjustments

2. Typical data quality and quantity

Conclusions

1. Avoid the usual mistakes.

2. Not all completed approaches can be reconciled.

3. Use appraisal theory to the extent possible to reconcile

1. Mimic the market

2. Use economic theory

4. Use practical considerations

1. Size of absolute adjustments

2. Typical data quality and quantity

Questions?

Questions?Questions?