In Part One we asked why the current definition of market value has been around without change for so long? We focused on item 4 in the current definition of market value which says:

“payment is made in terms of cash in U. S. dollars or in terms of financial arrangements comparable thereto”

Editor’s Note: This is Part Two of a discussion of the definition of market value by Bruce Hahn, CCIM, CRE, MAI, SRA. Read Part One Here.

LEVERAGE

The artificially low interest rates of the last few years do not represent financial arrangements that are equivalent to CASH in US dollars. The negative real rates are lower than the rate of inflation and offer an advantage over cash to anyone utilizing leverage at such a low cost. These artificially low interest rates remove the analysis of risk vs reward. Perceived lower risks encouraged real estate buyers (actually buyers of all asset classes) to take significant risks without fully considering the potential consequences. The market psychology expected that rates would remain low and that values would remain high or continue increasing! The market did not factor in the impacts that rapidly rising interest rates would have on real estate, and many other asset classes, that are becoming evident now.

LIQUIDITY

Let’s dig a little deeper in Part II. Savvy investors consider the impacts of both leverage and income tax consequences on their investment return with real estate. Deductibility of mortgage interest can save tax dollars, and the depreciation of an investment property can also bring similar savings on taxes. The cost of borrowing recently increased very rapidly by over 400 basis points in less than a year. Most people had not considered this risk. The rapid repricing of the cost of debt service brought sudden changes to both demand from buyers and a decline in values as buyers could only afford a smaller loan amount. Price is the only part that can change in this equation. So we see that in addition to Leverage, Liquidity also impacts real estate pricing, yet it is not considered within the current definition.

This is also evident with bonds, mortgage backed securities, and Treasuries, which have all experienced repricing as interest rates increased. Investors expect a market rate of return, so the only way to get that is to discount the principal of these securities until the discounted face value provides the expected market rate of return. This is what has caused banks to have liquidity problems. They would be okay if they held these securities to maturity and got paid off at full face value, returning all principal invested. Then the only loss would be the lower than market rate interest during the remainder of the investment period hold. Real estate has similar problems at present! So liquidity is a problem and it impacts value.

Real estate itself is highly illiquid – meaning you cannot get a buyer and sell immediately as you can with securities that trade on an open market. A buyer can be found for a bond or similar security usually within minutes or even less. Real estate usually takes a month or longer for the sale to be completed.

Banks currently have assets that they can’t sell because asset values have gone down. They do not want to realize a loss by selling before maturity. Demands for withdrawals by depositors cause extreme liquidity issues for many banks that have made seemingly safe investments in bonds without hedging against interest rates, or adequately considering these risks. The resulting bailouts from the FED and FDIC appear to have at least temporarily solved this liquidity crunch by providing money to meet depositor demands for withdrawals, without yet having to realize losses on bonds held.

Real estate markets that have become heavily dependent on high loan to value real estate loans will suffer when lenders cut back on lending activity and liquidity diminishes. Without the liquidity available in the last decade the real estate markets would operate very differently. If buyers had to pay all cash prices for real estate would be very different than they are today. Less liquidity is likely to negative impact the prices paid for real estate in such markets. This cycle is accelerated as lenders begin to experience losses from overextended borrowers as pricing softens. Further slowing liquidity as lenders tighten borrowing requirements as a result.

So why is the definition of market value so hopelessly out of date? Clearly risks with Leverage matter to real estate. So does Liquidity – so why don’t appraisers consider the impacts of Leverage and Liquidity as it can relate to real estate market value? Clearly they matter! And it seems highly likely that this will once again be illustrated by the real estate market very soon!