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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   July 2008

Appraising Appraisals

Impress your lender -- know your appraisal’s strengths and weaknesses

c_2008-07_schloss_spotMultiple times a day, mortgage brokers ask underwriters their loan-to-value (LTV) requirements on a certain property type. The answer is all too predictable: “Well, we have an appraisal at $ ____.”

Therein lies the rub.

Good brokers know that loans are not simply based on appraised value and that even a low LTV isn’t the final word for lenders considering deals worthy of their investment.

Nevertheless, appraisals are an important tool for many industries. Banks and insurance companies rely on these expert analyses of a property’s value when they make many important business decisions. When done well, appraisals can be quite accurate. Even when done poorly, appraisals still can provide important sourcing-market data, demographic information and property photos.

All appraisals are subject to certain limitations, as well. Here is a look at some of the more-important sections of a typical appraisal for commercial brokers, as well as places where even the best appraisers might get tripped up.

Scope of work

The “scope of work” is the first part of the appraisal that brokers should check. Found on the first or second page of an appraisal, this section defines the appraisal’s purpose and tells what the appraiser was hired to do. This is important because appraisers are contractors hired for a specific assignment; their scope may not include what you desire from the appraisal.

Generally, appraisers are asked to determine the value of a property “as is” or “as proposed.” When appropriate, they are asked to include multiple valuations, each at a different development stage. Appraisers’ scope also can include a “bulk sell-out” or wholesale value in addition to the retail value.

It is safe to assume that the scope is the first part of the appraisal that a lender reads; it makes sense for brokers to do the same. In other words, do not make the mistake of quoting an as-proposed valuation as the current value. Misinterpreting an appraisal’s scope is bound to raise a red flag with the lender.

Assumptions and conditions

The “extraordinary assumptions” and “hypothetical conditions” sections are necessary evils of the appraisal world. While often unavoidable, the use of assumptions and hypotheticals must be treated with extreme caution and scrutiny.

The basic difference between the two is that extraordinary assumptions presume as fact things that are unknown or unknowable. On the other hand, hypothetical conditions assume things to be true that are contrary to the known facts about a property.

In both of these sections, appraisers’ decisions can influence valuations in many ways. Here are a few examples:

  • Extraordinary assumptions: To illustrate how this section is used, consider the case of land proposed for large-acreage rural residential lots. The land is several miles from the nearest municipal sewer service, and a septic system is the only option for waste disposal.

    Cases such as this require a percolation test, which assesses a septic system’s viability -- but in this case, the test hasn’t taken place. Thus, the appraiser assumes the land percolates sufficiently and notes such in the extraordinary-assumptions section.

    Why has this occurred? Lenders don’t like gray areas, and the appraiser has turned one into a black-or-white assumption. It doesn’t take a wizard to realize that were this assumption proven false, the appraisal’s entire value equation falls apart.

  • Hypothetical conditions: An appraiser can value a property on the hypothetical condition that a level of entitlement has been achieved. In reality, these entitlements may be in-process, in the final approval stages or not even exist.

    This kind of hypothetical condition can be quite benign. Consider a subdivision that has passed all major hurdles and is a few administrative steps away from final approval. In this case, a call to a city-planning department might be all it takes to prove the entitlements are imminent.

    If the hypothetical condition suggests that the California Coastal Commission has signed off on a proposal to clear-cut a known condor habitat to make way for a big-box store, however, brokers should proceed with caution.

    Not all assumptions and hypotheticals can be avoided, and most appraisers use them only when necessary. When they are used, however, brokers should understand them to determine their potential effect on property value.

Valuation methodology

The core purpose of any appraisal is to derive a value. Commercial real estate appraisers use at least one of three generally accepted valuation methodologies: the sales-comparison approach, the income-capitalization approach and the cost approach.

Although each approach can be useful and accurate, each also has specific limits of which brokers should be aware.

Sales-comparison approach: This is the most common approach. It involves finding comparables, or “comps.” These are properties with which the subject shares characteristics such as size, location, age and views.

The best comps closely resemble the subject, and “sold comps” -- aka, recent transactions -- are preferred. The more time that has passed since the transaction, the less reliable the comp may be. In addition, some appraisals will use “listed comps,” which are based on list prices that could be significantly greater than real market value. Thus, they’re not as reliable.

After identifying comps, appraisers isolate features deemed superior or inferior to the subject and adjust the comp’s transaction price accordingly. For instance, if the subject property is a warehouse without railroad access, this could be deemed inferior to an equal rail-served comp. Appraisers also can adjust the comp’s transaction price downward to reflect how it might have traded if it was not rail-served.

It’s important to recognize the limits to the sales-comparison approach. First, note that comparable analysis is backward-looking and could include data on transactions in market conditions vastly different from those at the time of the appraisal. This is especially true in today’s shifting market. A good appraiser will consider market changes when adjusting the comps.

Another limit occurs when true comps don’t exist because of a lack of transaction volume or because a property is unique. In these cases, appraisers might venture well outside the subject’s local market to find comps or may strain to make multiple, large-scale adjustments to dissimilar comps. When either situation occurs, the accuracy of the comp analysis is suspect.

Smart brokers not only will read the comparable-analysis section but also could identify additional comps outside the appraisal that might be more indicative of market value.

Income-capitalization approach: Like its cousin, the “discounted-cash-flow approach,” this valuation method is based on a property’s capacity to produce income. Appraisers will calculate a property’s net operating income (NOI) by subtracting net expenses from net revenues. Then they’ll divide the NOI by an overall capitalization rate. The market tends to favor this method for valuing income-producing properties such as apartment buildings, retail centers and industrial properties.

The NOI can present some limits for brokers if it comes from historical operating data, as with an existing property, or from a pro forma built on future expectations, as with new construction or repositioned properties.

When historical data are used, note who provided it and how the information was verified. Property-owners who have anticipated selling or refinancing a property might show more income than they really generated. They also could hide expenses, exaggerate income or ignore necessary capital expenses to make their property more appealing. Even innocent property-owners can be sloppy or keep inaccurate records. Good appraisers will look to the local market and interview owners of similar properties to verify the accuracy of the data provided. It’s preferable when historical data have been independently audited and verified, but it doesn’t hurt to check.

With new construction or repositioning plays, past operating history is nonexistent or irrelevant. Instead, appraisers use pro forma or “best guess” numbers. Because there is no precedent for how this property will perform, appraisers also make multiple assumptions. Even small changes in these assumptions impact the results enormously.

Cap rates are another point to watch. They trend lower in markets and on product types where there is less perceived risk to the income stream. When determining the appropriate cap rate, appraisers look at the property’s relative position in the market, tenants’ credits, the supply and demand for space, and other local market conditions. A simple miscalculation can affect value greatly.

Appraisers also should recognize current market conditions in this approach, in addition to other factors -- such as leases that are close to expiration and situations in which the landlord and tenant are related entities. Each can affect how the market will value the property outside of the capped-NOI approach.

Cost approach: This approach evaluates the reproduction cost of the subject property. In other words, it assumes a property is worth no more than the cost to reproduce it.

Accordingly, the cost approach merely suggests where value might be capped. It does not accurately predict what a third party might be willing to pay. Although the cost approach is useful as a “gut check,” it’s rarely a true measure of market value.

To understand this, look no further than the condominium market in South Florida, where a glut of supply has pushed condo prices to levels well below replacement cost. The same is true of many residential subdivisions around the country where builders are dumping finished inventory below cost to lower their interest carry.

•  •  •

In addition to understanding an appraisal’s scope, assumptions and valuation approach, it’s also wise to recognize other points in appraisals.

Appraisers are not experts in all areas, and some appraisals might have trouble spots related to environmental, title, structural, development and survey issues. In some instances, they might overlook insurance costs -- such as the price of flood insurance in hurricane-prone areas. Appraisers also only make limited use of subjective determinations. Things such as design quality, aesthetics, materials, circulation and layout are difficult to evaluate in an appraisal but can affect value.

There is plenty more that goes into appraisals, however. True market value is a difficult thing to pin down.

When brokering a deal, it is important to understand that the lender has probably seen it all when it comes to appraisals. By reading and understanding the appraisal you are submitting and pointing out its strengths and weaknesses to the lender, you as a broker can add tremendous value to the loan process. 


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