RMA-SOCL: Appraisals for Lending Purposes (Bill Pittenger)
Risk Management AssociationFlorida Commercial Lending School2013Appraisals for Lending PurposesFocusing On Fundamentals
Seminar Coverage• Using the Appraisal to Evaluate Loan Repayment Risk.• Getting to Know Your Collateral.• Looking Behind the Numbers.• Value Is Definition Dependent.• Market Analysis & Economic Feasibility.• Proposed & Partially Complete Development• Development cost and why it’s important in the lending decision.• Value to a single purchaser -- the discounting process.• Cash flow patterns & Capitalization methods.• Discounted Cash Flow Analysis.• Common analytical deficiencies.
Property & Market LoanRepayment RisksRepayment of a commercial real estate loan can bejeopardized by any property or market condition whichmitigates the property’s ability to produce revenue that issufficient to operate the property AND service the debt.If the property cannot do both, the loan becomes borrowerdependent band rarely do borrowers have funds to operatethe property and service the debt independent of revenuefrom the security property.
CRE Loan Repayment Sources• Net rental income from security property• Net sale income from security property.• Disposition of security property• Other borrower resources.
Categories of Loan Repayment Risk• There are three fundamental categories of repayment risk in any real estate loan.These are borrower risk, property risk and market risk. Lenders must evaluate allthree risk categories to reliability assess a borrower’s ability to repay.• As a practical matter, many lenders fail to thoroughly evaluate all three categories.• Most lenders are adept at evaluating a borrower’s financial condition throughanalysis of loan applications, credit reports and financial statements, etc. Thisinformation alone however, is insufficient to make a reliable assessment of theborrower’s ability to repay a real estate loan since it fails to consider theborrower’s experience and ability to manage a real estate asset and it fails toconsider the risks associated with the security property and its competitivemarketplace.
Categories of Loan Repayment RiskB o r r o w e r R is kP r o p e r t y R is kM a r k e t R is kU n d e r w r it in g L o a n D e c is io n
Borrower RiskTimely loan repayment can be jeopardized by characteristicsrelated directly to the borrower. These characteristics mightinclude, but are not limited to, lack of professionalexperience, inept administration, lack of commitment toproject completion or ineffective project management.None of these characteristics are likely to be revealed by themost comprehensive appraisal report or even analysis of theborrower’s financial history.
Property Risk• The physical, functional, legal and economic characteristics of a security property need to becarefully evaluated in order to identify conditions, either existing or potential, which couldjeopardize a borrower’s ability to repay a loan. Examples of property characteristics include,but are not necessarily limited to:• Physical characteristics such as shoddy construction, as well as inefficient, aging ordeteriorating building components or mechanical systems can cause a property toexperience excessively high operating costs thereby limiting the funds available to theborrower to repay a loan. The borrower may be faced with a choice between operating theproperty or making loan payments; a no-win dilemma which usually leads to loan default.• Functional or design characteristics can frustrate a borrower’s ability to lease or sell newlycreated space or to keep existing space occupied and producing revenue sufficient to operateand maintain the security property and repay a loan. Examples may include, unusual floorplan, building design or other physical or functional characteristics which have limited marketappeal.
Functional & Design Characteristics• Inadequate parking in terms of the number or size of spaces or their proximity to thebuilding, inadequate or difficult access to the site or building, or inadequate elevators in amid or high-rise building are also examples of functional characteristics that can mitigaterevenue production.• Locational characteristics such as a misplaced improvement or one in a location dominatedby incompatible or undesirable uses or even uses which are detrimental or harmful canmitigate revenue production.• Other problematic locational characteristics might include a property in an area subject tosoil problems, environmental hazards or even flood, earthquake, sinkhole or wave action andwind velocity (waterfront properties). Finally, improvements which aesthetically clash withthe environment and surrounding land use could mitigate revenue production.• Important Note. Things that potential buyers ignore in a strong market suddenly becomehuge issues in a troubled market when the few buyers that exist get extraordinarily sensitive.
Zoning, Legal & Environmental• Zoning, land use, environmental or legal constraints can frustrate aborrower’s ability to use the property in the intended manner. If a loanhas been made and funds have been advanced, repayment may be injeopardy if a project cannot be completed as planned.
Market Risk• A security property will not exist in a vacuum. Rather, it will co-exist and more importantly, itwill compete with other similar properties for tenants or buyers. The lender, as part of itsunderwriting and loan decision process, must identify characteristics about the marketplacewhich could jeopardize the security property’s ability to attract tenants or buyers andtherefore to produce revenue necessary to operate the property and repay the loan. Forexample, excess supply of competitive space will put downward pressure on rents and valuesthereby mitigating the ability of the security property to produce revenue.• If market risk is to be effectively evaluated, it is necessary that both the amount ofcompetitive space and the time periods during which it will be competitive with the securityproperty be identified.• If the security property is an existing project currently competing for buyers or tenants, thenthe amount of competitive space may be known or at least knowable. If the securityproperty is proposed , under construction or subject to a change in use, it is not currentlycompeting for tenants or buyers but rather will do so in some future market place.
Market Risk• While there may appear to be sufficient current demand for the security property,the relevant point is the security property is not currently capable of competingfor tenants or buyers. It is therefore necessary to identify the space which is mostlikely to be competitive with the security property at the future time when thesecurity property is complete and ready to compete.• The supply and demand relationship in the marketplace will directly influence theability of the security property, whether it is existing or proposed to producerevenue and to do so in the time periods necessary to achieve timely repaymentof a loan.
Incomplete Use of Appraisal Information• Incomplete Use of Appraisal Information. Many lenders focus exclusively on the valueestimate contained in an appraisal report. They do so for two fundamental reasons. First,they use the value estimate as a guide to what the security property might be sold for in theevent foreclosure becomes necessary. This is an unreasonably restrictive – and arguablynaïve -- point of view since it implies the only risk associated with the security property is riskof foreclosure. It also implies that the property will be worth an amount equal to or greaterthan the amount it is worth at the time of the appraisal at some unspecified future timewhen and if foreclosure becomes necessary. Additionally, as we saw repeatedly in the recentrecession, foreclosed assets typically sell for less – sometimes much less.• Second, some lenders rely on the value estimate contained in an appraisal as a guide to themaximum amount of credit that can be extended over the life of the credit arrangement.This too is an unreasonably restrictive point of view. While the value of the security propertyis clearly relevant and necessary information to be considered in the loan decision process, itis not the only piece o9f information about the security property that should be considered.
Role of the Appraisal• An appraisal report is the primary source of information about two of three broadcategories of real estate loan repayment risk. As a result, it is imperative that realestate lenders have a reliable appraisal report containing sufficient currentinformation to make informed judgments about the security property and itscompetitive marketplace.• The appraisal process and the resulting appraisal report must also be consistentwith the complexity of the property being appraised. This implies that both thedepth of analysis and the information presented in the appraisal report can varydepending upon the complexity of the property, its competitive marketplace, andthe lender’s perception of risk in the transaction and even the structure of theproposed credit arrangement.
The Role of the Appraisal• Depth of analysis. Must be consistent with the complexity ofthe problem and the anticipated risk. Not policy, nor cost ordelivery time.• Commercial real estate versus commercial loan secured byreal estate (business loan).• Is an appraisal necessary?
Is An Appraisal Really NecessaryA s k : H o w w ill t h e b a n k b er e p a id ?A n s w e r : R e v e n u e d e r iv e df r o m r e n ta l o r s a le o f r e a le s t a t e .If r e p a y m e n t o f t h e c r e d it is in a n yw a y d e p e n d e n t o n r e v e n u e d e r iv e df r o m r e n t a l o r s a le o f r e a l e s t a t e , a na p p r a is a l o r e v a lu a tio n is n e c e s s a r y .A n s w e r : R e p a y m e n t w ill c o m ef r o m s o u r c e s N O T d e p e n d e n to n r e n t a l o r s a le o f th e r e a le s ta te c o lla t e r a l.A n a p p r a is a l is N O Tn e c e s s a r yA p p r a is a l O p t io n sC o m p le teo rL im ite dE v a lu a tio n O p tio nA p p r a is a l R e p o r tO p t io n sS e lf C o n t a in e dS u m m a r yR e s t r ic t e d
Caution: The Appraisal Lending Time Shift.T IM E L IN EC A U T IO N : M o s t a p p r a is a ls a r e p r e d ic a t e d u p o n h is to r ic a l e v e n t s to m a k e in f e r e n c e s a b o u t f u t u r e lo a n r e p a y m e n tP a s t P r e s e n t F u tu r eS a le s , r e n ta ls , a n d e c o n o m ic in d ic a to r s ( r a te s &r a tio s ) r e lie d u p o n in m o s t a p p r a is a ls w e r ee x tr a c te d fr o m h is to r ic a l e v e n ts .A ll lo a n s a r e r e p a id in th e fu tu r e r e g a r d le s s o fa s s u m p tio n s th a t m ig h t b e m a d e to th ec o n tr a r y .A p p r a is a lP r e p a r e d
What Can You Do?• Establish policies and procedures to ensure all categories of risk areeffectively and meaningfully evaluated in the loan decision process.• Identify the real source of repayment of most commercial real estateloans. In most cases that is the cash flow produced by the securityproperty.• Recognize that real estate markets are dynamic. Values change in directresponse to supply and demand relationships. You should thereforeanalyze expected supply and demand relationships and not just thosethat occurred historically or are occurring at the time the loan decision isbeing made.
Getting To Know Your Collateral• Important: It’s more than bricks and mortar.• Real property• Personal property• Intangibles• The effect of management
Getting To Know Your Collateral … continued• Important: Appraisal must match thecollateral and credit arrangement.• Multiple phase development.• Improbable assumptions.• Sum of the parts versus the whole.
Understanding Market Value• Market value versus value in use.• Market value definitions vary.• Professional standards & market value.• Federal regulation requires a very specificdefinition of market value.
Regulatory Required Market ValueDefinition"The most probable price which a property should bring in a competitive and openmarket under all conditions requisite to a fair sale, the buyer and seller, each actingprudently, knowledgeably and assuming the price is not affected by undue stimulus.Implicit in this definition is consummation of a sale as of a specified date and passing oftitle from seller to buyer under conditions whereby:• Buyer and seller are typically motivated;• Both parties are well informed or well advised and each acting in what he considershis own best interest;• A reasonable time is allowed for exposure in the open market;• Payment is made in terms of cash in U.S. dollars or in terms of financialarrangements comparable thereto; and,• The price represents the normal consideration for the property sold unaffected byspecial or creative financing or sales concessions granted by anyone associated withthe sale."
Potentially Troublesome ValueDefinition Components• What constitutes typical motivation?• Cash or its equivalent.• Concessions
Economic FeasibilityThere is not much need toknow what a proposed projectmight hypothetically be worthif it is not going to work.
“The trick is to discern a marketbefore there is proof one exists”-- Bill Lear
Economic FeasibilityAlthough economic feasibility has been defined in a number of contexts, fundamentally it is asimple comparison of expected costs ver-sus the benefits to be derived from those costs.When the expected benefits are found to be equal to or greater than the cost to producethem, a project may be judged to be economically feasible. Conversely, if the expectedbenefits are less than the cost to produce them, a project may be judged to be non-economic.Economic feasibility analysis seeks to answer this question: If this project is constructed, willit be worth an amount equal to or greater than the cost to create it?Question: Can you think of any economic reason tocreate something that, when finished, will be worthless than it cost to create?
Market Analysis & Marketability• Supply and demand analysis.• Relevant market segment in both product type and geography.• Analysis must be forward looking.• A major shortcoming of market analysis is that conclusions are too oftenpredicated upon historical or current data while ignoring the future in which thesubject will actually compete.• Real estate changes hands in an environment of expectations. Any analysis istherefore incomplete unless the analyst understands what is being expected byparticipants in the market place.
Market Analytical Considerations• The Basics• If it is built, will people care?• How much will they pay for it?• When will they pay for it?• How long will they pay for it?
Demand Considerations• How much space is currently being absorbed in themarketplace?• How fast is it being absorbed?• At what price is it being absorbed?• Baseline: How much space has historically been absorbed? Atwhat rate and at what price?
Supply Considerations• How much space currently exists?• How much is unleased or unsold?• How long has it been unleased or unsold?• How much space is under construction?• How much space is currently proposed?• When is it expected to come on line?
Supply Considerations• How much space has governmental approval? How likely is itto come on line and when will it compete?• How much space is on the drawing board?• How much is master planned?• What space is rumored to be coming on line?
Reconciling Supply and Demand• Are any apparent differences explainable?• In what time periods will competitive space be coming on lineand how does that compare with the subject’s completion?• Have turning points been identified?• Has net absorption been considered?
Why Market Analyses AreSometimes Unreliable• Over reliance on history.• Failure to identify and isolate relevant market segment.• Failure to recognize alternative outcomes.• Over reliance on mechanical extrapolation.• Failure to connect multiple events.• Blindness to external non-real estate influences.
“I skate where the puck isgoing to be, not where ithas been.”-- Wayne Gretzky
Highest and Best Use• The ultimate objective of property and market analysis is a conclusion of the highest and bestuse of the property.• Highest and best use has been defined in a variety of ways (all similar), however the thrust ofthe highest and best use concept is that reasonable and probable use that will support thehighest value, as defined, as of the effective date of the appraisal.• Both the vacant site and the improved property have a highest and best use at any giventime. The best use of the site may or may not be identical to the best use of the improvedproperty.• Highest and best use must also be consistent with the value definition.• Highest and best use must be reasonable and probable. That is, it is likely to occur soon ifnot immediately. Highest and best use is therefore not speculative.
Highest and Best Use• All too frequently, highest and best use is treated as if it were an assumption, rather than aconclusion derived from a specific analytic process. When it is treated in this fashion thehighest and best use section of an appraisal becomes boilerplate which is not seen as havingany relationship to the valuation process.• The Highest and best use estimate is critical part of every appraisal because it sets the stagefor the entire valuation process. Once the best use estimate has been made it will not onlygovern the type of data to be selected but also the valuation technique which will be used toprocess the market data.
Proposed and Partially CompleteDevelopmentP R O J E C T D E V E L O P M E N T & C O N S T R U C T IO N T IM E L IN ES iteA c q u is itio nZ o n in gA p p ro v a lsP la n sP e rm itsM o rtg a g ea n dE q u ityF in a n c in gS ta b iliz e dO c c u p a n c yo rS e llo u tP re -C o n s tru c tio n D e v e lo p m e n t A c tiv ity P o s t C o n s tru c tio n D e v e lo p m e n t A c tiv ityL e a s e U po rS e ll O u tC o n s tru c tio nP e rio d
Cost of Production Components• Land Cost / Value• Building Cost• Financing Cost• Marketing Costs• Closing Costs
Cost of Production …continued• Cost of sales and/orfinancing concessions.• Absorption periodexpenses.• Return on mortgage andequity capital.• Entrepreneurial profit
A Second Look at the Time LineP R O J E C T D E V E L O P M E N T & C O N S T R U C T IO N T IM E L IN ES iteA c q u is itio nZ o n in gA p p ro v a lsP la n sP e rm itsM o rtg a g ea n dE q u ityF in a n c in gS ta b iliz e dO c c u p a n c yo rS e llo u tP re -C o n s tru c tio n D e v e lo p m e n t A c tiv ity P o s t C o n s tru c tio n D e v e lo p m e n t A c tiv ityL e a s e U po rS e ll O u tC o n s tru c tio nP e rio d
Deductions and Discounts• Historical practice and result.• Value to a single purchaser.• Not just a regulatory standard.• Wholesale versus retail.• Result of the discounting process.
Deductions and Discounts• Unearned entrepreneurial profit.• Unspent dollars for …• Marketing• Maintenance• Property taxes on unsold units orunleased space.
Deductions and Discounts … continued• Tenant improvements notphysically in place.• Administrative expenses• Financing costs -- mortgage &equity.• Sales and/or financingconcessions.• Remaining building cost (asapplicable)
Income Capitalization TechniquesDirect CapitalizationGeneral RuleUse if property has achieved a stabilized level oflong term occupancy and income and expensesare expected to remain relatively stable goingforward.
Discounted Cash FlowGeneral RuleUse if stabilized occupancy (or sellout) has notbeen achieved and income and /or expenses areexpected to fluctuate going forward.Choice of direct capitalization or DCF should never be dictated bypolicy although it frequently is to the detriment of reliability.
Analyzing Discounted Cash Flow• Forecast period based on market evidence, not assumption.• Income and expenses must model reality. Rents can go up,down or stay the same. Don’t automatically insert an inflatorunless market evidence says so.• Income and expenses forecast in time periods they areexpected to occur.
Appraisal Regulation In Perspective• Underlying premise: LOAN REPAYMENT• Sets forth when appraisals (or evaluations) are required and when they are not.• Bank must control appraisal process.• Appraiser independence.• Appraisers must be certified or licensed as appropriate.• Only five specific appraisal standards.• The December 2010 Interagency Appraisal and Evaluation Guidelines added muchmore substance and guidance.
Current Regulatory “Hot Spots”• Appraiser independence.• As- is value (without speculative assumptions).• Appropriate and consistent use of abundance of caution and business loanappraisal exemptions.• Documentation of decisions.• Separating real and personal property value components.• Vacant land/lot analytics.• Standard of care -- “would a disinterested third party looking only at the fileunderstand and agree with my decision?
Common Analytical DeficienciesProperty Type• Vacant land: Failure to consider timing of land use.• Proposed Development: Failure to consider all costs associated with proposeddevelopment or partially completed development.• Income Property: Failure to consider timing of lease rollover, rent concessions,tenant improvements and retrofit costs.• Special Purpose: Failure to estimate market value.
Common Analytical DeficienciesDiscounted Cash Flow Analysis• Assumed rather than market based cash flow period.• Assumed period by period cash flow change.• Failure to include all appropriate expenses.• Failure to recognize cash inflows and outflows in the periods they are most likelyto occur.• Assumed or improperly developed discount rate.• General failure of DCF to model reality.
Common Analytical Deficiencies• Faulty application of value definition.• Assumed highest and best use conclusion.• Backward looking market analysis.• Faulty or missing economic feasibility analysis.• Inconsistencies among report sections.• Irrelevant or out of date area or neighborhood data.
Common Analytical Deficiencies …continued• Incorrect property rights appraised.• Assumption rather than reality based analyses and conclusions.• Confusing holding period, absorption period, normal marketing period andexposure period.• Assuming away what the appraiser was hired to do.
QUESTIONSComments, Questions, Observations or Subscribe to PublicationsWilliam “Bill” Pittenger, MAI, SRAwww.billpittenger.comE-Mail:William_pittenger@comcast.net