Real Estate Appraisal Review: Lessons from the Past. (Issues in Lending)
Clarke, Richard A., The RMA Journal
During the last downturn of 1988-91, many lenders accepted appraisals of commercial property values without making any real attempt to verify the appropriateness of the assumptions or to view resultant values with a healthy degree of skepticism. Given the increasing softness in commercial property values, it makes sense to revisit lessons learned during that time, if only to serve as a reminder to those lenders who shared my experiences and to assist newer lenders in focusing on recent history.
Highly optimistic valuations resulted in significant loan losses during the last real estate slump. To avoid similar problems in your commercial real estate portfolio, be aware of the following truths:
Appraisal data lags the market. Appraisers rely on detailed market data, which often takes months to compile. In a rapidly falling market, rents as reported from traditional sources therefore will be substantially below real-world conditions. The simple remedy is to visit similar properties and inquire about rental terms. If you are visiting a loan prospect and the building across the street has vacancies, just stop by.
Comparable sales occur with less frequency. In the early stages of a downturn, sellers tend to hold to historical price expectations and the volume of property sales therefore drops dramatically. This phenomenon, in turn, leads to stale comparables, which reflect historical but not current market rents. Challenge your appraisers to produce recent sales data to support their valuation assumptions. If such support is not available, require appraisal modifications or take other appropriate defensive steps such as lowering advance rates.
Landlord concessions may not always be visible. To attract tenants under weakening market conditions, property owners offer a variety of concessions such as free-rent periods, funding of unusual improvements sought by tenants, and/or absorption of extraordinary expenses. The sums involved may be quite significant and should be factored into any calculation of net effective rent.
Rollover risk reduces historical cash flow. Do not accept rent rolls as gospel if significant leases are about to expire. While it should be obvious that new tenants will be paying a substantially lower amount, many lenders and their supporting appraisers failed to anticipate this development the last time around. Similarly, if a key tenant is locked into an above-market rental arrangement, it is essential for the lender (not the appraiser) to perform the requisite credit analysis to confirm the likelihood that that rental stream will continue. At the bottom of a slump, it is also good practice to impute a conservative current market rental rate to excessive vacant space, which clearly could be rented if the owner is willing to accept such a low level of consideration.
Realistic cap and discount rates are essential. In calculating the present value of future cash flows and residual property values, make sure that discount and capitalization rates reflect risk-adjusted expectations of economic return. During the last debacle, appropriate adjustments to these critical determinants of value did not occur in a timely manner, and value became the amount naive bankers would be willing to lend rather than that being driven by more rational forces. During market downturns, perceptions of risk increase, which, when coupled with falling rental streams, create dynamic negative forces pushing down resultant property values exponentially.
Vacancy rate assumptions must be increased. This is an obvious step to take in a downturn scenario, but surprisingly few reduced historical vacancy rates early on in the last crunch.
Marginal properties suffer the most. With so many properties from which to choose during a slump, buyers require extraordinary discounts for poorly located, nonconforming, or poorly maintained properties. While environmental risk to the lender has been reduced over the past few years, it remains a substantial threat to conventional property owners and arm's-length purchasers, who will also require exceptional compensation. …