Dissecting a Commercial Appraisal Report
TASA ID: 1813
If you are contemplating a civil law suit concerning a commercial property or commercial mortgage, most often, an appraisal report is a major part of the problem. This article is not intended to be an all-encompassing tutorial but rather a summary understanding of what to look for, investigate and challenge in a narrative commercial appraisal report of an income property when you suspect that the report is less than stellar.
BACKGROUND:
There are two styles of written appraisal reports: narrative and form (U.R.A.R.). This article only deals with narrative reports.
While your focus is on proving that a bad appraisal caused or impacted a damages claim - and not on violations of The Uniform Standards of Professional Appraisal Practice (U.S.P.A.P.), due to a recent major change - you need a brief understanding of U.S.P.A.P. prior to January 1, 2016, where there were three types of written appraisal reports and now there are only two.
All appraisals of commercial real property (apartment, office, industrial, flex, retail, hotel, mobile home, garage, self-storage, vacant land, and sundry) that exceed a value of $250,000, must be performed and prepared in accordance with the minimum standards established by U.S.P.A.P.
The Appraisal Boards of all 50 states have appraisal licensing-certification programs. All have adopted U.S.P.A.P. as a mandatory compliance requirement for licensed-certified appraisers. Editions of U.S.P.A.P. are printed in a bound text and revised every two years. The current edition expires on December 31, 2017. The date the report was completed, not the date of value, determines which edition of U.S.P.A.P. applies to the report and appraiser.
A state appraisal board can bring formal charges against an appraiser, citing U.S.P.A.P. violations, based on investigation of a filed complaint. If you suspect a “bad” appraisal report, hire an expert to formally review the report. They can advise about its non-compliance with and offer a recommendation about filing a complaint. Complaints can be filed anonymously
At trial, avoid getting into lengthy testimony about U.S.P.A.P. as it could put a jury to sleep. Your expert can briefly testify about U.S.P.A.P. violations and the recommendation of filing a formal complaint. Based on the expert’s recommendation, it may be good to have a formal complaint filed. If the trial date is protracted, the state board may have taken action. If beneficial, you can advise of the outcome and, if not finalized, at least advise that a complaint was filed and is being investigated.
THE FIRST STEP:
As the date the report was completed, not the date of value, determines which edition of U.S.P.A.P. should have been used, the first step is deciding which edition of U.S.P.A.P. (2012-13, 2014-15, 2016-17 or later) applies for compliance purposes.
a.Types of written appraisals prior to January 1, 2016:
- Self-Contained: Basically a full and complete report that includes virtually everything performed by the appraiser. It should be well written, well explained and supported throughout. It should lead the client to the same conclusion of value as in the report.
- Summary: a scaled down version of a Self-Contained report as a number of items are only summarized or stated as opposed to being fully explained. Support for the items that are only summarized or stated must be contained in the appraiser’s work file to be produced later as, if/when required. After December 31, 2015, use of the label “Summary Appraisal Report” is not appropriate.
- Restricted Use: this type report is restricted solely to the client. It is generally written in an extremely abbreviated form as the focus is solely on telling the client the opinion of value. All of the support information must be in the work file to allow the appraiser, if subsequently requested, to expand the material, at the minimum, into creating a Summary report.
b.Types of written appraisals after January 1, 2016:
- An Appraisal Report: The 2016-17 edition of U.S.P.A.P. afforded a great deal of latitude about how much description, data, explanation, analyses and supporting information goes in the appraisal report. The depth of the material provided will be determined by the requirements of the appraisal assignment and the appraiser’s judgement. All of the support for information not fully discussed or explained in the appraisal report must be contained in the work file to be produced as, if/when required.
- Restricted Use: Same as above. The work file must contain all of the information to allow the appraiser, if subsequently requested, to expand the material into the newly defined “Appraisal Report.”
WHERE TO LOOK:
Letter of Transmittal:
a.Don’t spend time on this unless something obvious jumps out.
b.Look for the inspection date. Use judgement about the applicability of the date and the appraisal information.
c. If the date of value and the date the report was completed are different, both should be shown.
Appraiser’s Personal Location and Certification:
a.Is the appraiser locally based or from out of the region?
b.If out of the region, question why a local appraiser was not hired. A “carpet bagger” is often used to provide a value that a local appraiser will not.
c.If out of state, see if they are licensed in the state where the property is located. If not, ask if they obtained the temporary license required.
d.Does the appraiser have experience with the property type?
e.Does the appraiser have locational and market area familiarity?
f.In the Location and Surroundings/Neighborhood Description portion, was “canned” material used? If the report fails to describe the adjacent properties and what is nearby, North, South, East, and West, it is not properly descriptive and an adverse condition may have been overlooked, on purpose.
g.See if any trends have been examined and discussed. Is the neighborhood or local rental market stable, inclining or declining? Look for support, not just opinions. Many reports fail to discuss trends or support them.
h.Has the appraiser performed other work on the property within 36 months prior to this assignment? If so, it should be stated on the signed certification page unless deliberately being hidden. Question that carefully.
Review the Assumptions and Limiting Conditions:
a.Often “boiler plate” but not always. They set forth general assumptions which can include inapplicable, unrealistic and unattainable assumptions which, when read by someone with a limited understanding of the property, its location, its market, the applicable time period and similar, can show these as inapplicable or sometimes even ridiculous. They can be pointed to by the appraiser as a “get out of jail free” card. Understand them thoroughly to see if any seem inappropriate or ridiculous.
b.A commonly used one: “…assumes that the property fully complies with current zoning and all applicable laws," when it does not.
Review any Extraordinary Assumptions and Hypothetical Conditions:
a.These are specific assumptions used within a report to explain the use and/or assumed fact of something that is not supported with fact or information. Often things are assumed by an appraiser but not articulated and then missed by the reader.
b.These are not boiler plate and can be pointed to by the appraiser (as a hide behind) when challenged. If they don’t make sense, challenge them.
Review the Scope of Work explanation:
a.Did the appraiser explain what any reasonable appraiser, or their peers, would typically do and investigate in developing the report? Did they fail to investigate something that you believe to be material?
b.The Scope of Work should also expound on what the appraiser did not do (such as not using one of the three approaches to value) and why they felt it appropriate not to include or investigate something. Look for and challenge that.
Review the legal description:
a.Did they correctly and properly identify the subject property?
Review the Description of improvements:
a.Was an accurate estimate of the total square footage of the property, number of units, etc. provided A mistake here can be compounded throughout the report and value conclusion.
b.If existing, was the condition explained, e.g. age and condition of the roof, HVAC system, parking lot surface and similar.
c.If existing, if there was deferred maintenance it should be identified here. Check photos.
d.If existing, there should be an estimate of the property’s current effective age and its remaining economic life. Demand an explanation to support.
e.If a cost approach was performed, that information should be used to estimate depreciation.
Carelessness, misleading and inaccurate statements:
a.Such things should easily jump out at you.
The Cost Approach, it can be manipulated:
a.If new or proposed, actual costs should be available to be used.
b.If existing, was this approach excluded?
1.If so, the explanation is usually that: “due to the age and difficulty of estimating depreciation the approach was not meaningful.”
2.If so, decide if that is correct.
3.If the property is less than say 2-3 years old, that may not be a valid explanation.
c.If existing and approach performed:
1. Under land value, were sales REALLY COMPARABLE (location, size, zoning, etc.)?
2. Were they sold within the last year or longer?
3. Were they nearby or far away? When sales are far away and not within the last year, there needs to be a believable explanation.
4.See if there were more recent and local sales that were missed or purposely excluded. The sales are selected (or excluded) by the appraiser and can be used to MANIPULATE the land value included in this approach.
5.Adjustments to the comparables are also the appraiser’s judgement. Ask if visited and ask for a full explanation. If not visited how can they support comparability and adjustments?
6.If they used a cost manual, such as Marshall and Swift, to estimate the new replacement cost, you need to see the section used, the adjustments made and ask them to support. Often critical costs such as construction loan interest are not addressed. This is an area that can be EASILY MANIPULATED.
7.Check the arithmetic.
The Sales Comparison Approach, it can be manipulated:
a.If existing or proposed property, was this approach excluded?
1.If so, did their explanation say that due to a lack of recent and meaningful sales they excluded the approach?
2. If so, decide if that is correct. Investigate to see if there were sales that they missed or purposely excluded.
b. If approach performed:
1.Did they use land sales that were REALLY COMPARABLE (location, size, zoning, current rents)?
2.Were they sold within the last year or longer? If the sales were far away and not within the last year, there needs to be a believable explanation.
3.If they ascertained overall capitalization rates from sales for use later in the income approach, did they really have the detailed information to allow them to be used as valid? For example, did they obtain the current rents, vacancy, expenses and reserves used, or not used by the buyer or was the price based on some future assumptions that were not given? Most times much of that information is assumed and really not ascertained. Challenge that.
4.Check the adjustments and arithmetic.
The Income Approach, the biggest area where you will find inaccuracies and manipulation:
a.The annualized income, vacancy allowance, taxes, operating expenses and reserves are forecasted in an Income and Expense analysis format.
1.This is usually forecasted for the 12-month period after the date of value or for any number of years, typically 5-10, depending upon the capitalization method employed as discussed below.
b. Check all of the arithmetic. Often there are significant mistakes that are overlooked, and carried throughout the balance of the report and impact the value.
c. Income portion:
1. Leased or not, (and with exceptions such as a long term single occupied tenant lease, e.g. CVS, Walgreens, etc.) all income property appraisals SHOULD contain and be supported by a rental market study to support the contract or projected rent(s).This study will include the use of rent comparables.
2.The rental market study should discuss market absorption and make projections based on history and current market and economic factors. Did it?
3.A comparative grid showing adjustments should be included, as well as a reconciliation explaining the adjustments and final conclusion of the property’s market rent.
4.Were truly comparable properties used? (size, location, distance, quality of construction, age, amenities offered, rental structure (gross, net, etc.). This is another place that permits MANIPULATION by using incorrect comparables to estimate a higher rent than appropriate to support a higher value. Review of photographs and location maps provided can help your opinion.
5.If only the lease income is used and not the market rent, decide if it is appropriate or not. Some assignments only address the contract rent(s) with no market concern.
d. Vacancy and credit loss allowance:
1. With rare exception (e.g. a long term leased and occupied property with formally investment grade rated tenant) the analysis will have an annual allowance for vacancy and credit loss. This is usually 5% - 10% of income with more for hotels and self-storage centers.
2. This can vary tremendously based on the property type, the history of an existing property, current leasing situation and what the market is evidencing.
3. Question the support for the factor used and decide if understated to elevate value.
e. Operating expenses portion:
1. If an existing property, these should be based on a review of historical operating costs blended with judgement about future costs and further supported by a documented review of the operating expenses of comparable properties.
2. Challenge the support. “Low balling” operating expenses and real estate taxes is another way to artificially increase the annual N.O.I. and increase value.
3. For a “to be built,” or property being transitioned, the use of comparable operating expenses to support the projections is mandatory. Again, check for “low balling.”
f.Reserve for Replacements portion:
1.At a minimum, reserves should be created annually for:
a.Roof and structural replacement.
b.Appliances and carpet for apartments.
c.Tenant finish and leasing commissions for office, retail, industrial, and flex.
d.Furniture, Fixtures, and Equipment (FF&E) for hotel-motels.
f. Reserves:
2.If reserves have been ignored, the appraiser was probably attempting to overstate value. If they were included, the reasonableness of the estimates is what is important. Make the appraiser explain and defend the estimates.
3.If the direct capitalization method was employed, the estimate for annual reserves may or may not have been deducted depending upon the overall capitalization rate applied. That needs to be carefully explained.
4.Reserves are always shown in the income and expense analysis, prior to the N.O.I. of an apartment appraisal.
g.Annual Net Operating Income (N.O.I.) portion:
1.The N.O.I. is the estimated calendar or fiscal annual number remaining after all vacancy, taxes, expenses and reserves have been deducted from the annual income and before any debt service or income tax applicable depreciation.
2.Using one of the two Capitalization methods below, the N.O.I or series of N.O.I.s are converted into an opinion of value.
h.Capitalization:
1.There are two basic methods of income capitalization:
a.Direct Capitalization: basically a one- year (12-month period) “snapshot” of “stabilized” N.O.I. is capitalized into value into perpetuity by applying an overall capitalization (cap) rate.
b. Yield Capitalization: typically a 5 or 10 year projection of a series of annual N.O.I.s discounted into present worth along with a discounted, present worth, estimate of an assumed, reversionary (net) sales price at the end of the projection period. The aggregation produces the value. The method is also known as the Discounted Cash Flow method or DCF.
c. Sometimes both methods are employed and then reconciled to a final value.
d.According to The Appraisal of Real Estate: “…when applied correctly they (both capitalization methods) should result in similar value indications…”
2.The ASSUMPTIONS used in either approach is where you find the most MANIPULATION particularly when a DCF has been used as it employs a tremendous amount of assumptions and projections that can be VERY EASILY MANIPULATED.
3.The reasonableness of the assumptions is the key.
a.For apartments, in the author’s opinion, using a DCF is most often a waste of time. If employed, a red flag should go up that they were probably trying to artificially overestimate value by using aggressive and unrealistic increasing rent and N.O.I. projections. Exceptions can be when a major renovation is planned or when analyzing a repositioning from some other use, e.g. old office to new apartments.
The Income Approach
4.When a DCF is used, especially a 10-year forecast, if the rents increased every year and often faster than the operating expense increases, that is a good clue that the appraiser was trying to abnormally increase the property’s value. Many times, after the first year, the rents and expenses are continually increased by an annual factor such as 3% for the entire projection period. That does not happen in the “real world.” Make them justify the increases, especially after the first two or three years when contract leases and options roll over.
5.Since WW II, recessions have occurred in this country in integers of 2 to 10 years with 2 and 10 years being atypical. Most occur between 4 and 8 years. If you see a 10-year DCF that steadily inclines, you should challenge the projections for not considering the probability of a recession occurring during the projection period. The vacancy allowance and market rents should vary. Most appraisers will have a hard time defending their failure to consider that. Their excuse will be: “that’s how everyone does it.”
6.While a DCF can be employed to value a long term (10+ years) leased single tenant building, if the contract rent is fixed for term, as opposed to featuring periodic rent increases, it is easier to simply value via the direct capitalization method, especially if the tenant is rated as “investment grade.”
7.If the DCF method is employed, the estimate of each year’s costs, reserves or a combination (that would be funded out of N.O.I.), must be shown for each year and deducted before arriving at each year’s “net cash flow.” The “net cash flow” is then discounted into present worth via application of the selected discount rate. Challenge the discount rate to see if it makes sense.
a.If the reserves are for tenant finish or F, F & E, the annual cost should be increased by an inflation factor every year. Challenge if not.
b.Any applicable leasing commissions should be based on the new or renewed rents projected each year for each new or renewing lease and not a fixed per square foot cost noting that in some regions retail leasing commissions are a fixed per square foot cost.
c.In addition, a reserve amount should also be deducted when the annual net operating income is estimated in the 6th or 11th year for purposes of estimating the reversionary or future sale value. Again, that is subject to debate based on market conditions.
The Income Approach
i.Cap Rates and Discount Rates: Both are used to convert future cash flows into present value. Often this is where the most egregious manipulation occurs.
1.CAP RATES: These are used in direct capitalization to capitalize the N.O.I. into perpetuity/value. They are generated in two ways:
a.From the cap rates derived from the sale prices of leased comparables.
b.By building one via a method known as the Band of Investment Technique that uses mortgage financing (current as of the date of value) and the current equity dividend rate (cash on cash return) required by purchasers. A blended, weighted average of both produces the Overall Cap rate applied to the annual N.O.I.
c.If the Band of Investment Technique was used, check the reasonableness of the mortgage interest rate, amortization period and cash on cash return. Low interest rate, abnormally long amortization (35 years) and low cash on cash return produce a high value. Make the appraiser explain and support.
d.When the cap rate comes from sales, the appraiser may not have obtained sufficient detailed information to accurately apply them. If they were more than 6 months to 12 months old, they may not reflect current cap rates especially in changing economic times.
e.Long term leases with formally rated credit tenants can impact (lower) both the mortgage interest rate, as well as the cash on cash return expected.
f.If in direct capitalization they failed to include reserves and then applied a market sales derived cap rate they should have changed the cap rate dramatically to reflect reserves. In custom business practice most appraisers fail to do that. Challenge that. It can be a lengthy discussion.
2.DISCOUNT RATES: This is the factor that is applied to each estimated annual “net cash flow” and to the estimated net sale price in the future for reversion purposes.
a.Moving this rate up or down, even one half percent, will dramatically impact the value conclusion, thus it is easily MANIPULATED.
b. Among others, the appraiser should have developed this factor by considering:
i. the attitudes of buyers, sellers and investors
ii. the yields of more secure and/or comparable alternative investments such as treasury securities or corporate bonds
iii. current mortgage rates and other costs of capital
iv. publications of national or regional rates
Addenda and Photographs:
a.Check the subject photographs and maps.
i.Were they truly of the subject property?
ii.If the photos only showed views of the front perhaps they were hiding areas of concern not discussed in the report.
iii.Question who took the photographs and when.
b.Check the photographs of the comparables.
i.Did they match the addresses and descriptions given in the report?
ii.Were they old, e.g. did they show old dates?
iii.Were they taken by the appraiser or were they downloaded from the internet, or from an MLS or Assessor’s file?
iv.If the latter, question how meaningful comparisons could be made if not physically visited.
The Work File - If you suspect a bad appraisal be sure to subpoena the appraiser’s work file and look through it carefully. They are required to maintain this. You may find material, including
e-mails, that either help support or discredit the appraiser’s representations. Limit response time to minimize either the deletion or creation of work file information.
This article discusses issues of general interest and does not give any specific legal or business advice pertaining to any specific circumstances. Before acting upon any of its information, you should obtain appropriate advice from a lawyer or other qualified professional.
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