Risk Management AssociationFlorida Commercial Lending School

2013

Appraisals 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 Loan Repayment Risks

Repayment of a commercial real estate loan can be jeopardized by any property or market condition which mitigates the property’s ability to produce revenue that is sufficient to operate the property AND service the debt.

If the property cannot do both, the loan becomes borrower dependent band rarely do borrowers have funds to operate the property and service the debt independent of revenue from 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 all three 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 through analysis of loan applications, credit reports and financial statements, etc. This information alone however, is insufficient to make a reliable assessment of the borrower’s ability to repay a real estate loan since it fails to consider the borrower’s experience and ability to manage a real estate asset and it fails to consider the risks associated with the security property and its competitive marketplace.

Categories of Loan Repayment Risk

Borrower Risk

Property Risk

M arket Risk

Underwriting Loan Decision

Borrower Risk

Timely loan repayment can be jeopardized by characteristics related directly to the borrower. These characteristics might include, but are not limited to, lack of professional experience, inept administration, lack of commitment to project completion or ineffective project management.

None of these characteristics are likely to be revealed by the most comprehensive appraisal report or even analysis of the borrower’s financial history.

Property Risk• The physical, functional, legal and economic characteristics of a security property need to be

carefully evaluated in order to identify conditions, either existing or potential, which could jeopardize 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 or deteriorating building components or mechanical systems can cause a property to experience excessively high operating costs thereby limiting the funds available to the borrower to repay a loan. The borrower may be faced with a choice between operating the property 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 newly created space or to keep existing space occupied and producing revenue sufficient to operate and maintain the security property and repay a loan. Examples may include, unusual floor plan, building design or other physical or functional characteristics which have limited market appeal.

Functional & Design Characteristics• Inadequate parking in terms of the number or size of spaces or their proximity to the

building, inadequate or difficult access to the site or building, or inadequate elevators in a mid or high-rise building are also examples of functional characteristics that can mitigate revenue production.

• Locational characteristics such as a misplaced improvement or one in a location dominated by incompatible or undesirable uses or even uses which are detrimental or harmful can mitigate revenue production.

• Other problematic locational characteristics might include a property in an area subject to soil problems, environmental hazards or even flood, earthquake, sinkhole or wave action and wind velocity (waterfront properties). Finally, improvements which aesthetically clash with the environment and surrounding land use could mitigate revenue production.

• Important Note. Things that potential buyers ignore in a strong market suddenly become huge 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 a borrower’s ability to use the property in the intended manner. If a loan has been made and funds have been advanced, repayment may be in jeopardy 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, it will compete with other similar properties for tenants or buyers. The lender, as part of its underwriting and loan decision process, must identify characteristics about the marketplace which could jeopardize the security property’s ability to attract tenants or buyers and therefore to produce revenue necessary to operate the property and repay the loan. For example, excess supply of competitive space will put downward pressure on rents and values thereby 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 of competitive space and the time periods during which it will be competitive with the security property be identified.

• If the security property is an existing project currently competing for buyers or tenants, then the amount of competitive space may be known or at least knowable. If the security property is proposed , under construction or subject to a change in use, it is not currently competing 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 competing for tenants or buyers. It is therefore necessary to identify the space which is most likely to be competitive with the security property at the future time when the security property is complete and ready to compete.

• The supply and demand relationship in the marketplace will directly influence the ability of the security property, whether it is existing or proposed to produce revenue and to do so in the time periods necessary to achieve timely repayment of a loan.

Incomplete Use of Appraisal Information

• Incomplete Use of Appraisal Information. Many lenders focus exclusively on the value estimate 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 the event foreclosure becomes necessary. This is an unreasonably restrictive – and arguably naïve -- point of view since it implies the only risk associated with the security property is risk of foreclosure. It also implies that the property will be worth an amount equal to or greater than the amount it is worth at the time of the appraisal at some unspecified future time when and if foreclosure becomes necessary. Additionally, as we saw repeatedly in the recent recession, 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 the maximum 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 property is clearly relevant and necessary information to be considered in the loan decision process, it is 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 broad categories of real estate loan repayment risk. As a result, it is imperative that real estate lenders have a reliable appraisal report containing sufficient current information to make informed judgments about the security property and its competitive marketplace.

• The appraisal process and the resulting appraisal report must also be consistent with the complexity of the property being appraised. This implies that both the depth of analysis and the information presented in the appraisal report can vary depending upon the complexity of the property, its competitive marketplace, and the lender’s perception of risk in the transaction and even the structure of the proposed credit arrangement.

The Role of the Appraisal

• Depth of analysis. Must be consistent with the complexity of the problem and the anticipated risk. Not policy, nor cost or delivery time.

• Commercial real estate versus commercial loan secured by real estate (business loan).

• Is an appraisal necessary?

Is An Appraisal Really NecessaryAsk: How w ill the bank be

repaid?

Answer: R evenue derivedfrom renta l or sa le o f rea l

esta te .

If repaym ent of the credit is in anyway dependent on revenue derivedfrom rental or sale of real estate, anappraisal or evaluation is necessary.

Answer: R epaym ent w ill com efrom sources N O T dependent

on renta l or sa le o f the rea lesta te co lla tera l.

An appra isa l is N O Tnecessary

Appra isa l O ptionsC om plete

orL im ited

Evaluation O ption

Appra isa l R eportO ptions

Self C onta inedSum m aryR estric ted

Caution: The Appraisal Lending Time Shift.

TIM E LINECAUTION: Most appraisals are predicated upon historical events to m ake inferences about future loan repaym ent

Past Present Future

Sales, rentals, and econom ic indicators (rates &ratios) relied upon in m ost appraisals were

extracted from historical events.

A ll loans are repaid in the future regardless ofassum ptions that m ight be m ade to the

contrary.

AppraisalPrepared

What Can You Do?

• Establish policies and procedures to ensure all categories of risk are effectively and meaningfully evaluated in the loan decision process.

• Identify the real source of repayment of most commercial real estate loans. In most cases that is the cash flow produced by the security property.

• Recognize that real estate markets are dynamic. Values change in direct response to supply and demand relationships. You should therefore analyze expected supply and demand relationships and not just those that occurred historically or are occurring at the time the loan decision is being 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 the collateral 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 specific definition of market value.

Regulatory Required Market Value Definition

"The most probable price which a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller, each acting prudently, 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 of title 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 considers

his 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 financial

arrangements comparable thereto; and, The price represents the normal consideration for the property sold unaffected by

special or creative financing or sales concessions granted by anyone associated with the sale."

Potentially Troublesome Value Definition Components

• What constitutes typical motivation?

• Cash or its equivalent.

• Concessions

Economic Feasibility

There is not much need to know what a proposed project might hypothetically be worth if it is not going to work.

“The trick is to discern a market before there is proof one exists”

-- Bill Lear

Economic Feasibility

Although economic feasibility has been defined in a number of contexts, fundamentally it is a simple 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 produce them, a project may be judged to be economically feasible. Conversely, if the expected benefits 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, will it be worth an amount equal to or greater than the cost to create it?

Question: Can you think of any economic reason to create something that, when finished, will be worth less 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 often predicated upon historical or current data while ignoring the future in which the subject will actually compete.

• Real estate changes hands in an environment of expectations. Any analysis is therefore incomplete unless the analyst understands what is being expected by participants 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 the marketplace?

• How fast is it being absorbed?

• At what price is it being absorbed?

• Baseline: How much space has historically been absorbed? At what 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 it to 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 line and how does that compare with the subject’s completion?

• Have turning points been identified?

• Has net absorption been considered?

Why Market Analyses Are Sometimes 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 is going to be, not where it

has been.”

-- Wayne Gretzky

Highest and Best Use• The ultimate objective of property and market analysis is a conclusion of the highest and best

use of the property.

• Highest and best use has been defined in a variety of ways (all similar), however the thrust of the highest and best use concept is that reasonable and probable use that will support the highest 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 given time. The best use of the site may or may not be identical to the best use of the improved property.

• 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 if not 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 a conclusion derived from a specific analytic process. When it is treated in this fashion the highest and best use section of an appraisal becomes boilerplate which is not seen as having any relationship to the valuation process.

• The Highest and best use estimate is critical part of every appraisal because it sets the stage for the entire valuation process. Once the best use estimate has been made it will not only govern the type of data to be selected but also the valuation technique which will be used to process the market data.

Proposed and Partially Complete Development

PROJECT DEVELOPM ENT & CONSTRUCTION TIM E LINE

SiteAcquisition

ZoningApprova ls

P lansPermits

M ortgageand

EquityF inancing

Stab ilizedO ccupancy

orSellout

Pre-Construction Developm ent Activity Post Construction Developm ent Activity

Lease Upor

Sell O ut

ConstructionPeriod

Cost of Production Components

• Land Cost / Value

• Building Cost

• Financing Cost

• Marketing Costs

• Closing Costs

Cost of Production …continued

• Cost of sales and/or financing concessions.

• Absorption period expenses.

• Return on mortgage and equity capital.

• Entrepreneurial profit

A Second Look at the Time Line

PROJECT DEVELOPM ENT & CONSTRUCTION TIM E LINE

SiteAcquisition

ZoningApprova ls

P lansPermits

M ortgageand

EquityF inancing

Stab ilizedO ccupancy

orSellout

Pre-Construction Developm ent Activity Post Construction Developm ent Activity

Lease Upor

Sell O ut

ConstructionPeriod

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 or unleased space.

Deductions and Discounts … continued

• Tenant improvements not physically in place.

• Administrative expenses

• Financing costs -- mortgage & equity.

• Sales and/or financing concessions.

• Remaining building cost (as applicable)

Income Capitalization TechniquesDirect Capitalization

General RuleUse if property has achieved a stabilized level of long term occupancy and income and expenses are expected to remain relatively stable going

forward.

Discounted Cash Flow

General RuleUse if stabilized occupancy (or sellout) has not

been achieved and income and /or expenses are expected to fluctuate going forward.

Choice of direct capitalization or DCF should never be dictated by policy 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 inflator unless market evidence says so.

• Income and expenses forecast in time periods they are expected 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 much more 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 loan appraisal 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 file understand 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 proposed development 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 likely to 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 and exposure period.

• Assuming away what the appraiser was hired to do.

QUESTIONSComments, Questions, Observations or Subscribe to Publications

William “Bill” Pittenger, MAI, SRAwww.billpittenger.com

E-Mail: William_pittenger@comcast.net