When an economic calamity is so great it compels economists to reach for a new paradigm incorporating the value of collateral and the amount of leverage used to finance its ownership. When the understanding of commercial real estate operations and cash flow characteristics – and the ability to use computer programs to model it makes the three approaches to value – cost, sales comparison and capitalization of income – simplistic and, with one exception, anachronistic….
Δ First, the cost approach in which estimated value “is derived…by estimating the current cost to construct a reproduction of existing structure, including entrepreneurial incentive, deducting depreciation from the total cost and adding the estimated land value”* (which fluctuates based on market conditions) only works for special purpose properties as a reflection of value in use – as a factory which is designed and built to house production of a unique production process.
- Having been in a position to sell a Class B building in downtown St. Petersburg for under $15 per square foot in 1992 at the bottom of the last cycle which was empty in a time of oversupply I know that an empty building is not necessarily worth the cost of bricks and mortar and a developer adds value above replacement cost by developing and leasing the property which provides incentivized investment returns to both capital and management.
Δ Second, the sales comparison approach derives value “by comparing the property being appraised to similar properties that have been sold recently, then applying appropriate units of comparison making adjustments to the sale prices of the comparables based on the elements of comparison.”* This approach may be appropriate for owner-occupied housing where the principal of substitution is the primary basis for determining what a buyer would pay for a home; however, differences between commercial properties; including location, functionality and operational efficiency, lease structures and terms, and the capital structure, cost of capital and yield expectations of the buyer who pays “investment value” for a property; are too significant and extensive for an appraiser to be able to adequately address them in order to estimate the value of a comparable property.
- Being on the opposite side of a street or having more points of ingress can change the marketability of a property and reduce or increase market risk which should be reflected in the buyer’s yield expectation as reflected in the Internal Rate of Return and the resultant capitalization rate.
- Even if an appraiser used sales data on sales that closed as of the date of the appraisal, the information is dated since a normal commercial real estate deal takes between two and three months to negotiate and close with the purchase price generally agreed upon at the outset of the process – not the conclusion.
Δ Finally, the income capitalization approach which can be applied using two methodologies: (1) the capitalization of “one year’s income expectancy” at a “market-derived capitalization rate,” which happens to be the most commonly used method due to its simplicity; or (2) the discounting of “the annual cash flows for the holding period and reversion….at a specified yield rate.”*
- The capitalization of a one-year pro forma has the fatal flaw in that it implicitly assumes the net operating income from a property will be the same in perpetuity – and commercial real estate professionals including appraisers know that a property’s cash flow is not the same from one month to the next, much less does it remain the same for years on end. With the sole exception of a long-term absolute net leased single-tenant property, commercial real estate does not generate bond-type income streams. It has a mix quality of tenants with varying lease rollover times, vacancies and releasing costs.
- In addition, the traditional application of the income capitalization approach is to capitalize net operating income, which may be a proxy for net cash flow when there are no tenant improvements or leasing commissions to pay as is the case with apartment complexes, self-storage facilities and hotels but not with office buildings, shopping centers or industrial facilities. For commercial properties, the NOI should be reduced by an estimate of the annual expenditure for leasing costs and rollover vacancy to approximate the estimated net cash flow to be generated from the property operations. Problem is, appraisers cannot get the same information on competing properties in order to develop an appropriate cap rate.
Accordingly, the only reasonable method to establish what the accountants call “fair value” of commercial real estate is to forecast future cash flow from the operation and re-sale of the property and discount the resulting cash flows reflecting a prudent investor’s yield requirements given the cost of debt financing and the perceived market, operating and financial risk assumed through ownership in relation to other investment opportunities.
It is the 21st Century - we know better and we have the capability to estimate market value by employing the same tools investors use to establish investment value.
For the record, the generally accepted definition of market value (“The most probable price, as of a specified date, in cash, or in terms equivalent to cash, or in other precisely revealed terms, for which the specified property rights should sell after reasonable exposure in a competitive market under all conditions requisite for a fair sale, with the buyer and seller each acting prudently, knowledgeably, and for self-interest, and assuming that neither is under undue duress.”) is not at issue – the issue is that the aforementioned approaches to value are still accepted as a basis for estimating market value.
Accordingly, in my humble opinion, market value can only be based on the income characteristics of the subject property. Minimum standards would be established for the research and support used for developing the forecast assumptions used in preparing the cash flow forecast. Appraisals would be evaluated based on the assumptions used in estimating market rent, stabilized occupancy, downtime between leases, leasing costs, operating expenses, growth rates, capital improvement and replacement costs, reversionary capitalization rate and selling costs, and the yield, or discount rate, used to present value the future cash flows.
Δ The traditional cost, sales comparison and capitalization of income approaches would be used to test the reasonableness of the resulting range of values developed pursuant to the discounted cash flow approach within which “market value” is most likely to occur.
The Appraisal and Mortgage Financing Considerations
From a prudent lending perspective, the information contained in an appraisal provides many underwriting benchmarks – in addition to the traditional loan to value ratio - which provide establish loan sizing and structuring. For instance, prudent lending practice dictates that a construction loan should be capped at the cost of construction excluding land; however, in the last cycle, many non-recourse permanent loans were made based on appraised values far exceeded replacement cost which has increased the exposure to risk above which is prudent for commercial lenders: Permanent financing sizing should also be capped at replacement cost.
The objectively-created cash flow forecast used in an appraisal provides lenders with a timeline for potential default events like tenant rollover or major capital improvements or replacements enabling the loan officer to structure the loan with appropriate rollover and capital reserves. Further, the lender can determine a property’s ability to cover debt over the anticipated loan term and size the loan using a debt coverage ratio-based mortgage payment reflecting the minimum cash flow generated after unreserved leasing and capital costs including lost rent during rollover.
If an appraisal is being conducted for purposes of a loan application, the cash flow forecast should be for a minimum term of the loan plus at least two years. This timeframe allows a lender to fully evaluate the risk of default at maturity that may result from a major tenant rolling over immediately subsequent to the proposed loan maturity. Further, the lender can structure the loan with appropriate reserves and shorter amortization term to reduce the balance to reduce the default risk to an acceptable level.
It is clear from the impact escalating market value of commercial real estate based on unrestrained market liquidity and investor demand that the 20th Century valuation methods embraced by the Appraisal Institute and the financial community leads to ever escalating values in boom periods and draconian values in recessionary periods does not provide a prudent basis for loan sizing and structuring.
New loans, and loans to be restructured, need to reflect the property-specific risks of the collateral as reflected in an appraisal that appropriately reflects the cash flow characteristics of the property and the risks and returns of ownership.
- For instance, the interest rate and loan sizing parameter, loan to value ratio, would be influenced by the credit risk in the property’s tenancy and lease tenure, or rollover risk in the rent roll.
- The physical reserves would be structured to provide fro un-depreciated replacement cost in the year the expenditure is expected to occur as, ideally, the reserve and capital expenditure forecast would be obtained from a current property condition report.
The considerations in establishing the size and terms of a commercial mortgage loan extend far beyond loan to value and debt service coverage ratios – and it is time for mortgage lenders to fully utilize the information in the appraisal to minimize default risk.
Conclusion
The objective of policy-makers, regulators and bankers in the wake of the Great Recession is to provide prudently underwritten loans to qualified borrowers which will serve to eliminate, or at least moderate, market bubbles. Updating the appraisal methodology to reflect anticipated property performance is one of the first places to start. It is clear that the traditional approaches to estimate market value do not result in a value estimate appropriate for prudent loan underwriting and sizing.
My prediction is that issues involving collateral and collateral value will be at the forefront of financial and real estate industry concerns as we reach for the new economic paradigm. While traditional appraisals and broker’s price opinions will provide financial institutions a value benchmark, they will not provide the basis for the new economy.
It is time for the Appraisal Institute to effect a paradigm shift in the appraisal process of a commercial property – it is time for valuation methodology and loan underwriting to enter the 21st Century!
This is my first eblast this year but it is not my first post to my blog. I welcome your comments and opinions and look forward to continuing the dialogue.
We know real estate and we understand commercial mortgages - let me know if we can be of service.
Best regards,
Paul Jones, CPA, CRE, FRICS
* NOTE: All definitions are from The Dictionary of Real Estate Appraisal, Fourth Edition, Appraisal Institute, 2002.
Paul, You are exactly correct, but as a practical matter, this stands little chance of implementation. Why ? Developments must be better conceived to a higher standard allowing less speculation, thus raising the bar intellectually. Lenders will only be able to fund viable projects and will therefore see margins and volume shrink. Appraisers will resist the change because the additional analysis will take a greater effort meaning again, either higher cost or less return for time expended. Thanks for pointing it out, regardless. Doug Cutler
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