Appraisals Are Deeply Flawed
I recently wrote a column on HotelNewsNow stating that appraisal methodology was deeply flawed and that appraisals are essentially fairy tales based on a bunch of unsupported wild guesses by appraisers. They claim to be able to project cash flow, interest rates, discount rates, terminal value cap rates, and renovation requirements for 10 years and then they use some unsupportable discount rate to determine present value. It is all nothing more than wild guess compounded by more wild and unsupportable wild guesses. It short, appraisals to me, have no value, and were clearly proven to be nothing more than propaganda to support unrealistic loans in the 05-07 period.
In response to the column two appraisers commented that”appraisers are required by our standards and regulations to reflect the market. If the market is being optimistic we are required to reflect that. It is not the appraisers role to adjust projections or cap rates or values or opine if anticipated net income is not sustainable. We are merely reporters on the sidelines. If you want us to tell you what we really think then have us put our consulting hat on instead of asking us to do an appraisal.” Another appraiser said “we are required to reflect the froth”.
That says it clearly. Even the appraisers say their appraisals are nothing more than make believe to reflect what the clients wants them to say. In fact one appraiser responded to my column by saying “who are we to question the view of the borrower or the lender”.
Why do appraisers even bother with the make believe of 10 year cash flows, alleged terminal cap rates and all the rest. What they are admitting finally is they are merely making all that up in order to get the answer their client wanted in the first place. This is why when I created the first hotel CMBS programs in 1993 we refused in our underwriting to use any numbers or values the appraisers came with. We got appraisals just to fill the rating agency file folder.
Everyone would be much better to ask appraisers to provide real numbers and projections as the appraiser I quote above has suggested. Phony appraisals was one of the contributors to how we had the crash. They were used as excuses to make stupid loans. The rating agencies are the ones to drive this change. The servicers tell me they are relying much more on broker opinions of value than appraisals and they only get appraisals because they are required to by the PSA docs.
In 1993, our underwriting manual required the use of historic cash flows and then current cap rates to determine loan proceeds. Loan to value was only used to make sure we did not exceed a percent of the appraised value since we knew the appraised value was in excess of reality, we always wanted to below that test.
My intent here is to get the capital markets, the rating agencies, and the real estate industry to start to use appraisers properly, and to use their knowledge in a way that is helpful, and not to support excessive lending and stupidity. If the truth hurts as to projections and value, then loan proceeds should reflect truth and not bull. If we redo how loans are underwritten, and if we use the talents of the appraisers properly, we may just help save ourselves from the next crisis in the capital markets. Excessive lending and over inflated values always lead to a crash-that is reality, so let’s not repeat this costly history.
The quoted appraisers noted that the appraisals are pictures of the current market. We are asked to value the current market value of an asset based on what a well-informed investor would pay. And, as Mssrs. Greenspan and Prince noted last week, nobody (or at least very few) saw what was coming. When I track purchases in a market and see investors paying 5.0% cap rates on properties, my responsibility is not to tell the bank that 5.0% is not a reasonable rate (with that partially defined as a rate where the purchaser does not have to reach into his pocket every month to make a payment), but to tell the lender that, yes, in this market at this time this is what investors are paying.
I agree that 10-year cash flows go well beyond the foreseeable future. I apply a multi-year cash flow only when the projected cash flows are uneven and only until the cash flows show stability (when a property is either encumbered by long-term leases or the current leases are generally reflective of the market). And yield requirements are not that hard to guess; there are numerous competing investments with quoted yields that benchmark my projection.
Now when Tishman-Speyer bough Stuy.Town & Peter Cooper, they based their projections on forecasted “market” rents (assuming existing tenants would move out and allow market-based tenants to move in), not projected rent-controlled rents. In so doing they, the investor whose actions appraisers are supposed to predict, made a colossal blunder. However, the sales comparison approach would suggest that at that time I use their highly-inflated per unit purchase price in valuing a competing facility. If I use my standards of reasonableness, the loan does not get made, even though the property would have sold at a higher price than my conservative estimation allowed. Hence, I short-changed the client.
A lot of good institutions that I work for did not lose their shirt in the last crisis. They used solid underwriting. They made sure that the loans were well-collateralized. The lent on a reasonable LTV, with a good DCR. On other words, I did my work well and they did their work well, and they limited the troubled assets on their books.
The only reasonable conclusion is that appraisal are as “deeply flawed” as the investment community. Neither of us has a crystal ball. And I can tell you that appraisers who use their personal, conservative criteria in fast-moving, expanding market need to find a new line of business, because no bank will use them. As noted, market value reflects what a reasonable purchaser would reasonably pay for a property as of a given date. We reflect the market; if something is deeply flawed, look in the mirror.
IMO, the point of using a DCF is NOT to create a fiction, justify a pie in the sky value, be a prognosticator, it is to model the market. The intention is to model how the market participants are viewing the market and more directly, the subject being valued. The assumptions in the model should reflect the predominance of the market participants’s inputs in analyzing the market. Trying to figure out what is happening now is tough enough BUT if there are numerous leases coming due and other risk factors that a typical investor would consider, then using a DCF can be a useful tool to provide further validation of the direct cap method.
Course, I’m sure all of you other experts recall that we are to use “market exposure time” which is the marketing period PRIOR TO the effective date, NOT a marketing period going forward. Again, imo, this is the biggest cause of friction between appraisal values and client expectations when the appraisal is being used as part of the underwriting process.
In short you agree appraisers just make up cash flows and discount rates to get to the answer they wanted up front to satisfy the client
I take exception to the two comments by appraisers.. this is more reflective of their personal circumstances rather than the profession. Apparently, they picked the wrong clients for whom to work!! And, this is how they think the profession should be which is a very distorted view.
As in every profession and industry including real estate promoters, packagers, rating agencies, etc. there are bad apples. I think it is disingenuous to be blaming the problems on the appraisers. I find it very hard to believe that because the credit agencies were so reliant on appraisals that they totally missed the boat. We all know why they blew it because they are hired by the same party that is getting the rating.
Wall St. and the rest of the industry that depends on OPM and debt, want what they want. Just like attorneys who forum shop and junkies who shop for docs that will give them the scripts they want, those that retain the appraisers want what they want. They want to do the deal, borrow the max, lend the max, get high credit rating, etc. Real simple solution, use competent, honest appraisers, don’t predicate their employment on dishonest work or overly optimistic assumptions. With any service business, cash flow is king and to put the burden on the valuation industry is nonsense. Yes, appraisers should hold the line, turn down the work, walk the assignment, etc. BUT way too many times in the recent past, clients did get what they wanted, high numbers to make their deals work and the valaution companies that did this type of work were able to stay in business.
The problem is not the methodology but the use of it and application of realistic assumptions. Those that do that frequently many times are not doing work for the parties that you reference in your email for the same reason…. aren’t providing what the clients want in terms of numbers. The problem is with the real estate industry– the norms, the ethics, the means of compensation and emphasis on short term results and pushing the envelope.
As I’m sure you would agree, a very important ingredient in any service business is having the luxury of picking the right clients and ditching the ones that nothing but trouble. I submit, that this goes for the rest of the industry not just appraisers.
You’ve obviously had bad experiences with appraisers and appraisals. A ten-year cash flow is utilized by appraisers as it reflects what the market typically uses for investment properties. Sure, anybody predicting what the market will do in ten years is required to make a number of educated guesses. However, these assumptions are based heavily on historical data, investor perspectives, and both micro and macro-economic factors. Income and expense forecasts can be quite reliable with long-term leased properties. While renovation costs may significantly vary over the cash-flow period, appraisers do take into consideration the age and quality of various building components. They additionally rely upon property condition reports and cost estimates provided by reputable sources.
Terminal capitalization rates and discount rates may be subjective, as you opine, but no true alternative exists. Appraisers carefully study various survey sources – which are typically reflections of active buyers and sellers. They also seek the opinions of these same parties. Additionally, cap and yield rates consider the reliability and characteristics of the income stream – something which can be fairly well estimated based on the leased status of the property.
Get yourself a better appraiser, one who is not swayed by a buyer or a seller, but considers the true factors of market value. Your wide brush stroke of all appraisers/appraisals suggests you have been dealing with too small a canvas.
Thank you all who repsonded in depth to my blog today. My intent of all my blogs is to get people thinking and talking, not to attack anyone in particular- except of course Nancy Pelosi, but that is a whole other topic. I have made and analyzed many loans, I created hotel CMBS programs in 1993, and was one of the authors of the basic hotel underwriting manual for hotels at the time, and I have dealt with many appraisers in all product types. There is no question that appraisers are under terrible pressure to give the borrower and lender whatever they want. However, that is the problem. I think a lot of appraisers know better, but are pressured to essentially lie. If there was another process for hiring appraisers -like there needs to be another way to pay rating agencies, then we would have avoided the crisis because a lot us grown ups of knew for years that values were absurd and unsustainable and tried to say so. When Greenspan says he did not know and only 5 of his feinds knew, he is either so isolated or just CYA, that he is not credible. A lot of us knew. In 1993 two of us even talked about how it would all end very badly and how it would unfold. Anyone who was experienced in the capital markets and was objective, knew better.
My goal is to get the Appriasal Institute to change the metrics. At least use only 5 years, not 10. Give a range and a few subject to. There are always black swans circling- 9-11, Long Term Credit, peso crisis, and on and on,etc- which are unpredictable, but need to be mentioned that the appraisal assumes no black swans, but if one lands then the projections could be affected by x% and the result would be whatever. In short, give a realistic underwriting and not a whore’s repeat of what the borrower wants.
It was for all these reasons that when we wrote the original underwriting standards for hotel CMBS in 1993 first rule was only look at historic cash flow and never pay attention to the appraisal value other than to make sure you are not more than 60% of it or you will be way over lending.
I want to help prevent the next crash so let’s all discuss this proefessionally and find a better way.
Thanks for the article … not sure it should surprise anyone … but these days lots seem to be surprised by things I think are pretty obvious …
I think that the deeper layer that could be an interesting piece as a follow-up to this one … could be a look at the Fund management side of things … where the firms make money by buying and running the assets … and participate without a downside in residual …
Where do those allegiances run? …
How realistic an appraisal do they want? …
IS the “Made As Instructed” appraisal a tool for them?
Just like all lenders are not “loan sharks”, all appraisers do not just pull numbers and projections out of thin air. Market participants – by that I mean those who buy and sell commercial real estate – are what drives the demand for lending and appraisal services. As a valuation analyst with FirstService PGP Valuation, I put emphasis on prevailing insights and anticipations of market participants. What cap rates are they buying at? What returns are they looking to achieve on an investment? It just so happened that between 2005 and 2007, market participants had a high appetite for risk that turned out to be unsustainable. But markets are seldom static.
An important part of an appraisal to consider, especially when contrasting to a BOV (broker’s opinion of value), is the disinterested third party aspect. Whereas a BOV is more of a marketing tool to court a listing with an owner or asset manager.
I would suggest to those ordering appraisals to talk to appraisers and ask questions about market conditions. You may be surprised how knowledgeable they are outside of a structured appraisal document. But if you want to just file them away, that is fine with us too.
Mr. Ross,
I’m sorry to hear that you’ve received so many defective commercial appraisals that you’ve lost all confidence in them. All rates need to be supported. Direct cap, yield cap, equity dividend, vacancy, lease-up–every rate used must have support from the market. If DCF is used, economic conditions must be forecast to the end of the holding period, and going-out cap rates should be based on projected conditions supported by reasonable and probable market assumptions. Highest and best use should include consideration of every financially feasible use, along with a reconciled conclusion supported by the market analysis.
I’ve seen far too many commercial appraisals wherein the appraiser “felt” the highest and best use of the subject property was… whatever the client wanted to do with it. No cost-benefit analysis of feasible uses, indeed no mention of alternative legally permissible uses was found in these reports.
However, I know many good, competent appraisers who have been told, “We can’t use you because your values are too low.” These appraisers do a proper market analysis, out of which every rate used is supported. Their reports are of the quality that you say you want. Yet they are denied work because if their reports are used, the deal won’t work: In other words, a competent, well-written appraisal won’t allow the client to steal money from the government.
These clients are not fly-by-night scam artists. They are well-known financial institutions.
If you get an appraisal from me, you’ll get the kind of support that should be present. But if you’re like most lenders, you want the number you want, and you want to pay peanuts for it. All you can hire for peanuts is monkeys. I don’t work for peanuts, Mr. Ross. Many, many clients have declined to pay my fee for the work they “say” they want done. Colleagues have reported being handed a spreadsheet on electronic media and *told* to do the analysis in a certain way. If they refuse, they don’t get the job. (Hence, the standing wry joke: MAI = Made As Instructed.) I’m not an MAI yet, so I don’t get much opportunity to refuse such conditions. But refuse I will.
So send me your appraisal order and get out of my way. Don’t tell me what value you’re hoping for, how much you need to make the deal work, or how to do *any* analysis. If my report is poorly supported, turn it in to the state. Don’t tell me how to appraise, and I won’t tell you how to invest (unless such advice is part of the engagement conditions.) When clients browbeat and intimidate an otherwise honest appraiser, they should be content to get what they ordered.
To reinforce the fallacy that present controlling conditions will hold through the projection period is proven unrealistic by Mandelbrot’s Chaos theory. For those not familiar with Chaos math or any higher math than high school level an excellent easy to read and understand book on the subject is the former N Y Times’ science editor James Gleick’s book “Chaos Making a New Science”.
As one who spent 60 years as a commercial appraiser the teaching that if one finds three or more closely related comparable and one the adjusts them for differences between them and the subject property you found the market value of the subject property. Comparables represent past transactions. They are history even if they took place yesterday. That does not prove or give one the assurance that the appraised property will sell at or close to the analyzed conclusion without a demand study to see if there are potential buyers or tenants able and wanting to pay the appraised value of the subject property.
I appraised many of a commercial property that had vacancies caused by an over anticipation of demand for the space even though the existing tenants were doing well.
Without a demand study the appraisal is incomplete and can and should not be relied upon.
A radical example of the application of how chaos makes any reliance present available conditions will prevail though the projection period is demonstrated by the question I raise “What good was my lower Manhattan comparable data on 9/12 after 9/11 and who would use that data if asked to find a value on 10/1?. The example is extreme but makes the point.
Those of us who have done store location studies for a retailer understand that our real estate axiom location, location, location is really demographics, demographics, demographics. Mark Penn’s easy reading book “Micro-trends” will not only find it factually interesting but gives one what to look for when predicting a demand for local real estate and for retail renting professionals where to look for tenants.
The world does not run on linear equations only a piece of machinery that constantly repeats the same function during its life cycle does.
Anyone who is basing lending decisions on BPO’s (“The servicers tell me they are relying much more on broker opinions of value than appraisals and they only get appraisals because they are required to by the PSA docs.”) has no business being in the lending business. I have reviewed thousands of BPO’s and appraisals, and most BPO’s are not worth the paper they are written on. They rely upon listings and do not even analyze the history of those listings. And talk about someone who is “influence” to provide a value that they think will get them business??? Brokers tell sellers what they want to hear, and we all know that all sellers (myself included) are not objective and think their property is worth more than it really is worth. Now that may be a generalization, and I am sure there are brokers out there that do a good job, but isnt your whole blog a gross generalization of the appraisal industry?! I suggest EVERYONE involved (lenders, brokers, appraisers, credit people, rating agencies, etc) take a long hard look in the mirror and take responsability for this mess and make the necessary changes to prevent it from happening again.
Appraisers have to do as they are told by the client if they want a constant flow of deals/fees. Having had experience on the principal side, I have witnessed my company’s asset management team discussing with appraisers about what cap rate, expense assumptions or trends to use on deals. A development deal we finished in early 2009 at close to 170K per door was appraised at 110K per door stabilized. I witnessed my manager beating down the appraiser until we got the value close to 140K per door (hard number for the appraiser to swallow but he wants future business from us).
This argument can be made for why some of the big 4 real estate firms have removed such service lines as tax consulting. Creates a major gap between the valuations from the capital markets/investment sales group and the tax consulting team who helps owners reduce property tax.