It's difficult to overestimate the importance of accurate appraisals in the commercial real estate industry. Whether an investor is seeking an acquisition loan, refinancing or tax assessment, it pays to be aware of both the skills required of appraisers and of the forces reshaping the appraisal business.
The widespread securitization of real estate debt since the 1980s has led to a sea change in the appraisal world. Issuance volume of commercial mortgage-backed securities (CMBS) grew more than tenfold in the past decade alone, from $15.7 billion in 1995 to $169.1 billion in 2005. Consequently, appraisers have had to beef up on efficiency in order to keep up with the dramatic increase in the number and size of securitized deals.
Meanwhile, appraisals have taken on heightened importance because of their widespread usage. Every party up and down the capital stack of a securitized transaction — from the borrowers to bond buyers to attorneys — rely on appraisals.
Considering the growing need for valuation expertise, it's ironic that today's appraisers must work faster and for less compensation than they did a generation ago. Fees today are 30% lower than in the 1980s and turnaround times average 21 days, compared with 30 to 35 days just two decades ago, according to John Busi, who oversees Cushman & Wakefield's appraisal practice in the Americas. “Every change that's taken place in real estate finance should be pushing the market in the opposite direction,” he says. “Fees should be higher and timelines should be longer.”
An appraisal on a commercial property can cost anywhere from $3,000 for a bank branch or freestanding store to $100,000 for mixed-use development projects and multi-tenant office parks. Higher fees reflect the asset's complexity and advanced modeling necessary to calculate numerous leases and expenses in a property's cash flow. Final prices are usually determined through a competitive bidding process, which is one of the reasons those fees have been shrinking.
And while appraisers serve a multitude of new users, most of the newcomers are simply sharing a single appraisal prepared for a primary client. That means fewer fees to collect. “Rather than providing different services and collecting multiple fees, everyone's getting to see the show for the price of one admission,” Busi says. “It's placing a tremendous burden on appraisers.”
Appraisers are carrying that burden all the way to the bank, however. Despite fee compression, high volumes seem to be driving up revenues. The Valuation & Advisory Services unit at CB Richard Ellis, for instance, increased revenues by 33% year-over-year in the third quarter to $72.4 million, according to Bear Stearns.
Facts and fancies
Determining a commercial property's value is an inexact science, and often relies on the appraiser's experience and intuition as much as it does on recent sales data and property fundamentals. The basic approaches include income, price comparison, and replacement cost.
In most cases, the appraiser will blend two or more of these methods depending on the property type and the purpose of the assessment. An analysis for tax purposes may emphasize replacement costs less depreciation, taking into account unusual architectural or historic significance. For a loan or sale, the emphasis will shift to income from leases and how the property compares with similar assets that have sold recently. These factual analyses provide only part of a property's story, however.
The art side of an appraisal comes next, and requires the most skill. To determine the highest and best use for a property, the appraiser needs to be aware of potential buyers and their activities, and decide whether the property lends itself to popular development or redevelopment trends. Extensive experience in the local market is an advantage, if not essential, or key factors may be left out of the equation.
Science dominated in the 1990s, when commercial appraisals were primarily a formula process of sales comparisons, according to Busi of Cushman & Wakefield. In today's faster-moving up cycle, the appraisers must place greater emphasis on where they believe the local market is headed. “We've needed to be more nimble, more intuitive,” he says. “That's the art part.”
The faster the market moves, the more difficult the calculation becomes, says Theresa Nygard, senior managing director of KTR Valuation & Consulting Services in New York City. That's because there is a time delay between deals closing and prices becoming generally known. In a rapidly accelerating sales market, available sales data isn't necessarily in step with current value, so the appraiser needs a feel for the pace of rising prices.
A clear understanding of the potential buyers also can temper an otherwise numbers-based assessment, Nygard says. An appraiser assessing a tract in Greenwich Village, for example, would be missing the boat if he or she were unaware that New York University has been acquiring properties there. “They don't buy every property, but you need to consider the possibility. They are a factor in your neighborhood,” says Nygard.
Nygard recommends that appraisers keep in constant contact with local market participants as well as analysts in order to stay on top of trends that could affect property values. Part of her regimen includes networking regularly with real estate professionals through the Association of Real Estate Women — the real estate industry's oldest women's professional organization based in New York — and other industry organizations.
21st Century arrives
Technological advances, such as Web-based data bases, have both streamlined the valuation process and enabled providers to lower their rates in a competitive market. The largest appraisal firms, in particular, have boosted efficiency with technology and standardization. Cushman & Wakefield, for example, has spent millions of dollars on proprietary software, training modules and databases that put necessary property information at an appraiser's fingertips.
CB Richard Ellis has also invested millions in technology and training to build its Valuation & Advisory Services unit, Cushman & Wakefield's chief competitor in the national appraisal arena. CBRE boasts more than 400 appraisers in 53 U.S. markets, according to Douglas Haney, president of the company's Valuation & Advisory Services. “The appraisal industry has had to come into the 21st Century and increase capacity,” Haney says. “It's a competitive market out there. No one has an easy ride of it.”
Haney says a key to the success of CBRE's valuation group has been steady hiring and training in preparation for a wave of intense demand that is only now beginning to materialize. The large staff enables the company to tackle portfolios as quickly as a single appraisal — one deal required simultaneous appraisals on more than 400 properties.
The greatest driver of appraisal volume going forward will be CMBS loans, Haney predicts. Conduit loans have come to dominate commercial real estate finance and generally carry a term of 10 years or less, which leads to more frequent refinancing than in the days when 25-year loans were common. The demand to appraise properties being refinanced is compounding the demand created by new CMBS loans, he says.
Haney expects CMBS-driven demand for appraisals to outpace the supply of certified appraisers so much that the fee compression seen in recent years will begin to reverse. As early as this year, he says, appraisers may need to charge more for their services. “We are not making as many appraisers as demand indicates we will need,” he says. “That will eventually have an effect on fees.”
Even the best appraiser can miss a key feature or flaw in assessing a property, or make an incorrect assumption based on market trends that don't apply in a particular submarket. What are the most common causes of bad appraisals, and how can investors avoid them?
Appraisal fraud is rare in the commercial real estate world, says Terry Dunkin, who is president of the Appraisal Institute and oversees the eastern region for Colliers Valuation from an office in Baltimore. “The buyers and sellers tend to be more sophisticated in the type of analysis and due diligence they do, as opposed to a residential buyer who's not as familiar with the process,” he says.
A faulty appraisal is much more likely to be a mistake than an intentional crime. Even so, an innocent miscalculation can wreak havoc on carefully crafted acquisitions or re-financings, triggering costly delays or even killing the deal.
South Florida attorney Oscar Rivera has encountered several second-rate opinions regarding valuations. In a recent example, an appraised value was far higher than the client's due diligence suggested it should be.
A review by Rivera's firm found that the sales used for comparison were in a different submarket from the client's property and had skewed the appraisal. “The amount of experience an appraiser has in a particular geographic area is a prime consideration for how good a job we think they're going to do,” he says.
On other hand, unwelcome appraised values may simply reflect a rapidly evolving market. Rivera has two Florida clients that built complexes of residential condominiums based on pre-sale commitments, for example. Now that construction is completed on many of the homes, many are appraising below the contracted sales prices, making it difficult for the buyers to obtain financing.
Investors may face unique challenges in evaluating properties outside the United States. Some countries offer little historical data or sales information, so the appraiser must rely heavily on skill to compensate for the lack of market data.
Assess the assessor
The Financial Institution Reform and Recovery Act of 1989 set guidelines for states to more closely regulate licensing of third-party appraisers. Before that time, most banks and savings and loan offices used in-house specialists without certification. Now nearly every state requires varying levels of certification for appraisers serving commercial real estate lenders, according to New York appraiser Alice Palmisano.
“And the Appraisal Qualifications Board keeps adding more qualifications to all the categories,” says Palmisano, who is executive director of Brown Harris Stevens Appraisal & Consulting LLC. The Appraisal Qualifications Board is operated by The Appraisal Foundation and sets appraisal guidelines that are largely adopted at the state level.
Each state decides what level of certification an appraiser needs to work with a particular size or type of loan, but the Appraisal Institute oversees appraiser certification training.
The three professional titles include a basic appraiser; a residential specialist, which requires 200 classroom hours and 3,000 hours of professional experience; and a senior level that requires 4,500 hours on the job and 380 hours in the classroom.
Even if a particular transaction doesn't involve a loan, and is therefore exempt from lending statutes requiring the use of a certified professional, it's a good idea to stick with an industry expert who has attained one or more of the Appraisal Institute's designations.
“If there are any doubts in a commercial real estate transaction, the best thing an investor can do is hire an MAI appraiser to do the analysis,” says Dunkin, the institute's president. MAI is the institute's most senior appraiser certification.
Even with a certified professional, attorney Rivera advises clients against blindly accepting an appraisal that seems inconsistent with their expectations. The problem he most frequently encounters with appraisals is the use of incompatible sales in the price comparison.
“Appraisers are going to drive the deal, so you've got to be careful that you hire someone who knows what they're doing,” Rivera says. “If the property doesn't appraise, then the deal is dead. It's not something that can be taken lightly.”
Matt Hudgins is an Austin-based writer.