Review commercial real estate appraisal by Cutmytaxes

How to Review a Commercial Real Estate Appraisal Report:

How Can an Attorney Ascertain the Merit of an Appraisal?

John W. VanSanten, MAI – jvansanten@srr.com

SRR Journal: Before even discussing the appraisal report,

relative to office buildings or industrial parks, many appraisers

perhaps we should address the merit of the appraiser performing

simply do not have experience with them.

the work? What should attorneys look for in determining whether or not the appraiser is qualified for the matter at hand? John W. VanSanten: At the most basic level, the appraiser should certainly be licensed within the state where the property is located. And this really is a minimum requirement, because while licensing requirements vary among states, they are not overly burdensome to acquire, and many of them allow reciprocity or temporary licenses. In addition, it is preferable to have the MAI designation from the Appraisal Institute, which is really the preeminent professional association out there for real estates appraisers. An appraiser who holds the MAI designation should possess a high level of experience and qualifications. But in addition, and sometimes more importantly, an appraiser possessing real estate expertise specific to the subject property and market area is key. SRR Journal: Are there particular property types for which

SRR Journal: As it relates to the appraiser, how can someone reviewing a report investigate the credentials of the appraiser? JWV: There are a couple of resources which are generally available to the public. First, to verify if a person actually holds the MAI designation, you can use the “Find an Appraiser” function on the Appraisal Institute’s website which is www.appraisalinstitute. org. Second, with regard to licensing and state certification, the website for the Appraisal Subcommittee, which is www.asc.gov, can be used to determine if someone is actually licensed, if the license is current, if there have been recent violations, etc. SRR Journal: Turning our attention from the valuation expert to the valuation report, I understand that there are various types of reports: Self-Contained, Summary, and Restricted Use. Is there any difference among them as far as the scope of the work

specific experience may be more relevant than for others?

performed, or is this merely a matter of presentation?

JWV: Experience is certainly relevant for every property type, but

JWV: It is really just a matter of presentation as all three require

it is more important with some special purpose properties. By special purpose properties, I am referring to real estate which has been designed for a unique purpose, such as a stadium or perhaps certain health care facilities. Special purpose properties typically have few, if any, alternative uses due to the high cost in making modifications. Since these properties are less common

the same amount of work. But depending on the context for which the appraisal is being utilized, presentation can be important. For example, in litigation, some attorneys may want a Self-Contained report, believing it to be impressive through its exhaustiveness, while others may believe a Summary report is more appropriate to minimize unnecessary questions on matters with little relevance during cross examination.

SRR Journal: Real estate appraisals, unlike business valuations,

confirm the accuracy of data, but it will also allow the appraiser to

specifically discuss and ascertain the marketing period and

understand the motivations at the time of sale and whether or not

exposure time for the property. Would you please discuss how

it is an arm’s-length transaction.

these concepts influence value? And what should be done in determining these assumptions?

SRR Journal: Should the verification itself be cited within the

JWV: Exposure time is a retrospective look which answers how

particular transactions?

long a property had to be exposed to the market prior to selling on the valuation date. Marketing period is a prospective analysis. How long will the property have to be on the market from today in order to sell? If the real estate market is relatively stable, then these two concepts are going to be very similar in duration. However, if the market is appreciating or depreciating significantly, the time periods may be dissimilar. The relevance of these concepts really relates to consistency. If they suggest an appreciating market, has this translated into a higher conclusion of value? SRR Journal: Regarding the scope of work, can you think of any particular documents or areas of investigation that, if they are not performed, could significantly impact the appraiser’s opinion? JWV: The most obvious red flag would be the failure of the appraiser, or at least someone from his or her team, to have inspected the property. There are instances where the Scope of an Assignment has been limited to the point where a physical inspection is not required. In those cases, the appraiser has to make specific assumptions regarding the condition of the property. However, in matters involving litigation, an actual physical inspection of the

report? Who was consulted, when, and in relation to what

JWV: Whenever possible. I have witnessed too many litigious situations whereby an attorney crosses an expert only to have their verification non-existent or poorly documented. It really diminishes the credibility of the analysis. SRR Journal: Any valuation is performed as of a point in time, but, especially in today’s real estate market, there are rarely transactions that occur as of a particular valuation date, so past information must be reviewed. How far back in the past is appropriate? Is it six months? Two years? What is reasonable? JWV: It largely depends on the extent of price volatility in the market. In general, you want to stay as current as possible, but in recent years it has been extremely difficult to do so given the dearth of transactions out there. In addition, it varies from situation to situation and depends on the quality of data available. Typically only transactions within the last year or two are utilized, but it depends on the situation and the type of property being valued. To the extent market conditions have changed from the time of the transaction to that of the valuation date, adjustments should

property can be very important.

be made.

SRR Journal: What other critical subjects within a report should

SRR Journal: Moving on to the concept of highest and best use,

be reviewed?

it strikes me to be of tremendous significance to the appraisal,

JWV: The market analysis. Has the appraiser properly identified

appraisers as well as the reviewers of appraisal reports. Would you

the correct market for the property? For this situation, think of the

agree with that, and if so, is it an area which should be critically

very small industrial property which has a local or regional market

examined?

versus the Willis Tower where the market is national or perhaps even international. Who are the potential buyers/investors? Are they looking for properties locally, regionally, nationally, or internationally? The market analysis will dictate the search for comparable properties and ultimately which are chosen for

but I get the impression that it is not fully examined by a lot of

JWV: Absolutely. I think a lot of times appraisers tend to gloss over this concept, which can be a significant problem as it is a pivotal analysis underlying the entire appraisal. If the highest and best use analysis is wrong, the valuation conclusion is likely to be wrong.

indications of value.

Many appraisers simply assume, “well, it is an industrial property,

SRR Journal: As a matter of protocol, would you recommend

not be true. The analysis of highest and best use should look at the

that sources of market information always be disclosed within the

property twofold. First, what would be the highest and best use if

report? For example, if you were utilizing private databases, would

the property was vacant and available for development? Second,

you recommend that these databases be cited as well as how the

what is the highest and best use of the property as currently

search was conducted?

improved? There are four sets of criteria which help ascertain

JWV: Whenever possible, the appraiser should communicate how the information was gathered, and how it was verified. For example, even widely utilized resources, while great for information, possess inaccuracies. And since our conclusions may be highly sensitive to the information reported, it is critical that verification

so the highest best use is as industrial property”. That may or may

this: legal permissibility, physical possibilities, financial feasibility, and the maximum productive use of the property. Ultimately, the conclusions related to the highest and best use of a property should reflect how the universe of potential buyers would assess the investment opportunity.

occurs with public records and/or a party to the transaction such as the buyer, the seller, or the broker involved. Not only will this

SRR Journal: I imagine the test criteria you just described

a market participant to build the facility. But be careful here,

lend themselves well as to questions to ask the appraiser: Did

entrepreneurial profit must be market supported and there must

you examine what is legally permissible for the property as if it

be evidence that it exists.

were vacant? How did you assess the financial feasibility of an improvement to alter its highest and best use? Etcetera.

SRR Journal: The sales comparison approach to me, and I think

JWV: Yes, and I should add one caveat regarding legal

intuitive approach. A building is being valued, there is a similar

permissibility. Just because property may be zoned for a particular

building in the geographic market which sold for a particular

purpose does not necessarily mean that it is impossible to change

amount, and we can infer a value for the property in question from

that purpose. Agricultural land is frequently rezoned as residential

that sale. Is this approach ever not used? And if so, why?

subdivisions in the suburbs. Likewise, industrial land is often rezoned for commercial or residential uses in cities. The appraiser really needs to understand development trends in the area and the

any person outside of the real state profession, is simply the most

JWV: The main reason this approach may not be utilized is that there is insufficient applicable data. There may be some markets

propensity of the local municipality to revise zoning designations.

or some property types – again, special use property types are an

SRR Journal: Are there any market conditions or property types

reliability of the approach depends upon the quality and quantity

for which a reviewer should pay particularly close attention to the

of available data. This certainly has been more of a problem in

highest and best use analysis?

recent years. Depending on how limited the quality and quantity of

JWV: Yes, basically any time there is a significant change in market conditions – and by that I mean both positive and negative changes. Changes in market conditions bring changes to the underlying economics of particular properties. With appreciating

example – for which there simply are not any comparable sales. The

data may be, the approach may either be inapplicable or perhaps, still relevant, but to a lesser extent than normal. In those situations, the other approaches may receive relatively greater weighting in the conclusion of value.

real estate prices, a marginally profitable machine shop may

SRR Journal: You mentioned quantity of transactions. How many

consider a different location. The inability to find a suitable

do you require to draw meaningful pricing information?

replacement tenant may cause the owner – and the real estate appraiser – to assess whether or not the property should continue

JWV: Quantity depends on quality. All things being equal, the

as is or be torn down and built to suit trendy retail shops.

greater the quality of the comparables, the fewer number of

SRR Journal: The asset-based approach in business valuation

to look at the properties themselves: location, physical attributes

is infrequently utilized. Is that the same with its equivalent in real

such as overall property size and age, the legal rights conveyed,

estate appraisal, the cost approach? If not, how is it or should it be

etc., but it also has to do with information about the pricing. Has

utilized? Under what scenarios is it most likely to be used?

the pricing been appropriately verified? Were the financing terms

JWV: Of the three approaches, the cost approach is indeed the

comparables may be necessary. By quality, one certainly needs

unusual or typical?

least frequently utilized. But there are several situations where

SRR Journal: For how long is an appraisal relevant? This question

the approach may be the most relevant – and possibly the only

comes up frequently in the context of estate matters whereby an

approach which may be applicable. It is often relevant for new

election to use the value six months after the date of death may

construction. In these situations where you have good data on

be made. It is also relevant in litigation. For example in marital

construction costs, any adjustments for depreciation are likely

dissolutions where each side may be attempting to stipulate as

to be minor. Another example is that of special use properties.

to a valuation date.

These properties, which may have been built for a very specific manufacturing process or other need, do not sell very often, so there is limited data outside of a cost approach. It will always depend on the particular circumstance, but without sufficient market data to apply a Sales Comparison or Income Capitalization

JWV: In today’s market, the shelf life of an appraisal may be significantly limited. But it really depends on how the market has performed since the appraisal. And it certainly varies quite a bit by different markets and asset classes. For example, retail has been

Approach, the Cost Approach may be the best indication of value.

heavily impacted by the economic downturn, but not necessarily

SRR Journal: Can you please describe in general terms the steps

have experienced greater volatility than properties in the Midwest,

in performing a cost approach analysis?

but not necessarily for any given market or asset class. In general,

JWV: In very general terms, starting with the value of the land as if vacant, the cost to replace or reproduce the facility is added. A good question to ask the appraiser is how they derived these

to the same degree in any given market. Properties on the coasts

any reviewer of a report should have a heightened awareness of the possibility that the appraisal is dated – even if we may be talking about a period as short as six months.

cost estimates. What sources were utilized? To this value may be added, depending on the situation, entrepreneurial profit to induce

SRR Journal: When is the income capitalization approach

revenue generates net operating income to which is applied the

appropriate?

capitalization or discount rate, depending on which methodology

JWV: For the most part, whenever there is sufficient income data

is employed.

available to result in a reliable indication of value. Oftentimes, it

SRR Journal: Where do the capitalization and discount rates

will be the most appropriate and most reliable method of valuing

come from? That is, how is it determined and how should it be

a property. The income capitalization approach consists of two

documented within the report?

methods: direct capitalization and discounted cash flow. In direct capitalization, a stabilized level of cash flow is capitalized into perpetuity by dividing the estimated net operating income by a capitalization rate to derive value. With the discounted cash flow method, discrete cash flows are projected on an annual basis over a particular holding period, such as five or ten years. The present value of these cash flows are calculated and added to the present value of the property as of the end of the particular period of

JWV: Capitalization and discount rates are critical assumptions, and there absolutely needs to be strong support. This is an area where appraisers often fall-short – relying on unsupported assumptions about rates. For support, there are a number of resources available. First, comparable transactions imply overall capitalization rates. It can be calculated by dividing net operating income by the sale price. Second, investor surveys

time utilized.

and conversations with participants in the market provide current

SRR Journal: Regarding these two different methodologies within

more timely data on which to base assumptions. Lastly, rates

the income capitalization approach, when it is appropriate to use

can be derived from a band of investment analysis. This analysis

one versus the other? And how often, if at all, should a reviewer

reviews current financing terms that provide information on various

see both of them at the same time?

sources of capital. The analysis looks at both the cost of debt and

JWV: Theoretically, both should produce the same value as they are typically utilizing a lot of the same underlying assumptions. But which one should be employed depends on the expected cash flows. In situations where stable cash flows are expected, for example with long-term leases, there is little reason to use anything

expectations of investors, so in some respects this may provide

equity, which are then weighted to derive an overall capitalization rate, which implies an overall rate of return on and of the investment in real estate. Using all of these sources and weighing their relative merits at this point in time and for this particular property will allow the appraiser to determine capitalization or discount rates.

other than the direct capitalization approach. This situation is very

SRR Journal: What is the difference between a capitalization rate

common with an owner-occupied property. But if there are a

and a discount rate? Do they derive from different sources? Do

number of leases with frequent turnover, or if the property is not

they measure the same thing?

fully leased up yet, etc., then cash flows will fluctuate. In these situations, using a discounted cash flow methodology may allow for better flexibility in predicting cash flows and ascertaining the

JWV: No, they are different, but they share a key attribute. Theoretically, the discount rate is the “return on” an investment

valuation impact.

required by an investor for a given level of risk. A capitalization

SRR Journal: Whichever income-based methodology is being

investment required by the investor. This is another area to

used, they follow a basic format: estimate future cash flows and

review: Has the appraiser been consistent if both a capitalization

convert those cash flows into a present value equivalent. What are

rate and a discount rate been presented? The investor surveys

some of the key areas that should be reviewed regardless as to the

I previously mentioned tend to be the best sources for discount

methodology employed?

rates – this is what investors are looking for today as a return

JWV: As it relates to “revenue,” or rents, the estimate needs to comport with the interest being valued. The rents applicable to a fee simple interest may be very different from the rents applicable to a leased fee interest. The former will be driven by market rents

rate, however, reflects both the “return on” and “return of” the

on their capital. Sales of comparable properties can be great sources for capitalization rates. So an area to review is whether the assumptions on capitalization and discount rates are appropriately supported.

while the latter will solely incorporate current contractual rates. In

SRR Journal: In reconciling the different approaches – cost,

times of changing market conditions, this may have a profound

sales comparison, and income capitalization – I assume in general

impact on value even when comparing similar times periods.

you prefer to see some consistency between their respective

Vacancy is obviously another key assumption that needs to have

conclusions, but what happens if you do not? How do you derive

sound historical and/or market-based support. As it relates to

a conclusion of value given that circumstance? Essentially,

expenses, a key assumption involves reimbursements for or the

how do you reconcile the various methodologies – with or

pass through of expenses such as maintenance of common areas,

without consistency?

taxes, etc. So the terms and conditions of leases, both current and prospective, are a major assumption. Subtracting expenses from

JWV: All things being equal, you would like to see them be within

John W. VanSanten, MAI, is a Managing Director for the real estate

a reasonable range of each other. If they are not, the first course of

practice within the Valuation & Financial Opinions Group at Stout

action is to recheck the underlying assumptions of each approach.

Risius Ross (SRR). He has extensive experience in real estate

But, ultimately, it comes down to deciding which methodology

valuations of all types of commercial and special use properties,

should receive the most weight, which one is the best indication?

and has provided Expert Testimony in jurisdictions around the

The answer really comes down to a couple of things. First how

country. Mr. VanSanten can be reached at +1.312.752.3384 or

are the relative qualities and the quantities of the data available

jvansanten@srr.com.

for each method? If you have a lot of great sales, then a sales comparison approach could be a very powerful, reliable approach. Second, one should always keep in mind how an investor will look at the property. If cash flow is the primary driver, then the income capitalization approach may be most reliable. A lot of this goes back to highest and best use. SRR Journal: Do you have any concluding comments? JWV: I encourage all attorneys to look beyond the “Pretty Report” and take a closer look at the underlying analysis. Whether you are getting ready to cross-examine a witness or trying to get comfortable with your own expert, taking a critical look at the appraisal can make or break your case.