What Should Clients Look For in an Appraisal Report?

They’re long. Their language is characterized by highly specialized (and sometimes unfamiliar) terminology and legalese. They’re bursting with tables, charts, maps, and photos. But they demand to be pored over, and from cover to cover. The question remains, however: What’s the best way to read a commercial real estate (CRE) appraisal report?

Let’s begin by pinpointing the exact object of our inquiry. A commercial real estate appraisal (or a commercial real estate valuation) is a professionally calculated assessment of the value of a commercial property. A broad category, “commercial property” encompasses everything from office buildings to condominiums to industrial sites and vacant land. If commercial property is being bought, sold, taxed, insured, or developed, that activity can trigger an appraisal.

Appraisal Report Types

Appraisal (or valuation) is a process and therefore to be distinguished from appraisal reports, which are the outcome of this process and can take one of several forms.

  • Appraisal Report. Think of the Appraisal Report as a bread-and-butter narrative document. The required scope and level of detail in each Appraisal Report is determined by the appraisal professional and can vary widely depending on market and property complexities. Formerly known as a “Self-Contained Report” or “Summary Appraisal Report,” this new Appraisal Report format gives valuation experts extra discretion with regard to the amount of data, description, explanation, and analysis they include in their final write-up. Additionally, appraisers are required to “summarize” their findings for each Appraisal Report, meaning supporting documentation now may be kept in a separate work file.
  • Restricted Appraisal Report. As its name suggests, this report is much more abbreviated than its counterpart above. Its primary purpose is to provide the party requesting the appraisal (the client) an opinion of value. Many topics covered in depth in the Appraisal Report may only be “stated” rather than “summarized” (the latter being applicable only to the Appraisal Report) herein. Finally — and crucially — the Restricted Appraisal Report does not meet the criteria for descriptive detail set by most lenders and adjudicating bodies.

Furthermore, it should be noted that the market is now demanding many Evaluation Reports. According to federal banking regulations, an evaluation may be issued instead of a formal appraisal if:

  • the “transaction value” (generally the loan amount) is $500,000 or less;
  • the transaction involves certain renewals, refinances, or other transactions involving existing extensions of credit; or
  • real estate-secured business loans with a transaction value of $1,000,000 or less and the sale of, or rental income derived from, real estate is not the primary source of repayment for the loan.

Many appraisers are now producing Restricted Appraisal Reports and submitting them as Evaluations. This is permissible as long as appraisers are careful to label the appraisal a “Restricted Appraisal” and comply with the specific USPAP requirements and quality assurances (see below) related to the composition of formal appraisal reports.

Quality Assurance for Appraisal Reports

Whatever its type, and regardless of the audience for which it is intended, any worthwhile appraisal report must adhere to a set of professional guidelines known as the Uniform Standards of Professional Appraisal Practice (USPAP). By order of Congress, USPAP compliance is required for state-licensed and state-certified appraisers involved in federally-related commercial real estate transactions.

USPAP Rule 2-1 stipulates that each written appraisal report must:

Evaluation reports must comply with the Interagency Appraisal and Evaluation Guidelines as defined by the Federal Deposit Insurance Corporation (FDIC).

The Most Critical Features of Any CRE Appraisal Report

You’ve confirmed the report type. You feel confident that the document you are consulting adheres to USPAP’s best practices. What next? Look first to these sections or elements of your appraisal report to begin extracting the most value from its valuations.

1) Definitions. Does the appraiser define such key terms as “cap rate”and “damages?” Do they also provide sources and context for their definitions? An illustrative example serves to highlight the weight these definitions carry.

  • In cases of eminent domain, where only part of the property is condemned and appropriated by a government entity for public use, the terms “the value of the uncondemned land before the taking,” and “the value of the uncondemned land after the taking” are often a source of confusion.
  • Essentially, the use of these terms involves determining the value of an entire tract of land and then the value of the part being condemned and taken. The difference between those two figures yields the value of the uncondemned land before the taking. Next, the value of the uncondemned land after the taking is determined. The difference between these two figures — before and after the taking — is added to the value of the condemned tract of land, and the sum of the two yields the compensation due to the landowner.

2) Explanation of methodology. The previously described formats are the bones of a CRE appraisal report. The methodology the appraiser uses to determine the fair market value (FMV) of the property being evaluated can be likened to the report’s soul.

The three most frequently applied valuation methods are:

  • Cost Approach. Here, the appraiser focuses on the cost to rebuild the structure from scratch, factoring in the current costs of associated land, construction materials, and other expenditures related to replacing any existing structures.
  • Sales Comparison Approach. Also called the market approach, this method relies heavily on recent sales data for comparable properties. “Comparable properties” here translates into sold buildings with similar assets in the same market area. One drawback to this method is that, depending on market conditions, it can sometimes be difficult to find data sufficient to support the appraiser’s analysis.
  • Income Capitalization Approach. This method is based primarily on the income an investor can expect to derive from a particular property. Said expectations can be based, in part, on a comparison with similar properties. They may also be based on optimizations made to the existing property, such as improving the efficiency of maintenance services to realize cost-savings or adjusting rental rates to reflect current market conditions.

It should be emphasized that, for the professional appraiser, appraisal method selection is not necessarily an either/or proposition. Appraisers can and often do mix and match methods to provide the most accurate appraisal possible for the property in question. Either way, the report should speak to the rationale behind the appraiser’s choices.

3) Ownership history. Real estate properties, while material assets, are not immutable. They change over time, being put to different uses by different landlords. When assessing an appraisal report, look for the following items.

  • Identification of the property’s owner(s) of record (also known as the record owner).
  • Any questions regarding the title or state of ownership.
  • Relevant encumbrances (e.g., easements, liens, deed restrictions, etc.).
  • Enumeration of any recent sales, listings, offers, and/or options.

4) Market conditions.What a meteorologist is to the weather, the appraiser is to the economic forces affecting real property transactions. After reading through this section of an appraisal report, you should be able to answer the following questions.

  • How does the appraiser describe the prevailing market trends leading up to and as of the valuation date?
  • Has the appraiser reviewed relevant market indicators of value such as vacancies, competing projects, and available inventory? At LPA, our commercial real estate valuation experts constantly strive to track the pulse of the market using the very latest market analytics.
  • What information has the appraiser used to justify their adjustments?

5) Property interest appraised. Ultimately, the appraisal report should directly address the client’s — that is, your — stated interest in the property. If, for example, you want to move your business into a shopping center, the appraisal you receive should report on the fee simple interest, or the total value of the building and the land on which it is situated. If, on the other hand, your goal is to lease the property to a tenant or tenants, you want to know what it is worth to a landlord. The appraisal should therefore report on leased fee interest.

It is crucial for clients to specify this interest before property inspection commences. If the property interest is not identified (or has been misidentified), the valuations issued may not be absolutely accurate — or relevant.

In the decade since the last major financial crisis, commercial real estate (CRE) prices have experienced a historic recovery. By some measures, valuations for CRE property types as different as office towers and warehouses are as high as they have ever been.

Meanwhile, one year ago, the Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve System, and the Federal Deposit Insurance Corporation (FDIC) published a final rule officially raising the appraisal threshold for CRE transactions.

Specifically, this new regulation:

  1. Raised the appraisal threshold level at or below which appraisals are not required for CRE transactions from $250,000 to $500,000.
  2. Required the use of state-certified appraisers for CRE transactions above $500,000.
  3. Mandated that regulated institutions must obtain an evaluation of the real property collateral “that is consistent with safe and sound banking practices” for exempted transactions at or below $500,000.
  4. Made the use of appraisals for exempt CRE transactions at or below $500,000 optional, as appropriate, as in the case of higher-risk transactions discussed in OCC Bulletin 2010-42.

By and large, lenders have welcomed this change. The appraisal community, on the other hand, has expressed mixed feelings on the subject. To understand why — and to appreciate what the federal government’s decision could mean for your business — it’s first necessary to establish the proper perspective.

Appraisal Thresholds: A History Lesson

The regulations regarding CRE appraisal are a result of the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA), enacted in 1989 in the wake of that decade’s savings and loan crisis. One of the law’s primary purposes, as laid out in Title XI, was to ensure that future real estate appraisals adhered to uniform standards as enforced by certified (or licensed) professionals.

Congress amended Title XI in 1992, authorizing the appropriate federal agencies to establish a threshold level at or below which an appraisal by a state-certified (or -licensed) appraiser would not be required. In response, those agencies (the OCC, Federal Reserve, and FDIC) set the appraisal level at $250,000.

That figure endured, unchanged, for 24 years. For some representatives of the financial industry, that stasis had by 2018 hardened into a form of rigor mortis. Since the number of CRE transactions occurring above the $250,000 threshold had grown exponentially, they felt, regulatory requirements were now placing an undue burden on buyers, sellers, and loan originators.

In considering this change, the agencies had initially proposed raising the threshold to $400,000, while the National Credit Union Administration (NCUA) urged a $1 million threshold. In the end, the agencies negotiated a $500,000 threshold. In so doing, they exempted an additional 15.7 percent of CRE transactions from mandatory appraisal.

Finally, revising the appraisal threshold was also partly an outgrowth of a larger effort to streamline federal regulation. The Economic Growth and Regulatory Paperwork Reduction Act of 1996 requires regulators to conduct a review every 10 years to identify outdated, unnecessary, or onerous rules.

What Does the New Threshold Accomplish?

Arguments advanced for raising the CRE appraisal threshold neither end nor begin with the observation that the federal government had failed to keep pace with rapidly evolving market conditions.

Consider the rise of debt funds and mortgage real estate investment trusts (REITs) over the past decade. Data collected by Green Street Advisors shows that these funding sources were responsible for 42 percent of the growth in CRE lending volume from 2016 to 2017.

In the same timeframe, banks were still responsible for roughly a quarter of all lending volume, but that share was down from 2014 — a trend projected to continue. Many banks hope that raising the appraisal threshold will allow them to be more competitive with these other lenders.

A nationwide shortage of qualified appraisers created additional friction under the old $250,000 rule. In particular, many regulated institutions in rural areas were struggling to secure prompt appraisals, creating bottlenecks for their underwriting departments.

As supporters of the $500,000 threshold like to point out, lending volumes tend to increase and decrease faster than the supply of qualified appraisers. Consequently, boom cycles (such as the one currently prevailing) can exert extreme pressure on the appraisal industry. This scenario, in turn, can lead to a decline in quality control.

Thus — the argument goes — using more efficient, i.e., automated, evaluation methods on low-risk transactions can improve risk management overall by empowering lenders to dedicate their scarcest resources. i.e., human experts, to vetting riskier transactions. And there is much to be said for the wise allocation of such resources.

Is the New Appraisal Threshold An Overcorrection?

However, the most vocal opponents of the new rule are concerned that it could expose the CRE market to more risk. This is the position taken by the Appraisal Institute, whose President James L. Murrett has expressed the fear that one likely result of the rule change will be a return to the overly permissive, loan production-driven environment seen during the lead up to the financial crisis of 2008.

On the topic of competitive balance, meanwhile, some valuation experts argue that this rule revision may be unfair to licensed appraisers. From their point-of-view, the raising of the threshold favors the use of algorithms and automation tools over the knowledge and insights possessed by professionals with years of experience in determining fair market value (FMV).

Ultimately, raising or lowering the appraisal threshold does not change the fact that valuation reports written by actual human beings remain the “gold standard” in the CRE industry. Accuracy is one reason why. So is principled conduct. As many observers have noted, bias can infect even the most sophisticated machine learning procedures.

Well-written appraisal reports do more than check off boxes. And they are far from one-size-fits-all propositions. Each type of report contains unique business intelligence and has different applications. A truly actionable appraisal is as qualitative as it is quantitative. In its own way, it tells the story of the property’s past, present, and future, interpreting that narrative and making it relevant to the client’s interest in and plans for their investment.

In our experience, many — but not all — of our clients desire the level of protection a formal appraisal offers. That’s why, in addition to focusing on integrity, excellence, teamwork, and selfless service, we continuously innovate. Our compliance-based services and solutions are scalable, customizable, and nimble. Our CRE experts are skilled at producing a wider range of valuation services, which include both evaluations and restricted appraisal reports as well as traditional appraisal reports. Regardless of format, our experts also pride themselves on timely delivery, accuracy, and credible assignment results.

Markets fluctuate. But the conventional wisdom states that commercial real estate (CRE) almost always appreciates, provided you treat it like the investment it is. Key to achieving the highest rate of return on that investment is equipping yourself with the right data about your real property holdings, both those you own and those you’re considering acquiring.

But not all CRE valuations are created equal. Methodology matters, as does the integrity of the vendor providing this all-important service. In fact, and as widely reported, inflated valuations and appraisals were a significant contributor to the 2008 financial crisis.

Accurate valuations do more than provide the kind of actionable intelligence you need to make the right business decisions. They also protect you from liabilities and the sort of unpleasant surprises that can damage your company’s bottom line, future prospects, and reputation.

Read on to learn more about how businesses benefit from procuring accurate, principle-driven, unbiased commercial real estate valuations.

Selling

Imagine this scenario: all signs in your region point to a seller’s market in CRE. But how do you chart a course between the price you’d like to command, the amount of cash buyers are willing to spend, and what counts as fair market value?

You need numbers you can trust. Moreover, since the value of real property is realized over time, that means your situation is almost always fluid. Demand, utility, scarcity, and transferability can all be defined by volatility, even in a seller’s market. A truly accurate valuation will factor in these complexities when quantifying market value.

Underwriting

Valuations help underwriters assess and manage risk. They rely on these documents and expect them to be accurate, transparent, and free of potentially misleading information. In fact, the number one question underwriters need to answer is: “Does the actual value of the property justify the loan amount being requested by the borrower?”

Most underwriters will not approve a CRE mortgage unless they can establish a 60- to 80- percent loan-to-value ratio. An expertly prepared commercial real estate valuation report will provide the information the underwriter needs to feel confident in their calculations.

Planning Improvement

A valuation report can provide useful insights into how much you should spend on improving any given property. More importantly, it can also indicate whether or not you should develop the property at all. An accurate commercial real estate valuation will therefore take into consideration:

  • The current value of the land itself.
  • The costs (labor, materials, etc.) of replacing the property’s existing structures.
  • Any accumulated depreciation. In weighing depreciation, the valuation should assume that buyers wouldn’t spend more for commercial property than they would for acquiring land and building from scratch. The cost of these improvements might not exceed potential depreciation and can make prospective buyers wary.

Finally, a high-quality valuation will determine your property’s highest and best use — that is, the most profitable use of the property. If the cost of proposed improvements exceeds the highest profitable use, you’ll want to adjust your budget accordingly.

Compliance and Due Diligence

When you’re looking to expand your portfolio, you want to minimize your exposure to buyer’s remorse. Doing so entails being as thorough as possible before making any purchasing decisions. You have to dig beneath the surface to reveal hidden risks, unforeseen (but inevitable) losses, and any shaky foundations, all of which can doom your investment.

A qualified, credentialed commercial real estate valuation expert can help you at every step of the buying process. They will inspect the fundamentals of the property, vet sellers, and survey your compliance obligations to mitigate financial uncertainties. They will also assist in assessing the condition of the property (the land as well as any existing structures) as well as any potential use issues that might require additional investment to balance the cost of acquisition.

The Rise of Automated Valuation Models (AVMs)

The rise of Automated Valuation Models, or AVMs, has exerted some downward pressure on traditional real property appraisals. While AVMs are readily available to lenders, consumers, and real estate agents (especially those concentrating on residential properties), most of these algorithms have a major blind spot — specifically, they fail to account for a property’s physical condition. That’s because AVMs determine value using market averages and public records, both of which are notoriously slow to update with the latest data about real CRE transactions.

Furthermore, by relying on online information — the quality and integrity of which can vary significantly — AVMs can be influenced by misinformation, generating inaccuracies that can tilt negotiations in favor of buyers hoping to score on lowball offers. An experienced valuation expert who is both on-site and capable of telling the story of a property’s actual status is therefore increasingly valuable in an industry in which technology is still not as sophisticated as some may believe.

Commercial real estate ended 2018 on a high note, but has the industry missed any beats in 2019? The answer depends on how closely you attend to the trends, many of them long-developing, just now beginning to exert their influence in the marketplace.

We’ve asked the research, insights, and valuation experts here at LPA to share their thoughts about what the immediate future holds for owners of and investors in commercial property. Here are the top 5 commercial real estate challenges and opportunities our analysts are monitoring in 2019.

The millennials are coming

Millennials are aging. Now in their 30s, this huge (and hugely influential) demographic is leaving the city for the suburbs. But are the suburbs ready for millennials, their young families, and their sensibilities? For example, hip, trendy retails will need to rethink their urban-only storefronts, while employers may need to scout for office options beyond downtown. Additionally, millennials want easy access to mass transit. Metropolitan areas served by public transportation that connects commercial centers to residential neighborhoods therefore stand to reap the biggest benefits of the millennial migration. Nevertheless, millennials are only gradually likely to raise their historically low homeownership rate, meaning suburban rental properties may only increase in value.

The Opportunity Zone boom

Created by the 2017 Tax Cuts and Job Act, the Opportunity Zone program incentivizes the deferment (or elimination) of capital gains taxes by promoting investment in commercial and residential development in 8,700 specially designated areas across the United States. By lowering the risk associated with investing in previously underdeveloped and underserved communities, the program has sparked something of a gold rush. One developer in the Midwest has already pledged to pour $1 billion into Opportunity Zone projects and anticipates that this investment could grow to $20 billion by 2030. Yet questions about the program linger. Will acquisition costs, plus CapEx and OpEx, wipe out the potential tax savings? And what constitutes a reasonable return on such investment? Still, Opportunity Zones present a lot of upside, and those who find success early will also gain the expertise they need to control properties with even greater future potential.

Thinking outside the big box

Shuttered big-box stores have long been considered a form of blight. But CRE developers are getting rather innovative in their repurposing of these spaces and the massive footprint they leave. Some are carving up the original storefronts, creating new configurations of retail and restaurant spaces. Others are completely renovating, transforming them into residential, office or entertainment facilities. Credit co-tenancy clauses for this shift—or, rather, new legal precedents for the interpretation and enforcement of these key lease agreements provisions. For many businesses, the prospect of collaborating and evolving into new, multi-use concept together is more attractive than running a traditionally solo operation. Luckily, the multi-use concept aligns with shoppers’ values as well, giving retailers a better shot at keeping that “Open” sign in their window lit.

The rising cost of building

Unfortunately, other economic and social forces are driving up the price of new construction. That includes both tariffs on Chinese steel and Canadian lumber. Combine these international trade policies with a skilled labor shortage and the consequences for the CRE industry start to look quite serious. Not only are tenants facing higher maintenance fee and occupancy costs, but contractors and building service providers now must budget with tighter margins in mind. Rent increases are a real possibility barring an about-face from the White House, and investors should plan accordingly.

Industrial space scarcity

Vacancy rates in industrial spaces have dropped to an unprecedented 4.3 percent, with further drops a virtual certainty. The reason? E-commerce, which still has its own brick-and-mortar needs—namely, warehousing and distribution centers. Additionally, as more and more established companies adopt digital technology to cut down on the costs associated with operating traditional retail outlets, industrial spaces will remain both scare and in high-demand.

How are you planning to prosper in 2019?