Making Sense of CRE Valuations and Appraisals

Much attention has been paid to the immediate effects of the COVID-19 pandemic on public health and the economy. As the months continue to move by, the economic shutdown’s broader implications on commercial real estate begin to materialize. The pandemic has presented lenders, servicers, and appraisers with a unique problem: What is a property with severely impacted cash-flow worth, and what will the long-term impact on value be?

As defined, market value is “the most probable price which a property should bring in a competitive and open market under a) conditions requisite to a fair sale, b) the buyer and seller each acting prudently and knowledgeably, and c) assuming the price is not affected by undue stimulus.” From historical experience, the definition as constructed is reasonable and appropriate when markets are balanced and definable. However, when markets become dislocated, issues begin to arise.

The accepted understanding of market value relies on verifiable data and sound reasoning, not short-term occupancy and revenue declines caused by external forces. In this environment, Appraisers are challenged to reconcile the rapidly changing landscape and the confines placed on their work. With income, sales, and cost predictors few and far between, how can a user of appraisals extract the most value for their assets?

Begin with the end in mind:

Appraisers help their clients understand and apply a value to their portfolios under the current market circumstances. Ultimately, appraisals use a standard set of guidelines and regulations produced with a high level of rigorous research and documentation that supports the conclusion. However, a dive below any deal’s surface may reveal many different paths and potential outcomes, ultimately creating uncertainty in the business plan. For this reason, it’s prudent to keep in mind what questions you are trying to answer with an appraisal before engaging an appraiser. The devil is in the details, and understanding those details puts you ahead of the curb.

Consider the following. User A is looking to identify the value of a portfolio of distressed debt. An appraiser needs to determine the value of that note by valuing the asset collateral itself, foreclosure costs, asset procurement cost, and many other factors. This unique valuation scenario is tied directly to the market value definition; thus, a standard appraisal would not currently be accurate without any active market predictors. User A may not stand to benefit from an appraisal in the first place.

Consider this a change in mindset. It’s not just an appraisal, but an appraisal for a specific purpose. Having a game plan for the application and implementation of an appraisal and how it can inform the decision-making process increases the overall benefit it can bring.

Ask the right questions:

Once a comprehensive understanding of the deal and the desired outcome is reached, and an appraisal has been deemed necessary, full involvement throughout the appraisal process is required to ensure the desired result is met. This is not true for new loan originations where there is a distinct removal of all direct conversation between borrower/originator and appraiser.

Appraisers have been accommodating through the current times. However, without the proper comps to support their conclusions, appraisers will likely be hesitant to extend themselves at the behest of their clients. Therefore, a lack of proactive involvement and guidance might limit the overall value an astute appraiser can provide. Keep in mind that appraisers have great flexibility within the compliance regulations of USPAP’s, allowing them to give well-thought-out and supported appraisals. Take advantage of this by providing a clear explanation of how the appraisal will be used.

For example, consider the stage an asset is in. Collateral sitting in asset management, special servicing, workouts, diligence & advisory, or underwriting all present unique factors that can help guide appraisers to a more accurate value. Generally, appraisals will only present an as-is and an as-stabilized value. However, a defaulted asset in special servicing in need of a workout would likely require an estimate of liquidation value within a 6-month timeframe or other defined timeframe. Present the entire story of an asset rather than just its current state. Provide the appraiser with useful guidance so they can return a well-supported valuation.

Get a range of values:

Appraisers used to present market value as a range of values. Only when the tug-of-war between production and credit became untenable did the standard of providing a singular value occur. This standard is much too prevalent now with the emergence of larger firms’ automated programs that only provide final values. These systems cannot factor in a specific deal or asset’s nuances. While these systems lower the overall cost of appraisals, they also cheapen the quality. This large-scale standardization of processes has lulled many into misguided acceptance of the current appraisal status quo.

Enter COVID. With minimal traditional indicators currently available, a more nuanced approach is required. Encourage appraisers to provide a range of values along with a likely single value from within that given range, even if a single value suffices. This approach can help account for independent variables that undoubtedly exist within every appraisal scenario. Granting the appraiser flexibility to determine a value range within the assignment’s scope increases the value an astute appraiser can provide. It also allows the user to manage expectations and ascertain a broader range of possibilities.

Conduct a rigorous and thorough review:

Finally, rethink the appraisal review process for a new era. For too long, the appraisal review has been a review of compliance rather than an assessment of relevancy and provided value. Many appraisal users have become conditioned to file the resulting documents away after one glance, never to be seen again. While that level of trust is somewhat understandable within a balanced and quantifiable economic environment, current (and likely future) circumstances dictate careful due diligence of the assumptions used, the projections made, and the value range presented is essential. Highlight areas of confusion and follow-up with the appraiser for clarification on those points. Apply a level of rigor to the appraisal that ensures nothing has been overlooked, and all questions have been answered.

Many are beginning to ponder the effects this economic downturn might have on values post-COVID. Will appraisers be able to get on-site? If not, how could that affect the appraisal process? These questions will likely differ from region to region. We don’t have the necessary market indicators to fully understand how COVID impacts various property types, and we may not for some time. The expression, “one sale can make a market,” has never been more relevant. Still, understanding the assumptions involved in the appraisal process may transform this “check-the-box” requirement into a tool that can assist your decision-making.