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[Fee Simplistic] Thinking Outside The Tranche: Is It Time to Reinvent Appraisals For Income Properties?

Fee Simplistic is a regular post by Martin Tessler, CRE whom after 30 years of commercial fee appraiser-related experience, gets to the bottom of real issues by seeing the both the trees and the forest. Marty has never been accused of being a man of few words and his commentary can’t be inspired on a specific day of the week.

…Jonathan Miller





From illiquidity to insolvency, to default, to unemployment, to declining demand for space and consumer spending, to falling rents, growing vacancies and overall economic gloom coupled with looming mortgage refinancing in the face of a continued credit market freeze-up. Is it time to realize that this might well be the perfect storm? What lessons have we learned? It does not take Advanced Appraisal 501 to have foreseen that the frenzied market produced by low interest rates, CMBS securitization that off-loaded risk, easy credit and lax underwriting standards, if not their complete absence as in the residential sector, was a disaster waiting to happen (archival Soapbox postings would confirm).

The appraisal world however, true to its role in reporting what the market was experiencing as of the valuation date, could only report back market metrics of sales prices/square foot, going-in cap rates, cash-on-cash yields, expected investor yields, rental growth, and vacancy trends. And if the appraisal lived up to its fundamental requirements, it would include a section on supply and demand metrics for the particular use of the subject property. Anecdotally, I can count on the fingers of one hand the number of appraisal reports reviewed in my previous financial institution days that truly measured supply and demand factors in apartment sale and rental scenarios, shopping center appraisals where share of the market sales ratios were calculated, office space supply and absorption vs. employment growth. This is not to say that these metrics were not presented in the appraisal report but the manner of presentation was generally “boilerplate” filler to convey the feeling that these factors were being addressed.

We have gone from a capital driven market back to what will be prevailing supply and demand metrics in the specific geographic market of the subject property. In essence we will be forced to return to market analysis as the basis of valuation rather than rely on the frenzied deals of the past created by easy credit. Nowhere is this more evident than in an overview of the capital markets where in 2007 commercial property sales generated $500 billion in financing that declined to $150 billion in 2008. For 2009, loans projected for maturation refinancing total between $80-90 billion. The present closure of the securitization market will mean that valuations are going to have to be dead-on in their opinion of value and absent bonafide market analysis measuring supply and demand the appraisal will likely not be worth the paper it is written on.

This brings to mind the question of estimating value in a market that is virtually shut down and is stuttering along to find itself in volatile economic circumstances. Should the FIRREA/USPAP protocols be amended to mandate that every appraisal look at a downside risk scenario? Thus not only would the appraisal report the opinion of value as of the date of value but it would also include the lower end of value if economic and market assumptions did not pan out. If investors and lenders are exposed to the downside would it enable a thawing of the credibility and credit freeze prevailing today? My opinion is-yes it would at least help.

The Wall Street Journal, in a recent article reporting on the mezzanine debt that financed the acquisition of the John Hancock Tower [1], quoted a lawyer specializing in real estate that “tranche warfare” is starting in the battles over who will sustain losses or retain equity from overleveraged debt and how these are going to be battles never previously encountered. The article went on to point out how mezzanine debt was sliced and diced among different investors similar to the tranching of CMBS debt. Compounding the problem is the fact that if there was a default an appraisal was to be undertaken to determine which investors retained equity and who were wiped out. Needless to say, arguments over the appraised value have started. A major factor contributing to the cash flow shortfall was that in the two year period from the time of the purchase vacancy in the building went fro 0 to 15%. Whether this was on the radar screen of the appraisers or attributable to the market would have been something that turned up in a definitive market analysis. This will be a very interesting period for lawyers if not appraisers who may well discover that the slicing and dicing may well have produced values (or prices) greater than the sum of the tranched parts.

All hands on deck man your battle stations