The Diminishing Value of Appraisals

Retail News Blog put up good post this morning titled Capitalization Rates Without Market Activity which addresses the problem in the marketplace of determining property values with little or no market data available.  With fewer and fewer sale transactions taking place, appraisers are left in the dubious position of valuing property without comparable sales data.  According to the author, the market data is what represents a true “meeting of the minds” between buyers and sellers.  Without adequate data (quality and quantity), an appraisal may become nothing more than a best guess of value.  From the article:

One option for appraisers would be to make predictions of proper capitalization rates based on most recent bona fide transactions, whatever can be found. We can always defer to our infallible judgment and breadth of experience…but each of these data resources is vulnerable for lacking true emulation of the meeting of the minds in the marketplace.

I have always said that a property’s value is what someone is willing to pay for it (revolutionary, I know).  An appraisal may or may not agree with a particular buyer’s opinion of value.  In my mind the appraised value has had little worth because the buyer (the person with the money) has agreed to pay a specific price for a property based upon his or her own requirements.  This is not to say that appraisals are valueless.  I don’t think that.  I think they are very valuable for the financing side of a transaction, but I have always discouraged investors from relying too heavily on an appraisal as an accurate representation of market value for a few key reasons:

  1. Appraisals are based upon old information.  Comparable sales information often lags actual market activity by over 6 months.  This is fine in a stable marketplace but very problematic when values are moving up or down, especially in rapid fashion like we see today.  From the article:

    One of the fundamental weaknesses in understanding and projecting cap rates in transitional markets is the need to look in the rear view mirror at past transactions in order to try to make educated guesses about the next transaction. This is not as much of a challenge if stability characterizes the forecasted climate. We’re talking about capitalization rate forensics because market instability is diminishing our traditional levels of predictability.

  2. Appraisals are for banks (most of the time).  For banks, appraisals are very valuable and represent a necessary check and balance in the issuance of debt.  Banks have different risk tolerances than investors and are thus likely to value an asset differently than an investor.  Banks are usually looking at a property from a “what is my worst case scenario” standpoint while the investor is willing to place value on future benefits (increased income, development potential, break-up value, lease buyouts, etc.), leading to an apples-to-oranges comparison.

  3. Appraisers do not spend the majority of their time talking to buyers and sellers like brokers do.  Brokers are on the front lines when it comes to understanding the direction of the market and the appetite of investors.  I think the author concedes this point when he writes the following:

    If only we could use interviews with buyers that would identify their view of required cap rates needed to close a deal were the solution to the quest, we could stop this discussion here. Everybody’s got an opinion. We can’t fabricate capitalization rates, can we?

So the question now becomes one of utility.  How valuable is an appraisal in an environment where comparable data is unavailable?  Not very valuable at all from the standpoint of pinpointing a dependable value.  An appraisal will always have value to lenders due to regulatory requirements, but lenders should be careful from relying too heavily on their conclusions.  Lenders have moved to a place where conservatism rules the day so I don’t think there is too much reason for concern on this point.

Another factor making appraised values less important is the fact that any sales transaction going down with financing will likely have a substantial equity commitment from the buyer – 50%+ in many instances.  Add that to the fact that any property trading right now is most likely doing so at a value of approximately 30% off its recent high, and the lender has what is (hopefully) a safe debt position.  The conservative lending approach that dominates today means that an appraiser does not need to squeak out an extra 1/2 point in CAP Rate to make the debt coverage ratio work for the lender.  Effectively, there is a lot more margin for error than in the past.

It will be interesting to see how appraised values are considered by investors and factored into the feasibility of debt by lenders as the market continues to evolve (for better or for worse).  Only time will tell.

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