The author is James Stein, Certified General Appraiser and principal of Stein Valuation, Inc. He has focused on matters relating to commercial real estate appraisal since 1991. His experience includes appraisal analysis, highest and best use analysis, feasibility analysis, and due diligence reporting primarily in the Southern California five-county region, including Los Angeles, Orange County, Riverside County, San Bernardino County and Ventura County
We receive many calls from mortgage brokers and borrowers for value checks. In most cases, these requests are related to a refinance, a purchase money loan or a construction loan. In each case, it is typically stated that the borrower would like a “feel” for the property’s value before paying for a “full-blown appraisal.” Further, there is usually the dangling carrot of an appraisal assignment (either implied, inferred, or stated) at the end of the value check stick.
"While we understand the desire to have a comfort level that the appraisal will “come-in” at a desired value, value checks are simply bad for all parties involved."
The role of an appraiser is primarily that of an independent third party. But the concept of a value check fly’s in the face of such independence and can cause far more harm than good. The laws of most states recognize this and have made value checks ostensibly illegal through the adoption of the Uniform Standards of Professional Practice, USPAP.
Such illegality comes into play in several ways:
- first, USPAP makes it illegal to provide a value for a subject property without having inspected the property;
- second, USPAP states clearly that an appraisal may not be based upon a predetermined value;
- third, USPAP makes clear that if an appraiser states, writes, or otherwise transmits a value to another party, the appraiser is, in fact, reporting findings of an appraisal; which takes us to the fourth problem with value checks, reporting a value without having done the analysis is clear ethics violation.
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But what if the appraiser is just pulling comps for the client. The Appraisal Foundation, the authors of USPAP, has even clarified their position on this issue. If an appraiser has any input into the comps that are generated, he/she is guiding the results, which means that the appraiser is guiding the resulting value, or range of value, that his/her client will conclude to. Thus it is a violation of USPAP.
It is hopefully clear by now that value checks are indeed illegal, but ignoring the illegality for the moment, why are they simply a bad idea, even if intentions are good? The following three illustrations should clearly indicate how value checks can undermine the appraisal process and lead to uninformed decisions in commercial real estate transactions:
We recently worked on the appraisal of a property which included a mom-n-pop market, a fourplex, and three small commercial buildings. The site underlying all the properties was approximately one acre. We inspected the subject and began our appraisal analysis. After completing both an income approach and a sales comparison approach for each property, it was clear that the value, as-improved, would not support the requested loan amount. In the unlikely event that we would have provided a Value Check (and a down-n-dirty income analysis) the analysis would have ended well before this point.
But as part of the appraisal process we are required by USPAP to analyze the subject’s highest and best use as-vacant and as-improved. This requirement forces the appraiser to look deeper into alternate uses for the subject, including all legal and physically possible uses. We are then required to determine which use is feasible and finally, of those feasible uses, we must determine which will bring the highest return to the land.
In the case of the subject property, after digging deeper, it was determined that the highest and best use of the subject was for redevelopment of the underlying site. Simply put, the value of the land was higher than the value as-improved. More importantly to the discussion at hand, had we ended the analysis at the level of a Value Check, there is no way that the deal would have been consummated and everybody involved would have been harmed by our mistakes. The lender and its agents would have lost revenues because no loan would have been done, the buyer would have lost out on a very good purchase, or possibly, the seller would have been forced to reduce the price, and we the appraisers would not have had the appraisal assignment to complete.
Joe Appraiser receives a phone call from Moe Mortgage, who is a none other than a mortgage broker. Moe asks Joe to comp out a property that his client is purchasing for $2.2 million, and since Moe is one of Joe’s best clients, Joe obliges. Moe has told Joe that the subject is a retail building and gives him the address. Joe, concerned that he does not want to mislead his best client goes even further and looks up public records for the property and reviews the plat map. From those records, he finds that the subject building is a one-story retail building containing 5,000 square feet and is located on a 10,000 square foot parcel.
So, Joe does a quick comp search. Since he knows that the subject is in escrow for approximately $440/sq.ft. he runs the search using a sale price/sq.f.t. range of $400 to $480 per sq.ft. for retail buildings ranging in size from 4,000 to 8,000 s.ft. The search results in six comparables that are all relatively recent with a price range of $441 to $469 per sq.ft. Joe is very happy because he can keep his client happy and bring in the much needed assignment. So he calls Moe and tells him the good news. The subject’s value is approximately $440 to 470 per square foot, or $2.2 to $2.35 million.
Based on the positive results of the value check, Moe then engages Joe to complete the appraisal. One week later Joe goes to inspect the subject. Upon arriving at the subject he finds that the subject improvements consist of a 1,000 sq.ft. retail building with a 4,000 sq.ft. low-cost steel storage building at the rear.
Joe then inspects the comps that he had pulled and finds that they are all typical retail buildings ranging in size from 4,500 to 6,700 square feet. None have steel storage buildings in their configurations.
Does the above example sound ridiculous? If you think so, we agree!
The only problem is that this is a true example that I personally witnessed. What’s more, once Joe figured out that there was a problem he completed the appraisal. Moreover, there was no mention of a steel storage building in his appraisal report. The subject was simply stated to be a 5,000 square foot retail building.
The problems in this illustration are many and troubling, but most result from Joe having reported an appraisal based upon a predetermined value. Whether he desperately needed the appraisal work, was just trying to keep his client happy, or was simply being greedy, I do not know. I do know that once he reported the value from the Value Check he was somehow marred to it and the result was an appraisal fit the value.
Poor Joe gets a call another call from Moe for a Value Check. The subject is a proposed single-tenant casual dining restaurant building of the type typically utilized by IHOP, Denny’s, CoCo’s and Baker’s Square. The landlord/developer has owned the land for a while and figures he can make a mint by constructing the restaurant and getting a tenant when construction is nearly completed.
Joe’s initial comp search comes up with two nearly equal buildings on opposite corners of the same intersection as the subject.
Comp 1 is leased to any of the four national restaurant chains named above for 15 years with two 10-year options. There are 6 years remaining on the initial lease term. Rents are market based and include annual increases to reflect CPI increases. The property sold in the last three months for $255/sq.ft. with an Overall Capitalization Rate (OAR, or Cap Rate) of 8.75%.
Comp 2 - The comparable data indicates that the property sold one year ago for $250/sq.ft. and was vacant at the time of sale.
Joe is excited by Comp 1. He has found a comp he can hang his hat on. Moreover, Comp 2 lends excellent support to Comp 1, so he excitedly calls Moe and tells him the good news hoping he can complete the appraisal!
However, information about Comp 2 that could not have been reported in the comparable’s data sheet was that after purchasing the property the new owner, tried to lease it for six months before finally settling on the current occupant, a mom-n-pop start-up restaurant. Further, the terms of the lease were highly favorable to the tenant with an initial one-year term, two one-year options and flat rent for all three years. Moreover, the rental rate was well below levels required to support construction of a new building.
Upon first examination, these two comparables indicate profoundly differing views of the market. Comp 2 clearly indicates a lack of feasibility for the subject, while Comp 1 indicates that the credit of the tenant is strong enough to warrant an investment in the property at an 8.75% cap rate.
But what if further searches, analysis and verification showed that similar buildings with the same tenant as Comp 1 were transacting at sub 7.0% cap rates? This would suggest that the buyer saw much higher levels of risk associated with the comparable. Quite possibly the buyer was concerned that the tenant would close this location and he would have to redevelop the site with an alternate use.
While the above example is made-up, parts of the story are very real-world. We often see what appear to be discrepancies in the market that after closer examination end up supporting each other. This illustration shows clearly why USPAP requires that each comparable be verified by the appraiser. A down-n-dirty Value Check would never have revealed the whole picture of the market surrounding the proposed subject.
Value Checks may seem useful and reasonable to many on the lending side. After all they save their client money on appraisal fees. But in reality, Value Checks rarely make any sense at all. By doing a Value Check we appraisers stand a very real chance of locking ourselves into a predetermined value without having done any research or analysis. With independence shattered, we can then be pressured, either externally or internally, to make the appraisal fit the reported numbers. Thus, in my opinion USPAP’s rules are clearly grounded in a firm understanding of the real world of appraisal and are set-up to protect the appraiser’s role as an independent third party.
Moreover, while a Value Check may reflect an accurate value for a property, there is also a very strong chance that it will miss crucial data in the determination of market value for the subject property. The rules were written to protect against such instances.
Thus, I believe that it is apparent that a Value Check is not only potentially harmful to the appraiser, but it is equally harmful to all parties involved in a transaction be it for a construction loan, a refinance, or a purchase, as the data can mislead decision makers into making ill-informed decisions.
It is my hope that after reviewing this article, the reader walks away with a firm awareness of the pitfalls of Value Checks. While I do not for a moment believe I will persuade all interested parties, it is my desire that each will take with them an awareness that when one asks for a Value Check, they are asking not only for an appraiser to break the law, but that when an appraiser obliges and conducts a Value Check, the results can be far more harmful than they are useful.
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