Value Checks, Comp Checks, Comouts: an understandable wish, but a bad idea
We get a lot of 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 usually indicated that the borrower would like to “feel” the value of the property before paying for a “full appraisal.” Also, there is usually the dangling carrot of an appraisal assignment (whether implicit, inferred, or stated) at the end of the value check stick.
While we understand the desire for a comfort level that the appraisal will “come up” to a desired value, value checks are just plain bad for all parties involved.
The role of an appraiser is primarily that of an independent third party. But the concept of verification of value works against such independence and can do much more harm than good. The following three examples should clearly indicate how value controls can undermine the appraisal process and lead to uninformed decisions in commercial real estate transactions:
Figure 1:
We recently worked on an appraisal of a property that included a family market, a fourplex, and three small commercial buildings. The site underlying all properties was approximately one acre. We inspect the subject and begin our assessment analysis. After completing an income approach and sales comparison approach for each property, it became clear that the value, as enhanced, would not support the requested loan amount. In the unlikely event that we had provided a Value Check (and negative and negative revenue analysis), the analysis would have ended well before this point.
But as part of the evaluation process, the USPAP requires us to look at the highest and best use of the subject as vacant and as enhanced. This requirement forces the appraiser to delve into alternative uses of the subject, including all legally 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 greatest return to the land.
In the case of the subject property, after further excavation, it was determined that the highest and best use of the subject was for the redevelopment of the underlying site. Simply put, the value of the land was higher than the improved value. More importantly for the discussion at hand, if we had ended the analysis at the level of a security check, there is no way the deal would have been consummated and everyone involved would have been harmed by our mistakes. The lender and their agents would have lost revenue because no loan would have been made, the buyer would have lost a very good purchase, or possibly the seller would have been forced to reduce the price and we appraisers would not have had to complete the appraisal assignment.
Figure 2:
Joe Appraiser gets a phone call from Moe Mortgage, who is none other than a mortgage broker. Moe asks Joe to pay off a property his client is buying for $2.2 million, and since Moe is one of Joe’s best clients, Joe agrees. Moe has told Joe that the subject is a commercial building and gives him the address. Joe, concerned that he doesn’t want to cheat his best client, goes further and looks up public property records and checks the rig map. From those records, he finds that the building in question is a one-story commercial building containing 5,000 square feet and located on a 10,000-square-foot parcel.
So, Joe does a quick search for drafts. Since he knows the subject is escrowed for approximately $440/sqft. he runs the search using a sales price/sqft range of $400 to $480 per sqft. for commercial buildings ranging in size from 4,000 to 8,000 square feet. The search returns six comparables that are all relatively recent with a price range of $441 to $469 per square foot. Joe is very happy because he is able to keep his client happy and bring home the task that he so badly needs. So he calls Moe and tells him the good news. The value of the subject 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 hires Joe to complete the appraisal. A week later, Joe goes to inspect the subject. Arriving at the theme, he discovers that the theme improvements consist of a 1,000 square foot lot. commercial building with 4,000 square feet. Low cost steel storage building to the rear.
Joe then inspects the components he had removed and discovers that they are all typical commercial buildings ranging in size from 4,500 to 6,700 square feet. None have steel storage buildings in their configurations.
Does the example above sound ridiculous? If you think so, we agree!
The only problem is that this is a real example that I personally witnessed. Also, once Joe discovered there was a problem, he completed the assessment. Also, there was no mention of a steel storage building in his appraisal report. It was simply stated that the subject was a 5,000 square foot commercial building.
The issues in this illustration are many and troubling, but most are due to Joe reporting an appraisal based on a default value. Whether he desperately needed the appraisal job, was he just trying to keep his client happy or was he just being greedy, I don’t know. I know that once he reported the value to the value check, he somehow screwed up and the result was an appraisal that fit the value.
Figure 3:
Poor Joe gets a call from Moe for a value check. The subject is a proposed single-tenant casual dining restaurant building of the type typically used by IHOP, Denny’s, CoCo’s and Baker’s Square. The landlord/developer has owned the land for a while and believes he can make money building the restaurant and getting a tenant when construction is nearing completion.
Joe’s preliminary search shows two nearly identical buildings on opposite corners of the same intersection as the subject.
Comp 1 leases to any of the four national restaurant chains listed 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 has been sold in the last three months for $255/sf. with a Global Capitalization Rate (OAR, or Cap Rate) of 8.75%.
Comp 2: Comparable data indicates that the property was sold a year ago for $250/sf. and was vacant at the time of sale.
Joe is excited about build 1. He’s found a build he can hang his hat on. Also, Comp 2 provides excellent support to Comp 1, so he excitedly calls Moe and tells him the good news in the hope that he can complete the assessment.
However, the information about Comp 2 that could not have been reported on the comparable’s data sheet was that after purchasing the property, the new owner tried to rent it out for six months before finally settling on the current occupant, a familiar start. . upstairs restaurant. In addition, the terms of the lease were very favorable to the tenant with an initial term of one year, two options of one year and a fixed rent for all three years. Furthermore, the rental rate was well below the levels needed to support the construction of a new building.
Upon first examination, these two comparables indicate profoundly different views of the market. Comp 2 clearly indicates a lack of feasibility for the item, while Comp 1 indicates that the tenant’s credit is strong enough to justify an investment in the property at a capitalization rate of 8.75%.
But what if further searches, analysis and verification showed that similar buildings with the same tenant as Comp 1 were trading at cap rates below 7.0%? 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 place down and have to redevelop the site for an alternative use.
While the example above is made up, parts of the story are very real. We often see what appear to be discrepancies in the market that, upon closer examination, end up supporting each other. This illustration clearly shows why USPAP requires the appraiser to verify each comparable. An incomplete value check would never have revealed the full picture of the market surrounding the proposed item.
Conclusion:
Value checks may seem useful and reasonable to many on the lending side. After all, they save their clients money on appraisal fees. But in reality, value controls seldom make any sense. When doing a value check, we appraisers have a very real chance of being locked into a default value without having done any research or analysis. With independence shattered, then we can be pressured, either externally or internally, to make the assessment fit the reported numbers. Therefore, in my opinion, USPAP’s rules are clearly based on a firm understanding of the real world of appraisal and are in place to protect the appraiser’s role as an independent third party.
Additionally, while a value check may reflect an accurate value of a property, there is also a strong possibility that crucial data may be lost in determining the market value of the property in question. The rules were written to protect against such instances.
So I think it’s self-evident that a value check is not only potentially harmful to the appraiser, it’s equally harmful to all parties involved in a transaction, whether it’s 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 will walk away with a firm awareness of the pitfalls of value controls. While I don’t think for a moment that I will persuade all interested parties, it is my hope that each one takes with them the awareness that when one requests a value check, that when an appraiser compels and performs a value check, the results can be far more harmful than they are helpful.
