The following article was actually written by a hard money commercial loan competitor; but the article was so well-written that I simply had to memorialize it for my sons ... and my blog readers. My sincere thanks go out to Clay Sparkman for allowing me to republish this wonderfully written article.
Clay's Wonderful Article on How to Read a Commercial Loan Appraisal:
The most important thing that you must understand about any commercial loan appraisal (or other real estate valuation instrument) is that it is only as good as its logic. So that—in other words—you must never accept an appraisal’s conclusion regarding value without looking beyond the surface to understand the logic that leads to the conclusion and without making some reasonable determination as to the quality of the logical argumentation.
With that in mind, I offer you ten critical steps to follow when reading/analyzing (and thus attempting to assess the “goodness” of) a commercial loan appraisal.
(1) The very first thing you must ask as you analyze a commercial loan appraisal is to what degree is the appraisal transparent? In other words, how much of the logic leading to the value conclusion is on display for you the reader? If the answer is none, the appraisal is useless. Throw it away. If the answer is some (in other words there are gaps in the logic) then you must either (a) once again, decide to toss the appraisal, (b) decide to accept some degree of uncertainty, (c) attempt to fill the gaps on your own, or (d) contact the appraiser and see if she can provide the missing logic. (Sometimes the appraiser will have the information you need on file, but they just didn't include it in their final report.) Ideally the answer is none or very little, and the commercial loan appraisal can be said to be highly transparent. At any rate, you will need to be asking this question throughout your analysis.
(2) The next thing you need to do is get a handle on what is being appraised. Is it a home, a commercial building, a parcel of land? What are the basic specifications? Where is it located? Is it urban or rural? How desirable is the surrounding area? Are there functional inadequacies? If it is land, what horizontal infrastructure is in place or lacking and what does the current zoning allow?
(3) I have never heard anyone else say this, but I stand by it (at least when valuing buildings and structures; for valuing land, not so much): one of the first things I do after getting a basic sense of the property is go straight to the photos. (And by the way, make sure you have an original appraisal or color copies. The photos can be quite useful, but not if they are blacked out by copying and faxing.) I study the photos of the subject property and then I compare them to the photos of each of the various comps. You will be surprised at how often you will begin to sniff some bad cheese at this point in the process (particularly when dealing with structures). What you are looking for here is: (a) whether or not the comps are in the same general condition as the subject property, and (b) whether or not the comps are in the same general “class” as the subject property. By class I am referring to the level of quality and distinction of the property. If the answer to one or both of these is no, it is not necessarily game over, but you will now be looking even more closely at the adjustment matrix later on to see if the apparent differences are effectively accounted for to your satisfaction.
(4) Next, you will want to check the effective date of the value given. How current is the commercial loan appraisal? In a steady up economy we used to be comfortable using appraisals that were as much as 1-2 years old. We would adjust the value to be in-line with changes in the market. With the chaos of the past 5+ years, this method is not as effective and must be utilized with great care. Generally speaking (though this would depend to a certain extent on the region) you would want your appraisal to be less than 6 months old.
(5) Check carefully to see if there are any “subject to” items associated with the value. Generally this will initially be indicated by checking a box that indicates the appraised value is subject to certain additions, improvements, or modifications as indicated later in the appraisal. This of course is a critical item, so make sure you have read through the entire body of the appraisal so as not to miss any such “subject to” items or conditions.
(6) Look to see if any extraordinary assumptions are made by the appraiser. Here again, you will be forced to read through the entire body of the appraisal to be sure. On more than a few occasions I have seen what looked to be a perfectly reasonable appraisal completely neutralized (or actually nullified) at the discovery of one or more extraordinary assumptions. The problem with most extraordinary assumptions is that they are indeed extraordinary. If I am evaluating a parcel of bare land zoned rural agricultural, and an extraordinary assumption in my appraisal states that “The zoning will be changed to allow multi-unit residential at 8 units per acre.” … well chances are, the gig is up. Even if some serious local zoning change is in the works, what is the chance that you can count on it to come through and thus turn this “straw” property into gold?
(7) Take an accounting of the methods utilized for valuing the subject property. In my opinion, a market sales comparison approach is ALWAYS essential and should be the primary method—and the one given most weight—in valuing a property. The only true value in a market economy is the amount that others are willing to pay for it, and thus the attempt to estimate market value by looking at recent sales—though still at best a process of estimation—is the only method we have that goes to the heart of the matter. Beyond that, it would be nice to have a cost approach and an income approach (where relevant) but these are, in my opinion, at best a good way to cross-check the market value derived by the comparison approach.
(8) Another thing you need to take a close look at is the aging of the comps. If all the comps were sold quite recently, then you are good in this department. But if one or more of the comps are more than 6 months old, this may be a problem. The next step would be to look at the comp matrix to see how much the appraiser adjusts the target value to factor comp aging. If one or more of the comps are listings … well then, these aren’t really comps at all. I have seen comp workups using nothing but listings. This is totally unacceptable. Anyone can list a property for any price they want. It would perhaps be reasonable to have 1-2 listings along with at least as many “true” comps, but even this is getting into squishy territory. So here again, you would have to look at how the appraiser adjusted the subject value based on the “listing” comps.
(9) You should spend the majority of your effort fussing over the comp matrix. This is the matrix which compares various characteristics of the subject property with various characteristics of the comps and makes specific adjustments for each of the comps to arrive at adjusted values for the comps (effectively attempting to monetarily “convert” each of the comps into the subject property). If you have: (a) many adjustments, (b) large adjustments (relative to the price of the property), and/or many seemingly subjective adjustments, then you may want to seriously question the integrity of the appraisal. You will want to walk through each and every adjustment, and here again, you must look for transparency. Does the appraiser explain the logic behind his adjustment decisions? If not, you have a transparency problem. At the end of the day, you must be comfortable with the adjustments and you must feel that they are objective, transparent, well thought out, and seemingly reasonable. If not, you must either (a) discard the appraisal, (b) contact the appraiser for further explanation, and/or (c) revise one or more adjustments and revise the final subject value accordingly.
(10) And finally you will want to be sure and take a look at other methods of valuation utilized (generally income and cost on commercial loan appraisals). And then you will want to determine how the appraiser has gone about reconciling the different values arrived at utilizing different methods. Sometimes a weighted value approach is used. If so, how much weight is being given to the comp value approach relative to other methods utilized. As you may have guessed by now, I generally like to see all or at least the vast majority of weight given to the comp analysis. If the appraisal doesn't explain the reconciliation, you have a transparency problem. If the comp value approach is not given enough weight, you may want to fall back on the value arrived at by the comp value approach as your own final value.
And there you have it. There is a great deal more that can be said about reading an appraisal, and certainly this list of ten items is far from exhaustive, but it does give you a few things that you will not want to overlook. If anyone has their own favorite “crucial” steps, I would love to hear about them. Please let me know and I will share them with the group.
Last word: Don't think that you don't need to "read" a commercial loan appraisal just because you are the commercial loan broker or the borrower, thus relying on the work of the appraiser to be true and accurate given their credentials. I often ask brokers and borrowers if they have read the appraisals they have submitted, and what their opinion was. If they haven't read the appraisal or clearly haven't put the effort in to attempt to understand and make sense of it ... well that wouldn't necessarily kill the deal, but to my mind it highlights a potentially serious credibility issue. As a broker (and certainly as a professional investor borrower), you must read and understand the items that you are submitting. Anything less will generally become apparent to the lender and will ultimately undermine your ability to do your job effectively.
Vice President, Fairfield Financial Services, Inc.
This is George writing again. I made my sons, George IV and Tom, study Clay's superb article. My younger son, Tom, wrote back to me with the following wise comment:
These are essentially the exact same steps Angelica taught me to use when I didn't understand why she would accept one appraisal but not another.