In Defense of Value: Appraisers are Not to Blame

(TMA International Headquarters)

  A recent My View article questioned the use of forced liquidation values in relation to current “market” sales, based on the premise that, given the current state of the market, nobody who can afford to hold onto an asset would sell it right now.

The article pointed a finger at appraisers, implying that they are a significant part of the problem affecting bankers and borrowers in the current economic environment, the worst since the Great Depression. Specifically, the article claimed that appraisers are trying to force banks and developers to change their historic relationships with short-term fixes on long-term assets and that this will only continue to depress real estate values, decimate developers, and erode bank capital.

Fee appraisers who do their jobs properly and ethically remain completely independent of the interests of the parties involved in a transaction. Their goal is to report the most probable price at which a property would change hands between a willing buyer and seller.

Given this “most probable price” assumption, an appraiser is supposed to clearly indicate when true comparable sales are unavailable to form a conclusion through a market/sales comparison approach to value. An appraiser certainly should complete all due diligence on any possible comparable sales to be used in a final appraisal, and this includes understanding the form of sale of the property. For example, did the sale result from an auction or liquidation process or from an arm’s length negotiation?

There is no question that, especially over the past 12 months, the residential, commercial, and industrial markets have been flooded with properties offered at prices significantly below historical highs. However, one must look back at how a combination of economic factors brought us to this point, what the short-term predictions are, and why an appraiser cannot ignore these facts when a lender is relying on these conclusions. 

Consumer-Driven Economy

Over the past three decades, the U.S. economy has slowly transitioned from one defined by industrial companies to the current service-dominated economy. Service-oriented businesses thrive when consumers consistently spend significant portions of their disposable incomes. As a result, corporate revenues generated through consumer spending remain healthy enough to support the commercial real estate market because retail and office vacancies remain at manageable levels.

With industrial spending down significantly (and thus, industrial vacancies increasing), a turnaround in the U.S. economy is now highly dependent on a substantial return in consumer spending. However, this appears to be a major challenge over the short term. Even with a massive economic stimulus package in place, this recession is predicted to be the deepest and longest since World War II in terms of months of decline and recovery for total employment.

Before recent stock market gains, Americans had lost more than $10 trillion in equity, given declines in home values and pure investment equity. The expected impact on consumer spending based on a loss of this magnitude is more than $500 billion.

As of June 30 of this year, more than 90 percent of all metro areas were exhibiting negative job growth. Just 18 months earlier, this number was about 20 percent. From January 1, 2008, to June 30, 2009, 7 million jobs were lost. Between July 1, 2008, and June 30, 2009, the U.S. sustained its largest 12-month job loss in history and will finish the decade with fewer jobs than it began with, which will result in the worst “growth rate” since the 1930s.

Real, seasonally adjusted unemployment as of September 30 was 17 percent, far higher than the 10.2 percent figure generally reported. That’s because the real, seasonally adjusted rate includes those who are not fully employed and those who have become so discouraged that they simply stopped looking for work. This means that nearly one in five Americans who would like to work is either unemployed or employed far below his or her need and desire.[1]

Losses in disposable income and the psychological effects of equity losses on consumers have taken a severe toll in the retail sector. As a result, 2009 likely will be the first year in decades with a decline in nominal retail sales. Retail store closings and co-tenancy risk are on the rise, and many retailers will be challenged to survive negative sales growth.

These issues and the overall recessionary environment have caused distress in the following real estate market sectors:

• Apartments: Vacancies jumped to a new peak of about 7 percent in 2009, and household formation rates are very weak.
• Single-family housing: Foreclosure activity is rising sharply in the highest priced real estate sector. While foreclosures in the bottom tier are declining — because much of the subprime property inventory already has been foreclosed upon – more expensive properties are falling into foreclosure at an accelerated pace. These pricier properties carry very large mortgages and will create massive losses for banks and other lenders.[2]
• Office: The average vacancy rate is expected to peak near 20 percent by the end of 2010.
• Industrial: Adding to the distress already felt by U.S. industrials, trade flow through port cities has slowed as the global economy has been affected and, as a result, local distribution markets also are affected. Industrial vacancies, currently above 14 percent, are expected to peak near 16 percent in 2010.

As of June 30, 2009, the annualized net flow of commercial and multifamily mortgage capital turned negative. In addition, mortgage equity withdrawal as a percentage of disposable income was negative for the first two quarters of 2009, which had not occurred since the first quarter of 1993. Ultimately, these figures show that consumers have less barrowing capability to buy new homes and less capability (and desire) to use home equity capital to purchase goods and services. One result is downward pressure on residential, commercial, and industrial real estate values.

The percentage of construction loans in delinquency (30 to 89 days past due) has increased from about 5 percent to about 17 percent over the past two years. One major concern is that between April and August of this year, the value of commercial loans in “special servicing” (i.e., high distress) has doubled, to about $50 billion.

In terms of non-bank commercial mortgage maturities, 2012 is expected to be the peak default year as net operating income hits a trough.

In addition, property operating revenues are falling and remain under stress as fundamentals (absorptions, rents, occupancies) decline, along with the falloff in jobs. Also mirroring the job outlook, revenue declines will be greater than the past two recessions.

Prior to the start of the current financial crisis, the lending multiple was about 14 times on capital. During this recession (through June 30, 2009), the reported losses from banks, insurance companies, and government-sponsored enterprises (GSEs), such as Fannie Mae, totaled more than $1.61 trillion. Capital raised during this period was $1.36 trillion, resulting in a loss of $255 billion. Applying this loss to the pre-crisis multiple means that more than $3.5 trillion of lending capacity has been lost. 

Consistent, Precipitous Decline

The decline in the economy and its effect on the value of real estate has been consistent and precipitous over the past seven quarters. Because core factors remain weak in major market sectors, an appraiser has no choice but to consider these facts directly in every appraisal. The argument can also be made that in certain markets in which distressed sales are the only form of recent sales those transactions do establish current market value.

Like everyone else, appraisers want nothing more than a healthy economy in which new construction projects, mergers and acquisitions, property occupancy rates, and consumer spending all thrive. However, the current facts and short-terms indicators have shown that none of these economic drivers is on the upswing, and real estate values are affected accordingly. Appraisers cannot ignore reality.

[1] The Shepherd Investment Strategist, October 16, 2009, a service of JASMTS, Inc.