What Should Clients Look For in an Appraisal Report?
They’re long. Their language is characterized by highly specialized (and sometimes unfamiliar) terminology and legalese. They’re bursting with tables, charts, maps, and photos. But they demand to be pored over, and from cover to cover. The question remains, however: What’s the best way to read a commercial real estate (CRE) appraisal report?
Let’s begin by pinpointing the exact object of our inquiry. A commercial real estate appraisal (or a commercial real estate valuation) is a professionally calculated assessment of the value of a commercial property. A broad category, “commercial property” encompasses everything from office buildings to condominiums to industrial sites and vacant land. If commercial property is being bought, sold, taxed, insured, or developed, that activity can trigger an appraisal.
Appraisal Report Types
Appraisal (or valuation) is a process and therefore to be distinguished from appraisal reports, which are the outcome of this process and can take one of several forms.
- Appraisal Report. Think of the Appraisal Report as a bread-and-butter narrative document. The required scope and level of detail in each Appraisal Report is determined by the appraisal professional and can vary widely depending on market and property complexities. Formerly known as a “Self-Contained Report” or “Summary Appraisal Report,” this new Appraisal Report format gives valuation experts extra discretion with regard to the amount of data, description, explanation, and analysis they include in their final write-up. Additionally, appraisers are required to “summarize” their findings for each Appraisal Report, meaning supporting documentation now may be kept in a separate work file.
- Restricted Appraisal Report. As its name suggests, this report is much more abbreviated than its counterpart above. Its primary purpose is to provide the party requesting the appraisal (the client) an opinion of value. Many topics covered in depth in the Appraisal Report may only be “stated” rather than “summarized” (the latter being applicable only to the Appraisal Report) herein. Finally — and crucially — the Restricted Appraisal Report does not meet the criteria for descriptive detail set by most lenders and adjudicating bodies.
Furthermore, it should be noted that the market is now demanding many Evaluation Reports. According to federal banking regulations, an evaluation may be issued instead of a formal appraisal if:
- the “transaction value” (generally the loan amount) is $500,000 or less;
- the transaction involves certain renewals, refinances, or other transactions involving existing extensions of credit; or
- real estate-secured business loans with a transaction value of $1,000,000 or less and the sale of, or rental income derived from, real estate is not the primary source of repayment for the loan.
Many appraisers are now producing Restricted Appraisal Reports and submitting them as Evaluations. This is permissible as long as appraisers are careful to label the appraisal a “Restricted Appraisal” and comply with the specific USPAP requirements and quality assurances (see below) related to the composition of formal appraisal reports.
Quality Assurance for Appraisal Reports
Whatever its type, and regardless of the audience for which it is intended, any worthwhile appraisal report must adhere to a set of professional guidelines known as the Uniform Standards of Professional Appraisal Practice (USPAP). By order of Congress, USPAP compliance is required for state-licensed and state-certified appraisers involved in federally-related commercial real estate transactions.
USPAP Rule 2-1 stipulates that each written appraisal report must:
- Clearly and accurately describe the appraisal in a manner that will not be misleading.
- Contain sufficient information to enable the intended users of the appraisal to understand the report properly.
- Clearly and accurately disclose all assumptions, extraordinary assumptions, hypothetical conditions, and limiting conditions used in the assignment.
Evaluation reports must comply with the Interagency Appraisal and Evaluation Guidelines as defined by the Federal Deposit Insurance Corporation (FDIC).
The Most Critical Features of Any CRE Appraisal Report
You’ve confirmed the report type. You feel confident that the document you are consulting adheres to USPAP’s best practices. What next? Look first to these sections or elements of your appraisal report to begin extracting the most the value from its valuations.
1) Definitions. Does the appraiser define such key terms as “cap rate”and “damages?” Do they also provide sources and context for their definitions? An illustrative example serves to highlight the weight these definitions carry.
- In cases of eminent domain, where only part of the property is condemned and appropriated by a government entity for public use, the terms “the value of the uncondemned land before the taking,” and “the value of the uncondemned land after the taking” are often a source of confusion.
- Essentially, the use of these terms involves determining the value of an entire tract of land and then the value of the part being condemned and taken. The difference between those two figures yields the value of the uncondemned land before the taking. Next, the value of the uncondemned land after the taking is determined. The difference between these two figures — before and after the taking — is added to the value of the condemned tract of land, and the sum of the two yields the compensation due to the landowner.
2) Explanation of methodology. The previously described formats are the bones of a CRE appraisal report. The methodology the appraiser uses to determine the fair market value (FMV) of the property being evaluated can be likened to the report’s soul.
The three most frequently applied valuation methods are:
- Cost Approach. Here, the appraiser focuses on the cost to rebuild the structure from scratch, factoring in the current costs of associated land, construction materials, and other expenditures related to replacing any existing structures.
- Sales Comparison Approach. Also called the market approach, this method relies heavily on recent sales data for comparable properties. “Comparable properties” here translates into sold buildings with similar assets in the same market area. One drawback to this method is that, depending on market conditions, it can sometimes be difficult to find data sufficient to support the appraiser’s analysis.
- Income Capitalization Approach. This method is based primarily on the income an investor can expect to derive from a particular property. Said expectations can be based, in part, on a comparison with similar properties. They may also be based on optimizations made to the existing property, such as improving the efficiency of maintenance services to realize cost-savings or adjusting rental rates to reflect current market conditions.
It should be emphasized that, for the professional appraiser, appraisal method selection is not necessarily an either/or proposition. Appraisers can and often do mix and match methods to provide the most accurate appraisal possible for the property in question. Either way, the report should speak to the rationale behind the appraiser’s choices.
3) Ownership history. Real estate properties, while material assets, are not immutable. They change over time, being put to different uses by different landlords. When assessing an appraisal report, look for the following items.
- Identification of the property’s owner(s) of record (also known as the record owner).
- Any questions regarding the title or state of ownership.
- Relevant encumbrances (e.g., easements, liens, deed restrictions, etc.).
- Enumeration of any recent sales, listings, offers, and/or options.
4) Market conditions.What a meteorologist is to the weather, the appraiser is to the economic forces affecting real property transactions. After reading through this section of an appraisal report, you should be able to answer the following questions.
- How does the appraiser describe the prevailing market trends leading up to and as of the valuation date?
- Has the appraiser reviewed relevant market indicators of value such as vacancies, competing projects, and available inventory? At LPA, our commercial real estate valuation experts constantly strive to track the pulse of the market using the very latest market analytics.
- What information has the appraiser used to justify their adjustments?
5) Property interest appraised. Ultimately, the appraisal report should directly address the client’s — that is, your — stated interest in the property. If, for example, you want to move your business into a shopping center, the appraisal you receive should report on the fee simple interest, or the total value of the building and the land on which it is situated. If, on the other hand, your goal is to lease the property to a tenant or tenants, you want to know what it is worth to a landlord. The appraisal should therefore report on leased fee interest.
It is crucial for clients to specify this interest before property inspection commences. If the property interest is not identified (or has been misidentified), the valuations issued may not be absolutely accurate — or relevant.