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A Matter of Value

Mar 23, 2020
By: Daniel Zigler
A Matter of Value

When I was a college student studying finance, a professor explained that the theoretical value of any asset is the present value of the expected future cash flows from it. This is true for stocks, bonds, precious metals and real estate. The difficult part is to accurately estimate future cash flows (which include the price you sell it for). Since financial institutions often lend on real estate, the estimated value of it, including cash flows, is quite relevant.

The Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) has been around since 1989. However, in my experience, financial institutions involved in commercial lending did not always place a high priority on the regulations. This all changed after the real estate decline and recession during the late 2000s. The Interagency Appraisal and Evaluation Guidelines from 2010 highlighted and clarified the regulatory expectations for real estate valuations during this era.

Even for an institution following the guidelines and performing cash flow analyses, as quickly as we have seen the economy change in the last couple of weeks, it may be time to not only review these procedures but also consider whether adjustments to cash flows and appraisal policies need to be made based on facts and circumstances occurring and changing (sometimes daily!).

Nowadays, almost every financial institution has procedures in place to ensure independence in the appraisal ordering and review functions. However, that is where the similarities end. Some institutions hire outside providers to review their appraisals. Other institutions choose to review appraisals in-house, and the quality of the internal reviews can vary significantly.  

Some institutions utilize a simplistic “check the box” type of review for all types of real estate. The more sophisticated institutions review appraisals closely and ensure the valuation is reasonable. They pay attention to comparable sales, estimated rental rates and market cap rates. While residential appraisals are relatively straightforward, commercial appraisals can be very complex, depending on the type of property. Not all appraisers are experienced with all types of real estate, and the quality of their work can reflect that.

I have personally reviewed a significant number of appraisals over the years. Here are some of my thoughts:

  • Don’t rely on appraisals to sound the alarm for inflated real estate prices. Appraisals are a snapshot in time. Even appraisals on income-producing properties include a market component, which can skew valuations during real estate bubbles. Focus on the income approach for income-producing properties, and make sure the assumptions make sense.
  • Math errors happen. I have also seen instances where incorrect property and/or area information is copied and pasted from other appraisals. Remember that appraisers are human and can be under significant time constraints.
  • Appraisal methodologies can vary from appraiser to appraiser on the same property. This is especially true for properties that have values which are closely tied to the operation of a business (gas stations, car washes, hotels, etc.). The appraisal community can be somewhat divided on how to value properties such as these, and the approaches are not always consistent.
  • Appraisals often include several different values. Leased-fee values on income properties are often different from fee-simple values. Construction appraisals on income properties can include “as is” values, “as complete” values and “as stabilized” values. Lending on “as stabilized” values should be done cautiously, since the income and expense assumptions utilized by the appraiser may never come to fruition.

An important aspect of Wipfli’s loan review procedures is our ability to view the overall appraisal process. This includes how they are ordered, how they are reviewed and how the values are utilized. We compare the appraisal process to regulatory expectations and include best practice observations related to the process.  

Ask your Wipfli representative how we can help your institution with our business valuation services.


Daniel Zigler, CRC
Senior Specialist, Loan Review
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