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In Defense of Value: Appraisers are Not to Blame

A recent 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. Fingers are pointing to appraisers, implying that the appraisers are a significant part of the problem currently affecting bankers and borrowers, during the worst economic environment since The Great Depression. Specifically, there have been claims 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.

A fee appraiser, if he/she does his/her job correctly and ethically, remains completely independent of the interests of the parties in a transaction and produces a report that opines on the most probable price that a property would change hands between a willing buyer and seller. Given the “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. The appraiser is certainly supposed to have completed all of his due diligence on any possible comparable sales that will be utilized in the final appraisal, and this diligence includes an understanding of the form of sale of the property. For example, was the sale the result of an auction or liquidation process or an “arms-length” negotiation? While there is no question that, especially over the past twelve months, the residential, commercial and industrial markets have been flooded with properties being offered at prices significantly below historical highs, one needs to 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.

Let’s start by boiling it down to facts that are irrefutable: over the past three decades the American economy has slowly transitioned from one that was “industrial” dominated to one that is “service” dominated. Service-oriented businesses thrive when consumers consistently spend a significant portion of their disposable income. As a result, corporate revenues generated through consumer spending remain healthy enough to support the commercial real estate market as 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 for the following reasons:

• Even with the 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).
• As of June 30, 2009, over 90% of all metro areas were exhibiting negative job growth. Just 18 months prior, this number was approximately 20%.
• Between July 1, 2008 and June 30, 2009, the U.S. encountered its largest twelve month loss of jobs in its history; and between January 1, 2008 and June 30, 2009, 7 million jobs were lost.
• Before the recent stock market recovery, Americans had lost over $10 trillion in equity between the decline in value in home equity and pure investment equity.
• The expected impact on consumer spending based upon a loss of this magnitude is over $500 billion.
• The U.S. will finish the decade with less jobs than it began with, which will result in the worst “growth rate” since the 1930s.
• “Real”, seasonally adjusted unemployment as of September 30, 2009 was 17%, which differs from 10.2% as reported to the public. The Bureau of Labor Statistics publishes six levels of unemployment statistics, categories “U-1” through “U-6”. The “official unemployment rate” is the rate shared with the public (10.2% as shown above), whereas the real unemployment rate accounts for all those who are not fully employed or have simply stopped looking for work. This translates into the fact that nearly one in five Americans who would work are either out of work or are employed far below their need and desire.¹

One must then look at how this loss of disposable income and the psychological effect of equity losses on the consumer effects retail businesses:

• 2009 will likely be the first year in decades with a decline in nominal retail sales
• Retail store closings and co-tenancy risk are on the rise
• It will be challenging for many retailers to survive negative sales growth

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

• Apartment – Vacancies jumped to a new peak at about 7% in 2009, and household formation rates are very weak.
• Single-family housing – Foreclosure activity is rising sharply in the highest priced real estate. While foreclosures in the bottom tier are declining, as much of the subprime property inventory has been foreclosed on, the more expensive properties are falling into foreclosure at a very accelerated pace. These are the pricier properties which 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% by the end of 2010.
• Industrial – To add 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 are affected. Industrial vacancies, currently above 14%, are expected to peak near 16% in 2010.

Additional facts regarding the distress in the current environment can be summarized as follows:

• Property operating revenues are falling and remain under stress as fundamentals (absorptions, rents, occupancies) decline along with the decline in jobs. As is the case with jobs, revenue declines will be greater than the past two recessions.
• As of June 30, 2009, the annualized net flow of commercial and multifamily mortgage capital turned negative.
• 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 terms of construction loans, the percentage of construction loans in delinquency (30-89 days past due) has increased from approximately 5% to approximately 17% over the past two years.
• Prior to the start of the current financial crisis, the lending multiple was approximately 14x on capital. During this recession (through June 30, 2009), the reported losses from banks, insurance companies and government-sponsored enterprises (GSEs, e.g., Fannie Mae) was over $1.61 trillion, and the 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 over $3.5 trillion of lending capacity has been lost.
• 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.

The factual evidence presented indicates that the decline in the economy and its effect on the value of real estate has been consistent and precipitous over the past 7 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, where distressed sales are the only form of sale, that those sales do establish current market value.

Appraisers want nothing more than a healthy economy. A healthy economy means a market where new construction projects, mergers and acquisitions, property occupancy and consumer spending thrive. This scenario is the desire of everyone; 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.

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¹ The Shepherd Investment Strategist, October 16, 2009, a service of JASMTS, Inc.
² ibid

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