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CRE Finance World, Winter 2012

Valuing Appraisals: Evidence from the CMBS Industry Managing Director Executive Managing DirectorKC Conway, MAIBrian Olasov McKenna Long & Aldridge LLP Colliers International P experience. With the turbulence in CRE markets, recent to derive value without penalizing the property for “unobservableMarket value and fair value should be the same in theory in a liquidand functional market where there is sufficient market activity fortransaction testing. In an illiquid and dysfunctional market with a dearthof transaction activity, fair value allows a “waterfall” type analysisarticularly during volatile markets, commercial real estateprofessionals are often skeptical of the connectionbetween appraisals and transaction outcomes. Muchof this skepticism is based on anecdotal and personal liquidation experience captured by CMBS’s extensive reporting events” — like transactions, developer’s profit, etc. So when the requirements allows the authors to test these market perceptions. bank lender observes the market value at X when originated, the Drawing from over 2,000 recent liquidations, the authors analyze re-appraisal 12 months later in an illiquid market says Y, and the the relationship between recent appraisals on underlying properties REO department or special servicer says the property is worth Z and the gross proceeds realized from property liquidations as well when they own the collateral because the only buyers are all cash as property and loan characteristics that contribute to or detract distressed buyers, who is right? The three users are not operating from appraisal accuracy. from the same starting definition of value — one is estimating market value, another fair value to reclassify the loan and the other One of the two co-authors, we’ll resist saying who, recently addressed liquidation value because they have to dispose of the asset in 90 an Appraisal Institute conference. “This is a good news/bad news days. Any reconciliation into a reasonable range among the three story. The good news is that banks, regulators and CMBS servicers opinions of value is likely only a happy coincidence. Selecting must use you. The bad news is that lenders and servicers don’t which definition of value to apply is the genesis of many disputes believe what you tell them.” The message was not well-received. over real property value. With information now available from thousands of CMBS liquidations, we can now put this message to the test. Objectives of Analysis The recent liquidation activity in the CMBS industry provides What Do Appraisals Seek to Measure? a deep enough data set to empirically test several burning All of us in real estate lending have anecdotes about appraisals valuation questions: that don’t pan out close to the price at which the property later transacts. What exactly does an appraised value measure? Value How good are appraisals at predicting transaction outcomes? starts with limiting conditions and assumptions long before it migrates into market conditions, comparable data and selection Are there property types and markets that promote more reliable of key metrics like cap rates. Regulated lenders are initially focused appraisals? Does loan size play a role in improving value predictability? on “As-Is Market Value” until the loan goes bad. Then the lenders start to move into the GAAP accounting and legal world and inject How heavily should mortgage loan management decisions rely on terms like “liquidation value” and “fair value” into the mix. An as-is appraisals? If we widen the discussion outside of CMBS to include appraisal, that is, the property as zoned, as developed, as tenanted, banks, should loan portfolios’ carrying values be capped at the in its current condition, should reflect the value at which a willing appraised value of the loan collateral? buyer and willing seller, neither under duress, consummate a sale transaction after some reasonable marketing period and process. In extreme cases, should regulators close banks primarily due to This is the value every lender thinks they have when they make a declines in appraised values of their real estate loan portfolios? loan — value to match what they have in hand in a liquid and stable market. In an illiquid market, though, the time assumed to market a Among all major sources of CRE financing — banks, life companies property, and whether there is reasonable financing available, are and CMBS — only CMBS captures sufficient, standardized data to pivotal in determining the end liquidation price. In thinly traded markets question the correlation between appraised values and liquidation with limited or no debt financing (the case in many secondary and proceeds. This article attempts to measure that relationship. tertiary MSAs today), a liquidation sale with an urgency of time may bring half as much as a twelve month exposure. Are market Until the downturn in CMBS began in 2008, special servicing transfer conditions or the lack of financing most impactful? What is the rates were low and most loans required only slight modifications value? Better to ask which definition of value to apply: As-is Market after which they would be returned to the master servicer as Value; Liquidation Value; or Fair Value? re-performing or corrected mortgage loans. Losses through foreclosure and liquidation or, even less frequently, note sales A publication of Winter issue 2012 sponsored by CRE Finance World Winter 2012 35


CRE Finance World, Winter 2012
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