While commercial appraisals are a central part of evaluating real estate, the appraisal process itself can be frustrating and confusing – primarily since each assessment depends on the scope and nature of the specific property. My goal here is to help lenders, bank reviewers and appraisers better understand the commercial appraisal process to ensure projects are completed in a timely and efficient manner.
What is an Appraisal?
An appraisal is an objective, impartial, and unbiased opinion about the value of real property prepared by a State Licensed or Certified professional appraiser.
The appraiser’s role is to provide arm’s length, third-party, neutral, and impartial opinions about the value of real property and provide assistance to those who own, manage, sell, invest in, or lend money on real estate. Appraisers assemble a series of facts, statistics, and other information regarding specific properties, analyze this data and develop opinions of value. Some of the standards appraisers are required to comply with include:
- Uniform Standards of Professional Appraisal Practice (USPAP) – are considered the quality control standards applicable for real property.
- FIRREA and Bank Guidelines
- Interagency and Evaluation Guidelines
- SBA Appraisal Requirements
Defining the Appraisal Scope of Work
This is a decision where the lender can help the bank appraisal reviewer/analyst. In solving any problem, including an appraisal problem, there are three necessary steps to the process:
- Identify the problem,
- Determine the solution (or scope of work), and
- Apply the solution.
What Property Should be Appraised?
Does the collateral match what’s included in the appraisal? The borrower may own multiple properties, sometimes in close proximity to one another. It is beneficial and can save time and avoid follow-up questions and scope of work revisions to identify the actual property to be appraised. It is important to clarify if the borrower owns adjacent parcels and if they are to be included in the appraisal. Helpful information includes tax parcel numbers, legal descriptions, number of buildings, building size, etc.
Key Appraisal Items to Communicate
Fee Simple Interest – The fee simple interest is the most complete form of property ownership. Fee simple interest is defined as absolute ownership unencumbered by any other interest or estate, subject only to the limitations imposed by the governmental powers of taxation, eminent domain, police power, and escheat. Under fee simple ownership, a property owner may occupy the property and have the right to sell, lease, mortgage, or give an interest away.
Examples: Owner-occupied properties don’t have a lease in place and so the property is appraised based on market rents. Some building owners may structure a lease with a separate related entity that operates the business. Note that U.S. Small Business Administration (SBA) loans require a separate entity for the Eligible Passive Company (think real estate) and Operating Company (think business). However, these leases aren’t considered arm’s length because they are between related parties, can be canceled or revised at any time, and generally not relied upon.
Sometimes, a building will have all short-term (less than 12 months) leases. Most lenders will request the fee simple interest be appraised. The understanding here is the tenants could vacate and a more reliable value is provided by the fee simple analysis based on market rents.
Leased Fee Interest – Defined as the ownership interest held by the landlord, which includes the right to receive the contract rent specified in the lease plus the reversionary right when the lease expires.
Examples: A building owner has a single lease or multiple leases with tenants. When a property has longer-term leases in place, even at market rates and terms, the interest appraised is typically leased fee. The value may be the same as fee simple, but the interest is identified as a leased fee. Typical scenarios include single tenant buildings with leases exceeding 12 months and multi-tenant commercial buildings with varying lease expirations.
Helpful Items to Provide for the Appraisal
- Site and Building Details
- Title work
- Environmental Information
- Purchase Agreement
- Income Information
- Arm’s length vs. related party leases
- Historical Income & Expense Statements – Verify the owner’s consolidated statements match up with tax returns
- Signed lease documents, detailed rent roll, etc.
- New construction or planned renovations – Actual construction cost statements, plans, material specifications, etc.
What is Market Value As Is and When is it Used? The estimate of the market value of real property in its current physical condition, use, and zoning as of the appraisal date. (Interagency Appraisal and Evaluation Guidelines) Note that the use of the “as is” phrase is specific to appraisal regulations pursuant to FIRREA applying to appraisals prepared for regulated lenders in the United States. The concept of an “as is” value is not included in the Standards of Valuation Practice of the Appraisal Institute, Uniform Standards of Professional Appraisal Practice, or International Valuation Standards.
(Source: The Dictionary of Real Estate Appraisal, Sixth Edition, Appraisal Institute, Chicago, Illinois, 2015)
SBA Appraisal Requirement – If the loan will be used to acquire an existing building that does not require construction, the appraiser should estimate market value on an as-is basis. If the appraiser estimates the value other than on an as-is basis, the narrative must include an explanation of why the as-is basis was not used.
What is the actual occupancy of the property? Lenders, prior to sending the loan request to the review appraiser, find out what the building occupancy is. If a building has significant vacancy (above market), more than one value is generally required. This simple step ensures the proper bid request is made.
Prospective Market Value As Completed and As Stabilized
Prospective market value may be appropriate for the valuation of a property interest related to a credit decision for a proposed development or renovation project. According to USPAP, an appraisal with a prospective market value reflects an effective date that is subsequent to the date of the appraisal report. Prospective value opinions are intended to reflect the current expectations and perceptions of market participants, based on available data. Two prospective value opinions may be required to reflect the time frame during which development, construction, and occupancy will occur.
The prospective market value—as completed—reflects the property’s market value as of the time that development is expected to be completed. The prospective market value—as stabilized— reflects the property’s market value as of the time the property is projected to achieve stabilized occupancy. For an income-producing property, stabilized occupancy is the occupancy level that a property is expected to achieve after the property is exposed to the market for lease over a reasonable period of time and at comparable terms and conditions to other similar properties.
SBA requirements for prospective values – If the loan will be used to finance new construction or the substantial renovation of an existing building, the appraisal must estimate what the market value will be at completion of construction. (“Substantial” means rehabilitation expenses of more than one-third of the purchase price or fair market value at the time of the application.) After construction is completed, lender must obtain a statement from the appraiser, general contractor, project architect, or construction management firm that the building was built with only minor deviations (if any) from the plans and specifications upon which the original estimate of value was based. If the lender cannot obtain such a statement, the lender may not close the loan without SBA’s prior written permission.
I believe it’s important for appraisers to communicate with their clients to avoid surprises and ensure the appraisal process is as smooth as possible. At Simonson Appraisals, our core passion is transparency – helping our clients make sound investment decisions, and solving real estate problems to achieve their financial and business goals.
What has your experience been navigating the appraisal process?
Mitchell Simonson, MAI has been in commercial real estate for 16 years and founded Simonson Appraisals on January 1, 2019. Mr. Simonson enjoys writing about and discussing commercial real estate, personal development and business. Do you have questions on these topics? Contact him today!