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Deciphering The Appraisal Formula

The scientists of appraisals factor in all value components in order to produce a sound property appraisal.

Thanks to the greatly improved market, appraisers are finding themselves back at center stage, and not necessarily enjoying it. The last time the spotlight shone on the profession was when regulators, legislators and analysts took the appraisal industry to task -- and in a few cases took individual appraisers to jail -- for contributing to the inflation of values that led to the collapse of the real estate market.

Although the majority of appraisers performed with honesty and diligence, the prevailing view today, within the industry as well as out, is that the accepted practices of the previous decade provided inadequate protection against overvaluation in a period of rapid growth.

"The market in general is much more cautious today," says Richard W. Latella, MAI, senior director, retail valuation group for Cushman & Wakefield, New York. "More checks and balances are in place. Lenders and investors want assurance a property will hold its value."

A major shortcoming in the past, says Michael Green, vice president of Real Estate Analysts Ltd., St. Louis, was the failure to consider a property's performance over time. Real estate values had increased consistently, or at worst remained steady, for such a long period of time that many people were seduced into believing increases would continue. At the minimum, a property would retain its current value, and most likely, the value would grow.

"Ten years ago people looked at a one-year snapshot. Now you're looking to do a discounted cash flow analysis for five, eight, 10 years down the road," Green says.

Making such long-range projections, however, requires much more sophisticated analysis of both the property and the market, as well as the analysis of many more factors than were previously examined in a typical appraisal. Moreover, each of these factors has to be broken down into its components.

Along with the obvious factors such as revenues and expenses, the appraiser must take into account location, tenancies, tenant credit ratings, lease terms, market trends, sales trends, demographic trends and investment trends. Each of these in turn must be broken down and examined in detail. In many cases, the appraiser must also consider the potential for alternative uses, expansion or renovation, or retenanting to determine "the highest and best use."

Current values Appraisers vary greatly in their view of values over the past year. According to Lee Weaver, a retail specialist with Tampa, Fla.-based Pardue, Heid, Church, Smith & Waller, the market is very strong. "We've seen values increase steadily over the past three years," he says.

Harvey M. Levin, MAI, director of appraising for Philadelphia-based Colliers Lanard & Axilbund Appraising Co., on the other hand, says only regional malls and power centers have experienced significant increases in value. Latella says the opposite -- neighborhood and community centers have increased their values by 10 to 20 percent overall, but regional and power centers have lost value in some instances.

Myra McCain, MAI, president of Delta Associates Inc., Alexandria, Va., has seen little change in either direction. "Retail has been a hot property category for about the last year, but I haven't seen any increased values yet," she says.

Despite the differences in how they describe current conditions, appraisers agree that values will move upward from this point. "I would expect a steady increase given all the activity," says McCain. Latella even sees the beginning of a turnaround in values for regional and power centers due to the "voracious appetite by REITs (real estate investment trusts) to build their portfolios."

Based on a survey Cushman & Wakefield did this summer, Latella pegs average cap rates at 9.3 percent for neighborhood and community centers, 9.7 percent for power centers and freestanding big-box stores, 8.3 percent for regional malls and 9 percent for specialty retail. All have climbed two-tenths to four-tenths of a point since a similar survey in 1996, except for neighborhood and community centers, which dropped from 9.6 percent. He expects the cap rate for regional malls to begin declining in about six months.

Complexity on the increase Traditionally, says Green, the amount of income produced overall was sufficient information, but now appraisers must track thestream from each category of tenant, and sometimes from each tenant.

"Investors and landlords want appraisers to section out the income stream, separating Class A from Class B and Class B from mom-and-pop. They want a much more detailed analysis of where the income is coming from," he says.

>From this type of detail, he continues, a risk assessment can be performed for each component or group of components. A center where each class of tenant accounts for one third of the income spells greater risk than one where top credit tenants produce 80 percent of the income.

Evaluating other factors has become equally complex. According to Levin, location remains king. "We're seeing the old axiom still holding true: location, location, location," he says.

Determining a location's effect on value, however, requires careful analysis of demographic trends. Green uses changes in St. Louis to illustrate the importance of demographics. The population, which has remained stable for 20 years, he says, might lead an appraiser to assume nothing much has changed.

But in fact, the makeup and densities of the population has changed significantly. Middle class neighborhoods became poor, while shabby areas with character began attracting young professionals. A new freeway interchange wiped out one neighborhood, while at the same time abandoned warehouses by the river were turned into stylish residences.

Similarly, says Weaver, appraisers need to anticipate future changes in a shopping center's operations. How long do the leases run, and do they all expire about the same time or all at different times? Is the supermarket up-to-date or a likely candidate for closure by the chain? If it were to close, are there tenants with equivalent draw to replace it? Do any of the tenants belong to chains that are in financial difficulty or likely to be in financial difficulty before long? Are the successful mom-and-pop tenants nearing retirement age, or simply growing tired of running a store?

Complicating matters, many of these issues may be gray areas, and gray areas, says McCain, can cause the biggest headaches. For example, if a chain is closing all its 10-year-old, 35,000 sq. ft. stores and building 55,000 sq. ft. ones, what is the status of a five-year-old, 45,000 sq. ft. store?

Challenging reassessments Appraisers say that wherever values have risen, it has triggered a rise in assessed values. The extent and timing of the rise depends largely on the aggressiveness of the local assessor's office. Sales almost always lead to reassessment. However, expansions and renovations may not because the local recorder's office typically would not receive notice of improvements to properties under existing ownership.

Eventual reassessment is inevitable, although laws vary from state to state as to how often local assessors are required to perform reassessments. In Massachusetts, says Kaye, counties reassess all properties every three years. Every project has a grace period of whatever time remains until the next blanket assessment period, whether that's one month or three years. "It is very common for appraised values to be in excess of assessed values because of the lag," he says.

During the downturn, many landlords petitioned for reassessment in the expectation market values had dropped. Challenges today are much less common because owners recognize that values in general have picked up since the early 1990s. When challenges do occur, says Levin, the intent generally is to argue for a smaller upward adjustment rather than no adjustment or a downward adjustment.

According to Weaver, it is difficult to successfully challenge an assessment based on a recorded sale price. Buyers would have to somehow argue they overpaid, or they could argue the price reflected potential that may or may not be realizable. In many cases, the latter argument is true but unlikely to prevail because most assessors would regard the sale price itself as evidence the potential can be realized.

Challenging a reassessment of a property that has not changed hands has greater chance of success. In general, says Levin, income-producing properties tend to be taxed at a higher proportion of value than residential properties, which leaves leeway for compromise. In addition, he says, assessors today routinely overvalue retail property based on the general sense of optimism about real estate and the economy.

Choosing an appraiser Although REITs are moving toward the classification of real property as a commodity, market conditions vary so greatly that most appraisers call it a mistake to try to apply a standard formula to every property. Consequently, they recommend that a property be appraised by someone from the local community.

"An outside appraiser is going to have a tough time knowing the things a local appraiser has almost a sixth sense about," says Green.

He uses planning and zoning issues as an example. Appraisers not familiar with a community will know current regulations and, if they are diligent, planned changes. What they will not know, says Green, are changes that are likely to occur later.

"We keep track of where new highways are going, where population is moving. We think we can identify areas where there is likely to be changed zoning in the future, before it has even been discussed," he says.

Green acknowledges his firm does work in other regions, but he emphasizes it is always done in alliance with a local firm. "We're part of a nationwide network. We will ally ourselves with a network member in the area we're going to be working in," he says.

Green advises owners or their managers also learn appraisers' history and qualifications, how long they have been in the community and how well they know the different areas of town. They should also have the ability to properly analyze both a property and the market. Finally, he says, they should be able to produce a report in a reasonable time frame.

McCain reports her company does market feasibility work as well as appraisal, which she says makes more it "more attuned" to counseling clients.

"In my view, the best appraisers are those who have a consulting facet to their practice," she says. "The best source of information is an active client, one who is a market participant, as opposed to a lender client, who is what I call a passive participant."

Future trends The healthy U.S. economy promises to sustain value for the next five to 10 years at least. However, retail property values will not rise significantly higher in the near term.

"I think we're starting to push toward the upper limits of value. We will reach that in the next 18 months," says Levin.

The big worry is that values will rise beyond what the market can truly support, leading to another collapse. "I don't see a trend to overvaluing," says Latella. He does, however, note that a few markets face a potential threat of overbuilding, and he warns that appraisers must be careful to take that potential into account.

Latella acknowledges that appraisers can get caught up in the market's fundamentals and rely too heavily on selling prices in determining value. "If buyers continue to be very aggressive in their underwriting, we're going to mirror those trends and give high values," he says. "But I would hope that appraisers would learn from their mistakes and be more cautious today if things begin to get out of hand."

The task, he says, is to recognize that prices are increasing but apply caution to make sure prices are not inflated. Especially necessary, he stresses, is the recognition that not all properties are increasing in value at the same pace.

Latella says the involvement of REITs helps stabilize the market. "REITs are looked at very closely by Wall Street and other analysts, which is a controlling factor if things start to get out of hand. There's a lot more market scrutiny, and with more and more properties being securitized or going into REITs, the scrutiny will intensify," he says.

Weaver thinks shopping centers are gradually becoming equivalent to bonds as investment vehicles. "The modern prototype shopping center is going from a lot of local space to a nationallyanchored and tenanted center. That really decreases the risk because you've got a steady income stream backed entirely by creditworthy tenants. The risk becomes predictable," he explains.

He points to technological advances as another stabilizing factor. "The advent of leasehold analysis programs allows us to ... analyze down to the smallest detail," he says. "By using the Internet along with demographic programs, we are able to make forecasts about expenditures and market growth that weren't possible in the past. Everything is right there on my desktop computer."

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