Friday, March 30, 2012

Some Thoughts about Appraiser/Valuer Responsibility

Unfinished construction of beach condos in Brazil

This month has witnessed a certain game-changing event for the U.S. commercial appraiser profession – the first FDIC lawsuit against commercial appraisers since the Savings and Loan crisis over 20 years ago. (For the 54% of readers who are outside the U.S., the FDIC is the Federal Deposit Insurance Corporation, a U.S. government entity that seizes insolvent banks and tries to resolve bad loans.) This lawsuit is a precursor of more to come, based on the numerous legal actions already taken against residential appraisers.

Two Michigan appraisers are being sued because they performed an “as is” valuation of a residential subdivision as if it was complete, when in actuality development had not yet started. This led to a loan loss that contributed to the failure of Michigan Heritage Bank.

One of the appraisers had previously appraised the proposed subdivision exactly as it was, a proposed subdivision, but the developer contacted the appraiser at a later date to tell her that the project was complete and that the subdivision needed to be appraised as complete. The appraiser did so without going to the property to verify completion.

Perhaps the appraiser was duped, or perhaps she was knowingly complicit in this misrepresentation by her client and thought that exculpatory clauses in her report protected her. A typical exculpatory clause might read like this:

No responsibility is assumed for accuracy of information furnished by the client.”

Such a clause is standard in just about any U.S. appraisal report, but is this not just an abdication of responsibility? This clause evidently did not work, because she now finds herself and her boss being sued by the U.S. government.

This misrepresentation of an unbuilt property as complete without proper disclosure is a violation of U.S. laws and USPAP (Uniform Standards of Professional Appraisal Practice), yet I have seen this practice commonly done in other countries such as Singapore and Canada and have commented on this in previous posts.

I was recently involved in a similar situation in which two other appraisal firms valued an 85-year old, multi-story warehouse building with the assumption that the elevators worked. "How were we supposed to know that the elevators didn't work?" (I like to push the buttons, but if I get the common excuse, "the elevator just broke yesterday", I ask for evidence of a current elevator inspection certificate.) My client, a direct lender, never instructed the appraisers to make this "extraordinary assumption" which turned the search for the true market value into a meaningless academic exercise--a hypothetical estimation of value "as if the elevators worked".

The standard of appraisal practice today seems to be to value each property as if nothing was wrong with it, and then declare this assumption to be a limiting condition of the valuation report. It reduces an appraiser's sense of "duty of care".  Why bother to determine if the property is a SuperFund site (U.S. list of properties requiring toxic cleanup or remediation) when you can just assume that it's clean.  Why bother to verify that utilities are available to the site when you can just assume so?

One central problem of the appraisal/valuer profession is the abdication of responsibility

Now that I have had the chance to read appraisal/valuation reports from every continent except Antarctica, I find abdication of personal responsibility to be endemic to the worldwide commercial appraiser/valuer profession, which causes me to propose the following manifesto:

1. An appraiser or valuer should care about all users of his report. Not only must he care about the welfare of his immediate client, but also about others who could rely on his report. An appraisal report done for a mortgage broker, for instance, may also be the basis for a lending decision from a direct lender who could lose money if the property is overvalued. If appraisers want to earn the same respect as doctors, we should be mindful of that part of the Hippocratic oath which proclaims “Do no harm”.

2. Accuracy, rather than report length, should be the primary goal of the appraisal process, as that is what contributes most to the soundness of decisions based on appraisals. In the North American commercial appraisal profession, too much emphasis is made on constructing lengthy reports full of canned comments and not enough emphasis is made on research and analysis. Some appraisers even purchase software that adds pages more of canned comments. Reports can do without paper-wasting, tree-killing comments like “Los Angeles is on the west coast of the United States of America in the western hemisphere of Earth, the third planet from the Sun.” I have also found myself perplexed in the past by appraisal instructor who have said "Your estimate of value doesn't matter. Only the report matters." Ask any client -- of course, the value matters!

3. Appraisers need to verify important facts about the property being appraised. Tenants should be verified as occupying the space they are said to be occupying. Representations about building area or land area should be verified by measurement or by public documents. Entitlements or planning approvals should be verified by recent official documents or better yet, by calling on the relevant public agencies. Relying on a property owner's statements without verification just invites fraud.

4. Whenever doubts arise, the appraiser should investigate or recommend investigation rather than make the extraordinary assumption that nothing is wrong. If the financial statements do not seem credible, he should request tax returns. If the ceilings are stained, he should look at the roof. If a subdivision is dependent upon well water, he should request a well water report. Assuming that nothing is wrong turns appraisals into meaningless academic exercises that lead to overvaluation.

When I was starting out in this profession in the 1980s, I had a mentor who would tell me to "stop agonizing" and just put down a number. I'm glad I didn't follow that advice. He eventually lost his license and company.  My clientele pays me to agonize.

The application of professional appraisal standards

Professional valuation standards go part of the way in alleviating these aforementioned problems.

USPAP, despite being vague and watered down over the years, has improved the credibility of American appraisal reports and is also followed by many Canadian appraisers.

Internationally, IVSC (International Valuation Standards Council) has published a lengthy set of international valuation standards that would also improve valuation practice for commercial real estate and other asset classes, if followed, including a specific application standard for valuation of property interests for secured lending -- important for protecting the lending industry. It will be difficult to promulgate such standards, though, if IVSC continues to charge money for a book-length publication rather than publish it for free on the Internet. Unless there is a legal mandate or clients start insisting on valuations that meet these standards, I would not expect appraisers and valuers to go out of their way to buy this book. An appraiser declaring that his report has met these standards often faces the reality that the client does not know these standards or have access to them.

In the mean time, it would be a good thing if the commercial appraisers and valuers of the world could agree on a much briefer oath or manifesto that would protect the interests of those who rely on our reports, much like the Hippocratic Oath for physicians. You may say that I’m a dreamer, but I’m not the only one.
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Sunday, March 18, 2012

Appraisal of a Planned Oceanfront Community near Natal, Brazil

View to the south of the city of Natal and the Redinha Bridge opening up development opportunities in the beach towns north of Natal

Ponta Negra beach on the south side of Natal.

This assignment was to value a planned community (“Palm Springs”) already under construction next the beach town of Muriu, a northern suburb of Natal, a rapidly growing city of 800,000 and capital of the northern Brazilian state of Rio Grande do Norte. Muriu is a fishing village that has grown to include a “Millionaire’s Row” of residences owned by wealthy citizens of Natal.
Lobster boats of Muriu

The completion of Redinha bridge (see top photo) on 11/20/2007 opened up development opportunities in the towns north of Natal (including Muriu), and further highway improvements have been announced for the bridge and the northern part of Natal (as reported in the Tribuna do Norte 3/13/12) which will reduce commuting time from Muriu to Natal from 35 to 20 minutes.

What is significant about this is that Muriu will no longer just be a community of weekend and vacation homes; it can now also serve as a bedroom community for upper middle class commuters to Natal. Professional people will now be able to commute to high-paying jobs in the city while simultaneously living at the beach.

As this is my second valuation assignment in Brazil so far this year, this illustrates the dearth of local project financing available within Brazil, where banks charge high interest rates and developers are forced to turn to the U.S. and Europe for capital. A residential project such as this is typically initially funded by cash deposits of 10 to 15% of purchase price by the end buyers, which limits the available upfront money needed to build infrastructure. This can create a serious shortage of capital needed to build the necessary infrastructure.

Other cities making highway improvements towards beach cities have seen property booms in those beach cities. For example, in the Dominican Republic, the extension of the freeway from Santo Domingo to the airport and beyond created a building boom in the beach town of Juan Dolio and a new resort community known as Costa Blanca. Buyers have predominantly been local professionals from Santo Domingo.

These further highway improvements to Natal, the construction of a new stadium, as well as the opening in 2013 of a gigantic new airport, the largest in South America, are being done in preparation for the World Cup games in 2014. Natal will be one of the World Cup venues.

Consequently, in addition to demand from local buyers, there will also be increased exposure to tourists who may also turn into buyers.

The Principle of Ruinous Competition

As can be expected, once the bridge was completed, many developers announced their own residential development projects in the beach towns north of Natal. One developer even locked up commitments in 2009 from David Beckham for a soccer academy and former princess Sarah Ferguson for an equestrian center for a 1350-home project in Caraubas, 50 km north of Natal. Development has still not begun.

Although it is customary in Brazil to not start development until enough monies are collected through lot sales, the British developer of Palm Springs wanted to boost his credibility by starting development right away, particularly to counteract the distrust that Brazilians have developed against other British developers who sell lots and collect deposits for years without starting development. (My previous post on Brazil featured a project that had been selling lots for 6 years without yet starting development.)

There have been so many announced projects, but only two, including the one I am appraising, have started construction, and the other one, the Natal Ocean Club farther to the north, has suspended construction as a result of a new federal law preventing development within 100 yards of the shoreline, which is a big setback for some beach projects.
Subject property

If this particular developer’s strategy is correct, he should have the only construction-ready project when demand for homes north of Natal escalates after continuing road improvements, a major new airport, and escalating tourism to this area.

I am dusting off the old “subdivision development method”, a discounted cash flow methodology that can only safely be used when a residential project can be considered economically feasible (something I have not seen for a while), but a favorable confluence of events seem to support this project.
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Saturday, March 17, 2012

Some thoughts about "geographic competency" in international assignments

U.S. appraisers are largely governed by a document known as Uniform Standards of Professional Appraisal Practice. One key rule in USPAP is called the Competency Rule.

The Competency Rule requires that the appraiser determine his own competency prior to an appraisal assignment, and if he lacks certain competencies necessary to complete the assignment, he must disclose the lack of competency to the client and then take all the steps necessary to acquire the competency needed to complete the assignment correctly. This Rule also specifically states that “in an assignment where geographic competency is necessary, an appraiser who is not familiar with the relevant market characteristics must acquire an understanding necessary to produce credible assignment results for the specific property type and market involved.

Sometimes when I’m socializing with other appraisers and I mention my international work, I encounter an indignant residential appraiser who asks “What about the Competency Rule!?”

For instance, during a coffee break at an appraisal seminar, I told a Senior Residential Appraiser that I had just returned from appraising one square mile of beachfront land in Fiji. He sternly rebuked me with “What about the Competency Rule?”, as if an American appraiser cannot possibly conduct market research there without a subscription to the Fiji residential MLS (multiple listing service).

I can understand residential appraisers’ preoccupation with geographic competency when out-of-town appraisers invade their turf and don’t even know that the next block from the house being appraised is in a better or worse school district.

As for Fiji, my client already knew I had never been there, saying “We know, and we trust you to ask the right questions,” whereupon I made the efforts to learn the market for this entitled leasehold development land in Fiji. [I have been there three times since.] This included a visit to the relevant government office to discuss planning approvals and Fijian law relating to leasehold interests, and interviews with two appraisers with local knowledge, including the always-helpful Professor Matt Myers, MAI from the University of the South Pacific in Fiji. It also involved reading countless news articles and blogs about other large-scale, beach-oriented tourist developments and their progress.

A locally done appraisal had already been provided by the borrower. It used small lots as comps for this one-square-mile parcel and failed to disclose that one of the two ground leases was expiring in one year. How much value can be assigned to an expiring ground lease with no assurance of renewal? This Fijian property was later foreclosed on. The local appraiser has since lost his appraisal license.

Another time, I was sent to review an appraisal report in Canada. The question from the client was “Does this appraisal meet USPAP standards?” Discussing this on an on-line appraisers forum, one appraiser became indignant. “What about the Competency Rule?”

My response was that I saw myself as more of an authority on USPAP than Canadian appraisers, some who say they comply with USPAP, but really don’t. In this particular case, the Canadian appraiser violated USPAP by failing to properly disclose “extraordinary assumptions”. In this instance, his report assumed the land had been legally subdivided, but it hadn’t been.

Commercial appraisers don’t criticize me about the geographic scope of my work, probably because there is no guarantee that a local appraiser is competent in the property type being appraised. Most local commercial appraisers do not know how to appraise gas stations or golf courses or hospitals, for instance. Sometimes a specialist needs to be called in from out-of-town, particularly when the only comparable sales available are likely to be in other states, as for ski resorts, for instance.

But there are sometimes other reasons making it preferable to bring in an outside appraiser, such as:

1. Independence from local powerbrokers. I once appraised a proposed lakeside development in a relatively unpopulated county, and the developer, who insisted that his property was worth $5 million, also insisted that a local “MAI” (member of the Appraisal Institute) be used instead. I searched for my client and found only one MAI in the entire county. He told me that he had already been contacted by the developer and refused the assignment. He said that the property couldn’t possibly be worth $5 million and that if he gave his honest opinion, which would probably be around $1 million, he might not be able to get any more work in that county, a common problem for any appraiser in a small market, as was described by Appraisal Institute President Richard Powers at the Appraisal Foundation's Fraud Symposium in 2006. Once you've upset Boss Hogg (The Dukes of Hazzard), he’ll make sure you never appraise in Hazzard County again.

2. Objectivity. Some appraisers think as boosters for their local community, even saying with a straight face that the laws of economics (such as the law of supply and demand) do not apply to their own community. Some are also hamstrung by old data and don’t stay alert to recent new trends. I started my career in Texas in the mid-1980s and saw it then, and then encountered it again when I moved to California in the late 1980s. As vacancies escalated, some local appraisers refused to believe that commercial property values were decreasing. It had never happened before in their states.

3. Having a broader perspective. One of my specialties is super-regional malls, and I often have to gather data from several states. It brings a smile to my face when a local residential appraiser suggests that I can't appraise the local regional mall because I don't have access to the local MLS (listing service for residential properties.)

4. Level of training. There are many countries that do not set any minimum level of training or credentialing for persons advertising themselves as appraisers or valuers. And even if they did have proper training, there is often no local enforcement of ethics.

5. Lack of sanctions against dishonest appraisers.  Unfortunately, in most countries, an appraiser or valuer is no more than the paid advocate of the one who hired him.  I recently worked in a Caribbean nation, for instance, where the "most respected" local appraiser valued the subject property at more than twice the price the property had been listed for sale for the last 4 years. 

6. Lower level of due diligence.  My number one client does not allow me to delegate valuation work.  I'm allowed to hire a local appraiser to accompany or advise me, but this client expects more research than the typical valuer/appraiser is prepared to do, such as background checking, studying listings, and exhaustive verification of the property owner's representations.

Some larger properties may need a larger perspective, too.  Consultant Stephen Roulac, for instance, states:

The local expert may know the local scene, but may lack knowledge of how the local scene fits into the larger context...The local expert may have no real idea whether out-of-town capital would be interested or not interested in that market.  The local expert may be clueless as to whether people residing in other places would want to live in that market, locate a retail store in that market, or put an office in that market. Relying too heavily on the local expert may be a big mistake.”[1]

[1] Stephen Roulac, 255 Real Estate Investing Mistakes, Property Press: San Rafael, CA, 2004, p. 239.

The USPAP Competency Rule is actually a good rule. I do my best to comply with it, and I don’t see the Rule as automatically prohibiting me from getting on an airplane to go value a property, as long as I discuss the matter with my client beforehand, the client trusts me enough to continue with the assignment, and I perform the necessary inquiries and market research to become familiar with the distant market.
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