Thursday, January 30, 2014

Discounted Cash Flow Analysis throughout the world – Who does it right and who does it wrong?

I entered the appraisal profession at an opportune time – in the mid-1980s, when discounted cash flow (DCF) analysis had come into vogue in the real estate industry.  The crowning moment for DCF’s new place in real estate investment analysis became apparent in the purchase of the Pan Am building (now the Met Life building) in New York in early 1981.  The price paid shocked many, as it reflected a “going-in” capitalization rate of just 4% for an 18-year-old building in a time of high inflation. 

Manhattan was just awakening, though, from a 1970s stagflation-induced real estate coma of no new construction, and the rapid expansion of the financial industry brought the Manhattan office market to full occupancy, with rents increasing 50% from early 1979 to the end of 1980.  The buyers of the Pan Am Building relied on a DCF model based on cash flow projections for years into the future, anticipating the ability to re-lease space at much higher rental rates.  In this context, the purchase price was justified.

I was recruited out of graduate school by Jones Lang Wootton, where I was promptly put to work creating DCF models for regional malls and high-rise office buildings owned by their institutional clients.  My work wasn’t questioned because my superiors had never been taught DCF analysis and did not understand how it worked.  Many of my business school peers also landed into cozy positions not previously available to new graduates, all because they could perform DCF analyses.

In hindsight, all of the DCF models of the 1980s were toxic, rosy fantasies which failed to consider the possibilities of overbuilding and recession.  Hundreds of billions of dollars were lost based on DCF models – and will continue to be lost, as I am about to explain.

Between 1988 and 1998 I worked as a bank review appraiser and chief appraiser and reviewed a lot of commercial real estate appraisal reports, noticing that when appraisers used both a DCF model and a direct capitalization method in their reports, the DCF model usually produced higher estimates of value.  One reason why was because they projected income growth equal to or exceeding expense growth, contrary to the documented operating histories of most income properties.

In examining the long-term operating histories of income properties, expenses increase faster than revenues over the life of the building. This is why expense ratios are higher for older buildings, as is graphically demonstrated by a typical subset of BOMA data in Figure 1, and is equally supported by IREM data.  Notice how the line representing the operating expense ratio for each age subcategory increases in slope relative to gross income.  The numerator, Expenses, is increasing faster than the denominator, Gross Income.  This is a graphical proof of expenses increasing faster than income for income properties.


                                                           FIGURE 1

Data from BOMA (Building Owners and Managers Association)

There is a logical reason for this. As a building ages, it becomes less competitive in its marketplace and the rate of rental increase slows, while the aging of the property requires increasing maintenance and capital improvements expenditures. This is the reality of physical and functional obsolescence.

The natural end of the economic life of a building is when expenses finally exceed collectible income. If expenses typically grew no faster than income, on the other hand, no building would become obsolete. That would be nice for building owners, but the real world does not operate in this manner.

DCF models which forecast expense growth to be the same rate as consumer price inflation are therefore fundamentally wrong.

Since it is so hard for some appraisers and valuers and even the Appraisal Institute to accept this, let me present an analogy – your car.

What are your likely operating expenses for your car in its first year of operation? Perhaps $100 to $200 for oil changes. With consumer price inflation currently at about 2%, would you predict the car to cost you $102 to $204 in its second year of operation? $104.04 to $208.08 in the third year? What about the 10th year? Would you expect operating expenses in the range of only $119.51 to $232.02? No, because the car is a deteriorating asset, and many parts will need replacement.

A building is a deteriorating asset, too. There are two forces governing expense growth – price inflation and increasing maintenance and capital improvement needs. This places the rate of expense growth higher than price inflation alone.

The above graph, indicating the typical pattern of expenses increasing faster than income for income properties, was originally part of my book (see sidebar) for the Appraisal Institute, but was not allowed by the editors, as the Appraisal Institute maintains that income and expenses increase at the same rate. This is also reflected in the 13th Edition of The Appraisal of Real Estate, published by the Appraisal Institute in 2008, in which DCF models indicate decreasing operating expense ratios as buildings age. This is a mysterious retrogression for the Institute, who published my uncensored article on DCF analysis in The Appraisal Journal in 1990. To deny now what I wrote then makes me wonder if they’ve been hijacked by the Flat Earth Society.  It also suggests that a generation of MAIs has been taught to overvalue properties using DCF analysis.

The Appraisal Institute may be a formidable opponent for me to challenge, but fortunately, I have rules of arithmetic on my side.

Why is this matter so important? Most DCF models project 11 years of cash flows, and the underestimation of expense growth gets compounded, resulting in serious overvaluation.

One of my fellow Appraisal Institute authors, Howard Gelbtuch, assembled and edited an enlightening book entitled Real Estate Valuation in Global Markets, in which highly decorated appraisers and valuers from many nations explain how real estate valuation is done in their countries. Once again, most who presented DCF models had final year operating expense ratios lower than beginning expense ratios. Many of the violators were Western nations that are considered financially sophisticated. Other nations getting it wrong were:

Belgium, Canada, Czech Republic, Denmark, France, Germany, Hong Kong, Italy, New Zealand, Poland, Portugal, Saudi Arabia, Spain, Sweden, Taiwan and Turkey.

Which nations got it right? Nations less likely to be considered part of the supposedly sophisticated Western herdthink:

Argentina, Bulgaria, Chile, Indonesia, Japan, Romania, South Korea, and the Turks and Caicos Islands.

Getting beaten by the likes of Argentina and Bulgaria in DCF analysis should shame appraisers and valuers from the most affluent Western nations into "stepping up their game".

Next stop:  Lagos, Nigeria

Tuesday, January 21, 2014


Beijing's Wangfujing Night Market, a popular tourist spot.  One of the closest stalls in the photo sells barbecued scorpions.

In traveling throughout China, I have been constantly surprised to find most hotels to be independently owned and managed and unaffiliated with known franchises. The higher end hotels (such as Peninsula, Swissotel, Raffles, Hyatt) are an exception, as they are particularly suited to serving Western travelers, but at this stage in China’s march towards prosperity, with its burgeoning middle class, the time seems ripe for major hotel companies to consolidate the remainder of the Chinese lodging industry, just as was done during the 1960s and 1970s in American history, when hotel names such as Hilton and Holiday Inn became commonplace.

China has now reached a threshold in which leisure travel is taking off, presenting opportunities for mid-priced and economy hotel chains to gain market share. Meanwhile, the new Chinese leader, Xi Jinping, has spent the last year cracking down on wasteful spending by government workers, such as stays at 5-star hotels, and local governments have enacted similar restrictions, so far as to cause 56 5-star hotels to request that they be re-labeled as 4-star hotels. This should redirect much government and business travel into midscale hotels.

Entrepreneurial forces have already been put to work to consolidate the midscale hotel market, as several Chinese companies have been building midscale hotel chains (in the 2 to 4 star range), achieving economies of scale, brand awareness and customer loyalty. These hotel chains are relatively new; none existed as a franchise before year 2003. The creation of a strong hotel brand adds great value to each such branded hotel because of central reservation systems and guest loyalty rewards programs (although the Internet has slightly eroded this value).

The most noticeable Chinese franchises are 7 Days Inns, a limited service chain similar to Super 8 (which is also common in China), Jinjiang Inns, a state-owned hotel company that covers the higher end of “midscale”, and Hua Zhu Hotels Group, an assemblage of several different brands such as Starway, Hi Inn and Hanting.

Hanting Beijing Wangfujing Hotel, with nightly rates starting at $46

Hua Zhu has particularly attracted attention recently because of its very rapid growth, surpassing Jinjiang Inns before 2010 to become China’s largest hotel chain. Hua Zhu Hotels Group had its IPO on NASDAQ in 2010 (as China Lodging Group) and has expanded its reach from 413 hotels at the time of its IPO to 1425 hotels today, with 152,879 rooms in all. China Lodging Group stock (symbol HTHT) opened on NASDAQ in 2010 at $13.50 per share and is now trading at $26.60 per share. There have been two days this month in which HTHT was listed on Yahoo Finance’s top 5 stocks “gaining on unusual volume”.

Hua Zhu Hotels Group has existed since 2005, and its revenues expanded 60-fold in 6 years, as follows:

Year Revenues (RMB) Earnings (RMB)           # of hotels
2006 54,031,000
2007 235,306.000        -111,623,000
2008 764,249,000        -136,162,000                 167
2009 1,260,191,000        42,545,000                 236
2010 1,738,493,000      215,751,000                 438
2011 2,249,597,000      114,832,000                 639
2012 3,224,527,000      174,887,000               1035
2013* 4,153,000,000*    221,000,000 **           1425
**first 3 quarters

As of the 3rd quarter of 2013, average daily occupancy was 94%, average daily rate was 186 RMB ($30.74) and REVPAR (revenue per available room) was 175 RMB ($28.93). While these numbers are lower than those of 2010, Hua Zhu explains it is because they are shifting towards lower-tier cities in their expansion. Meanwhile, their frequent guest program is reported to have more than 13 million members, constituting 80% of room nights sold.

Because the Hua Zhu brand is now so well established, Hua Zhu can now move from a business model in which most of their hotels were once leased and operated to a business model emphasizing managing and franchising, enabling Hua Zhu to expand its reach with much less capital and operations risk, much like the other most successful hotel franchises. 60% of their hotels are now managed and franchised vs. owned as leasehold.

The recent dip in share price to $26.60 would indicate a price/earnings ratio of 28 for the trailing 12 months, but the first two quarters reported minimal earnings (mainly due to depreciation expense) despite strongly positive cash flows from operations, whereas the last two quarters had respective earnings of 39 cents per share and 50 cents per share, suggesting a much lower PE ratio based on forward earnings. The recent dip in price seems to be caused by a general overreaction to the most recently reported  dip in PMI (from 50.5 to 49.6) in China.  Even the Chinese internet stocks such as QIHU (down 10% after the report) and YY (down 7.4%) are behaving in similar fashion despite being unrelated to the manufacturing sector.

Disclosure: I own this stock.

Shanghai's Xujiahui District and Starway Xujiahui Royal Garden Hotel, with rack rates starting at $76

Monday, January 20, 2014

Commercial Real Estate Values Rising Due to Cap Rate Compression

My previous posts have discussed this situation in Hong Kong and Singapore, but the same phenomenon is at work in the U.S., too.

Many are trumpeting the return of rising commercial real estate values in the U.S., but how much of this rise is organically grown rather than the effect of artificially low interest rates?  By “organically grown” I mean growth based on improving net operating incomes at the properties being measured.
Buying properties just because the market is going up due to cap rate compression would be just as illogical as buying stocks because their price/earnings ratios are going up.  Such an investor would just be paying more for the same amount of income.

Last fall I appraised a portfolio of southern California industrial and retail properties for a divorce, requiring me to estimate market values as of year 2013 and year 2002.  All but one property had increased in value in those 11 years and the average increase was 51%, yet the majority of properties were earning less net operating income (NOI) than 11 years previously.

Examining just those properties that suffered declining net income, the average NOI was 17% below 11 years ago, but the average value was 28% higher than 11 years ago.

What made these declining properties worth more?  The most obvious answer is the compression of capitalization rates in response to artificially low interest rates resulting from the Federal Reserve Bank’s doses of “quantitative easing”.  The range of cap rates in 2002 was 7.5 to 9%.  The range of cap rates in 2013 was 5.5 to 6.1%.  NOI divided by .055 is going to yield a much higher value than NOI divided by .09.

One could argue that today’s low cap rates are a vote of confidence in the future of these properties and a rebounding economy, but how can one be confident about properties that have been declining in economic performance for the past 11 years?    

It requires a leap of faith to value these properties as if their NOIs will start rising again, particularly since these were mostly older properties, built before 1980.  Yet, I’ve seen this happen once before, in the early 1980s, when the lack of commercial real estate construction after 1974 resulted in a serious shortage of commercial space by the end of the 1970s.  Nevertheless, I don’t see a nationwide shortage of commercial space today, only some small pockets which have supply constraints.

The concern I have here is that when the Fed tapers its “quantitative easing”, the consequent rise in interest rates will quickly reverse the gains in commercial real estate value.  In a matter of months we have already seen the US 10-year bond rate rise from 1.6% to 2.82%.  Is this a portent of rising interest rates to come?

For instance, what if cap rates returned to the levels of 2002?  The subset of properties that fell 17% in NOI but rose 28% in value would consequently see a 35% reduction in value from today’s values. 

“Quantitative easing”, of course, is just a euphemism for “money printing”.  My economics courses at the University of Chicago taught that the consequence of rampant money printing was inflation, which is indeed what happened in the 1970s in the U.S.  Inflation can manifest itself in consumer prices, or also, more recently, in asset price inflation, as the extra money now somehow finds its way into the coffers of the upper class, enabling them to bid up equities and art prices to record levels.  It’s getting so hard to buy a decent Picasso for less than $20 million nowadays.

The natural consequence of inflation is an increase in interest rates, as investors want to be compensated for the erosion of purchasing power over time.  Real estate capitalization rates are correlated with interest rates, so one can expect the commercial real estate market to face some major headwinds in the future.

Similar consequences may happen overseas, too, as all of the major central banks, even China, which did it again today, have been printing money to recover from the Global Financial Crisis 5 years ago.

Soundly run nations, such as Switzerland, are also adversely affected by the declining level of confidence in other currencies.  When investors lost confidence in the Euro, for instance, they traded Euros for Swiss Francs, temporarily elevating the value of the Swiss Franc before the Swiss government stepped in to devalue its own currency in order to preserve its export markets.

In my previous travels in Asia, I’ve seen commercial properties sold at ultra-low capitalization rates, in the 2 to 3% range, in places such as Hong Kong, Singapore, and Shanghai.  Residential cap rates are even lower.  With cap rates this low, there is little margin for interest rate increases before the streets become flooded with red ink and real estate values are pushed downwards.

Singapore skyline.  Top photo: Hong Kong Central


Monday, December 23, 2013

An Appraisal in the Bakken area near the U.S.-Canadian border

A “man-camp” erected to house incoming oil workers, 99% of whom are male. At this man-camp, each worker gets an 8’ by 10’ room including a lavatory and window. Beyond the front door is a security guard who frisks residents for alcohol and drugs. Also note the security perimeter fence. If it resembles a prison, it is only to keep oil workers sober enough to safely operate heavy machinery.

The Bakken Formation, an entirely subsurface shale formation underneath North Dakota, Montana, South Dakota, Saskatchewan and Manitoba, has become the biggest oil find in North America in the last half century, and is bringing boomtown conditions to western North Dakota towns and cross-border Canadian towns.

The U.S. Geological Survey estimates up to 503 billion barrels of oil in the U.S. portion of the Bakken formation, of which 7.4 billion barrels are recoverable using today’s horizontal drilling and hydraulic fracturing (“fracking”) technology. This shale also holds an estimated 6.7 trillion cubic feet of natural gas, too. North Dakota oil production alone is now up to 871,000 barrels per day, estimated to exceed 1 million barrels per day in 2014. 25% of the Bakken formation is on the Canadian side of the border, though.

Most of the major oil and oil service companies are scrambling to build space up here, which is why I was evaluating a business park on the North Dakota side of the border and receiving a glimpse into the distortions in real estate markets caused by sudden economic booms. Within the business park alone, for instance, all lot sales had been at full list price, a phenomenon I had not seen in a few years.

Typical industrial park

The first distortion in boomtowns, of course, is the extreme shortage of housing for incoming workers. This is a real worry for oil firms and oil service firms desperately in need of manpower. The most common solution has been the erection of employee “man-camps” such as in the photos above and below. Sometimes, employee housing is installed in available space within industrial buildings, including truck garages.
Each mobile home houses up to 5 men

Newcomers often arrive to find hotel rooms sold out at high rates, such as $250 for a weekday night at the Holiday Inn Express or $197 for the Microtel in Williston, 70 miles south of Canada and one of the worst affected North Dakota towns. Apartments are full and nonworking apartment residents have had to leave the community after seeing their rents quadruple. Some newcomers resort to living in their cars at first. Then comes winter. The morning temperature on the day of my arrival on the last day of fall was minus nine degrees Fahrenheit, and temperatures have been known to go below minus 20 in the winter.

Retailers and restaurants cannot find enough workers when the oil industry pays much better. McDonalds is paying employees up to $17 per hour, but some fast food restaurants, such as Carl's Junior, have now closed their dining areas and serve customers only through drive-through. There is not enough manpower to clean and maintain interiors. The local unemployment rate is 1.8%.

The Manitoban towns of Virden (population 3114 and known as “the oil capital of Manitoba”) and Waskada (population 225) are also experiencing boomtown conditions such as a severe shortage of housing and hotel rooms, with real estate developers turning empty buildings into employee lodging.

Hotel rooms are also in short supply in southeastern Saskatchewan, and the oil town of Estevan, population 13,000, now has housing prices that match those of Calgary, another city made rich by oil, and the local Best Western charges starting rates of $160 for a weekday night. Meanwhile, in the town of Killdeer, ND, where I was working, asking prices on wood-framed mid-century houses start at around $300,000.

PS: The loan on the business park was funded by Kennedy Funding Financial out of Englewood Cliffs, New Jersey.


Tuesday, December 3, 2013

Declining golf course values in Asia parallel U.S. golf industry decline

The recently closed Kajang Hills Golf Club in a southern suburb of Kuala Lumpur

Revenues per golf course in the United States have been declining for more than a decade now, even when the main economy was improving. Revenues have been declining not just since the last recession but since the previous recession which coincided with the NASDAQ crash of 2000.

This is due to the twin problems of static or declining golf course usage and overbuilding of new golf courses by residential subdivision developers recognizing that golf courses increase the values of surrounding residential lots. For the subdivision developer, a golf course is often conceived of as a loss leader to enhance the value of the remaining development.

Private golf courses (“country clubs”) depend upon the sale of high-priced memberships, and these courses are even more adversely affected by current circumstances because:

1. Private clubs have traditionally had higher expense ratios (estimated at 84% in 2003, probably > 100% now) and lower profit margins than semiprivate or public golf courses in order to preserve their prestige and exclusivity, and

2. Private club memberships were sometimes bought by members not just for golfing use, but also because of their perceived investment value. These buyers have now departed from the market, making it difficult for country clubs to increase revenues as current members die off or else fail to pay their dues.

Every golf course I have appraised in the last decade has had negative operating income, as were the comparable golf course sales analyzed, but this property type still gets appraised by other appraisers as if new ownership is all that is needed to turn around an unprofitable golf course and that the industry will suddenly turn back to profitability. They often estimate value by using discounted cash flow models based on projections of improving cash flows and return to profitability. Many golf course appraisal specialists are also beholden to golf course owners and developers and produce inflated estimates of value for them.

The golf course valuation textbook most often referred to by appraisers is Analysis and Valuation of Golf Courses and Country Clubs, by Arthur Gimmy and Buddie Johnson, which was published in 2003. This excellent book offers much useful knowledge on golf course valuations, but was not written for the times we are currently in. At that time, the decline in golf course revenues was thought to be the result of a brief recession and that revenues would once again increase after the recession ended. Instead, revenues continued to decline.

Being an American appraisal textbook, there is ample discussion of the Three Approaches to Value (Cost Approach, Sales Comparison Approach and Income Approach), with most emphasis on the Income Approach, and rightfully so for any investment property. But their presentation of the Income Approach requires direct capitalization or yield capitalization of a positive net operating income, either at present or else in the rosy future, and this steers appraisers towards the use of unrealistic discounted cash flow models in which the 13-year declining trend suddenly reverses course.

Gimmy and Johnson also offer some other useful valuation techniques which are more appropriate to today’s circumstances (positive revenues, negative net operating income), such as the use of “total revenue multipliers”, “golf revenue multipliers” and “greens fee multipliers”, which I use instead when I appraise golf courses which are losing money and showing a pattern of increasing losses. They classify these methods, though, as “sales comparison approach” methods rather than “income approach” methods, while I contend that these methods are the new income approach for golf course valuations in light of the extreme shortage of profitable golf courses. Their classification of these multiplier methods as only allowable in a sales comparison approach only confuses appraisers who are required to perform an income approach in the valuation of a golf course.

These methods are difficult to apply to private clubs, however, in which most of the revenues come in the form of membership fees. Luckily, the private clubs I have appraised so far were already moving towards semiprivate status – allowing non-members to pay daily fees – and this data can be used to impute certain revenue multipliers corresponding to what would be received as a public (non-membership) golf course.

Some of the golf course buyers I have met are inexperienced in golf course management, but think that their success as bankers or lawyers will assure their success in this difficult business. Many golf course purchases seem to be vanity purchases, too, motivated more by social climbing than by economic fundamentals, as it can be a boost to the ego to have the town’s most important people playing golf on your golf course.

Asian golfing industry

I have heretofore considered the decline in golf course values as a phenomenon confined to the USA and the destinations dependent upon American tourists, such as the Caribbean.

In my recent tour of Asia I was surprised to find declines in the golfing industry in Japan, Korea and Malaysia, three countries which had growing golf industries until recent years.


It had been difficult to find collated data on the Malaysian golf and country club industry until the Inland Revenue Board (the Malaysian IRS) started enforcing full taxation last year on the advance fees collected from new members, which are typically 80% of the full membership fees. In the country clubs’ accounting statements, these revenues are prorated over the term of the membership, but IRB wants to tax the revenues at the time of collection, which adversely affects the finances of this industry. So far, it has identified 180 private golf clubs, almost 90% of the golf courses in this country, with about 500,000 golf club members, and has assessed a total tax bill of more than 600 million Malaysian Ringgit (about $200 million) for these clubs, or an average of about $1 million per club.

Prior to this sudden tax bill, a Malaysian blogger had reported that most of the country clubs were already running at a loss and that golf club membership fees had already declined by more than half. Just as in the U.S., buyers of memberships who previously bought in expectations of capital appreciation in the value of their memberships have now departed the market. Deflation in golf club membership fees is a self-fulfilling prophecy, because it encourages potential new members to wait until there are further price reductions. Such private clubs often end up as semi-private -- having to allow in non-members who can pay daily fees for use of the golf course, but this in turn demotes the exclusivity of the club.

South Korea

South Korea is facing a similar situation. The Korea Golf Course Business Association has been monitoring golfing numbers for 30 years now and has reported steadily increasing numbers in rounds played, which were about 18 million last year. They count 248 golf courses, of which 20 have now registered for court receivership.

Noticing the increasing financial strains at private clubs, existing members have been suing the clubs for the return of their initiation fees, which they had also initially considered as appreciating investments. This is no trivial matter. The Korean Herald reports that there has been an average of 100 new lawsuits per month, and the total amount requested in these lawsuits is 7 trillion Korean Won (about $7 billion). Somehow, this number doesn’t seem right, because if it was true, these lawsuits would bankrupt the Korean golf industry.


Japan ranks second worldwide to the U.S. in golf demand, and third in supply (2350 golf courses) but half of Japan’s country clubs have gone bankrupt since the Japanese economic bubble burst around 1990. In Japan’s case, golf demand peaked earlier than in the U.S. and Korea, and as of 2010 (KPMG Benchmark Survey) the number of golfers in Japan had declined by one sixth, from 10.2 million to 8.5 million since 1992, the peak year, but rapid golf course development in the 1990s led to oversupply.

When demand exceeded supply in the 1980s, the Japanese golf industry also evolved towards a private club membership system which collected “deposits” from new members, which were refundable at any time without any adjustment for interest. As the Japanese economic malaise continued for a second decade, many members started requesting deposit refunds, forcing many golf clubs into bankruptcy due to the lack of cash to make refunds.


The private golf club industry have been adversely affected in the U.S. and Asia for the same fundamental reason, that such memberships were previously bought as investments with potential for capital appreciation. Now that such memberships have been depreciating in value, with many clubs facing bankruptcy, golfer-investors who purchase private club memberships as investments have left the market, leaving only those who purchase golf club memberships for nonfinancial reasons, such as playing golf. New golf courses were also developed in expectations of continuing growth in membership, while the number of golfers in these aforementioned countries has either remained flat or has declined, thus leading to oversupply of golf courses in general.

Friday, November 29, 2013

Interview techniques for appraisers and valuers

Each ACFE (Association of Certified Fraud Examiners) Fraud Conference has an optional pre-conference seminar on a subject of special interest by a dynamic and authoritative speaker.  This year’s presentation was on Forensic Interview Techniques for Fraud Examiners and Auditors by Jonathan Davison, director of Forensic Interview Solutions Ltd of New Zealand.  These interview techniques are meant to solve fraud crimes, but part of the job of a diligent real estate appraiser is to prevent fraud, thereby ensuring a more accurate valuation, and these interview techniques can be useful to the appraiser who cares about his clients enough to protect them from fraud.

Jonathan Davison
Mr. Davison travels the world for the ACFE, studies the investigative interviewing methods of various countries and measures their effectiveness on various quantitative scales. He has made investigative interviewing into a science.

Most people’s perceptions of "investigative interviewing" are not based on reality, but on dramatic representations, particularly in American television media.  Davison made a statement to the effect of “Don’t be Starsky and Hutch, be Columbo”, which immediately resonated with me, because in my own book on real estate fraud prevention (see right-hand sidebar), I also lauded fictional LAPD Lieutenant Columbo as having a particularly effective interviewing technique.

Columbo never starts an interview with a suspect by telling him that he is a suspect, and he is humble, deferential, friendly, inquisitive and persistent enough to keep the suspect talking under a false sense of security, revealing valuable clues along the way. He is a modest man who dresses poorly, drives an old car, and is easily underestimated.  It's only at the end of several encounters that Columbo finally does his trademark "Just one more thing…” that takes the suspect by surprise when he provides proof of the suspect’s guilt, with the suspect often having been tricked into proving his or her own culpability. And throughout the whole process, Columbo never shows any disrespect for the suspect.

What does this all mean, though, to real estate appraisers, investors, or lenders, when a crime has not yet been committed?  The answer is fraud prevention.

When starting any valuation assignment or performing a property inspection, I assume that the representatives I interact with are honest, but I remain alert to clues that they may be otherwise.  This often starts with honesty-calibrating questions.  The attorneys I work with advise other lawyers to only ask questions in court that they already know the answers to, and I do this to a limited extent when I start the interview process.

An appraiser should have already done homework on the appraised property prior to his inspection.  One honesty-calibrating question I like to ask is “Who owns the property, when was it acquired, and for what price?” The reason it works so well in the USA, Canada, Australia, the UK and some other British Commonwealth countries is that it is usually public record. If the answer to this first question is a lie or exaggeration, I remain on guard for more lies to come. Like Lieutenant Columbo, pretending to be ignorant of certain facts lays the bait for spotting liars or exaggerators, and it never ceases to amaze me that property owners, brokers, or other stakeholders are willing to believe that appraisers are ignorant. 

Keeping the property owner talking, even if I already know the answers to the questions, often dislodges inconsistencies or details that may have otherwise remained hidden and can open up new lines of questioning.  Inconsistencies are often clues to misrepresentations, as the truth should not vary.  Spotting inconsistencies is the way how Columbo caught killers and is standard investigative interview technique.

For instance, in one loan application I received three almost-identical purchase contracts from stakeholders in a purchase and sale transaction, with the one difference being that the amount of acreage being sold differed significantly but the total purchase price was identical in each contract. Situations like this make me suspect that the purchase transaction is not real.

In a private moment with the seller, I had the following conversation:

Me:  So, where are you going next?

Seller:  What do you mean?

Me:  After the sale closes, what will you do next?  Where will you move to?

Seller:  We’re not going anywhere; we’re going to have a lot of work to do, developing this property.

Me:  Oh.  I thought you were selling the property.

As it turned out, the buyer and seller were partners and old military buddies, and the purchase contracts were sham documents.

In another instance, the owner could not get his story straight about the tenant improvement allowance he would be giving a new tenant, a state legislator. I called the state legislator and found that the landlord had forged her name on a lease and she had no plans on moving offices.

I also stay alert for seemingly innocuous but odd statements, as I try to discern a purpose for any unusual statement. For instance, one Puerto Rican land developer talked of using one particular escrow company for his purchases.  This is often done to steer business to a relative or a friend who owns an escrow company, which is of no particular concern to me, but it is also a common element in mortgage fraud, and a quick Internet search of this developer's name disclosed that he had been convicted of mortgage fraud a year earlier and was fined $1 million. The court should have jailed him so he wouldn't keep on repeating the same tricks.

Sequential ordering of questions

Mr. Davison advises starting interviews with non-threatening questions, and when inconsistencies are identified, ordering the questions from "least impactive to most impactive" to preserve the cordiality of the interview.  As for my own interviews, I save any controversial questions until after I have been driven back to my car, as I often appraise in remote areas.  In the Dominican Republic, I waited until after I had left the country, as the developer claimed to be a personal friend of the president.

The moral of the story is that when an appraiser starts getting unusual statements and different answers to the same question, a lot more questioning and digging is in order. Also see my recent blog post on "Critical Thinking Skills".

Monday, November 25, 2013

ACFE Asia Pacific Fraud Conference and Observed Patterns of International Real Estate Fraud

I have been a member of the Association of Certified Fraud Examiners for 11 years now, and last week I attended their annual Asia Pacific Fraud Conference for the second time. I found it surprising that this year’s conference was held at the Marina Bay Sands casino hotel in Singapore, considering that gambling is a popular form of money laundering in Asia, but perhaps ACFE wanted us to see it firsthand.

I received useful knowledge from this conference, even if it did not directly relate to real estate. To this purpose, I thought I would summarize here the types of fraud and attempted fraud I have been encountering in my own international real estate work.

One of the things I learned early in my career at Jones Lang Wootton was that the dodgiest deals often had to travel the farthest in securing investors or financiers, so one must consider that international real estate transactions already present an elevated risk for fraud. Here are the types of fraud or misrepresentations I have personally witnessed:

Common scams:

1. Puffery regarding the quality of the distant real estate assets. “Resort land” is often no more than a sugar plantation or a mangrove swamp with or without development approvals. What is represented as “next door” to a prime area is often more distant than represented. Leaseholds about to expire have no value without documented proof of renewal in place. “Rental yields” often fail to stand up to scrutiny. “Substantially sold out projects” sometimes hang by a thread in the form of a minimal 5% deposit from would-be buyers (which buyers are willing to forfeit if the value of their lot declines by more than that). In this line of work, I am sometimes placed in the uncomfortable position of asking myself “they made me fly thousands of miles to see this?”

2. Bait and switch. One property is advertised or being pledged as collateral for a loan, but documents submitted to me are for another property. One particular ploy to watch for in Latin America is when documents refer to “Lote S/N”, which is an abbreviation for “Lote Sin Numero”, or “Lot without a number”. It may not be the same property, and professionals will need to be consulted to establish its proper identity.

3. No valid purchase contract. A foreign loan applicant must submit a valid, executed contract to purchase a property he does not yet own in order to receive purchase money financing. The purchase contracts I often receive are often submitted as a draft document in MSWord, with many blank fields, without proper signatories, and sometimes the seller is not the same party as the present property owner. These flaws do not allow me to consider the purchase contract to be valid, and they only arouse suspicion instead. Think about it -- how did you close on the purchase of your first home without a binding purchase and sale agreement? Yet these foreign buyers will tell me of impending purchase closing deadlines without even having ratified agreements in place.

There are two different scenarios in which I’ve seen this done:

a. There is another real purchase contract for a lesser amount of money, or

b. There is no proof that the legitimate owner of the property consented to sell the property or even knows about the phony purchase contract. This latter scam seems to be increasing.

4. Misrepresentation of ownership (similar scam to 3b). Foreign loan applicants sometimes attempt to pledge other people’s properties as collateral for a loan. One common ploy is when they present excuses as to why I cannot contact the rightful owner, such as “he is a high government official who is hiding his assets”. These scams quickly fall apart when the borrower cannot produce documents that an owner would be expected to have, such as a property tax bill or the actual development plan that has been officially approved. Government officials’ secrets are safe with me, any way; my job is to perform due diligence on a particular piece of real estate, not judge the integrity of government officials or violate principles of confidentiality. My job is completely apolitical.

5. Compromising the property inspection. Yes, I like to ride helicopters, but the proffered helicopter ride is often done to prevent me from discovering true ground conditions. Mangrove swamps can appear to be solid ground from the air, for instance, and rugged terrain can sometimes resemble terrain than it is flatter than it really is. In Fiji, I rented a hotel room a quarter mile’s walk up the beach from the subject property so that I could walk to the property that I was only allowed to see from a helicopter. It turned out to be a mangrove swamp. Likewise, after insisting in Belize that I be taken to the property’s edge, only then did I find out that the property could not even be reached by 4-wheel drive vehicle. I would have had to rent a tractor.

6. Tricking the appraiser by showing him or her the wrong property. I have seen MAIs from famous international real estate firms fall for this trick, which should not happen to any appraiser or valuer who has the ability to identify a property on a map or the ability to read a legal description. When will this skill be taught in real estate valuation courses?

7. Attempting to influence the lender or appraiser with biased feasibility or valuation reports from “experts”. Despite what is sometimes a long list of credentials of the expert, the biases are usually evident in the reports themselves, which are often revealed through disclaimers or “extraordinary assumptions”. I hesitate to be convinced by an expert who is being paid to be an advocate for a particular real estate transaction, especially if they are being paid to meet me or travel with me or pretend to be my new best friend.

Even scientific and engineering reports from other countries can be biased. I remember one environmental report that conveniently removed one legally protected mangrove location in between the first and second editions of their report, thereby reducing the number of mangrove locations from 3 to 2. Luckily, I saved a photo of the problematic mangrove location.

I used to be challenged by clients for rejecting reports from famous firms, but the reports from these firms provide all the ammunition I need to discredit them, such as disclosures of pre-existing conflicts of interest, mandatory indemnification agreements in the valuation of questionable projects, and other disclosures indicating a lack of due diligence or verification of borrower-submitted data.

Wednesday, November 13, 2013

Appraisal of Waterfront Lots in Bimini, The Bahamas


Several years ago, the real estate industry perceived a proliferation of “high net worth” individuals (HNWs) seeking second or third homes, and the development industry geared up to build 5-star vacation resorts with expensive villas or lots to prepare for the onslaught of the latest nouveau riche.
Then the Global Financial Crisis happened, creating the dual adverse effects of lessening the ranks and solvency of the nouveau riche and also leaving behind partially completed resorts that had no hopes of being completed according to their original scale because of a steep drop-off in sales.  Buyers became much more hesitant to provide cash down payments when they questioned whether the resort would not be completed or else completed without the promised amenities.
Tourism has been seriously affected by the crisis, too, which has resulted in less eyeballs exposed to these resorts under construction.
This situation has resulted in my traveling to many tourist destinations to appraise failed resorts in places such as Fiji, Mexico, Costa Rica, Puerto Rico, Brazil, and Barbados. 
Normally, when I see sales stop for a year or more, I never see a recovery.  New buyers are scared off, thinking that the resort might never be finished and they would be left holding overpriced raw land in a wilderness lacking services and amenities.
Against this backdrop I was sent to look at a waterfront lot sales program at a struggling resort in Bimini.  There were 41 lots sales initiated in 2012, but only one in 2013, although a previous phase of development produced a deepwater marina and over 350 condos and villas. These lots were typically sold as pairs, creating “sea-to-sea” parcels with a beachfront lot paired with a bayfront lot suitable for a dock. Sales prices were each over $1 million (USD or Bahamian dollars, which are equivalent).

Normally I would perceive the sudden drop-off in sales in 2013 as an indicator of another moribund resort, but these developers were able to find a savvy, deep-pocketed partner to bring back confidence and hope, and that partner was the Genting Group, the successful Malaysian casino and resort operator. For those unfamiliar with the Genting Group, their largest casino operation is their casino on Singapore’s Sentosa Island. Their Sentosa casino and the more visually prominent Marina Sands Casino Hotel are the two casinos that have catapulted Singapore into third place, behind Macau and the United States, in gaming revenues worldwide.  
They already built a casino in this resort and it is now operational.  Gamblers are ferried in from Miami (only 48 nautical miles west), where gambling starts on the boat when entering international waters and can proceed to the Bimini casino, which was built to showcase gorgeous views of the Caribbean rather than to shut out the outside world, as most casinos do.

There are many people who would not care to live near a casino, but the new casino is allowing the addition of more amenities, such as enhanced food and beverage operations, and a 300-room hotel which is currently under construction.  A tourist hotel can be a nuisance, but it can also offer management services for those who own high-end villas on their beach lots and need maintenance, security and domestic services while they are away.  A typical service might include the provision of fresh groceries and flowers in anticipation of the owner’s return.

Predicting the sale of these lots, and at what prices, is still a guessing game, but the shot in the arm by the Genting Group at least gave me hope that the lots could be sold as the number of visitors and amenities increase, and my assignment was to estimate a bulk sale value achievable within one year.  Without the fortunate game change for this resort, I might have had to value the remaining unsold lots as raw land, particularly since there were 106 more unsold lots that were not part of the collateral.

Monday, November 11, 2013

Critical Thinking Skills Needed for Real Estate Appraisers and Valuers

My posts on Scotland and Trinidad in September were critical of "chartered surveyors" who allowed false information to enter the valuation process with exculpatory phrases such as “the developer informs us that…” without verifying such information, even if it seemed preposterous. I did not intend to suggest that chartered surveyors were worse than valuers and appraisers elsewhere.  The same problem exists  throughout the world, including my home country of the USA.

Part of the problem is that “critical thinking” skills are not part of the valuer’s training in any nation where I have interacted with local valuers. 

In the English-speaking world, valuers are trained using “business school” methods.  Instructions in problem-solving start with set, unchallenged assumptions, and the question is not asked, “What if the information and assumptions are wrong?” or "What if the property owner is lying?" There is an intermediate step which is being neglected, the step that consists of verification, exemplified by such questions as "How do we know that the building measures 25,000 square feet?" Did we measure it? Did a government entity measure it?  Did we get the number off the rent roll? (Rentable areas are often inflated by landlords.) Or were we just "informed" by the owner?

Consider, for instance, that the larger the property, the less likely it is that the appraiser will measure it.  In a recent appraisal of a 44-structure industrial campus, the owner represented building area as 256,000 square feet, claiming the measurements to be from the county tax assessor's office. The assessor's measurements were 54% smaller.

In Latin America and some other nations, valuers enter the profession through the field of architecture or engineering, and their more scientific education is even more dependent upon problem-solving that starts with set, unchallenged assumptions. I find many of these architects and engineers overly rely on the Cost Approach and also lack skill in discerning current market conditions (which need to be known in adjusting the Cost Approach for “external obsolescence”, the loss in value due to unfavorable market conditions or external adverse influences).

Imagine if all appraisers and valuers verified the information about the subject property that they relied on.  The world would receive more accurate valuations.  Instead, trainers of valuers indoctrinate their students into providing multiple “Assumptions and Limiting Conditions” that merely serve as disclaimers that complete due diligence was not performed, and then they have the nerve to call this "good appraising"! Remember that "Assumptions and Limiting Conditions" serve to protect appraisers and valuers from liability and not to protect the client.  Take the following example:

In the Scotland post, (, I spoke of a former munitions site appraised as the site of a new, 5-star hotel, with the valuer stating the assumption that no environmental contamination was present (almost never the case with a munitions site), even with abundant metal scrap visibly leaching oxides into the soil, underneath signs warning persons to keep out due to ongoing asbestos removal. 
Making this assumption in the “Assumptions and Limiting Conditions” section of an appraisal is not good appraising; it is aiding and abetting fraud. Sure, a valuer is not professionally trained in measuring environmental contamination, but a valuer does not have to be an environmental expert to state visible evidence in his or her report.

Once I had a debate with another appraiser on an on-line appraisers' forum.  I mentioned that I had one client who insisted that I inspect the roof on every building that I appraised for them.  This other appraiser seemed angered by my remarks and insisted that roof inspections were outside the scope of an appraiser’s duties and it was dangerous to our profession to think otherwise. He even stated that it was even unethical to state my roof observations because it would infer that I was representing myself as a roofing expert. That had been what he was taught.

I remember a situation with a former Honeywell building in Minnesota in which missing or worn-out roof flashings resulted in rain and snow melt leaking down inside the exterior walls and destroying several hundred thousand dollars of computer equipment. Now which appraiser is more likely to get sued – the one who pointed out the obvious hazard, or the one who performed an incomplete property inspection and had the attitude of “That’s not my job”?

The truly concerned appraiser or valuer (who cares about his clients) needs to think about whatever may affect the market value of the property.  This includes being properly informed in matters of construction and design, environmental hazards, flood zones and protected wetlands, demographic analysis, and microeconomic analysis of the equilibrium between supply and demand.  Anything less could make the valuation a meaningless academic exercise and is an abdication of professional responsibility.  It can also hurt the client.

This also answers a question I occasionally get asked, which is why do I get sent overseas to perform valuations where local appraisers are available?  The answer is that I offer my clients extra due diligence that they have learned not to expect from other appraisers or valuers, who instead provide pages and pages of disclaimers and limiting conditions. When others say "That's not my job" I say "I will make it my job."

But let us take "critical thinking" to an even higher level.  Shouldn't we as appraisers and valuers also question valuation techniques that may be incomplete or unsound to begin with? 

The appraisal profession has been deficient in its use of discounted cash flow (DCF) analysis, for instance. Some appraisers and appraisal organizations teach that future expenses will grow no faster than future income, when in reality, a building is a deteriorating asset and expenses will almost always increase faster than the rate of price inflation. So many commercial loans have failed because reliance was placed on an unrealistic DCF analysis.

Appraisers have also been surprisingly resistant to the concept of looking at listings as comparable sales data. If listings are found indicating lower market values than most recent sales, this is the warning indicator to inform appraisers of a declining market. In that case, listings will indicate the new, reduced ceiling of value.

Some appraisers refuse to use comparable sales that are foreclosures or in foreclosure, even if the appraised property is also in foreclosure. Someone has taught them to do this. This can result in overvaluation.

Critical thinking can sometimes fly in the face of professional orthodoxy, which may not always hold up to logic. There is a status quo maintained by professional "Grand Poobahs" whose power is dependent upon a lack of change.  Professional orthodoxy is sometimes not that much different than a religion. Many years ago, religious leaders were asked the question, "What would you do if Science invalidates part of your religion?" (We all know that the Earth is not flat.) The answer that impressed me most was from the Dalai Lama. He said, "Then Buddhism would have to change." Likewise, the appraisal profession will also need to change with the times. 

PS:  For younger or foreign readers, the above illustration is of a television character named "Sergeant Schultz", an incompetent prison guard played by John Banner in the 1960s television sitcom "Hogan's Heroes". His stock phrase was "I know nothing, NOTHING!" even though he sometimes knew that his prisoners were up to no good, but could be persuaded to look away by a piece of chocolate.  

Thursday, November 7, 2013

Appraisal in Abaco, The Bahamas

The appraisal was for refinancing purposes, but the subject property was the largest on a cay with only 110 homes, a substantial number being second homes for wealthy foreigners. This was the former residential estate of a well-known American commercial family dynasty.

Complicating the situation is that 37 of these homes on this cay are currently listed for sale. Just as elsewhere in the Caribbean and Latin America, the supply of vacation homes for sale is currently greater than demand.

Also complicating the valuation was the high value of land as well as the high cost of construction in the Bahamas, which forces an appraiser to segregate each home sale into components of land value and improvement value. On the continental mainland, the abundance of land makes land values cheap, but on a cay which measures about 2 kilometers by 100 meters and is surrounded by the sea, the constrained land supply makes land much more valuable, similar to Manhattan and San Francisco, where natural barriers also constrain the supply of land, making real estate more expensive.

Likewise, labor and materials are usually brought in from other islands and sometimes other countries, such as Haiti, adding to construction costs in the Bahamas.

Rather than using a normal adjustment grid, I performed a multiple regression analysis based on nine sales. From a statistical point of view, the sample size is not good, but still better than the classical adjustment grid method of valuation. The two variables which proved to be statistically significant were land area and finished living area, and I also tested variables for lineal feet of beachfront, number of docks, number of bedrooms, and a dummy variable for presence of a protected harbor (useful during hurricane season).

For this particular cay, for instance, the coefficient for land value was shown to be $745,286 per acre, while the local appraiser had already been using $750,000 per acre in his adjustment grid. The results were remarkably similar.

PS:  A $5,170,000 loan was subsequently made by Kennedy Funding of Englewood Cliffs, New Jersey.