Monday, October 13, 2014

The Issue of Client Pressure on Valuation Results in International Appraisals

Costa Rican subdivision overlooking the Gulf of Nicoya

It has been almost 3 months now since I’ve done a foreign appraisal assignment, and there are a couple of reasons for this.

1. I’ve had a large increase in business in appraisals of domestic “solar farms” (photovoltaic energy generation) in the U.S. Southwest, and

2. Foreign appraisal assignments have been offered to me with “conditions” that would compromise the ethical code most appraisers follow, conditions which would require me to deceive lenders or the U.S. Internal Revenue Service.

Here are some situations:

1. An owner of a high-end condo on Grand Cayman Island was fishing for an appraiser who could guarantee that his condo was worth $2 million in every year that he has owned it since 2006. But the Caymans have had the same rise and fall as every other Caribbean condo market, and it would not seem reasonable to anyone, including the Internal Revenue Service, that it had been worth the same amount in every year since 2006. The fact that he did an e-mail broadcast of these appraisal conditions to other appraisers could also end up getting him into trouble with the IRS, who provides rewards to whistleblowers.

2. Developers of ocean view residential subdivisions in Brazil and Costa Rica wanted to me to provide current market value opinions on their subdivisions without having me visit their properties. Yes, I was already familiar with their subdivisions, but a determination of current market value requires me to know current market conditions in these respective localities, requiring that I visit and analyze competing subdivisions, too.

“Desktop appraisals” (appraisals done without a property inspection) have limited reliability for overseas properties and are not likely be taken seriously by lenders, either. I also need to see if amenities, such as the guardhouse, pools, recreational areas are operational and that infrastructural development is continuing.

Thursday, August 7, 2014

Shelf corporations in international real estate transactions

Grand Cayman's famous Ugland House, the address of 19,000 corporations

Most readers know what shell companies are. Many offshore locations, such as British Virgin Islands, Cayman Islands, and Cyprus are known for harboring shell companies because of their privacy laws, and shell companies are sometimes used for illicit purposes, tax evasion and money laundering.

But wait! This Wyoming office building houses 60,000 corporations.

A “shelf corporation” is an aged shell company that has a multiyear history of being in business and may also have a credit history and bank account, but no other assets or income. Shelf corporations are created by third party vendors to sell to buyers seeking a misleading history of credit and longevity for their own new enterprises. These shelf corporations are offered for sale on the Internet. Just do a Google search of “shelf corporation for sale” and you will find many shelf corporations that are legally created in the U.S., in states such as Nevada, Wyoming and Delaware, which promise privacy, secrecy, and protection from litigation. Named directors of these corporations are often down-on-their-luck individuals who consented to sell their names just like they would sell their blood to blood banks.

There are legitimate uses for shelf corporations, too, such as the ability to rapidly start up a business in a state that has a lot of red tape for start-ups.

Since most of my work is for lenders, though, I see the seamier side of this business. If the lender has made a loan to a shell or shelf corporation, and the loan defaults, the lender ends up trying to recover their money from a corporation which has no assets, no income and no accounts receivable.

I am sometimes confronted with purchase contracts in which the seller or buyer, or both, are LLCs, shell corporations or shelf corporations, leaving me unable to judge whether the purchase is an arm’s length transaction (a sale to unrelated parties). As an appraiser, however, I can only estimate a value supported by market data, and if the transaction is not arm’s length, it will become obvious. Many other appraisers will try to “hit the purchase price”, any way, with strange selection of or adjustment to comparable sales.

Every state in the U.S. has either a Secretary of State office or Department of Corporations office from which one can obtain names of the principals of LLCs and corporations, and it is helpful in determining whether a purchase transaction is arm’s length (different names on each side of the transaction), unless those entities are located in Nevada, Wyoming or Delaware.

Working in the United Kingdom last year, I was thrilled with the functionality of the UK Companies House web site – one web site for all of the corporations in the UK, so much easier than working in the U.S. It provided addresses, directors’ names, and dates for and changes of company names or directors. It also allowed me to easily establish that the sale contract I was looking at was for the sale of the property from one shelf corporation to another shelf corporation sharing the same directors — in other words, a completely bogus transaction.

The ICIJ, International Consortium of Investigative Journalists, has been documenting known offshore shell companies and their addresses. If in doubt about an address, one can check it out on their web site, They also have a list of the nations having the most offshore shell companies, which is helpful in its own right. For instance, a few weeks ago I was looking at a deal in Mexico in which the developer was a company in Cyprus. Red flag. Cyprus is not known for its real estate developers, just its reputation as a haven for shell companies.

Clues that you’re dealing with a shell or shelf corporation include:

1. No web site.
2. The principals of the organization have only hotmail, gmail or yahoo e-mail addresses.
3. The web site is “Under construction”. Sometimes there is verbiage about “amazing things to happen”.
4. No present location for company staff.

For example, in a situation I encountered in 2012, in which a piece of raw desert land was being purchased for $1.6 million above the price it had been listed at for two years, the buyer claimed to be looking for a location to build a 100,000 square foot corporate headquarters building for an unknown high-tech company. They had a web site under construction with the words:

“Company is in stealth mode while we develop the team, the infrastructure and the technology. Details to follow in Fall 2011.”

The corporation had no current location. A search of LinkedIn showed about 4 employees scattered all over the country, hardly enough for a 100,000 square foot building. No plans, specifications or blueprints were presented for the building, only artists’ renderings.

When he was unable to show established business operations, the CEO then talked about “secret government contracts”. Suspecting that my client had not performed due diligence on this loan applicant, I ordered a simple $25 on-line background check on the CEO and found:

1. Two criminal convictions, one for check fraud
2. Two bankruptcies
3. Two legal judgments against him
4. No background in high technology, but a bachelor’s degree in political science.

I could go on and on, but I quickly came to the conclusion that his company did not exist and his lack of recent accomplishments suggested that he may have been the kind of person typically recruited as a “straw buyer” in a fake purchase scam. If you participate in certain LinkedIn real estate groups, for instance, you may sometimes see offers of up to $50,000 to participate as a front man in a commercial real estate purchase. This is called “nominee fraud” by the FBI.

Wednesday, July 23, 2014

Appraisal in Lima, Peru

An interesting cityscape resulting from upzoning approved in the 1990s. Many of the office buildings erected then have a lack of windows.

This was a one-acre site, improved with an old mansion from decades ago, situated in Lima’s main financial district, San Isidro. Per JLL (Jones Lang LaSalle), the office vacancy rate in San Isidro was measured at the end of 2013 at just 1%, so a site such as this one would have great value to commercial real estate developers.

Many Latin American cities are divided into municipios, or municipalities, which are similar in concept to the boroughs of New York City. During the 1990s, the municipio of San Isidro, a sort distance south of Lima’s central business district, was upzoned to building heights ranging from 4 to 32 stories, and most of the banks relocated to this district, making San Isidro Lima’s de facto financial district, but also home to many embassies, too. This is one of the nicest areas of Lima.

Lima and Peru have in recent years undergone rapid economic expansion, averaging 7% per year and predicted to be 6% this year, and the supply of office and residential space has been unable to keep up with rapidly increasing demand from redevelopment ventures. This has resulted in urban land values spiraling upward, quadrupling since 2006.

In places like Manhattan, New York, such land is often appraised on a “value per square foot of allowable building area”, which is based on land prices divided by site area divided by FAR (Floor Area Ratio). Such a method does not work quite so well here in Lima because many lots are so small that high density construction is not efficient, partially because of required setbacks. There are many lots of less than 400 square meters (4280 square feet) zoned for 7 stories of construction, and perhaps their main value is to serve as part of an assemblage of a larger site, which is being done all over the financial district in San Isidro.

The Lima office of Colliers International, which seems to be the most active global broker in Latin America (based on seeing their signs), was generous in providing comps. However, I found that price per square foot of FAR was not working as a unit of comparison; it was seriously undervaluing many sites with allowable building heights of 7 stories, which are selling for more than $3000 per square meter.

Because of the number of available comps, I performed a regression analysis on the data in order to isolate possible adjustments to comparable sales for both building height and for site area. Because of low sample sizes in commercial real estate markets, such regressions cannot meet the high standards of the scientific community, yet they are better than pulling adjustments out of thin air, the last resort of many appraisers. The regression suggested an adjustment of $170 per square meter of site area for extra floor allowed to be built. The adjustment for site area was more understated, a premium of $60 per square meter for every extra 1000 square meters of site area.

This assignment reminded me of a similar assignment in San Jose, Costa Rica last summer. The shortage of land within the central cities of prospering Latin American cities is resulting in a profound amount of redevelopment, and it must be an exciting time to be a real estate developer in many Latin American cities.

Saturday, July 5, 2014

Common Denominators Seen in Mexican Land Scams

After six years of appraising in Mexico I’ve seen the following patterns that warn me when I am being deceived.

1. My favorite one is when the loan applicant’s representatives take me to a prime location and then point to their property in the distance. “There it is,” they tell me. I tell them that my client requires me to set foot on the property, which is not really true (setting foot on the property is my requirement), but wouldn’t I look foolish and my client be harmed if I didn’t know find out that the land is a mangrove swamp? Sometimes it’s hard to tell from above, as can be seen in the following photos from Isla Mujeres:

2. Another pattern is when excuses are made as to why I cannot meet the property’s true owner. A common response is “We have power of attorney; it doesn’t matter,” but the document supposedly conveying the power of attorney is not convincing, either that is excessively old, it conveys power to yet another individual who is not present, or it does not actually convey power of attorney and the loan applicants are just hoping that I can’t read Spanish. Some feel compelled to provide a photocopy of the owner’s driver’s license or passport, hardly a standard of proof.

3. The borrower’s representatives all have business cards labeling them as marketing or public relations consultants, yet they claim to be real estate developers. “Show me your development plan” is a good question to flush out fake real estate developers.

4. When I request a current predial (property tax bill) for the property, deceivers instead supply a predial from years before. Years 2008 and 1993 are favorite years. Year 2008 is the year before Mexican tourist land values started crashing. Year 1993 was the year that the peso was devalued by 1000:1, so every assessed value appears 1000 times larger than it actually was. The inability to obtain a current predial might also indicate that the borrowers do not actually currently represent the true land owner.

On a related note, Citibank announced in February fraud-related losses in Mexico of $400 million in their Banamex subsidiary and has also experienced hundreds of millions of dollars in losses in previous years in ill-fated Mexican residential subdivisions.  In 2011, I pitched my own Latin American appraisal services to their chief appraiser for Latin America, who is actually a gringo in Atlanta. I was then told that I cannot serve Citibank because I am "not a national firm", even though the first three years of my career were spent at international firm Jones Lang Wootton, now JLL.

Next year, a client hired me to appraise a proposed residential subdivision outside Mexico City and also hired the local Cushman and Wakefield Valuation and Advisory Services office in Mexico City.  C&W came up with an appraised value 15 times as high as mine and the client got us on a 3-way conference call to resolve this discrepancy. The C&W appraiser was a young girl right out of college.  I noted that her report had incorrect zoning for the site.  She said that she did that because the broker told her to, but there was no documentation that a change in zoning was occurring and the neighboring subdivision had only been able to sell less than 20 lots. My client told her "Don't assume anything".

Perhaps Citibank's insistence on using "national firms" is what has caused them so many losses in Mexico? Perhaps this also explains why Cushman is facing over $10 billion in appraisal malpractice claims.


Sunday, June 29, 2014

Appraisal of a proposed resort project near the Canadian Rockies

Curiously dead ground vegetation for a proposed vacation resort

These were 130 acres in a town west of the Canadian Rockies popular with snowmobile enthusiasts. Local leaders want to make their town the “Next Canmore”, an expensive vacation community about one hour's driving distance west of Calgary and the first town east of Banff, Alberta's most famous ski destination. This town, though, was 300 miles west of Edmonton.

The local authorities, eager for economic development, had granted entitlements to a developer to build 183 condos and 70,000 square feet of commercial space. To impress how much political support she had for this project, she invited the mayor to have lunch with us. I ordered a “moose burger”, but I was also informed by the two that the restaurant didn’t really serve moose meat.

No feasibility study had been done, but I was told that there was a waiting list of 250 for the condos, and substantial "verbal interest" for the commercial space (meaning no leases or letters of intent). It turned out that the waiting list for the condos was just as real as the mooseburgers. It was just a collection of names and addresses of people who had responded to ads in snowmobile magazines, and there had been no discussion of prices, nor had there been any contracts signed.

The condos were priced quite steeply, from $430 to $455 psf Canadian, with prices ranging from $350,000 to $680,000, in one high density building. The town itself, though, had 21st century homes on their own lots for sale for less than $270,000. Per Landcor, the data service I use in BC, the highest priced home sale in the last year had been at a price of just $225,000, a new log home of 1068 square feet on a conventional-sized city lot.

124 of the 130 acres were a former rail yard previously used by the Canadian National Railway. Railyards are often heavily contaminated through years of washing out tank cars. Rail ties, too, were treated with arsenic to resist rot before being set in place. The photo demonstrates a mostly grey area of dead ground cover, punctuated by young pine trees, a tell-tale sign of contamination.

The properties had been acquired at the peak of the market in 2007, and in my previous valuation assignment in BC, I noticed that the sale of vacation properties began to considerably diminish after 2007. Yet, in this situation, the developer had appraisals done by Canadian appraisers estimating land value several times as high as the acquisition price in 2007. It gives me the impression that the Canadian appraiser profession is less effectively regulated and policed than in the U.S.

Tuesday, June 17, 2014

Another appraisal assignment in Nayarit, Mexico raises red flags of possible fraud

This was the appraisal of nearly 1000 hectares (over 2000 acres) of beachfront land, my third appraisal in Nayarit. There were many red flags to cause me to be suspicious:

1. The borrowing entity was a company in Cyprus, a country known as a hotbed of offshore shell companies (2267 identified so far by ICIJ). Shell companies are notorious for straw officers and directors and untraceability. Think of Cyprus as another Cayman Islands.

2. The borrowing entity had no history and no web site.

3. The borrowing entity did not own the land but had a JVA (joint venture agreement) with the landowner, a Mexican national.

4. The principal of the Cypriot company consistently misspelled his own name throughout the JVA.

5. All the bank account information of the Cypriot company had the company name misspelled.

6. As with Mexican land scams I’ve uncovered, the borrower’s representatives extolled the development possibilities for the land, but their credentials were not as real estate developers, but as marketing or public relations consultants.

7. No credible development plan was presented, but I was told that there was an agreement with the “Canadian Retirement Association” to build thousands of vacation homes for Canadian retirees. I have been unsuccessful in verifying the existence of the Canadian Retirement Association.

8. The Toronto phone number I was given for the Canadian Retirement Association connected me to a man who seemed to be more fluent in Spanish than in English and who bragged about his 75 “advertising awards”. This is not the talk of someone who would be trusted to manage a Canadian pension fund.

9. Similar to the Mexican land scams I’ve seen, I never got to meet the actual property owner, but I was given a document that assigned the right to mortgage his land to one of the borrower’s representatives. As I learned today at the ACFE Fraud Conference in San Antonio, identity fraud is a growing problem in Mexico as it is here in the USA, so I have to be careful.

10. As with Mexican land scams I’ve seen, my request for a current predial (property tax bill) instead yielded a predial from 2008, raising the possibility that the property has diminished in value since then or even the possibility that there was no affiliation with present owner such that a current predial could be provided.

Having been collecting listing data on this part of Nayarit for the last two and a half years, I noticed that asking prices on beach land in this area have declined up to 60%. Regardless of the suspicions I had about the loan request, the appraised value fell short of what was needed, any way.

Land loans are an ideal conduit for fraud in Mexico, by the way, because the value is so hard to determine, accurate information is so hard to come by, and it is easy to hire a Mexican appraiser to appraise the land for $100 million.


Tuesday, May 13, 2014

Another appraisal in the Bakken area of North Dakota/Canada

Bakken is a subsurface shale formation underneath North Dakota, Montana, South Dakota, Saskatchewan and Manitoba and has become the biggest oil find in North America in the last 40 years (not since Alaska). North Dakota has the most favorable location over the Bakken foundation and has undergone boomtown economic conditions similar to the Alberta Oil Sands near Fort McMurray, Alberta.

In my latest appraisal assignment, I appraised a massive RV (Recreational Vehicle) Park which provides temporary housing for hundreds of new workers in the oil and oil service industries as well as a motel with fully occupied RV spaces behind it.

Being a boomtown economy, there is an extreme shortage of housing for incoming workers. This is a real worry for oil firms and oil service firms desperately in need of manpower; in the last measurement of unemployment in Williams County, home to the largest Bakken-area city of Williston, the last measured unemployment rate was 0.9%, and other Bakken-area counties were at around 1.5%.

RV Parks have been the quickest solution in providing new housing, and the 765 space RV Park I appraised was actually in the business of wholesaling its spaces to housing contractors who then erected temporary housing, either in the form of manufactured housing (as seen in left of above photo) or else recreational vehicles themselves (as seen on right of above photo).

In this case of such an enormous RV park, the gross income multiplier seemed to be the most reliable method of valuing, as the collected rent per pad was much lower than for much smaller RV parks in which the landlord needed no intermediaries to lease RV pads.  Using “price per pad” established by much smaller parks would have overvalued the subject park.

The motel averaged occupancy of about 90% last year, while for the first third of this year it has been close to 100% and is budgeted to average 93.5% for the year.  Despite the high occupancy, room revenue multipliers in this region were not found to be higher than motels in other states; only the incomes were high.

Numerous motels are also being erected and designed to be extended stay lodging.  At the new Telluride Lodge where I was staying, which advertises itself as "executive housing" to distinguish itself from the other more blue collar housing choices available, I checked in to find no soap or shampoo in the bathroom.  In my trip to the front office to explain these missing items, the incredulous front desk clerk offered me a bottle of dishwashing liquid instead.
"Executive housing" offered at Telluride Lodge south of Watford City

Room revenue multipliers at motels listed for sale started at a remarkably low 2 x revenues.

What accounts for the pessimism of investors?  Perhaps the most obvious reason is the slowdown in employment growth, which was close to 50% per year prior to 2012 but only 6.5% in the last year, which is still good, but is temporary housing and lodging being built too fast to cope with a coming slowdown?

The most labor intensive phase of an oil boom is the exploratory phase.  Extraction requires less personnel and is also a declining number.  Based on these realities the North Dakota state government's Oil and Gas Division and North Dakota State University are both predicting that Bakken-area employment will begin to decline starting in 2020. Maybe this why so many investors want their returns upfront in the form of current returns.  As the need for exploration personnel lessens, too, will the need for temporary housing lessen.

Friday, April 4, 2014

Another Appraisal at Playa Novillero, Mexico

This assignment called for the appraisal of 91 hectares of beachfront land at Playa Novillero very near some land I previously appraised in 2012. Playa Novillero is Mexico's longest beach at 82 kilometers, but is isolated and lacking in visitors. Despite being zoned for tourist development, land uses at the beach reveal abandonment rather than new development.

The beach is ideal for families, having about 50 meters of sand extending inland and shallow depths for a long distance out, but the beach is busy only week per year during a Mexican holiday week.

There are no close international airports. Last time I was here it took 2 hours to get here from the Mazatlan airport, and this time it took me 4 hours to travel from Guadalajara. Decent roads end at the town of Tecuala, which is 22 km inland from the beach, and arriving at the small village (population 249) at the south end of the beach, one has to drive up the beach to access the beach properties. This time our GMC got stuck in the sand and I had to get down on my chest several times to clear the soft sand from around the tires.

Most of the beach homes are abandoned.

As in the last Mexican appraisal assignment, the loan applicants were pledging as collateral a property that they did not own yet, although they did possess a 4-year-old purchase contract and a document conveying "Special Irrevocable Power" for 5 years, with less than a year from the end of the contract. They said they were taking their time executing the purchase contract, but there was no plan to close on the purchase at the time of loan funding, leaving the lender with the prospect of having no collateral for the loan.

Just as in the other beach property assignments, the most consistent indicator of value in this case was the price per lineal meter of beach front.

Sunday, February 16, 2014

An Appraisal in Nigeria, Land of Inconvenient Factoids

Ikoyi neighborhood in Lagos

A factoid is defined by Wikipedia as “a questionable or spurious (unverified, false, or fabricated) statement presented as a fact, but without supporting evidence.” A good appraiser learns how to distinguish between facts and factoids. A bad appraiser does not care.  In my latest assignment in Nigeria, I found the nation to be as rich in factoids as it is in oil.

I was initially given 2 weeks’ time to submit a valuation report on an 11-unit luxury apartment building in the prestigious Ikoyi neighborhood of Lagos, Nigeria’s largest city. In contacting the borrower, I stipulated that tenants had to be notified in advance that I would be entering their apartments during my property inspection. The borrower then informed me that this could not be done, because Nigerian Law required that an attorney be hired to provide 21 days’ advance notice to each tenant. Was this law real, or just a factoid? These apartments were labeled as “corporate serviced apartments”, which suggested to me that they received regular maid service of some kind, and how often do maids need a legal writ to clean a room?

The importance of seeing inside the apartments was mainly to verify occupancy, as the subject neighborhood of Ikoyi in Lagos has become seriously oversupplied with new, luxury 3 bedroom 3 bathroom apartments.

Several years ago, prior to the Global Financial Crisis, Ikoyi was known as the most expensive neighborhood on the African continent. Flats were selling for more than a million dollars and renting for $5000 to $7000 per month. The last canvassing of vacant apartments in Ikoyi in late 2012, however, indicated a vacancy rate of 42%.

The subject property was represented as fully leased at individual unit rents of $58,000 to $60,000 per year, or about $5000 per month. Was this real or just a factoid?

Arrival at Lagos Airport

The Nigerian embassy in Washington had provided my visa and told me that no immunization certificates were needed for entry into Nigeria when traveling from USA or northern Europe. When I was exiting customs at Lagos Airport, however, a customs agent asked for my proof of Yellow Fever immunization (which I had left at home). I told her what the embassy had told me, but she told me that all persons entering the country had to show the card. Was this the truth or just a factoid?

Without my Yellow Fever card, she said that I would be sent back home [having wasted more than $10,000 on a plane ticket]….unless….I could pay a fine. “How much is the fine?” I asked. “How much can you pay me?” she responded. “$50,” I said. She said “No, $100.” When I tried to hand her the $100, though, she cautioned me to not display the money, instead instructing me to go to the men’s room and then place the $100 in my passport, which she took out of my folded passport as I exited Customs. As this was the first of other attempted extortions to come, I learned one useful thing – Nigerian civil servants do not like to be witnessed taking bribes.

Back home from Nigeria, I read the current issue of The Economist, which had an article entitled "Big Country, Thin Skin", stating that Nigerian "corruption is so endemic that many visitors pay their first bribe before they have even left the airport."

Research in Ikoyi

Since the crisis, demand for luxury apartments has weakened, and some major oil companies such as Shell, Exxon and Schlumberger have constructed their own employee housing. Meanwhile, construction of new luxury 3 bedroom apartments continues unabated.

In driving through Ikoyi at 9 pm, it was eerie to see so many dark, empty residential towers. I wanted to see the subject property at night (one way to estimate occupancy), but the borrower told me that he had no permission to enter the subject’s gated Parkview Estate community during the night.

He couldn’t get permission to visit his company’s property? Either this was another factoid or neither he nor his company really owned the building. Neither he nor his company was named on the Certificate of Occupancy, the Nigerian version of title.

The inspection

I was actually shown only one apartment the following day, and the functionality of the building was not impressive, with long narrow apartments, no elevators, minimal fenestration, and no power on during my inspection, despite the presence of two back-up generators.
Center hallway inside unit
Typical bedroom
In the U.S., when an appraiser inspects a building represented as fully occupied and finds the power turned off, this is an instant red flag, but there are many power blackouts per day in Lagos, which has one of the world's least reliable electrical infrastructures. That is why many buildings there have back-up electrical generators, and the subject property had two of them to guarantee 24 hours-a-day electrical service.

Most new apartments in the U.S. have separate electrical meters for each apartment, so I asked to see the meters just in case only one meter was turned off. There was only one meter for this whole property, though, and I noticed that common area electricity was turned off, too. For the period of time I was at the property, about 45 minutes, the power was off the whole time, which would be a situation unacceptable to real occupants as food perishes in dark refrigerators and freezers, and fussy executives don’t want to come home to walk up three flights of stairs in the tropical heat to a warm apartment.

There were no signs of other tenants during my 11 am weekday inspection, although there is the possibility that all tenants would be at work. Nevertheless, there were no personal effects or plants in windows or on balconies to indicate that anyone lived there. The two cars in the parking lot belonged to staff only.

On that basis I had to conclude that the property was vacant. I don’t give loan applicants “benefit of the doubt” in face of evidence to the contrary. Moreover, an examination of documents further made their claims of rent and occupancy to be absurd.

The documents

Despite repeatedly requesting operating statements for 2012 and 2013 prepared by a property manager or accountant, I instead received an Excel spreadsheet for 2013 indicating that 12 units out of 11 had been occupied at rents of $58,000 to $60,000 per unit per year (representing 109% occupancy) at rents well above asking rents in the neighborhood, with relatively few expense items listed, all in very round numbers (not typical of an accountant’s report or professional management report), and not including usual line items such as building insurance, water, sewer or property management. The report appeared to have been hastily prepared and not consistent with standard worldwide real estate accounting procedures.

I did find 10 of the subject property’s apartments listed as available for rent on the Internet for the dollar equivalent of $36,810 per year each, or about 40% less than what the borrower had represented as being rented for at the time, which was November 2012.

On that basis I dismissed the operating statement and rent roll as factoids and not facts.

Leaving Lagos

The passenger screeners were greedy. I normally travel with both a laptop and an I-Pad, but did not take the I-Pad out of my luggage. The first passenger screener informed me that failing to take out the I-Pad was a violation and I would need to pay a fine. I asked “How much?” and she said “Just drop it into the luggage tray” without specifying an amount. I took out Nigerian currency from my wallet and hurriedly dropped a 100 naira note into the luggage tray, failing to compute that my bribe amounted to the equivalent of only 60 U.S. cents. She just looked at it, irritated, and said “Take it back”.

I stuffed my remaining Nigerian currency into my right pocket and was then greeted by a personal screener (frisker). He detected the wad of cash in my pocket and asked to see it. He then asked how much I could give him, and I just responded with a loud “How much do you want?” That seemed to embarrass him and he hurriedly let me pass.

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