August 9, 2022

Overcoming Low Appraisals in a Market of Rising Costs

With the onset of the COVID-19 pandemic, the world rapidly changed. Lockdowns, travel restrictions, and general unease gripped the public, causing disruptions in every facet of the economy.

Drastic changes in supply and demand, the Suez Canal blockage, the war in Ukraine and a $3 trillion relief package have given rise to the worst inflation in 40 years. The Federal Reserve is fighting inflation with the few tools it has, but will it be enough, and what will be the lasting consequences?

The traditional method to combat inflation is to raise interest rates. However, some believe the rising prices of raw materials is partly due to price gouging and profiteering. Medical practices across the country continue to build and expand their practice facilities, but uncertain and increasing construction costs are wreaking havoc on budgets.

General contractors are unable to lock in guaranteed maximum prices, creating mismatch between appraisal values and final budgets, which leads to challenges for groups looking to finance their building.

Some groups have recently received a nasty surprise when their banker reports a low appraised value compared to actual costs, which can result in additional equity needed.  Here are some tips to keep your project going:

Understanding the Scope  

It can be helpful to know the types of values which an appraiser could be told to use by the bank as it could drastically impact the concluded value on which the bank will lend. There are three basic values:

  1. The “fee-simple” fire sale value (value of the property without a tenant),
  2. The market value (value of the property based on comparable sales in the area, and
  3. The leased value (value based on the cash flows the building will generate).

The first two approaches tend to be conservative, while the third can paint a more representative picture from the borrower’s perspective. The value of the lease should equal the value of the property. 

Be Proactive

Once the bank engages the appraisal firm, it should reach out to you to request detailed information on the property. Have the information ready and in an organized format. This allows the appraiser to understand the current building status and assists with the fact-finding. Another key piece of information is the current lease. This will help the appraiser identify comparable sales (“comps”) and, more importantly, it will denote a value based on cash flows.

The lease becomes more important for new construction deals as it proves that there is a tenant who is willing to lease the property for X years at a rate of $Y/SF. If an official lease has not been executed, a letter of interest (“LOI”) or an income statement proforma would also be helpful. Ideally, the appraiser will conclude a leased-fee value (value based on cash flows of the building) rather than a fee-simple value (value of the property in a fire sale). Your information should also include any comps that have recently been sold or leased that reflect a desirable market value.

React to an Adverse Appraisal Valuation

If you have an appraisal valuation that comes up short of expectations, what do you do? First, don’t panic; then seek to understand. You will have a few options as follows:

  • Challenge the Concluded Value

Banking is a highly regulated industry and when it comes to appraisals, there is a certain set of guidelines that each bank follows (FIRREA). The bank’s size will dictate their “flexibility” (larger banks are more heavily regulated and monitored than smaller banks), and almost all banks will say they have an external department that deals exclusively with appraisals. Your relationship manager may only garner so much influence when dealing with appraisal inquiries. Therefore, when appealing an appraisal valuation, you will likely only get one shot. To help form a strong argument for an appeal, focus on:

  • Fee Simple versus Leased Fee –

This relates to the first point about understanding the scope. Most commercial real estate properties “should” be evaluated on a leased-fee basis (arm’s length transaction between a landlord and tenant documented by a lease). The key here is that the bank will almost always want to look at the property value from a “fire-sale” perspective (e.g., fee-simple valuation). The trick will be convincing the bank or the appraiser to believe the lease would survive in the event of a sale. The base case scenario here is a sale-leaseback. Make sure you include any offers and LOIs you might have recently received.

  • Request the Bank to Challenge –

The bank can also challenge the appraiser from their internal real estate valuation department but keep in mind that this is the same team that provided the appraiser with the set of instructions in the first place. That being said, mistakes do happen, and the bank may agree with you. 

  • Alternative Options

 If you have exhausted your appeal options and still do not receive the value to support your project, there are two choices:

  • Pivot to another lender and get a new appraisal. This has worked for several of our clients.
    • Borrow more from the bank (usually a second lien or stub note). Keep in mind these notes will not amortize as slowly as a primary real estate loan and can adversely impact cash flow and returns.