1. Risk Management Association
Florida Commercial Lending School
2013
Appraisals for Lending Purposes
Focusing On Fundamentals

2. Seminar Coverage
• Using the Appraisal to Evaluate Loan Repayment Risk.
• Getting to Know Your Collateral.
• Looking Behind the Numbers.
• Value Is Definition Dependent.
• Market Analysis & Economic Feasibility.
• Proposed & Partially Complete Development
• Development cost and why it’s important in the lending decision.
• Value to a single purchaser -- the discounting process.
• Cash flow patterns & Capitalization methods.
• Discounted Cash Flow Analysis.
• Common analytical deficiencies.

3. Property & Market Loan
Repayment Risks
Repayment of a commercial real estate loan can be
jeopardized by any property or market condition which
mitigates the property’s ability to produce revenue that is
sufficient to operate the property AND service the debt.
If the property cannot do both, the loan becomes borrower
dependent band rarely do borrowers have funds to operate
the property and service the debt independent of revenue
from the security property.

4. CRE Loan Repayment Sources
• Net rental income from security property
• Net sale income from security property.
• Disposition of security property
• Other borrower resources.

5. Categories of Loan Repayment Risk
• There are three fundamental categories of repayment risk in any real estate loan.
These are borrower risk, property risk and market risk. Lenders must evaluate all
three risk categories to reliability assess a borrower’s ability to repay.
• As a practical matter, many lenders fail to thoroughly evaluate all three categories.
• Most lenders are adept at evaluating a borrower’s financial condition through
analysis of loan applications, credit reports and financial statements, etc. This
information alone however, is insufficient to make a reliable assessment of the
borrower’s ability to repay a real estate loan since it fails to consider the
borrower’s experience and ability to manage a real estate asset and it fails to
consider the risks associated with the security property and its competitive
marketplace.

6. Categories of Loan Repayment Risk
B o r r o w e r R is k
P r o p e r t y R is k
M a r k e t R is k
U n d e r w r it in g L o a n D e c is io n

7. Borrower Risk
Timely loan repayment can be jeopardized by characteristics
related directly to the borrower. These characteristics might
include, but are not limited to, lack of professional
experience, inept administration, lack of commitment to
project completion or ineffective project management.
None of these characteristics are likely to be revealed by the
most comprehensive appraisal report or even analysis of the
borrower’s financial history.

8. Property Risk
• The physical, functional, legal and economic characteristics of a security property need to be
carefully evaluated in order to identify conditions, either existing or potential, which could
jeopardize a borrower’s ability to repay a loan. Examples of property characteristics include,
but are not necessarily limited to:
• Physical characteristics such as shoddy construction, as well as inefficient, aging or
deteriorating building components or mechanical systems can cause a property to
experience excessively high operating costs thereby limiting the funds available to the
borrower to repay a loan. The borrower may be faced with a choice between operating the
property or making loan payments; a no-win dilemma which usually leads to loan default.
• Functional or design characteristics can frustrate a borrower’s ability to lease or sell newly
created space or to keep existing space occupied and producing revenue sufficient to operate
and maintain the security property and repay a loan. Examples may include, unusual floor
plan, building design or other physical or functional characteristics which have limited market
appeal.

9. Functional & Design Characteristics
• Inadequate parking in terms of the number or size of spaces or their proximity to the
building, inadequate or difficult access to the site or building, or inadequate elevators in a
mid or high-rise building are also examples of functional characteristics that can mitigate
revenue production.
• Locational characteristics such as a misplaced improvement or one in a location dominated
by incompatible or undesirable uses or even uses which are detrimental or harmful can
mitigate revenue production.
• Other problematic locational characteristics might include a property in an area subject to
soil problems, environmental hazards or even flood, earthquake, sinkhole or wave action and
wind velocity (waterfront properties). Finally, improvements which aesthetically clash with
the environment and surrounding land use could mitigate revenue production.
• Important Note. Things that potential buyers ignore in a strong market suddenly become
huge issues in a troubled market when the few buyers that exist get extraordinarily sensitive.

10. Zoning, Legal & Environmental
• Zoning, land use, environmental or legal constraints can frustrate a
borrower’s ability to use the property in the intended manner. If a loan
has been made and funds have been advanced, repayment may be in
jeopardy if a project cannot be completed as planned.

11. Market Risk
• A security property will not exist in a vacuum. Rather, it will co-exist and more importantly, it
will compete with other similar properties for tenants or buyers. The lender, as part of its
underwriting and loan decision process, must identify characteristics about the marketplace
which could jeopardize the security property’s ability to attract tenants or buyers and
therefore to produce revenue necessary to operate the property and repay the loan. For
example, excess supply of competitive space will put downward pressure on rents and values
thereby mitigating the ability of the security property to produce revenue.
• If market risk is to be effectively evaluated, it is necessary that both the amount of
competitive space and the time periods during which it will be competitive with the security
property be identified.
• If the security property is an existing project currently competing for buyers or tenants, then
the amount of competitive space may be known or at least knowable. If the security
property is proposed , under construction or subject to a change in use, it is not currently
competing for tenants or buyers but rather will do so in some future market place.

12. Market Risk
• While there may appear to be sufficient current demand for the security property,
the relevant point is the security property is not currently capable of competing
for tenants or buyers. It is therefore necessary to identify the space which is most
likely to be competitive with the security property at the future time when the
security property is complete and ready to compete.
• The supply and demand relationship in the marketplace will directly influence the
ability of the security property, whether it is existing or proposed to produce
revenue and to do so in the time periods necessary to achieve timely repayment
of a loan.

13. Incomplete Use of Appraisal Information
• Incomplete Use of Appraisal Information. Many lenders focus exclusively on the value
estimate contained in an appraisal report. They do so for two fundamental reasons. First,
they use the value estimate as a guide to what the security property might be sold for in the
event foreclosure becomes necessary. This is an unreasonably restrictive – and arguably
naïve -- point of view since it implies the only risk associated with the security property is risk
of foreclosure. It also implies that the property will be worth an amount equal to or greater
than the amount it is worth at the time of the appraisal at some unspecified future time
when and if foreclosure becomes necessary. Additionally, as we saw repeatedly in the recent
recession, foreclosed assets typically sell for less – sometimes much less.
• Second, some lenders rely on the value estimate contained in an appraisal as a guide to the
maximum amount of credit that can be extended over the life of the credit arrangement.
This too is an unreasonably restrictive point of view. While the value of the security property
is clearly relevant and necessary information to be considered in the loan decision process, it
is not the only piece o9f information about the security property that should be considered.

14. Role of the Appraisal
• An appraisal report is the primary source of information about two of three broad
categories of real estate loan repayment risk. As a result, it is imperative that real
estate lenders have a reliable appraisal report containing sufficient current
information to make informed judgments about the security property and its
competitive marketplace.
• The appraisal process and the resulting appraisal report must also be consistent
with the complexity of the property being appraised. This implies that both the
depth of analysis and the information presented in the appraisal report can vary
depending upon the complexity of the property, its competitive marketplace, and
the lender’s perception of risk in the transaction and even the structure of the
proposed credit arrangement.

15. The Role of the Appraisal
• Depth of analysis. Must be consistent with the complexity of
the problem and the anticipated risk. Not policy, nor cost or
delivery time.
• Commercial real estate versus commercial loan secured by
real estate (business loan).
• Is an appraisal necessary?

16. Is An Appraisal Really Necessary
A s k : H o w w ill t h e b a n k b e
r e p a id ?
A n s w e r : R e v e n u e d e r iv e d
f r o m r e n ta l o r s a le o f r e a l
e s t a t e .
If r e p a y m e n t o f t h e c r e d it is in a n y
w a y d e p e n d e n t o n r e v e n u e d e r iv e d
f r o m r e n t a l o r s a le o f r e a l e s t a t e , a n
a p p r a is a l o r e v a lu a tio n is n e c e s s a r y .
A n s w e r : R e p a y m e n t w ill c o m e
f r o m s o u r c e s N O T d e p e n d e n t
o n r e n t a l o r s a le o f th e r e a l
e s ta te c o lla t e r a l.
A n a p p r a is a l is N O T
n e c e s s a r y
A p p r a is a l O p t io n s
C o m p le te
o r
L im ite d
E v a lu a tio n O p tio n
A p p r a is a l R e p o r t
O p t io n s
S e lf C o n t a in e d
S u m m a r y
R e s t r ic t e d

17. Caution: The Appraisal Lending Time Shift.
T IM E L IN E
C A U T IO N : M o s t a p p r a is a ls a r e p r e d ic a t e d u p o n h is to r ic a l e v e n t s to m a k e in f e r e n c e s a b o u t f u t u r e lo a n r e p a y m e n t
P a s t P r e s e n t F u tu r e
S a le s , r e n ta ls , a n d e c o n o m ic in d ic a to r s ( r a te s &
r a tio s ) r e lie d u p o n in m o s t a p p r a is a ls w e r e
e x tr a c te d fr o m h is to r ic a l e v e n ts .
A ll lo a n s a r e r e p a id in th e fu tu r e r e g a r d le s s o f
a s s u m p tio n s th a t m ig h t b e m a d e to th e
c o n tr a r y .
A p p r a is a l
P r e p a r e d

18. What Can You Do?
• Establish policies and procedures to ensure all categories of risk are
effectively and meaningfully evaluated in the loan decision process.
• Identify the real source of repayment of most commercial real estate
loans. In most cases that is the cash flow produced by the security
property.
• Recognize that real estate markets are dynamic. Values change in direct
response to supply and demand relationships. You should therefore
analyze expected supply and demand relationships and not just those
that occurred historically or are occurring at the time the loan decision is
being made.

19. Getting To Know Your Collateral
• Important: It’s more than bricks and mortar.
• Real property
• Personal property
• Intangibles
• The effect of management

20. Getting To Know Your Collateral … continued
• Important: Appraisal must match the
collateral and credit arrangement.
• Multiple phase development.
• Improbable assumptions.
• Sum of the parts versus the whole.

21. Understanding Market Value
• Market value versus value in use.
• Market value definitions vary.
• Professional standards & market value.
• Federal regulation requires a very specific
definition of market value.

22. Regulatory Required Market Value
Definition
"The most probable price which a property should bring in a competitive and open
market under all conditions requisite to a fair sale, the buyer and seller, each acting
prudently, knowledgeably and assuming the price is not affected by undue stimulus.
Implicit in this definition is consummation of a sale as of a specified date and passing of
title from seller to buyer under conditions whereby:
• Buyer and seller are typically motivated;
• Both parties are well informed or well advised and each acting in what he considers
his own best interest;
• A reasonable time is allowed for exposure in the open market;
• Payment is made in terms of cash in U.S. dollars or in terms of financial
arrangements comparable thereto; and,
• The price represents the normal consideration for the property sold unaffected by
special or creative financing or sales concessions granted by anyone associated with
the sale."

23. Potentially Troublesome Value
Definition Components
• What constitutes typical motivation?
• Cash or its equivalent.
• Concessions

24. Economic Feasibility
There is not much need to
know what a proposed project
might hypothetically be worth
if it is not going to work.

25. “The trick is to discern a market
before there is proof one exists”
-- Bill Lear

26. Economic Feasibility
Although economic feasibility has been defined in a number of contexts, fundamentally it is a
simple comparison of expected costs ver-sus the benefits to be derived from those costs.
When the expected benefits are found to be equal to or greater than the cost to produce
them, a project may be judged to be economically feasible. Conversely, if the expected
benefits are less than the cost to produce them, a project may be judged to be non-
economic.
Economic feasibility analysis seeks to answer this question: If this project is constructed, will
it be worth an amount equal to or greater than the cost to create it?
Question: Can you think of any economic reason to
create something that, when finished, will be worth
less than it cost to create?

27. Market Analysis & Marketability
• Supply and demand analysis.
• Relevant market segment in both product type and geography.
• Analysis must be forward looking.
• A major shortcoming of market analysis is that conclusions are too often
predicated upon historical or current data while ignoring the future in which the
subject will actually compete.
• Real estate changes hands in an environment of expectations. Any analysis is
therefore incomplete unless the analyst understands what is being expected by
participants in the market place.

28. Market Analytical Considerations
• The Basics
• If it is built, will people care?
• How much will they pay for it?
• When will they pay for it?
• How long will they pay for it?

29. Demand Considerations
• How much space is currently being absorbed in the
marketplace?
• How fast is it being absorbed?
• At what price is it being absorbed?
• Baseline: How much space has historically been absorbed? At
what rate and at what price?

30. Supply Considerations
• How much space currently exists?
• How much is unleased or unsold?
• How long has it been unleased or unsold?
• How much space is under construction?
• How much space is currently proposed?
• When is it expected to come on line?

31. Supply Considerations
• How much space has governmental approval? How likely is it
to come on line and when will it compete?
• How much space is on the drawing board?
• How much is master planned?
• What space is rumored to be coming on line?

32. Reconciling Supply and Demand
• Are any apparent differences explainable?
• In what time periods will competitive space be coming on line
and how does that compare with the subject’s completion?
• Have turning points been identified?
• Has net absorption been considered?

33. Why Market Analyses Are
Sometimes Unreliable
• Over reliance on history.
• Failure to identify and isolate relevant market segment.
• Failure to recognize alternative outcomes.
• Over reliance on mechanical extrapolation.
• Failure to connect multiple events.
• Blindness to external non-real estate influences.

34. “I skate where the puck is
going to be, not where it
has been.”
-- Wayne Gretzky

35. Highest and Best Use
• The ultimate objective of property and market analysis is a conclusion of the highest and best
use of the property.
• Highest and best use has been defined in a variety of ways (all similar), however the thrust of
the highest and best use concept is that reasonable and probable use that will support the
highest value, as defined, as of the effective date of the appraisal.
• Both the vacant site and the improved property have a highest and best use at any given
time. The best use of the site may or may not be identical to the best use of the improved
property.
• Highest and best use must also be consistent with the value definition.
• Highest and best use must be reasonable and probable. That is, it is likely to occur soon if
not immediately. Highest and best use is therefore not speculative.

36. Highest and Best Use
• All too frequently, highest and best use is treated as if it were an assumption, rather than a
conclusion derived from a specific analytic process. When it is treated in this fashion the
highest and best use section of an appraisal becomes boilerplate which is not seen as having
any relationship to the valuation process.
• The Highest and best use estimate is critical part of every appraisal because it sets the stage
for the entire valuation process. Once the best use estimate has been made it will not only
govern the type of data to be selected but also the valuation technique which will be used to
process the market data.

37. Proposed and Partially Complete
Development
P R O J E C T D E V E L O P M E N T & C O N S T R U C T IO N T IM E L IN E
S ite
A c q u is itio n
Z o n in g
A p p ro v a ls
P la n s
P e rm its
M o rtg a g e
a n d
E q u ity
F in a n c in g
S ta b iliz e d
O c c u p a n c y
o r
S e llo u t
P re -C o n s tru c tio n D e v e lo p m e n t A c tiv ity P o s t C o n s tru c tio n D e v e lo p m e n t A c tiv ity
L e a s e U p
o r
S e ll O u t
C o n s tru c tio n
P e rio d

38. Cost of Production Components
• Land Cost / Value
• Building Cost
• Financing Cost
• Marketing Costs
• Closing Costs

39. Cost of Production …continued
• Cost of sales and/or
financing concessions.
• Absorption period
expenses.
• Return on mortgage and
equity capital.
• Entrepreneurial profit

40. A Second Look at the Time Line
P R O J E C T D E V E L O P M E N T & C O N S T R U C T IO N T IM E L IN E
S ite
A c q u is itio n
Z o n in g
A p p ro v a ls
P la n s
P e rm its
M o rtg a g e
a n d
E q u ity
F in a n c in g
S ta b iliz e d
O c c u p a n c y
o r
S e llo u t
P re -C o n s tru c tio n D e v e lo p m e n t A c tiv ity P o s t C o n s tru c tio n D e v e lo p m e n t A c tiv ity
L e a s e U p
o r
S e ll O u t
C o n s tru c tio n
P e rio d

41. Deductions and Discounts
• Historical practice and result.
• Value to a single purchaser.
• Not just a regulatory standard.
• Wholesale versus retail.
• Result of the discounting process.

42. Deductions and Discounts
• Unearned entrepreneurial profit.
• Unspent dollars for …
• Marketing
• Maintenance
• Property taxes on unsold units or
unleased space.

43. Deductions and Discounts … continued
• Tenant improvements not
physically in place.
• Administrative expenses
• Financing costs -- mortgage &
equity.
• Sales and/or financing
concessions.
• Remaining building cost (as
applicable)

44. Income Capitalization Techniques
Direct Capitalization
General Rule
Use if property has achieved a stabilized level of
long term occupancy and income and expenses
are expected to remain relatively stable going
forward.

45. Discounted Cash Flow
General Rule
Use if stabilized occupancy (or sellout) has not
been achieved and income and /or expenses are
expected to fluctuate going forward.
Choice of direct capitalization or DCF should never be dictated by
policy although it frequently is to the detriment of reliability.

46. Analyzing Discounted Cash Flow
• Forecast period based on market evidence, not assumption.
• Income and expenses must model reality. Rents can go up,
down or stay the same. Don’t automatically insert an inflator
unless market evidence says so.
• Income and expenses forecast in time periods they are
expected to occur.

47. Appraisal Regulation In Perspective
• Underlying premise: LOAN REPAYMENT
• Sets forth when appraisals (or evaluations) are required and when they are not.
• Bank must control appraisal process.
• Appraiser independence.
• Appraisers must be certified or licensed as appropriate.
• Only five specific appraisal standards.
• The December 2010 Interagency Appraisal and Evaluation Guidelines added much
more substance and guidance.

48. Current Regulatory “Hot Spots”
• Appraiser independence.
• As- is value (without speculative assumptions).
• Appropriate and consistent use of abundance of caution and business loan
appraisal exemptions.
• Documentation of decisions.
• Separating real and personal property value components.
• Vacant land/lot analytics.
• Standard of care -- “would a disinterested third party looking only at the file
understand and agree with my decision?

49. Common Analytical Deficiencies
Property Type
• Vacant land: Failure to consider timing of land use.
• Proposed Development: Failure to consider all costs associated with proposed
development or partially completed development.
• Income Property: Failure to consider timing of lease rollover, rent concessions,
tenant improvements and retrofit costs.
• Special Purpose: Failure to estimate market value.

50. Common Analytical Deficiencies
Discounted Cash Flow Analysis
• Assumed rather than market based cash flow period.
• Assumed period by period cash flow change.
• Failure to include all appropriate expenses.
• Failure to recognize cash inflows and outflows in the periods they are most likely
to occur.
• Assumed or improperly developed discount rate.
• General failure of DCF to model reality.

51. Common Analytical Deficiencies
• Faulty application of value definition.
• Assumed highest and best use conclusion.
• Backward looking market analysis.
• Faulty or missing economic feasibility analysis.
• Inconsistencies among report sections.
• Irrelevant or out of date area or neighborhood data.

52. Common Analytical Deficiencies …
continued
• Incorrect property rights appraised.
• Assumption rather than reality based analyses and conclusions.
• Confusing holding period, absorption period, normal marketing period and
exposure period.
• Assuming away what the appraiser was hired to do.

53. QUESTIONS
Comments, Questions, Observations or Subscribe to Publications
William “Bill” Pittenger, MAI, SRA
www.billpittenger.com
E-Mail:
William_pittenger@comcast.net