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Reviewing commercial appraisals is more difficult in distressed markets. In turbulent times, market participants are uncertain about the direction of the market, there are fewer sale and rental transactions, and historical market reference points are not meaningful. Often, the valuation can result in difficult and unpleasant financial consequences for the borrower and financial institution. Several questions on what should you look for when reading a commercial appraisal on collateral in a distressed market are presented. These questions include: 1. Is the analysis grounded in the current market, or stuck in the past? 2. Does the property analysis take a hard look at factors that create appeal and value? 3. Does the report properly analyze the subject sales and listing history? 4. Is the highest and best use analyzed in light of current market conditions? 5. What can you learn from the Cost Approach?

REVIEWING COMMERCIAL APPRAISALS is more difficult in distressed markets. In turbulent times, market participants are uncertain about the direction of the market, there are fewer sale and rental transactions, and historical market reference points are not meaningful. Often, the valuation can result in difficult and unpleasant financial consequences for the borrower and financial institution. So what should you look for when reading a commercial appraisal on collateral in a distressed market?

1 Is the analysis grounded in the current market, or stuck in the past?

* In a fast-moving and turbulent market, information becomes stale very quickly. The report should include and apply the most recent economic reports, supply and demand surveys, and capitalization rate studies.

* In order to stay current, the appraiser needs to have frequent discussions with real estate market participants (buyers, sellers, property managers, and real estate agents/brokers). The report should reference these interviews with market participants and analyze the most pertinent comments and how they impact the subject value.

* Appraisals are opinions based on historical data and anticipated performance. When market conditions shift, the significance of historical data is low. Without reference to the new market environment, the past sales, leases, and capitalization rates are no longer relevant. To balance stale historical data, look for the appraiser's use of trend analysis, interviews with market participants, downward adjustments to reflect declining market conditions, and comparable listing transactions.

2 Does the property analysis take a hard look at factors that create appeal and value?

* Properties exhibiting physical or functional inadequacies are less competitive and tend to suffer from accelerated or exaggerated declines when markets are weak or distressed. An inadequacy that may be overlooked by buyers/tenants in a strong market may become a major competitive disadvantage when supply exceeds demand.

* Check to make sure that required and preventive maintenance has not been deferred by cash-strapped owners/managers.

3 Does the report properly analyze the subject sales and listing history?

* Appraisers are required to analyze a three-year sales history for the subject. (Three years is a minimum, and appraisers can go back to any prior sale.) The sales history analysis should be tied to the market analysis and to the market conditions adjustment in the Sales Comparison Approach. For an income-producing property, the sales history analysis should comment on changes in income, occupancy, expenses, and capitalization rates.

* The listing history of the subject provides important perspective on market acceptance of the property. Has the property been offered for sale in the past three years? What is the history of pricing changes? Have offers been made? What factors have prevented the sale of the property? Answers to these questions can support-or undermine-the valuation.

4 Is the highest and best use analyzed in light of current market conditions?

* When market conditions change, highest and best use can change. The feasibility of proposed development must be tested using current market measures. Land value is unreliable if it's based on a proposed development plan that currently is not feasible. Some current property uses may have been implemented under more robust market conditions. In today's market, another use might make more sense. Highest and best use cannot be assumed; it must be proven and tested.

5 What can you learn from the Cost Approach?

* Compare the cost new (including land) to the appraised value to determine the discount to cost. Buyers in distressed markets often look at cost as the "real" value and make purchase decisions based on the implied discount. Look at the age of the improvements and ask yourself, "Would I pay x percent of cost new for this property?"

* Look to the land-to-value ratio as a measure of the true nature of the collateral. In depressed markets, the ratio of land to property value can change dramatically. When land value is more than 50% of the overall value, collateral begins to take on the risk profile of vacant land. Land value that is more than 75% of the total property value indicates that the improvements are nearing the end of their productive lives and redevelopment may be in the near future.

* Use the cost information to test the feasibility of the project. Feasibility is a major barrier to new supply in depressed markets, but this has the benefit of insulating the subject from competition. When a project is not feasible, the depreciation analysis should recognize the presence of external obsolescence.

6 Does the Sales Comparison Approach support adjustments to market conditions and include current offerings?

* Sales must be adjusted for changes in market conditions. Be aware that market changes have been uneven, and adjustments must reflect this. In some markets, conditions were stagnant in 2007, declined slowly in the first three quarters of 2008, fell dramatically in the fourth quarter of 2008, and then dropped more slowly in 2009 than in the fourth quarter of 2008.

* The use of current offerings provides important perspective on the market. In addition to consummated sales, listings should be reported and analyzed. When listings are presented, the analysis should comment on the listing price. Is it realistic, or out of touch?

* Distressed sales should be included and analyzed. When necessary, adjustments should be made for conditions of sale.

* The slower market pace has reduced the number of transactions, limiting the appraiser's choices when selecting comparables. Have an open mind when the appraiser "stretches" to find recent comparables.

7 Does the Income Approach mirror the attitudes of current market participants?

* The Income Approach requires the appraiser to simulate the decision-making process of an investor. Accordingly, the appraiser must stay abreast of changing investor attitudes and not base valuation assumptions on out-of-date information.

* Rental rates may be based more on listings than on dated comparable leases. Leasing concessions are more common in weak or distressed markets.

* Vacancy projections need to be balanced and to reflect long-term performance. Just as a stabilized 8% vacancy deduction might be taken in past markets with 4% actual vacancy, current increases in vacancy should not cause excessive stabilized vacancy projections. The goal is to mirror investor actions.

* Expenses are still increasing. Beware of management attempts to trim expenses with short-term savings. Expense ratios should be increasing when rents fall, not declining.

* Owner-occupied properties or spaces are typically treated as leased. In some circumstances, concerns about the business prospects of the owner-occupant may warrant deduction of absorption costs (lost rent, tenant improvements, leasing commissions). Watch for overly conservative "go dark" valuations that treat stable owner-occupants as occupancy risks.

* Capitalization and discount rates will increase in distressed markets. In the current environment, the lack of credit and tighter underwriting standards are raising rates further, but the increases in cap rates are not uniform. Whereas Class-A cap rates have increased 50-150 basis points in some markets, the rates for Class-B/C property have gone up 200-400 basis points. In market downturns, there is often a flight to quality that exacerbates the decline for lower-quality investments.

* Look for rates that are supported by multiple sources: for example, those extracted from comparable sales transactions, published investor surveys, interviews with market participants, and band-of-investment analysis. A well-supported capitalization rate is logically related to market activity, is tested for reasonableness, and demonstrates the appraiser's consideration of the relevant factors affecting the property.

8 Does the analysis of absorption in properties with vacant space examine the broader supply-and-demand trends as well as current competition?

* The absorption analysis should look at the broad forces impacting the subject. The underlying factors that reduced demand (for example, lack of credit, reduced consumer spending, and lower employment) can change quickly. The supply-side factors (for example, available land, standing inventory, and conversions) are much slower to change. Market imbalance attributed to oversupply will linger much longer than imbalances related to soft demand.

* The absorption forecast should look at current and anticipated completion. A comparison of the subject to its direct competition is critical to supporting the absorption forecast.

Performing appraisals in distressed markets is not easy, so reviewers should not expect perfection. However, appraisals must deliver relevant information on the market and the collateral because the credit stakes are so high.