Inside Third & Bond: Week 32

What do you call someone who compiles and analyzes voluminous data of problematical accuracy from sources of dubious veracity and derives therefrom a numerical quantification of value commensurate with ambient configurations of the open market and promulgates thereby a precise written declamation which delineates his observation, deliberations and conclusions all done while he feigns absolute ignorance of the machinations of Buyers, Sellers, Brokers and Lenders, compensated only by that penurious stipend known as the professional fee?
An appraiser, of course!

Okay, so that joke, which we got from an appraiser humor website, would have gotten high-fives in an appraisal office but will probably earn us crabby comments here. Still, it’s an apt lead-in to this week’s topic of appraisals, something that ends up sounding much more complicated than it needs to be in part because of the layers of jargon that come along with it. It’s really pretty simple: the bank wants an independent opinion of the market value of the project they are lending money on and we want a high appraisal so the bank will lend us as much money as possible and we can spend our equity elsewhere.

It’s not quite white-knuckle time, but we are watchful of the appraisal inputs and outputs…

…Valuations tend to move like the pendulum swing of underwriting—in good times, valuations can be slightly exuberant, and now, in belt-tightening times, we have to ensure that appraisals don’t end up way too conservative.

How does the appraiser get to the estimated market value and how do we try to affect that process? To start, there are three valuation methods: Replacement/Cost, Market, Income Capitalization.

Replacement/Cost
The rationale for replacement/cost valuation is that the value can be estimated by how much it would cost to buy the land and rebuild the structure. This approach assumes no one would pay more for the property than it would cost to replace it. Replacement refers to rebuilding the same project but using updated design, materials, etc. Reproduction refers to creating an exact replica and is not likely to be used for new condominium projects.

The cost estimate for replacement can be made through a thorough review of line items for material and equipment or a more general per square foot number applied for a certain type of project in that generalized location. The cost of the land and depreciation are derived from comparable data. Overall, this method is better to use with newer structures and is particularly important for unique projects like public works.

We provide appraisers with the complete development budget, including details of the acquisition. This is the same budget that the bank has already seen and that is used to get to the initial term sheet, which precedes the appraisal.

Market
Also referred to as the sales comparison approach, this valuation method is based on data from recent sales of highly comparable projects. The rationale is that no one will buy the property for more than what similar properties on the market have gone for recently. For this approach to work, the comparison projects must represent normal market transactions (i.e., not foreclosures, etc.) and adjustments must be made for the differences between properties (e.g., size, scale, age, quality). For example, if the comparison project has high end luxury finishes while the subject property has middle of the line finishes, then there would be a negative adjustment. Adjustments can be positive or negative.

We like to offer the appraisers a summary of what we think are the best comparison properties for our project. While appraisers are given budgets and descriptions of the property to be built, it is still useful to let them know by way of comparisons where our project fits into the market. It is also helpful in that appraisers don’t always know all of the comparable projects in a given neighborhood they tend to have macro level data that they sift through to get to the properties that they base their opinion on. In the case of Third & Bond, the original appraisal didn’t include L3 as a comparable property even though it is by far the most similar project to hit brownstone Brooklyn in the last three years.

Income Capitalization
This approach assumes a direct relationship between income and value. The value of the property is a conversion of the income expected to be produced over the economic life of the project. There are a number of different ways to get to this value. The simplest is to make assumptions about how much rent would come in and subtract out the costs such as operating expenses, capital improvements, and likely vacancy level. Then this net income is divided by a cap rate (a number that accounts for risk, time, interest on the capital investment and recapture of the depreciating asset).

In the end, the appraiser has to reconcile between the various approaches. There is always a differential between the appraisal as a condominium (i.e., highest and best use) and the appraisal as a rental. The appraiser provides its value conclusions as if the site were vacant land, upon completion under both a rental and a condo scenario, and upon stabilization in a rental scenario. Both the rental and condo scenarios take into account the value of the 421a tax abatement.

There has been some back and forth on Third & Bond because of some of the choices made in the original appraisal. Fortunately, we can use our relationship with the bank to talk through any concerns we have and provide more detailed information to the appraiser, such as lists of comparable sales in contract/closed and projected costs. There’s an old joke that the professional designation for appraisers, MAI, actually stands for Made as Instructed. Once term sheets are issued, bankers want the deal to happen (they only get paid if there’s a closing) and appraisers want to get rehired, so if there’s a glitch in the process, everyone goes home unhappy. This results in what some might call a clubby relationship between banker, borrower, and appraiser…

Ultimately though, the appraisal is meant to be an independent opinion and the appraiser makes the final call.

And until that call is made, we’ll refrain from posting any of the OTHER jokes we found about appraisers on-line…
Inside Third & Bond: Week 32 [Brownstoner]
Inside Third & Bond: Week 31 [Brownstoner]
Inside Third & Bond: Week 29 [Brownstoner]
Inside Third & Bond: Week 28 [Brownstoner]

From our lawyers: This is not an offering. No offering can be made until an offering plan is filed with the Department of Law of the State of New York.”