How Are Appraisers Ensuring The Credibility Of Their CRE Valuations Despite COVID-19-Related Market Uncertainty?

How Are Appraisers Ensuring The Credibility Of Their CRE Valuations Despite COVID-19-Related Market Uncertainty?

Lowery Property Advisors

09/14/2020

CRE valuation experts are accustomed to having a robust set of tools at their disposal. Unfortunately, COVID-19 has transformed what was once a very reliable hammer into a stubbornly crooked nail.

Since March 2020, transaction velocity has slowed significantly. Real Capital Analytics (RCA) recently reported that July 2020 marked the fourth month in a row that U.S sales volumes across all property types fell by double digits. In fact, Q2 2020 was notable for all the wrong reasons. As RCA notes, “transaction volume dropped 68 percent to the lowest level for a second quarter since the Global Financial Crisis.”

CRE sales comps are literally few and far between. Actors moved to buy, hold, and sell for reasons that would have made little sense this time last year have only exacerbated the effects of this data scarcity.

How can appraisers guarantee that their reports contain credible, actionable business intelligence in a market where only illiquidity and uncertainty exist in abundance?

According to LPA’s own CRE valuation experts, five best practices have served them — and their clients — exceptionally well throughout the pandemic. Read on to learn more.

1) Avoid extraordinary assumptions

Appraisers are not fortune-tellers, and appraisals are not crystal balls. Appraisals are highly informed opinions backed up by as much data as the appraiser can muster. And, even when it is up-to-date, that data is always historical to some degree. Unless a choice has been made, an action taken, or a statement recorded, it cannot be referenced or analyzed.

That said, in stable markets that are following forecasts, appraisers can be more confident that what they observe today will not disappear altogether tomorrow. Even if they turn out to be false, such ordinary assumptions would not materially affect the appraiser’s conclusions regarding the value of a specific property. COVID-19 has elevated the risk involved in making such assumptions.

Appraisers need to become more comfortable dealing with the unknown for the time being. Of course, our profession remains upbeat about CRE’s resilience. The data we have regarding past economic downturns speaks to the nature and extent of that resilience. However, we cannot assume that the COVID-19 outbreak will be so short-lived that its effects will represent a mere blip in market performance. Buyers are not necessarily getting — and quickly recovering from — cold feet because of the pandemic. Deals may be taking longer to close because buyers need more assurances that the properties they are acquiring meet rigorous health and safety standards. Moreover, what look like delayed transactions may eventually reveal themselves to be leading indicators of a long-term shift in demand or supply.

Accuracy can be a moving target. It is not a transcendent ideal. It is contextual. At this time, one of the best approaches appraisers can take is to render that context more visible — and, in the process, their reports more transparent. That means appraisers must take full ownership of their opinions, support those opinions as best they can, and safeguard those opinions from being proven fundamentally mistaken no matter what the future holds.

2) Be collaborative

Comps may be elusive these days, but that doesn’t mean that valuable information has simply evaporated. If anything, the information that is available carries more weight than ever. Because it is more scattered and may be lurking in unexpected (or rarely probed) nooks and crannies, appraisers should anticipate that they will have to expend more energy in collecting that information.

However, appraisers should dedicate a portion of that energy to forming and strengthening their professional relationships. If information-gathering is more burdensome due to the pandemic, the solution to that problem is to put more shoulders underneath that load.

That collaboration should begin with participation in casual but thoughtful conversation. Who else is trying to gain a better understanding of what’s happening in the CRE market? Brokers are one such party, but appraisers should consider widening their social circles to encompass a diverse cohort of CRE stakeholders: lenders, property attorneys, government officials such as zoning officers, journalists, and scholars.

Appraisers should consider these conversations exploratory and be willing to answer as many questions as they pose. Before appraisers can bridge the data gap opened up by down sales, they need to achieve a bird’s-eye view of the market’s terrain. Fact-finding, on the other hand, requires a formal survey. The good news is that, having cultivated collaboration and a sense of community via those thoughtful conversations, appraisers have begun to identify a statistically significant sample population.

This summer, LPA conducted a survey to answer three pressing questions about CRE markets across Texas and the Southwest.

  1. What impact has COVID-19 had on property value?
  2. How has COVID-19 impacted cap rates?
  3. How has COVID-19 impacted occupancy rates?

Using this instrument, we were able to quantify anecdotal evidence we had gleaned from other sources, transforming it into more than 1,000 data points. You can learn more about this survey and download a copy of the Summary Report by reading the August 2020 installment of LPA Insights.

3) Examine deals as closely as you would sales

Surveys serve to emphasize another key point: in a pandemic, comps are no longer the be-all and end-all. In the absence of sales data, cost and income must play a larger role in appraisal methodology.

Digging into the finer details of a sale can provide illuminating information. This applies to acquisitions that aren’t even true property acquisitions. Here in Texas, major oil and gas companies have been increasingly trading in loans and notes to build up their cash reserves. Of course, property values still play a role in underwriting those assets. Meanwhile, those looking to liquidate both performing and non-performing inventory — especially in the hospitality and retail sectors — are generating new, 30- to 60-day valuation snapshots.

Under such conditions, cap rates alone aren’t likely to provide realistic projections. The suspension of nearly all social and business activity prompted by the pandemic caused revenues to plummet off a cliff. Appraisers eager to bolster their calculations should consider leveraging other analytical tools, such as NOI and DCF. Such tools also help appraisers avoid making punitive assumptions based on moment-to-moment market fluctuations.

Moreover, asking how a deal got made can highlight possibly emerging trends. What motivations and assumptions did both buyer and seller bring to the negotiating table? What concessions may have helped the deal go through? What other dynamics affected the sale, and how were they negotiated?

The goal of thinking outside the box and digging into market intelligence is not to stuff appraisal reports with filler. The goal is to learn as much about actual market conditions as possible. Those learnings will only give any hard data included in an appraisal report extra dimension and resonance.

4) View trends from multiple points of view

Similarly, extracting actionable market intelligence from this mixed and matched data will require a bit more imagination. As always, appraisers would be wise to follow industry news. Yet, now more than ever take, appraisers must also read beyond the headlines and give equal consideration to opposing points of view. Doing so can help them sort out the short-term risks from long-term ones.

A case study can help illustrate this point. At the outset of the pandemic, businesses everywhere implemented full-time work-from-home policies. Sending workers home and asking them to stay there proved to be a low-impact and cost-effective way to adhere to social distancing guidelines.

Yet what value does office space posses in a world where everyone telecommutes? Unfortunately, extrapolating from this question can quickly turn into a form of spiraling, with one doomsday scenario after another emerging as an inevitable outcome of this cultural shift.

Worse, to not consider alternatives would be to ignore emerging counter-trends and offsetting market forces. After months of remote work, more and more employees have a renewed appreciation for the office. Elizabeth Brink and Arnold Levin of Gensler believe that the office of the future will be a “collaboration touchpoint.” Kelly Griffin, a principal at the architecture firm NBBJ, expects physical workplaces will become more “intentional… [places] to connect with others, leading to increased social space, amenities, and conference rooms.”

If Griffin’s description sounds quite similar to a co-working space, that may be no accident. If demand for flexible, reconfigurable, centrally located collaboration spaces rises in the coming months, so too might occupancy rates.

5) Invest even more in developing — and leveraging — your local market expertise

COVID-19-related uncertainty has amplified each local market’s unique characteristics. New York is not Los Angeles, and neither is Dallas — which just surpassed both cities as the top CRE market in the U.S. (by sales volume). To understand North Texas’ ascendance, it would help to ask someone who has boots on the ground there.

LPA’s appraisers have long understood the virtue of thinking and acting locally. They’ve also tracked the local effects of black swan events before. Hurricane Harvey ravaged the Texas Gulf Coast in August and September of 2017. The storm damaged over 700 businesses, whose hurricane-related losses ultimately exceeded $100 billion. Houston, Beaumont, Port Aransas, and several other cities began rebuilding in 2018. Those efforts led to labor and supply shortages, driving construction costs up — and keeping them there.

All across Texas, both landlords focused on IRR and tenants concerned about their leases felt these inflationary pressures. Now, the contraction in new and speculative construction prompted by COVID-19 may already be contributing to a welcome correction in construction costs.

Is this correction buoying new construction in markets like Houston, Austin, San Antonio, and Dallas-Fort Worth? Very possibly. But the real lesson here is that it takes local market expertise to recognize a variable such as this — much less factor it into an appraisal and assess how consequential it is to the accuracy of the final valuation report.

At LPA, our appraisers are as passionate about the accuracy of their CRE valuations as they are about contributing to the economic vitality of the communities where they work and live. From the Dallas-Fort Worth Metroplex to Houston, San Antonio, Midland-Odessa, El Paso, and into New Mexico, Oklahoma, and Louisiana, they’re committed to providing you with the market intelligence you need to make the most informed real property decisions.

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