Appraisals Can Address Valuation Objectives, Other Issues

There is no doubt that, given changing markets, keeping the appraisal up to date is an ongoing challenge. But it is equally important to have a useful appraisal, an evaluation that addresses specific information goals.

Sometimes a standard appraisal can properly cover the bases but miss the objective. After all, most appraisals are prepared for and focused on issues considered most important to lenders, not necessarily to buyers or owners in distress.

When dealing with appraisers, savvy owners are rightfully careful when it comes to avoiding encroachment on subjective valuation issues. But it is proper to let appraisers know why they are ordering an appraisal. In fact it is perfectly permissible to brief appraisers to be sure he or she focuses on both generally accepted valuation issues as well as what is important to those who commission the appraisal.

Generally appraisers welcome input about why the appraisal is being requested so that they can do a better job of making their investigation relevant to a given situation. This is particularly true for properties that involve land development, renovation or new construction, because there are strategic issues in addition to the basic question of what it is worth now. An example might be the possibility that it would be more intelligent to either delay the development or re-conceptualize the development to a more profitable use. In that case, valuation is a key ingredient in making those choices.Of course, there are also ongoing challenges for the appraisers themselves. In the current market environment, appraisers face the difficult task of finding comparable market information. There have not been many transactions and, for a variety of reasons, those deals that have been done may not always be indicative of current market value.

An issue facing many market participants is the delicacy of parsing the details of a transaction to determine if it meets the standards of market value. These standards require the appraiser to consider the influences and objectives of buyers and sellers who are assumed to be acting prudently, knowledgeably and without undue duress. While no one believes that the inflated prices of 2006 and 2007 will return anytime soon, it is equally likely that some current transactions represent distressed sales and are therefore below actual market value.

For an investor trying to determine an appropriate strategy for distressed real estate, it may be appropriate to ask the appraiser to provide not only his or her best estimate of the current market value but also an estimate or a range of the property's current distressed value. For some investors, understanding the potential arbitrage between those two sets of values could prove to be immensely valuable.

There has been a lot of discussion among market participants this year about whether or not current values are all inherently reflective of a distressed real estate market and, therefore, at least by definition, do not represent true market values. One way to deal with this problem is to rely more on discounted cash flow models rather than comparable sales when determining value. Of course this approach only transfers the debate to a different platform. Instead of asking what current comparable sales and rentals are, the appraiser will need to provide an opinion of what future sales or rentals are likely to be.

On the one hand, this means that the valuation process will become even more subjective and judgmental. On the other hand, if the assumptions on which the DCF models are based are well supported and meet the "reasonable man" test, the resulting value estimates will be more transparent and potentially more accurate.

Peter Brooks is executive director of Ernst & Young's Transaction Advisory Services. You can reach him at peter.brooks@et.com.The views expressed herein are those of the author and do not necessarily reflect the views of Incisive Media or Ernst & Young LLP.