Five pieces to the appraisal puzzle during COVID-19
The coronavirus outbreak is not the first time appraisers have had to deal with valuation of property during what is technically known via the Interagency Appraisal Guidelines (IAG) as a period of “Material Change.” Although these guidelines that U.S. financial institutions must adhere to for “Federally Related Transactions” are now a decade old (last issued December 2, 2010), they are still the road map for appraisers when performing an appraisal for a financial institution. As stated in the Background section within the December 2010 issued IAGs, “these Guidelines, including their appendices, address bank supervisory matters relating to real estate appraisals and evaluations used to support real estate-related financial transactions.” In other words, they are both a big-deal and are still valid with no waivers (yet) during COVID-19.
It is also important to understand how these guidelines came into being and where they are rooted in law to then ask if they can be waived or modified during COVID-19. Title XI of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) requires each banking Agency (FDIC, OCC, Federal Reserve, NCUA, etc.) to prescribe appropriate standards for the performance of real estate appraisals in connection with “federally related transactions,” which are defined as those real estate-related financial transactions that an Agency engages in, contracts for, or regulates and that require the services of an appraiser. The Agencies’ appraisal regulations must require, at a minimum, that real estate appraisals be performed in accordance with generally accepted uniform appraisal standards as evidenced by the appraisal standards promulgated by the Appraisal Standards Board (that is what appraisers and bankers know as USPAP – now referencing the 2020-2021 edition), and that such appraisals be in writing. An Agency, such as the FDIC, may require compliance with additional appraisal standards if it makes a determination that such additional standards are required to properly carry out its statutory responsibilities. In summary, neither the Interagency Appraisal Guidelines or USPAP (the two source documents governing appraisals for bank real estate lending) have been modified or waived in part or whole during COVID-19. As Congress is in recess until April 20, 2020, and a new USPAP was just published for the CY 2020-2021 period, do not look for relief coming from modified USPAP or IAG.
With the aforementioned background for those that are practicing appraisers, as well as those that may just be consumers of appraisal services, the five pieces to the appraisal puzzle during COVID-19 are the following:
1. There are three primary resources to consult during COVID-19 regarding the appraisal process: the Appraisal Institute (AI), The Appraisal Foundation (TAF), and the respective state appraisal boards - in Alabama the state board is the Alabama Real Estate Appraisers Board (REAB). Each of these resources now have dedicated COVID-19 sections on their websites to aid with appraisal questions. The state level is good for translating a macro question, like “Is an appraiser an essential service” to your respective jurisdiction – or another jurisdiction if you have an assignment in another state. The Appraisal Foundation (TAF) defers almost all matters and questions to either the respective states – or to USPAP and IAG which have not been modified or waived during the COVID-19 outbreak. The Appraisal Institute COVID-19 section on their website is thorough, and the AI answers the critical questions that are being presented, ranging from: i) Can or should I do an inspection? ii) How can I assess the market conditions with dated economic information? and iii) How do I determine value change with a dearth of transactions?
2. Are Appraisers considered an “Essential Service” during the COVID-19 outbreak and Shelter-in-Place” orders? Generally, the answer is yes, but the respective Shelter-in-Place Orders (SIPOs) recognize the importance of maintaining critical infrastructure and the importance of essential services, and many of these SIPOs have cited the broad “Financial Services” sector for essential work classifications as established by the Cybersecurity Information Sharing Agency (CISA). The guidance from CISA - which cites support services to the financial services sector - appears to support inclusion of real estate appraisal services under the definition of critical infrastructure. However, the guidance is not explicit. Appraisers need to check specifically with their state appraisers board - or the Appraisal Institute website which is capturing which states have appraisers specifically listed as an “Essential Service.”
On March 30, 2020, Florida Trend Magazine published a feature on this matter and linked a March 25, 2020, letter to the National Governors Association on just this topic. In that letter, the respective real estate industry organizations, such as the Appraisal Institute and National Association of Realtors, noted that just seven states (Delaware, Hawaii, Illinois, Indiana, Massachusetts, Ohio, and Wisconsin) have specifically recognized the critical role that appraisers play in real estate transactions, and have deemed appraisal services to be one of a number of real estate related services that must continue. Alabama defers to CISA guidance.
3. Inspections – Can and should appraisers make property inspections during the COVID-19 outbreak? The short and oversimplified answer is it depends. It depends on answering three questions.
First, what are the “Shelter-In-Place” orders in both the appraiser’s and the property’s jurisdiction and then whether the appraiser feels that BOTH the CISA guidelines are sufficient to make them an “Essential Service;” and second that the appraiser and occupant of the property feel it is appropriate and necessary.
Next, it depends on the client and the agreed upon Scope of Work in the appraisal assignment. If it is a MF appraisal for say Fannie Mae, Freddie Mac or one of the GSEs (Government Sponsored Enterprises), they have agreed to waive interior inspections and permit the appraiser to do what is known as a “desktop” appraisal (one without interior inspection). If it is a bank lender, clarify this matter at the get-go during the COVID-19 outbreak!
Finally, the answer does NOT depend on USPAP or Interagency Appraisal Guidelines (IAG). Neither requires inspection of the property to produce a “credible” appraisal. Both do require, though, two things: i) that the appraiser disclose in the appraisal that he/she did or did not inspect the property; and ii) the appraiser attain sufficient information to describe and understand the property’s physical attributes to render a credible appraisal. The first item, disclosure, is easy to handle in both the Letter of Transmittal and the appraisers Assumptions and Limiting Conditions. The latter is more subjective. Does the appraiser, for example, have blueprints and a survey to know the appropriate measurements of the site and building? Can the appraiser attain relatively recent photos from either the client or property manager to rely upon for interior views and determination of finishes for comparison to sale transactions? What the appraiser cannot do is just disclose that no inspection was made, and then make no effort to attain sufficient information about the property to describe it, measure it and render a “credible” opinion of value. The burden is on the appraiser to make additional effort. If the aforementioned are not possible, the appraiser should not accept the appraisal assignment.
4. Highest and Best Use: For too long this foundation element in an appraisal assignment has been glossed over citing a combination of: i) the current use is the best indication of highest and best use; and ii) that the four tests in determining highest and best use have been met (physically possible, legally permissible, economically feasible and maximally productive).
Decades ago, the industry did a good job teaching this concept and actually making appraisers do, for example, a land residual analysis in appraisals to prove the current use was both economically feasible and the most financially beneficial use of the economically feasible options. Those days are long gone, but the practice may return as we discover how COVID-19 is revealing the current use may not be the highest and best use. Think, for example about auto plants converting to manufacture PPE (Personal Protective Equipment), or hotels being converted to hospitals. During this COVID-19 outbreak the industry will see the need to reassess use after thousands of retail store closings, acceleration of online everything from groceries to telemedicine, and whether “experiential retail” even exists post COVID-19.
Do not assume this foundation element away as many in our industry did pre-coronavirus. Here is a link to a recent story on the conversion of a Sheraton Hotel in Dallas to a “COVID-19 Care-aton” hospital. What is its value as-is today as a hospital and what is it after COVID-19 and the building has to be sanitized for its next use? Think of the CapEx cost adjustment to convert both ways. Think whether there is a residual stigma associated with the building in perpetuity where COVID-19 patients were treated and maybe died? Look back to the Legionnaires Disease outbreak in the 1980s and 1990s for guidance on impact to hotel properties.
5. Appraising during periods of “Material Change.” Material Change is a defined term in the Interagency Appraisal Guidelines that recognizes market conditions have been significantly disrupted and likely trigger valuation erosion. Appraisers need to reflect back on periods like the Gulf of Mexico oil spill by BP in 2009 and even farther back to the initial oil patch shock and S&L Crisis of the late 1980s and early 1990s. There are important clues as to how to measure market conditions when economic data is stale or there is a dearth of sale and lease transactions. It requires more primary research by the appraiser and both appraisers and bankers need to allocate for that in both the time frame and fee to perform an appraisal in a period such as this. The best advice from a 30-year, multi-generation MAI appraiser that lived and practiced through all the aforementioned periods of “Material Change” is three-fold: i) communicate with primary industry participants like brokers, property managers, lenders and university real estate centers as your subscription comp services are not going to have the same kind of forward-looking market intelligence; ii) ask a lot of why and what-if questions (why is this shopping center still tenanted versus another one – tenant mix more weighted to consumer staples retail vs consumer discretion or experiential use) as they force you to look up and forward to the valuation answer; and iii) revisit your appraisal template and refresh things like: i) Assumptions & Limiting Conditions to address topics like inspection; and ii) boiler-plate MSA analyses and statistics that are now all out of date and could result in a “misleading appraisal report.” The appraisals produced today in this period of “Material Change” are tomorrow’s litigation cases.
For an examination on the accuracy of appraisals during the last major period of “Material Change” during the 2009 financial crisis, check out the New York Times article Accuracy of Appraisals is Spotty (May 8, 2012 by Julie Satow. This article features a study published in the winter edition of CRE Finance World, the publication of the CRE Finance Council, and based on appraisal data from the research company Trepp, LLC, for March 2007 through September 2011. Using data from thousands of securitized real estate bonds in which the properties were foreclosed on and liquidated (the largest such appraisal study conducted even to date in 2020), the study by KC Conway, MAI, CRE (then an executive managing director at the brokerage firm Colliers International), and Brian F. Olasov (then a managing director at the law firm McKenna Long & Aldridge) found a wide discrepancy between the appraisal values and the eventual sales prices of the properties. This study examined why appraisals were so criticized from a CMBS securitization perspective, and the damage that resulted to banks. Also, there are lessons learned that may assist appraisers through this period of “Material Change.”