How to Review a Commercial
Real Estate Appraisal Report:
How Can an Attorney Ascertain the Merit of an Appraisal?
John W. VanSanten, MAI – [email protected]
SRR Journal: Before even discussing the appraisal report,
relative to office buildings or industrial parks, many appraisers
perhaps we should address the merit of the appraiser performing
simply do not have experience with them.
the work? What should attorneys look for in determining whether
or not the appraiser is qualified for the matter at hand?
John W. VanSanten: At the most basic level, the appraiser should
certainly be licensed within the state where the property is located.
And this really is a minimum requirement, because while licensing
requirements vary among states, they are not overly burdensome
to acquire, and many of them allow reciprocity or temporary
licenses. In addition, it is preferable to have the MAI designation
from the Appraisal Institute, which is really the preeminent
professional association out there for real estates appraisers.
An appraiser who holds the MAI designation should possess a
high level of experience and qualifications. But in addition, and
sometimes more importantly, an appraiser possessing real estate
expertise specific to the subject property and market area is key.
SRR Journal: Are there particular property types for which
SRR Journal: As it relates to the appraiser, how can someone
reviewing a report investigate the credentials of the appraiser?
JWV: There are a couple of resources which are generally
available to the public. First, to verify if a person actually holds the
MAI designation, you can use the “Find an Appraiser” function on
the Appraisal Institute’s website which is www.appraisalinstitute.
org. Second, with regard to licensing and state certification, the
website for the Appraisal Subcommittee, which is www.asc.gov,
can be used to determine if someone is actually licensed, if the
license is current, if there have been recent violations, etc.
SRR Journal: Turning our attention from the valuation expert to
the valuation report, I understand that there are various types of
reports: Self-Contained, Summary, and Restricted Use. Is there
any difference among them as far as the scope of the work
specific experience may be more relevant than for others?
performed, or is this merely a matter of presentation?
JWV: Experience is certainly relevant for every property type, but
JWV: It is really just a matter of presentation as all three require
it is more important with some special purpose properties. By
special purpose properties, I am referring to real estate which
has been designed for a unique purpose, such as a stadium or
perhaps certain health care facilities. Special purpose properties
typically have few, if any, alternative uses due to the high cost in
making modifications. Since these properties are less common
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the same amount of work. But depending on the context for which
the appraisal is being utilized, presentation can be important. For
example, in litigation, some attorneys may want a Self-Contained
report, believing it to be impressive through its exhaustiveness,
while others may believe a Summary report is more appropriate to
minimize unnecessary questions on matters with little relevance
during cross examination.
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SRR Journal: Real estate appraisals, unlike business valuations,
confirm the accuracy of data, but it will also allow the appraiser to
specifically discuss and ascertain the marketing period and
understand the motivations at the time of sale and whether or not
exposure time for the property. Would you please discuss how
it is an arm’s-length transaction.
these concepts influence value? And what should be done in
determining these assumptions?
SRR Journal: Should the verification itself be cited within the
JWV: Exposure time is a retrospective look which answers how
particular transactions?
long a property had to be exposed to the market prior to selling
on the valuation date. Marketing period is a prospective analysis.
How long will the property have to be on the market from today in
order to sell? If the real estate market is relatively stable, then these
two concepts are going to be very similar in duration. However, if
the market is appreciating or depreciating significantly, the time
periods may be dissimilar. The relevance of these concepts really
relates to consistency. If they suggest an appreciating market, has
this translated into a higher conclusion of value?
SRR Journal: Regarding the scope of work, can you think of any
particular documents or areas of investigation that, if they are not
performed, could significantly impact the appraiser’s opinion?
JWV: The most obvious red flag would be the failure of the appraiser,
or at least someone from his or her team, to have inspected the
property. There are instances where the Scope of an Assignment
has been limited to the point where a physical inspection is not
required. In those cases, the appraiser has to make specific
assumptions regarding the condition of the property. However,
in matters involving litigation, an actual physical inspection of the
report? Who was consulted, when, and in relation to what
JWV: Whenever possible. I have witnessed too many litigious
situations whereby an attorney crosses an expert only to have their
verification non-existent or poorly documented. It really diminishes
the credibility of the analysis.
SRR Journal: Any valuation is performed as of a point in time,
but, especially in today’s real estate market, there are rarely
transactions that occur as of a particular valuation date, so
past information must be reviewed. How far back in the past is
appropriate? Is it six months? Two years? What is reasonable?
JWV: It largely depends on the extent of price volatility in the
market. In general, you want to stay as current as possible, but
in recent years it has been extremely difficult to do so given the
dearth of transactions out there. In addition, it varies from situation
to situation and depends on the quality of data available. Typically
only transactions within the last year or two are utilized, but it
depends on the situation and the type of property being valued.
To the extent market conditions have changed from the time of
the transaction to that of the valuation date, adjustments should
property can be very important.
be made.
SRR Journal: What other critical subjects within a report should
SRR Journal: Moving on to the concept of highest and best use,
be reviewed?
it strikes me to be of tremendous significance to the appraisal,
JWV: The market analysis. Has the appraiser properly identified
appraisers as well as the reviewers of appraisal reports. Would you
the correct market for the property? For this situation, think of the
agree with that, and if so, is it an area which should be critically
very small industrial property which has a local or regional market
examined?
versus the Willis Tower where the market is national or perhaps
even international. Who are the potential buyers/investors?
Are they looking for properties locally, regionally, nationally,
or internationally? The market analysis will dictate the search
for comparable properties and ultimately which are chosen for
but I get the impression that it is not fully examined by a lot of
JWV: Absolutely. I think a lot of times appraisers tend to gloss over
this concept, which can be a significant problem as it is a pivotal
analysis underlying the entire appraisal. If the highest and best use
analysis is wrong, the valuation conclusion is likely to be wrong.
indications of value.
Many appraisers simply assume, “well, it is an industrial property,
SRR Journal: As a matter of protocol, would you recommend
not be true. The analysis of highest and best use should look at the
that sources of market information always be disclosed within the
property twofold. First, what would be the highest and best use if
report? For example, if you were utilizing private databases, would
the property was vacant and available for development? Second,
you recommend that these databases be cited as well as how the
what is the highest and best use of the property as currently
search was conducted?
improved? There are four sets of criteria which help ascertain
JWV: Whenever possible, the appraiser should communicate
how the information was gathered, and how it was verified. For
example, even widely utilized resources, while great for information,
possess inaccuracies. And since our conclusions may be highly
sensitive to the information reported, it is critical that verification
so the highest best use is as industrial property”. That may or may
this: legal permissibility, physical possibilities, financial feasibility,
and the maximum productive use of the property. Ultimately, the
conclusions related to the highest and best use of a property
should reflect how the universe of potential buyers would assess
the investment opportunity.
occurs with public records and/or a party to the transaction such
as the buyer, the seller, or the broker involved. Not only will this
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SRR Journal: I imagine the test criteria you just described
a market participant to build the facility. But be careful here,
lend themselves well as to questions to ask the appraiser: Did
entrepreneurial profit must be market supported and there must
you examine what is legally permissible for the property as if it
be evidence that it exists.
were vacant? How did you assess the financial feasibility of an
improvement to alter its highest and best use? Etcetera.
SRR Journal: The sales comparison approach to me, and I think
JWV: Yes, and I should add one caveat regarding legal
intuitive approach. A building is being valued, there is a similar
permissibility. Just because property may be zoned for a particular
building in the geographic market which sold for a particular
purpose does not necessarily mean that it is impossible to change
amount, and we can infer a value for the property in question from
that purpose. Agricultural land is frequently rezoned as residential
that sale. Is this approach ever not used? And if so, why?
subdivisions in the suburbs. Likewise, industrial land is often
rezoned for commercial or residential uses in cities. The appraiser
really needs to understand development trends in the area and the
any person outside of the real state profession, is simply the most
JWV: The main reason this approach may not be utilized is that
there is insufficient applicable data. There may be some markets
propensity of the local municipality to revise zoning designations.
or some property types – again, special use property types are an
SRR Journal: Are there any market conditions or property types
reliability of the approach depends upon the quality and quantity
for which a reviewer should pay particularly close attention to the
of available data. This certainly has been more of a problem in
highest and best use analysis?
recent years. Depending on how limited the quality and quantity of
JWV: Yes, basically any time there is a significant change in
market conditions – and by that I mean both positive and negative
changes. Changes in market conditions bring changes to the
underlying economics of particular properties. With appreciating
example – for which there simply are not any comparable sales. The
data may be, the approach may either be inapplicable or perhaps,
still relevant, but to a lesser extent than normal. In those situations,
the other approaches may receive relatively greater weighting in
the conclusion of value.
real estate prices, a marginally profitable machine shop may
SRR Journal: You mentioned quantity of transactions. How many
consider a different location. The inability to find a suitable
do you require to draw meaningful pricing information?
replacement tenant may cause the owner – and the real estate
appraiser – to assess whether or not the property should continue
JWV: Quantity depends on quality. All things being equal, the
as is or be torn down and built to suit trendy retail shops.
greater the quality of the comparables, the fewer number of
SRR Journal: The asset-based approach in business valuation
to look at the properties themselves: location, physical attributes
is infrequently utilized. Is that the same with its equivalent in real
such as overall property size and age, the legal rights conveyed,
estate appraisal, the cost approach? If not, how is it or should it be
etc., but it also has to do with information about the pricing. Has
utilized? Under what scenarios is it most likely to be used?
the pricing been appropriately verified? Were the financing terms
JWV: Of the three approaches, the cost approach is indeed the
comparables may be necessary. By quality, one certainly needs
unusual or typical?
least frequently utilized. But there are several situations where
SRR Journal: For how long is an appraisal relevant? This question
the approach may be the most relevant – and possibly the only
comes up frequently in the context of estate matters whereby an
approach which may be applicable. It is often relevant for new
election to use the value six months after the date of death may
construction. In these situations where you have good data on
be made. It is also relevant in litigation. For example in marital
construction costs, any adjustments for depreciation are likely
dissolutions where each side may be attempting to stipulate as
to be minor. Another example is that of special use properties.
to a valuation date.
These properties, which may have been built for a very specific
manufacturing process or other need, do not sell very often, so
there is limited data outside of a cost approach. It will always
depend on the particular circumstance, but without sufficient
market data to apply a Sales Comparison or Income Capitalization
JWV: In today’s market, the shelf life of an appraisal may be
significantly limited. But it really depends on how the market has
performed since the appraisal. And it certainly varies quite a bit by
different markets and asset classes. For example, retail has been
Approach, the Cost Approach may be the best indication of value.
heavily impacted by the economic downturn, but not necessarily
SRR Journal: Can you please describe in general terms the steps
have experienced greater volatility than properties in the Midwest,
in performing a cost approach analysis?
but not necessarily for any given market or asset class. In general,
JWV: In very general terms, starting with the value of the land as
if vacant, the cost to replace or reproduce the facility is added.
A good question to ask the appraiser is how they derived these
to the same degree in any given market. Properties on the coasts
any reviewer of a report should have a heightened awareness
of the possibility that the appraisal is dated – even if we may be
talking about a period as short as six months.
cost estimates. What sources were utilized? To this value may be
added, depending on the situation, entrepreneurial profit to induce
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SRR Journal: When is the income capitalization approach
revenue generates net operating income to which is applied the
appropriate?
capitalization or discount rate, depending on which methodology
JWV: For the most part, whenever there is sufficient income data
is employed.
available to result in a reliable indication of value. Oftentimes, it
SRR Journal: Where do the capitalization and discount rates
will be the most appropriate and most reliable method of valuing
come from? That is, how is it determined and how should it be
a property. The income capitalization approach consists of two
documented within the report?
methods: direct capitalization and discounted cash flow. In direct
capitalization, a stabilized level of cash flow is capitalized into
perpetuity by dividing the estimated net operating income by a
capitalization rate to derive value. With the discounted cash flow
method, discrete cash flows are projected on an annual basis over
a particular holding period, such as five or ten years. The present
value of these cash flows are calculated and added to the present
value of the property as of the end of the particular period of
JWV: Capitalization and discount rates are critical assumptions,
and there absolutely needs to be strong support. This is an
area where appraisers often fall-short – relying on unsupported
assumptions about rates. For support, there are a number
of resources available. First, comparable transactions imply
overall capitalization rates. It can be calculated by dividing net
operating income by the sale price. Second, investor surveys
time utilized.
and conversations with participants in the market provide current
SRR Journal: Regarding these two different methodologies within
more timely data on which to base assumptions. Lastly, rates
the income capitalization approach, when it is appropriate to use
can be derived from a band of investment analysis. This analysis
one versus the other? And how often, if at all, should a reviewer
reviews current financing terms that provide information on various
see both of them at the same time?
sources of capital. The analysis looks at both the cost of debt and
JWV: Theoretically, both should produce the same value as they
are typically utilizing a lot of the same underlying assumptions.
But which one should be employed depends on the expected
cash flows. In situations where stable cash flows are expected, for
example with long-term leases, there is little reason to use anything
expectations of investors, so in some respects this may provide
equity, which are then weighted to derive an overall capitalization
rate, which implies an overall rate of return on and of the investment
in real estate. Using all of these sources and weighing their relative
merits at this point in time and for this particular property will allow
the appraiser to determine capitalization or discount rates.
other than the direct capitalization approach. This situation is very
SRR Journal: What is the difference between a capitalization rate
common with an owner-occupied property. But if there are a
and a discount rate? Do they derive from different sources? Do
number of leases with frequent turnover, or if the property is not
they measure the same thing?
fully leased up yet, etc., then cash flows will fluctuate. In these
situations, using a discounted cash flow methodology may allow
for better flexibility in predicting cash flows and ascertaining the
JWV: No, they are different, but they share a key attribute.
Theoretically, the discount rate is the “return on” an investment
valuation impact.
required by an investor for a given level of risk. A capitalization
SRR Journal: Whichever income-based methodology is being
investment required by the investor. This is another area to
used, they follow a basic format: estimate future cash flows and
review: Has the appraiser been consistent if both a capitalization
convert those cash flows into a present value equivalent. What are
rate and a discount rate been presented? The investor surveys
some of the key areas that should be reviewed regardless as to the
I previously mentioned tend to be the best sources for discount
methodology employed?
rates – this is what investors are looking for today as a return
JWV: As it relates to “revenue,” or rents, the estimate needs to
comport with the interest being valued. The rents applicable to a
fee simple interest may be very different from the rents applicable
to a leased fee interest. The former will be driven by market rents
rate, however, reflects both the “return on” and “return of” the
on their capital. Sales of comparable properties can be great
sources for capitalization rates. So an area to review is whether
the assumptions on capitalization and discount rates are
appropriately supported.
while the latter will solely incorporate current contractual rates. In
SRR Journal: In reconciling the different approaches – cost,
times of changing market conditions, this may have a profound
sales comparison, and income capitalization – I assume in general
impact on value even when comparing similar times periods.
you prefer to see some consistency between their respective
Vacancy is obviously another key assumption that needs to have
conclusions, but what happens if you do not? How do you derive
sound historical and/or market-based support. As it relates to
a conclusion of value given that circumstance? Essentially,
expenses, a key assumption involves reimbursements for or the
how do you reconcile the various methodologies – with or
pass through of expenses such as maintenance of common areas,
without consistency?
taxes, etc. So the terms and conditions of leases, both current and
prospective, are a major assumption. Subtracting expenses from
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JWV: All things being equal, you would like to see them be within
John W. VanSanten, MAI, is a Managing Director for the real estate
a reasonable range of each other. If they are not, the first course of
practice within the Valuation & Financial Opinions Group at Stout
action is to recheck the underlying assumptions of each approach.
Risius Ross (SRR). He has extensive experience in real estate
But, ultimately, it comes down to deciding which methodology
valuations of all types of commercial and special use properties,
should receive the most weight, which one is the best indication?
and has provided Expert Testimony in jurisdictions around the
The answer really comes down to a couple of things. First how
country. Mr. VanSanten can be reached at +1.312.752.3384 or
are the relative qualities and the quantities of the data available
[email protected].
for each method? If you have a lot of great sales, then a sales
comparison approach could be a very powerful, reliable approach.
Second, one should always keep in mind how an investor will look
at the property. If cash flow is the primary driver, then the income
capitalization approach may be most reliable. A lot of this goes
back to highest and best use.
SRR Journal: Do you have any concluding comments?
JWV: I encourage all attorneys to look beyond the “Pretty Report”
and take a closer look at the underlying analysis. Whether you
are getting ready to cross-examine a witness or trying to get
comfortable with your own expert, taking a critical look at the
appraisal can make or break your case.
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