Pitfalls for Lenders

For a banker, half the battle in lending is in avoiding the pitfalls.  Certainly, no one wants to be the lender whose appraisal costs so much that the borrower goes elsewhere.  On the other hand, no one wants to be the lender who got an inadequate appraisal and as a result is on the hot seat years down the road, when the loan has gone bad.  Better to get a good appraisal.  The first step in a good appraisal is to ask the appraiser the right questions.  Better to get the questions right at the start.
 
A lender needs an appraiser who can help define what questions need to be answered.  Here are a few of the main questions to help frame the assignment.
 
Sales, Income, or Cost – Which Method? 
An appraiser may (and usually should) apply more than one method of analysis.  But however many are applied, the final value usually relies on one.  For retail buildings, that most often is Income.  For owner-occupied industrials and offices, it is Sales.  For any property type, it is almost never Cost.  The Cost Method is often applied to special use properties like places of worship and schools.   But it can greatly overstate what a property would bring if it were put on the market.  The lender who makes a loan based on Cost may have a loan that is underwater on day one.
 
Simple Capitalization or DCF?
A Discounted Cash Flow analysis that spreads the number across the page year by year can display some things better than can Simple Capitalization.  On the other hand, Simple Capitalization is simple.  It is more easily understood.  The answer usually is to use whichever method buyers and sellers would use.  Sometimes, the answer is Simple Capitalization.  Sometimes it is both.
 
Is the Value the Sum of the Parts?
Probably not.  Are ten $500,000 condominiums worth $5,000,000?  Not if there is no one out there who would pay that.  If the buyer is someone who would sell out the units for a profit, the buyer would incur holding costs and costs of brokerage and would require that profit.  Those factors result in a substantial discount, to a price well below the sum of the parts.
 
“As Is” or Stabilized?
Do you need to know what that office building is worth now, when it is half occupied and half built out, or what it is worth when it is full and complete?  Probably, both.  The numbers can be very different.  The loan is safer if the lender knows the value of the building at each step on the way to stabilized occupancy.
 
What’s the Dirt Worth?
For some commercial properties, the building that is on the site is really a diversion from the true value, which is in the land.  Industrial buildings are demolished to make way for apartments and schools.  Old gas stations are razed to make their sites into bank branches.  To assume that a property’s highest value comes from whatever is on it without testing the land itself for value can miss a large source of potential collateral.