Appraisal review tips for bankers: Part 3: now you see it, now you don't

RMA Journal, The, Sept, 2005 by Frank DiLorenzo

This series is intended to help a bank's beginning to intermediate-level appraisal reviewer identify some of the more common issues.

In the income capitalization approach to value, the appraiser must include items that may or may not directly match the actual financial expenses of the subject property. This is because the appraiser's deductions must reflect what is true for the market (keep in mind the appraiser is estimating market value) as opposed to what may be true for a particular owner. This fact can cause confusion for customers when they eventually receive a copy of the appraisal. Typically, there are three basic deductions that may differ from (market) reality:

1. Vacancy.

2. Replacement reserves.

3. Management fee.

The reviewer needs to be well versed on why these items are treated as they are.

Vacancy. For a variety of reasons, an appraisal quite possibly will reflect a level of vacancy that is higher or lower than the current vacancy of the property. For example, let's say a subject property is leased at market rents but is consistently near 98% to 100% occupancy, whereas the market routinely reflects 93% occupancy as the norm. There could be contributing factors that explain why the subject property is more desirable than competing properties, but in most cases this situation would translate into higher rents, so occupancy probably would also be affected. Another possibility could be superior management. There certainly are instances where active property managers stay on top of their tenants with respect to their leasing intentions to renew and with respect to their performance and ability to meet rent obligations. Those managers also actively cultivate long-term prospects and have potential replacement tenants lined up.

Why, then, does the appraiser reflect a 7% vacancy factor rather than the historical average of 2% for the property? It's because superior property management by a particular owner does not translate into "market value," that is, the value to a typical owner in the market. Of course, if the appraiser can specifically identify why the subject property is superior to the comps in terms of market vacancy--because of location, amenities, or other strength--he or she may appropriately use that superiority as a justification for a lower vacancy factor.

The appraiser is required to reflect the market value of the property. While the property may, in fact, be worth more to an exceptional property manager who can maintain occupancy rates that are higher than the market, the appraiser must reflect the value of the property to a generic owner in the market who demonstrates only a market level of property management expertise.

Replacement reserves. From the property owner's point of view, a replacement reserve is not reality. It is not an actual cash expense that will appear on his or her tax return. (For some reason, the IRS won't let people deduct expenses that they don't actually incur.)

So if it's not an actual expense, why is it included? Replacement reserves are a provision for expenses associated with replacing or repairing items that suffer wear and tear over time, such as the roof, carpeting, and painting--real costs of ownership that do arise periodically. The reserves are based on the estimated remaining useful life of those types of items. Accordingly, the financial impact must be recognized.

Replacement reserves are not to be confused with actual repair and maintenance expenses--the more normal day-to-day expenses of the property, such as cleaning crew, snow removal, lawn care, window washing, and so forth. These expenditures must also be included in the income capitalization approach to value.

Management fee. A professional property management fee generally ranging from 3% to 10% of effective gross income (depending on the scope of the responsibilities) is necessarily included in the income capitalization approach. The borrower often will ask, "Why is the appraiser going to ding me for a management fee? I'm going to manage the property myself: I don't have to pay a manager to manage the property for me!" Again, we must look at the market. An investor normally will hire a professional to oversee the management of the property, including things like collecting rents and making sure the property is properly maintained.

Beware of the "Double Whammy"

From time to time, you may find that a property owner doesn't want to be bothered with tenant turnover or constantly having to seek out new tenants to keep the property occupied. One method to achieve higher-than-market occupancy is to charge rents that are below market rates. The appraiser needs to recognize this, because by charging lower-than-market rents to achieve higher-than-market occupancy, the owner has, in effect, already built in the "vacancy factor." If the appraiser were then to apply a market vacancy factor, the property's income stream would have accounted for vacancy twice--the double whammy. Please don't confuse an inferior property where rents actually should be lower, with a typical market-quality property, where the owner merely elects to choose an easier method in which to manage it.