Appraise Your Appraisal
As an owner planning to refinance, or as a buyer acquiring a property, you may have little, if any, say in the selection of an appraiser. The importance of these sometimes-overlooked appraisal documents can't be overstated. The sigh of relief upon receiving a loan commitment should tempered by the phrase “subject to an appraisal.”
The relevance of an appraisal comes into play in many ways. For example, conventional loan commitments are typically based on a certain percentage of loan to value (LTV) or loan to purchase price, whichever is less. Loans backed by the Small Business Administration also adhere to similar guidelines. In other words, a buyer and seller may come to terms on a price, but if the appraisal is lower than that price, the loan will be based on the appraised value, not the purchase price.
It's critical to learn about what goes into appraisals, how to best work with an appraiser and what to look for in hotel appraisals. Can an appraiser using “old rules of thumb” in improving market conditions undervalue your property? Can your appraisal shortchange you in a good market? What steps can you take to ensure a good report? Can your broker assist you? Can your bank contact, usually a loan officer, assist you?
Due to regulatory guidelines, financial institutions typically contract for the appraiser independently, despite the fact that you pay for the work. Due to internal policies, some lenders won't even share the finished product or value conclusion with the owner/borrower. Ask about your lender's policies in these matters early in the process. Obviously, in private lending situations or if you commission the work yourself for internal decision-making, you're more in control of the selection process. Understanding the process and the product of hotel appraisal is a benefit to you in understanding your own asset and maximizing its real value.
I posed a set of questions to several industry professionals about hospitality appraisals in the current state of our industry. The answers were interesting and may prove helpful in refinancing and sales transactions, or just when you want to find out how much your hotel is worth.
Steven H. Gold, managing director and co-founder of Los Angeles-based Hotel Financial Strategies, believes the biggest problem is that “economists are always projecting increasing cap rates and we're always making future projections.”
The selection of a terminal cap rate is very difficult. The cap rate or overall rate for a hotel-or any income-producing property — is a key component of value derived by the appraiser in an income approach. Capitalization is the conversion of income into value. Capitalization of one year's net operating income (NOI) provides one indication of value, called direct capitalization. The cap rate (“going-in”) rate used in this way of valuing your hotel takes into account an implied holding period and the time value of money, among other things.
Another method, the discounted cash flow analysis, uses the terminal cap rate to which Gold alludes. This type of analysis projects several years of operation into the future. Present value of those future cash flows is considered along with the value of the property at the end of the holding period. That value is estimated using the terminal (end, or “going-out”) cap rate.
Most owners are very familiar with interest rates and their impact on debt. Cap rates play as important or an even greater role in the estimation of value. These inter-connected rates-interest and cap-are both numbers we should all be familiar with. For example, as a seller you establish a selling price using an eight-percent direct cap. For a property with $250,000 net operating income, the indicated value is $3,125,000. You strike a deal with a potential buyer, and that buyer's bank commits to a 75-percent loan. If the appraiser hired by the bank uses a nine-percent cap rate, your equity in the deal increases by more than $250,000-one year's cash flow. Which one is the real value?
It's key to learn about conditions in your market. Institutional owners often call on brokers to provide an opinion of value as a benchmark. So working with a professional and reputable broker can yield a realistic selling price since it does neither the seller nor the broker any good to establish too high a price just to obtain the listing. In the above scenario, you as the seller are an informed participant and can discuss the appraisal's methodology with some degree of familiarity and knowledge.
RATE CAP VOLATILITY
All of our respondents discussed the volatility of cap rates in the recent past, with very low indices in many markets today. Steve Gold says cap rates are lower than they've ever been — citing properties in central business districts that are selling at four-percent cap rates. He also cautions that an interest rate hike down the road could leave properties bought in this boom market upside down without sufficient debt coverage.
Allan Jutte, senior real estate analyst with CB Richard Ellis Valuation & Advisory Services, also addressed the difficulties in cap rate selection. An interesting point he makes is that in an improving marketplace, or in the instance of some trophy markets, i.e., San Francisco, Palm Beach, etc., cap rates based on trailing 12 months' performance or sales data can't always be relied upon.
According to Jutte, “Cap rates didn't mean anything in San Francisco when things were in the red. But that didn't mean there was no value.” San Francisco endured the perfect storm: the dot.com bust, SARS epidemic fears, general economic slowdown and a lot of new product in the market. “But prices were still going up,” he says. “It depends on the upside.”
Responses were mixed about whether lenders typically understand hospitality appraisals. Jeff Lugosi, senior vice president of PKF Consulting, says “lenders are happy to lend on hotels in an up-cycle and I believe they fully understand appraisals in most instances.”
Lugosi raises another important point: that the LTV is set by the lender, not determined by the appraisal. On the other hand, Alan Jutte believes that in many cases the understanding of hotel real estate itself, not just the appraisals, is not what it should be. “Hotel appraisals are not necessarily complicated, but they are complex,” he says. “It takes experience.”
Jutte agrees that a hotel's fortunes can change very quickly, again calling for an experienced hospitality appraiser. As to LTV ratios, it wasn't long ago that hotel loans were hovering at 60-percent loan to value. Gold is concerned that the spread may be too thin in deals with higher ratios — as aggressive as 80 percent in some cases. His firm looks at today's conditions, projects out three to four years, adds about two percent and makes a loan at 75 percent of that figure in hopes that debt coverage and the borrower's position are both safer down the road.
Appraisals are sometimes thought of as a necessary evil — a checklist item to be put in the bank's file along with your social security number. However, the appraiser is charged with estimating the value of the real estate, supporting that value to the client, the state and to appraisal governing bodies. The lender relies on that value in determining the amount of your loan. Educate yourself to the process so that you can be an active participant in the process.
Stephen Taylor, CHA, is managing director for Horwath Hospitality & Leisure's West Palm Beach office offering brokerage and consulting. He has written on real estate, branding, operations and technology. Reach him at firstname.lastname@example.org or 561-575-6590.
What You Can Do
Hospitality appraising is a specialized area of the industry and while as a buyer, you may not have much control, there are some proactive steps you can take.
In the early stages of the process, ask the lender about its guidelines:
Is the appraiser experienced in hospitality work?
Are the results shared with the borrower? Can I get a copy of the report?
If a recent appraisal has been performed for a third party, will the lender use that report?
Here's what you need to consider if you're selling a property:
Call on your broker's expertise; obtain their opinion and solicit their market knowledge.
Cooperate with the appraiser's requests for information.
Withholding data in fear that the appraiser might reach a higher number without your input rarely works.
Here are some tips if you're commissioning your own appraisal:
Ask to see a sample of the appraiser's work.
Make the engagement clear as to fee and time of delivery.
Briefly discuss general market conditions and get a feel for the appraiser's familiarity with your product.
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