Construction and Development Lending (Reprinted with Permission)

By Bill Moreland, Bank Reg Data

This week reviews Construction & Development lending. The review is a lot more complicated than I had originally considered, and therefore longer than my usual diatribes.

While not an opus, it may feel like one as we cover industry trends, delinquencies and growth. The short version is that Construction lending has gone through massive reductions with the biggest banks pulling back the most. Many smaller community banks, however, are increasing lending.

The word “growth” is not really an accurate definition of what’s been happening nationally with Construction & Development lending. The table below details aggregate bank C&D Lending (2nd Column) by Quarter along with the percentage C&D lending is to total loans (3rd Column):

After peaking at $631 Billion in 2008 Q1 (7.92% of total lending) construction loans have been on a steady and dramatic decline. Currently, U.S. banks have $254 Billion in Construction loans which accounts for 3.46% of total lending. Year over year, this is down from $354 Billion which is a 28.09% drop.

1-4 Family construction is sitting at $47 billion (18.62% of total C&D) and is down from $203 Billion (32.26%) in 2008 Q1. The $47 Billion figure is the lowest since reporting the number began in 2007 Q1.

Construction & Development Delinquency and Charge Off Trends

Early Stage Delinquencies (light green line) are collectively at 1.71% which is slightly higher than Q2, but much lower than rates going back to Q4 2007. These lower rates bode well for future performance.

Unfortunately, nonperforming loans are still very elevated at 14.57%. The larger banks continue to have higher NPL rates while the smallest Community Banks (sub $250 Million) have the lowest NPL rates. Sub $50 Billion in assets, there is a direct relationship between bank size and NPL rates. You can see the trend on the 3rd chart. here.

Year Over Year Growth Rates by Asset Size

Earlier we discussed that year over year Construction lending has dropped by 28.09%. The chart below details growth rates (drop rates) by asset size. 

The larger the bank, the faster they have been shedding Construction & Development loans. The table below details the top 10 Construction & Development lenders from 2010 Q3 and where they are now:

Regions has shed 46.81% of their Construction loans in the last year and is sitting at a 23.47% NPL rate. They have restructured 18.11% of their C&D loans. The good news is that as they increase their restructured levels it is driving the NPL rates on the restructured loans down from 59.42% to 47.76%.

Community Bank Year Over Year Construction Loan Growth by State

For this section I have included banks with less than $2 Billion in assets and who had Construction loans in both 2010 Q3 and 2011 Q3. While not a perfect indicator, it should be a reasonable approximation of Community Bank Construction lending activity over the last year.

As a group, the national Community Bank “sector” had a year over year drop of 18%. The biggest drops came in the West – Oregon’s community banks experienced a 34.88% year over year drop in construction lending. The “best” (or I should say lowest) drops in year over year lending came in the Mid-West, Gulf-Coast and Northeast.

Certainly, the only area to experience actual construction loan growth was Washington DC. The 4 community banks headquartered in DC that have construction loans increased their year over year construction lending by 30.56%.

So, to summarize, we’ve seen aggregate construction lending drop 28.09% in the last year and observed reductions happening in all asset size categories. To end there, however, would be to tell only part of the story.

Construction Loans to Total Loans Percentage Since 1992

While 3.46% for 2011 Q3 looks extremely low compared to the ratio since 2008 Q4, a longer perspective provides a slightly different viewpoint.

The massive amount of C&D loan reduction is masking growth trends.

Because of weighting, it is easy to imagine from the charts/data above that there are no banks increasing their construction loan portfolios. Naturally, and since I’m bringing it up, this is nowhere near the case. I looked at all banks that had construction loans in either 2010 Q3 or 2011 Q3 or both periods (the vast majority). The table below details the 6,220 institutions and whether or not they grew their 2011 Q3 C&D lending over 2010 Q3 levels:

Surprisingly, 31.38% of institutions actually increased their lending year over year. This is not to say they grew their portfolios 31.38%, but rather they did increase the dollar amount at least $1 year over year. Finally, note the relationship with asset size.



Posted in Land Valuation | Tagged , , , , , , | 1 Comment


By James R. MacCrate, MAI, CRE, ASA


One wonders how the current financial crisis developed in this country. After all, we have faced  numerous financial crises dating back to the early 1800’s. The financial institutions, regulators, accounting firms, credit rating agencies, and the major Wall Street firms have not studied the history of other periods of financial duress or ignored what has been learned in the past. If you are interested in some problems and warning signs, please read the following and see if you can determine when it was written and where it was published.  This is a direct quote:

“Real Estate Lending – Potential Problems

Real estate lending abuses have been given a lot of publicity due to the problems encountered by financial institutions that have suffered substantial losses from problem real estate loans. These problems have not been confined to any particular area of the country. Many of the problems revolve around inflated appraisals, land flips (interparty transactions), fraudulent sales contracts, forged title documents, misapplication of loan proceeds, financing of nonexistent properties, loans in the name of trustees, holding companies and offshore companies to disguise the true identity of the actual borrowers and fraudulent loan applications from purchasers, including false income statements, false employment verifications, false credit reports and false financial statements. In many cases, important documentation is missing or is intentionally deficient in an attempt to conceal material facts.

Warning Signs

  1. An unusually large number of loans in the same development are exactly equal to the institution’s minimum loan-to-value (LTV) ratio for real estate mortgages.
  2. The institution has an unusually high percentage of “No Doc” loans. (A “No Doc” loan is one in which extensive documentation of income, credit history, deposits, etc., is not required because of the size of the down payment, usually 25% or more. Theoretically, the value of the collateral is to protect the lender.)
  3. Borrower has never owned a home before and does not appear to have the financial ability to support the size of the down payment made.
  4. Property securing loan has changed ownership frequently in a short period of time. Related entities may be involved.
  5. Insured value of improvements is considerably less than appraised value.
  6. Appraiser is a heavy borrower at the institution.
  7. Appraisal fee is based on a percentage of appraised value.
  8. Borrower furnishes his/her own appraisal which is a photocopy of an appraisal signed by a reputable appraiser.
  9. Use of “comparables” which are not comparable.
  10. Appraisal is based on an estimated future value.
  11. All comparables are new houses in the same development that were built by the same builder and appraised by the same appraiser.
  12. An unusual number of “purchasers” are from out of the area or out of state.
  13. Credit history, employment, etc., are not independently verified by the lender.
  14. Large number of applicants have income from sources that cannot be verified, such as self-employment.
  15. Applicant makes $90,000 per year and only wants to purchase a $90,000 home.
  16. Applicant is 45 years old but credit history only dates back five years.
  17. The institution’s normal procedure is to accept photocopies of important documents rather than to make their own copies of the originals.
  18. If copies of income tax returns are provided, columns are uneven and/or do not balance.
  19. Appraiser is from out of the area and not likely to be familiar with local property values.
  20. Close relationship exists between builder, broker, appraiser and lender.
  21. Construction draws are made without visual inspections.
  22. All “comparables” are from properties appraised by the same appraiser.
  23. Generally, housing sales are slow, but this development seems unusually active in sales.
  24. There seems to be an unusual number of foreclosures on 90% to 95% loans with Private Mortgage Insurance on homes in the same development built by the same builder. (Sometimes it is cheaper for the builder to arrange for a straw buyer to get the 95% loan and default than it is to market the home if the market is sluggish.)
  25. Applications received through the same broker have numerous similarities.
  26. Sales contracts have numerous crossed out and changed figures for sales price and down payment.
  27. Appraiser for project owns property in the project.
  28. Lending officer buys a home in a project financed by the institution.
  29. Assessed value for tax purposes is not in in line with appraised value.
  30. The project is reportedly fully occupied, but the parking lot always appears to be nearly empty.
  31. The parking lot is full, but the project appears empty. Nobody is around in the parking lot, pool, etc.
  32. After a long period of inactivity, sales suddenly become brisk.
  33. Sales contract is drawn up to fit lender’s LTV requirements. Buyer wants an $80,000 home but has no down payment. The lender only lends 80% of appraised value or selling price. Contract is drawn up to show a selling price $100,000 instead of the actual selling price of $80,000.
  34. Builder claims a large number of presold units not yet under construction while many finished units remain unsold.
  35. Employment of prospective borrower/purchaser is 100 miles from location of property while comparable housing is readily available within 10 miles of employment.
  36. Applicant’s stated income is not commensurate with his/her stated employment and/or years of experience.
  37. Applicant’s financial statement shows numerous assets that are self evaluated and cannot be readily verified through independent sources.
  38. Applicant claims to own partial interests in many assets but not 100% in any asset, making verification difficult.
  39. Appraised value of property is contingent upon the curing of some property defect such as drainage problems.
  40. Applicant’s financial statement reflects expensive jewelry and art work but no insurance coverage is carried.
  41. Applicant’s tax return shows substantial interest deductions, but financial statement shows little debt. For example, the borrower’s tax return shows substantial mortgage interest deductions, but the self-prepared financial statement shows no mortgage or a very small mortgage.
  42. Appraised value of a condominium complex is arrived at by using the asking price for one of the more desirable units and multiplying that by the total number of units.
  43. Loans are unusual considering the size of the institution and the level of expertise of its lending officers.
  44. There is a heavy concentration of loans to a single project or to individuals related to the project.
  45. There is a heavy concentration of loans to local borrowers with the same or similar real estate collateral which is located outside the institution’s trade area.
  46. There are many loans in the names of trustees, holding companies, and/or offshore companies but the names of the individuals involved are not disclosed in the institution’s files.
  47. A loan is approved contingent upon an appraised value of at least a certain amount and the appraised value is exactly that amount.
  48. Independent reviews of outside appraisals are never conducted.
  49. The institution routinely accepts mortgages or other loans through brokers but makes no attempt to determine the financial condition of the broker or to obtain any references or other background information.
  50. Borrower claims substantial income but his/her only credit experience has been with finance companies.
  51. Borrower claims to own substantial assets, reportedly has an excellent credit history and above average income, but is being charged many points and a higher than average interest rate which is indicative of high risk loans.
  52. The institution allows borrowers to assign mortgages as collateral without routinely performing the same analysis of the mortgage and mortgagor as they would perform if the institution were mortgagee.
  53. Asset Swaps – Sale of other real estate or other distressed assets to a broker at an inflated price in return for favorable terms and conditions on a new loan to a borrower introduced to the institution by the broker. The new loan is usually secured by property of questionable value and the borrower is in weak financial condition. Borrower and collateral are often outside the institution’s trade area.

Suggested Action

Review all real estate files and request any missing documents. Review appraisals to attempt to determine whether any land flips have been involved. Compare appraised value to other stated values such as assessed value or insured value. Attempt to identify any pattern or practice which appears to be suspicious such as a large number of borrowers having the same employer, a large number of properties appraised by the same appraiser, a large number of loans presented by the same broker, a large number of out-of-territory borrowers, etc. If possible, visit construction sites to see activity is as represented.”

Conclusion and Answer

Believe it or not, this was written and published by Federal Deposit Insurance Corporation in January 1990 in the DOS Manual of Examination Policies as Bank Fraud and Insider Abuse (1-90).  It was faxed to me at Price Waterhouse LP on February 19, 1991 at 3:51 PM EST by the FDIC Library while my group was reviewing loan portfolios at five lending institutions from Tampa to Buffalo.  Amazing, isn’t it?  Probably, the folks who understood these issues and directives are retired or forced into retirment or fired during the period from 2004 through 2008.

Special Thanks to Maureen McGoldrick, MDM Appraisals, LLC for her contributions.

Posted in Appraisal Reviews, Ethics, Real Estate Litigation Support, Residential Properties | Tagged , , , , , , , , , | 3 Comments

The Department Store Conundrum

By Maxwell O. Ramsland, Jr., MAI, CRE and Shannon M. Luepke

Market value is the standard by which appraisers, assessors, and other valuation professionals conduct their practices. Market value versus price is an issue that has been debated for decades by valuation professionals. Price, whether it’s a single sale or an aggregate of community based sales, is clearly an indication of market value when adjustments are made for dissimilar characteristics. Cost, while a corollary of both price and value, is an attribute of far less significance when viewed from a strict market perspective. Yet, cost remains a valuable yardstick for appraisers.

The department store conundrum involves both price and value, and to a lesser degree cost. The department store conundrum was first articulated by Professors William Kinnard and Jeffrey Fisher when they hypothesized, in effect, “…if it cost $70.00 per square foot to build an anchor department store, then why is it when they sell, they sell for about half of their replacement cost new?”

While Fisher and Kinnard’s conjecture is not as challenging as it once was, the solution is complex. They contend that the answer lies with the business enterprise feature of the property and emanates partially from the developer’s subsidy of the department store. The authors herein contend that Fisher and Kinnard’s conjecture is correct as far as it goes, but there is new empirical evidence from the marketplace that more fully explains the department store conundrum. That evidence consists of several market sales of anchor department stores of variable ages experiencing steep discounts from their actual cost and/or replacement cost new. The evidence strongly suggests that Fisher and Kinnard were right when they first observed the department store conundrum.


Anchor department stores have taken the prime position in regional and super-regional shopping centers since their advent in the 1950s. The very design of the shopping center was to create a finite shopping environment which brings a mix of national, regional and local businesses together into a central location. These businesses operate independently of one another, but have a defined common goal to advertise and promote their business jointly within that controlled environment. The theory, design and environment were natural for the anchor department store, and as new malls were developed, anchor department stores expanded at multiples of two, three and four, etc.

In recent years, as many of the earlier shopping centers began to age, the industry began to question the economic life of a typical shopping center, and began to acknowledge that its economic life, due to functional and/or architectural obsolescence, may be considerably shorter than its physical life. Concomitantly, the retailing marketplace was going through its own transformation as freestanding discount department stores and big box developments began to provide formidable competition to the malls and anchor department stores. Reacting to the competitive pressure, anchor department stores began to contract or downsize their physical properties, and to consolidate brand names. Then, in the middle of this natural metamorphosis, a recessionary economy took hold. The natural result of this change has been consolidation, downsizing, and repositioning of the retail market. A by-product of this change has been more comparable data including the sales of several anchor department stores.

Currently, due to a variety of market conditions, anchor department stores represent what is commonly referred to as a “limited-market property” or “a property that has relatively few potential buyers at a particular time.” As such, there are a finite number of anchor department store brands in existence today, e.g., Macy’s, JCPenney, Nordstrom, Sears, Dillard’s, etc., compared to a decade ago. Furthermore, in any given operating mall it is highly likely that a particular brand name, or a subsidiary of the remaining brands, already exists. Thus, the supply and demand relationship for anchor department stores is influenced by the disequilibrium between the buyers, sellers and users in the marketplace.

The declivitous direction of the retail market over the last few years has served to call attention to the changing trends in retailing, and exacerbates the identity of inherent obsolescence in larger, multi-story department stores. Most retailers will agree that department stores are not designed or built like other generic or general purpose retail properties. Discount department stores, for example, tend to be built as smaller, single story, consumer accessible structures, which represent what most appraisers refer to as a “general purpose” retail type building. Similarly, office buildings are typically constructed with a multi-tenant objective with flexible and re-usable tenant improvements for maximum efficiency. By contrast, anchor department store layouts, size, construction materials, fixtures, etc., are designed for specific merchandising or product displays with specific areas dedicated to traffic efficiency, customer service, fitting rooms, and to a lesser degree management offices and merchandise stock areas. The lighting, for example, is intended as a combination of normal illumination and special lighting for merchandise display areas. Wall mounted case goods with crown molding and wainscoting have the appearance of being real estate to the observer, but represent trade fixtures to the retailer. In-store boutique displays of named brand vendors, e.g., Polo, Nautica, Ralph Lauren, are custom-made trade fixtures designed to promote the merchandising and brand identification of the vendor. These boutiques are trade fixtures to the vendor and their size, shape and construction are stipulated to between the boutique and the department store in various merchandising agreements between the parties.

Of considerable importance is that each major department store has its own particular “trade dress” or signature identification. Dillard’s stores have a far different appearance from Sears stores, both of which are recognizable to the casual shopper. Nordstrom stores are also easily recognizable. While some stores tend to imitate many of the more successful features of other department stores, this rarely alters their own particular trade dress overall.

There is also a size differential between anchor and discount department stores. While discount department stores represent approximately 70,000 to 100,000 square feet of ground floor space, anchor department stores are mostly two stories and sometimes three stories in height, and contain 100,000 to 300,000 square feet. Therefore, anchor department stores are distinctly different in physical characteristics from those of discount department stores, thus making retail sales figures, rental rates, and economic comparisons between them less than meaningful.

For the average consumer, the physical distinctions between the anchor and discount department store are subtle and non-discernible. They have no relevance to the consumer other than product availability and price points. To the experienced appraiser, however, a department store’s trade dress, the boutiques, the second or third floors, and the size differentials all represent a superadequacy (an excess in the capacity or quality of a structure or structural component; determined by market standards) in terms of resale or alternate use considerations. Therefore, superadequate features, coupled with a limited supply of potential users and/or buyers, sets the stage for obvious market discounts, or as expressed in the valuation lexicon: obsolescence.

A highly important element to be recognized in the valuation of an anchor department store is the knowledge that it is very unlikely one anchor department store will adopt or use the trade dress (tenant improvements) of another anchor department store. This condition alone results in an immediate discount of most, if not all, surviving tenant improvements in a store, regardless of the age or condition of the tenant improvements. For example, when Von Maur purchased the former Lord & Taylor store in the Polaris Fashion Place Mall in Columbus, Ohio, the property was stripped of Lord & Taylor’s three year old tenant improvements and replaced with the Von Maur trade dress. While there are exceptions to this practice, it is generally an axiom of the industry that the trade dress of one anchor will not be re-used by another anchor. This practice supports the hypothesis that the actual construction cost of an anchor department store represents a value-in-use to the retailer rather than a fee simple or generic use to other retailers. Hence, the business enterprise component attributed to Professors William Kinnard and Jeffrey Fisher. The derivative of this argument is that functional and/or external obsolescence are inherent in the department store’s initial construction as well as its actual cost of construction. To the appraiser/assessor, it is a challenge to identify and quantify these components in the appraisal process.

Anchor Department Store Obsolescence – The Theory

When department stores are built they strive to set up their tangible real estate as separately identifiable and distinctive from their competition. From low end stores with vinyl fast tracks and inexpensive ceiling tile to higher quality stores with marble fast tracks and decorative ceiling treatments, the design, materials and quality of the store’s interior finish serves to portray the distinctive image or trade dress of a particular retailer, with the unquestionable objective being to promote the store and set its products apart from its competitors.

Many facets of a department store, that at first appear to be real estate, are actually trade fixtures that have been installed for merchandise or product display purposes. Interior wall treatments are set up for the purpose of displaying goods, clothing, shoes, tools, tires, etc. Spot, track and can lights are placed within a store to focus on certain displays or merchandise. The conjoining of real estate and trade fixtures is part of a store’s merchandising plan, and represents an investment in real and personal property, furniture, fixtures, marketing design, etc. Hence, the concept of a value-in-use to the merchant begins to make sense.

In many areas of a department store there are vendor specific and vendor supplied tenant finishes. Polo’s mahogany wood trim and accent moldings are intended to create an atmosphere for selling the Polo product line. Nautica flooring, wall cases, and crown molding do the same. The initial costs of these specialized trade fixtures are costs to the store, however, and are fully or partially reimbursed by the vendor. When the merchandise agreement ends, the fixtures are not used for other product lines, and removal costs are paid by the store. While these finishes appear as real estate, they are not tenant finishes that are transferable nor suitable for another user of the space, which means that their economic life/useful life is likely to be shorter than that for “standard” building components.

From a fee simple perspective, department store obsolescence can be either external or functional. Department stores generally incur market based functional obsolescence from two sources: from the fact that when a store is originally built, it is designed and built to project the store brand’s particular “trade dress,” and/or the store’s size and multi-story configuration.

A source of market based external obsolescence is that the sales productivity and income being generated by the department store is not sufficient to sustain its level of operations. Most often, a department store’s market based obsolescence is a function of both external and functional obsolescence. For example, a store’s size can contribute to both its functional and external obsolescence. Imagine a store doing $30 million of sales per annum. If the store had 300,000 square feet, the sales per square foot, which is the common denominator of all retail activity, would be $100.00 per square foot. By contrast, if the store had 150,000 square feet, its sales productivity would be $200.00 per square foot. With the average anchor department store having sales of approximately $180.00 per square foot, and a given gross leaseable area of 148,796 square feet, it is obvious that both functional and external obsolescence can be present simultaneously.

Documentation of Functional Obsolescence

The Dictionary of Real Estate Appraisal originally defined functional obsolescence as, “An element of depreciation resulting from deficiencies or superadequacies in the structure.” Currently, the definitions that are in the IVS Glossary is “a loss in value within a structure due to changes in tastes, preferences, technical innovations, or market standards. Functional obsolescence includes excess capital costs and excess operating costs. It may be curable or incurable. Also, called Technical Obsolescence” and in the Dictionary of Real Estate Appraisal as “the impairment of functional capacity of a property according to market tastes and standards.”

Functional obsolescence can be calculated based on the superadequacy of an actual department store as compared to the replacement cost new of a hypothetical department store without the store’s particular trade dress or tenant improvements. For example, the superadequacy of interior finish has been quantified below by performing a replacement cost new estimate for a generic store of the same size and quality of an actual operating store, but without its interior physical attributes. For analytical purposes, functional obsolescence is considered to be the depreciated difference between the replacement cost new of the existing store costing, say $15,200,000 against the cost of the same generic store without tenant improvements. The calculations are summarized below:

External Obsolescence

The Appraisal Institute originally defined external obsolescence as, “An element of depreciation; a defect, usually incurable, caused by negative influences outside a site and generally incurable on the part of the owner, landlord, or tenant.
Now, The Dictionary of Real Estate Appraisal, 5th ed. defines external obsolescence as “an element of depreciation; a diminution in value caused by negative externalities and generally incurable on the part of the owner, landlord, or tenant.”

Department Store Obsolescence Study

The authors have coordinated a study of 12 anchor department store sales having ages of from 2 years to 48 years. On the following pages, the theory, the methodology, and the trend line by age is graphed and presented. The trend line of total obsolescence serves to demonstrate the relationship between price and obsolescence as properties age.

Documentation of Obsolescence Methodology

The technique employed to identify obsolescence from all sources is the traditional building abstraction method. This method first removes the land value from a sale price to arrive at the residual building value as shown below for a hypothetical store. Calculations are as follows.

*Physical depreciation is based on the ratio of a store’s interior finish to the total cost. For example, if the interior finish of a store represents approximately 30% of the replacement cost new, and has a useful life of 12 years, the calculation for physical depreciation is as follows:

A Representative Comparable

As previously mentioned, the authors have investigated 12 sales of anchor department stores. The stores range in size from approximately 77,500 square feet to 225,000 square feet, and average 156,000 square feet; they range in age from 2 years to 48 years, the average age being 11 years.

The comparable illustrated is a former department store in the Midwest. The sale information and obsolescence calculations are as follows:

As noted, the seven year old store was depreciated by approximately 55% overall, of which 33.7% represents obsolescence.

*It is noted in an earlier calculation of functional obsolescence that it is then possible to bifurcate obsolescence between external obsolescence and functional obsolescence.

Presented below are the results of the authors’ obsolescence study. The subset of obsolescence comparables are graphed and summarized below. The trend line of obsolescence clearly explains the severe discounting of anchor department store sales that take place in sales less than ten years of age. Naturally, as properties age, the differences between physical depreciation and obsolescence tend to inversely converge as evidenced by the graph below.

From the market based evidence presented, it appears that Professors William Kinnard and Jeffrey Fisher‘s department store conundrum continues to be confirmed by the presence of new empirical data. The department store sales, which represent a value in use from a cost basis, adjusted for physical depreciation, unamortized tenant finish (trade dress), and other superadequacies tend to result in purchase prices considerably below their replacement cost new. As the obsolescence study strongly suggests, depreciation from all sources averaged approximately 65%, of which total obsolescence represented 38%.

Challenged by the conjecture of Professors William Kinnard and Jeffrey Fisher, the authors contend that the department store conundrum can be confirmed and justified by employing existing market data, and carefully quantifying the various components of functional and external obsolescence.

Special Thanks to Maureen McGoldrick, MDM Appraisals, LLC and James R MacCrate, ASA, MAI, CRE, MacCrate Associates LLC for their contributions

Posted in Depreciation, Real Estate Valuation Methodology, Retail Stores | Tagged , , , , , , , | 1 Comment

Rates of Return on Office Buildings in Manhattan vs Other CBDs

By James R. MacCrate, MAI, CRE, ASA


No one can deny that Manhattan is an interesting city that attracts real estate investors from all over the world. Properties in Manhattan command higher prices per square foot and lower capitalization rates in comparison to most places. In fact, it is often said that investing in Manhattan is as safe as investing in treasuries. Motivations for investing in income properties in Manhattan are many, including an inflation hedge that preserves real value of capital as well as a return on capital. Over the long haul, the returns historically are commensurate with the risks involved, and real estate performs as well as alternative investments (common stocks). Do investors accept a lower pre-tax return on investments in Manhattan in comparison to other central business districts? One measure of investment performance is by comparing overall capitalization rates (Ro) or, alternatively, discount rates in different metropolitan areas for the same or similar competitive investments. By analyzing the expected returns over time published by various companies in various metropolitan areas, an investor can determine if the expected returns are lower in Manhattan.

 Definitions and Sources

For the purposes of this demonstration, the definitions that will be used have been obtained from the Appraisal Institute, The Dictionary of Real Estate Appraisal, Fifth Edition or the studies reviewed. The capitalization rates, discount rates, and other data are based on the Korpacz Real Estate Investor Survey, PricewaterhouseCoopers‘ Korpacz Real Estate Investor Survey®, and PwC Real Estate Investor Survey™. The returns are the expected unleveraged returns reported over time.

The overall capitalization rate (RO) is defined as “an income rate for a total real property interest that reflects the relationship between a single year’s net operating income expectancy and the total property price or value (RO=IO/VO). This is also known as the “going-in” capitalization rate. According to the survey, “the overall cap rates reported in this survey reflect investors’ expectations of property performance.”

The discount rate is defined as “a yield rate used to convert future payments or receipts into present value; usually considered to be a synonym for yield rate.” A yield rate considers all expected property benefits, including the proceeds from sale at the termination of the investment and is synonymous to the internal rate of return (IRR). According to the survey, “discount rate (IRR) is the internal rate of return in an all-cash transaction, based on annual year-end compounding.”

The residual capitalization rate is defined as the “overall capitalization rate used in calculation of residual price; typically applied to the net operating income in the year following the forecast.” The residual capitalization rate is also known as the terminal capitalization rate (RN), “going-out” capitalization rate, or the reversionary capitalization rate.

Since it is difficult for real estate appraisers to obtain overall capitalization rates and discount rates from actual transactions, surveys are useful in providing support for the expectations of investors at the specific point in time that the appraisal is being conducted. An appraisal is a “snapshot” in time of one’s opinion of market value based on the actions of informed market participants. The historical relationships between the various rates of return on real estate investments and similar returns on alternative investments provide a test of reasonableness for the rates selected by an appraiser. Appraisers must be careful using this data because yield requirements vary and the survey may reflect biased yield rate expectations from buyers and sellers.

Expected Average Overall Capitalization Rate Comparison

The average expected capitalization rates reported in the survey for Manhattan office buildings was compared to the average expected capitalization rates for office buildings in the national central business districts.

Historically, the average expected overall capitalization rates for office buildings in Manhattan have been lower than the average expected overall capitalization rates for office buildings in the national central business districts. There was a brief period during the late 1990’s, during 1998-1999, when the reverse was true.

Over the time period that was reviewed, the average difference in the expected capitalization rates for office buildings was approximately 0.62% lower in Manhattan, while the median difference was 0.68%.

 Expected Average Discount Rate (IRR) Comparison

The average expected discount rates (IRR) reported in the survey for Manhattan office buildings was compared to the average expected discount rates (IRR) for office buildings in the national central business districts.

This graph indicates a slightly different story in that the average expected yield rates were quite comparable between the first quarter 1995 and the third quarter 1999. For a brief period after 9-11, the average expected yield on office buildings exceeded the national average, but quickly the yields expected in Manhattan on office buildings fell lower than the national average in the central business districts.

Over the time period that was reviewed, the average difference in the expected discount rates for office buildings was approximately 0.25% lower in Manhattan, while the median difference was 0.32%.


There are many factors that impact the expected returns on real estate investments, including interest rates, supply and demand, vacancy, rental growth rates, changes in expenses, etc., but over the long term, office buildings in Manhattan have commanded lower returns in comparison to other central business districts in the United States. This tends to indicate that the market participants see less risk in investing in office buildings in Manhattan in comparison to other central business districts. In addition, Manhattan data is also included in the national data and after culled out, the spread would even be wider.

 Special Thanks to Maureen McGoldrick, MDM Appraisals, LLC and Max Ramsland, MAI, CRE, Ramsland-Vigen, Inc for their contributions.

Posted in Capitalization Rates, Discount Rates, Office Buildings | Tagged , , , , | 1 Comment

Real Estate Appraisal Scope of Work and The Appraiser’s Data Request

By James R. MacCrate, MAI, CRE, ASA


The valuation of real property interests is an orderly process that has been developed over the years to produce credible results. This process defines the problem and the scope of work that is necessary to develop an opinion of value for the intended users of the report for a specific function, i.e., such as estate tax planning, to obtain a mortgage loan, to protest the real estate tax assessment, etc. The Scope of Work is so important that the Uniform Standards of Professional Appraisal Practice (USPAP) has included an entire section describing this rule.

Scope of Work Rule

Scope of Work is defined by Uniform Standards of Professional Appraisal Practice (USPAP) as “the type and extent of research and analyses in an assignment.” Scope of Work Rule states that an appraiser must for each appraisal, appraisal review, and appraisal consulting assignment: identify the problem to be solved; determine and perform the scope of work necessary to develop credible assignment results; and disclose the scope of work in the report. An appraiser must collect and analyze information about the subject property, the real estate market and competitive sales and leases that are necessary to properly develop the appraisal, appraisal review or appraisal consulting assignment. This includes gathering adequate information about the subject property. Usually, real estate appraisers develop a data request list or “wish list” of information about the subject property that is required to properly produce reliable conclusions. It is extremely important that property owners do not withhold critical information. Doing so can produce conclusions that are misleading and erroneous.

Data Required

The Real Estate Valuation/Advisory Services Group at the “OLD” Price Waterhouse LLP, led by Roger J. Grabowski, ASA and Richard D. Wincott, MAI, developed data request lists that were submitted to the property owners before the appraisal process would be begin. This information is absolutely critical in order to produce credible and reliable assignment results. Some of the information that a real property appraiser might request includes, but is not limited to, the following:

  1. Contact name and phone number of property manager, leasing agent, and appropriate person to arrange for the property inspection.
  2. Date of valuation.
  3. Access to building plans and specifications.
  4. Plot plans or survey for the property.
  5. Legal descriptions.
  6. Copy of current title insurance policy, if available.
  7. Deed restrictions, covenants, easements.
  8. Five-year ownership history.
  9. Three-year history of assessments and taxes, including assessor’s real estate tax ID numbers.
  10. Copies of all ground leases, if applicable (abstracts/summaries acceptable, if in sufficient detail).
  11. Access to copies of all leases.
  12. Current rent roll by tenant and lease abstracts.
  13. Blank copy of standard tenant lease agreement.
  14. Copies of most recent tenant billings, showing calculation of pass-through billings.
  15. Three-year occupancy history detailing tenant retention rate and down time between leases.
  16. Summary of tenant improvement allowances granted to existing tenants within the last three years.
  17. Floor plans delineating tenant spaces.
  18. Engineering reports for five years preceding the valuation date, if any (i.e., hazardous materials, assessments and physical condition survey).
  19. Detailed scope and cost of recent (5 years) and prospective capital improvements (3 years) or repairs.
  20. Detailed annual income and expense statements and tax returns for the last five years.
  21. Year-to-date operating statements.
  22. Annual budget for current year and proposed budget, if available.
  23. Copies of management or leasing agreements (abstracts/summaries acceptable, if in sufficient detail).
  24. Summary of offers to purchase/lease and/or current listings for sale/lease, if any, within the last five years.
  25. Any “unusual” conditions that should be considered in the appraiser’s analysis.
  26. Copies of any appraisal reports, market studies, tenant profiles, or marketing plans completed within the last five years.
  27. Comparable leases and building sales that the owner has access to.

The owner of the property knows the property extremely well and the appraiser is just learning about the property. This property specific information improves the learning curve of the appraiser and saves time, and possibly lowers the cost of the appraisal on income-producing property. If the real estate appraiser has this information before the property is inspected it provides the appraiser with insight about the property and specific property issues that may be addressed during the inspection. This information provides the real estate appraiser with the major economic and physical factors of the property being appraised that are major determinants of value.

Conclusion and Credible Assignment Results

An appraiser must not allow assignment conditions to limit the scope of work to such a degree that the assignment results are not credible in the context of the intended use. If the appraiser does not obtain this information, the scope of work is limited. If the financial institution, mortgage broker, real estate broker, and the lawyer do not provide this information to real estate appraisers prior to the start of the assignment, the final conclusions may not be credible and reliable, and, in fact, may be misleading to the intended users of the appraisal report, including rating agencies, the IRS, and the secondary mortgage market participants. In developing income and expense statements and cash flow projections, an appraiser must weigh historical information and trends and factors that affect the anticipated income and expenses. Value is, after all, the present value of the anticipated future benefits to be derived from the property.

 Special Thanks to Maureen McGoldrick, MDM Appraisals, LLC for her contributions.

Posted in Appraisal Process, Uniform Standards of Professional Appraisal Practice | Tagged , , , , , , , , , , , , , , , | 2 Comments