7 Commercial Property Red Flags

Commercial Property

Think about your most recent trip to the beach: As you carried your beach chairs across the boardwalk, were you met with calm and clear water, or did you find yourself faced with hazardous conditions? Red flags offer indications of warnings at the seaside and beyond. In fact, the earliest record of a red flag being issued as a warning dates back to 1777. Nowadays, the term red flag refers to anything we should be made aware of, and when it comes to CRE, that could range from compliancy to property rights. We’ve narrowed it down to seven commercial real estate red flags that lenders should be on the lookout for from appraisers. With our guidance, your commercial appraisal should certainly be smooth sailing.

1. Unsupported conclusions.

One of the first things lenders should be aware of is unsupported conclusions such as capitalization rates, vacancy estimates, discount rates, etc. In general, a lower cap rate indicates there is less risk associated with the investment (due to increased demand) and a higher cap rates can be associated with higher risk alternatives. However, it’s important that the NOI is evaluated along with vacancy estimates and discount rates. All of these things play a part in an appraiser’s property analysis.

2. No “As Is” value per interagency guidelines.

Interagency guidelines say value means an opinion or estimate, set forth in an appraisal or evaluation, whichever may be appropriate, of the market value of real property, prepared in accordance with the agency’s appraisal regulations and guidance. For loans to purchase an existing property, the term “value” means the lesser of the actual acquisition cost or the estimate of value. As you know, “As Is” value is the value of the property in its current condition. Often we find that the lender will ask for a value “As If” the property is not affected. That is reasonable for a secondary value, however, Interagency Guidelines require the true As Is value and thus the “As Is” value should be stated.

3. USPAP compliancy.

Like we’ve discussed before, an appraisal must “be performed in accordance with generally accepted appraisal standards as evidenced by the appraisal standards promulgated by the Appraisal Standards Board of the Appraisal Foundation” – in other words, since the appraisal has to comply with the ASB, the appraisal essentially must also comply with USPAP.

4. Highest and best use issues.

According to the Appraisal Institute, highest and best use is commonly one of the weakest areas in an appraisal. If for some reason an appraiser does not adequately analyze the highest and best use for a property, the entire appraisal and value conclusion could be at risk. Look for red flags that don’t address the property as is in relation to its highest and best value.

5. Property rights (fee simple versus leased fee).

Be sure that an appraiser addresses the property rights as a part of the appraisal to avoid errors. Fee Simple and Leased Fee refer to the bundle of rights, also known as Property Rights.  These rights include the right to sell an interest, the right to lease an interest, the right to occupy the property, the right to mortgage an interest, and the right to give an interest away. Once the property has been leased, regardless of the terms of that lease, the owner no longer has the right of occupancy, the right to lease, or the right to give an interest away. To make a long story short, if a property is encumbered with a lease, the property should be appraised with a Leased Fee valuation. Often lenders will ask for a Fee Simple valuation on a leased property since the tenant’s terms will end at the time of closing.  Like we discussed above, the value of the property is based on an appraiser’s inspection date which would be the Leased Fee.

6. Reconciling subject data versus market data.

Take note: Reconciling data, and especially the subject data versus the market data, is often a weak point in appraisals. If a property rents for $10 per square foot, but the market rent is $15 per square foot, the difference should be reconciled. It’s not uncommon that an appraiser could use the market rent to estimate the value without consideration that the actual rent is much lower. Essentially, this is a hypothetical value because it does not represent the property as it currently exists. While the difference between the actual and market rents may ultimately be found to produce little difference in value, it still must be supported and reconciled within the appraisal. Be on the lookout for this possible red flag.

7. Environmental factors.

There are a wide range of possible environmental issues. One thing you can do is know which factors should be considered by the appraiser and therefore prominently considered within the report. Overall, all environmental issues should initially be considered a red flag until otherwise considered and analyzed. One thing to note: because red flag issues vary so significantly, there is no real reasonable way to know if a red flag will affect value. They could effectively have little to no effect on the value, or they could significantly affect the value. Be prepared for either scenario.

The bottom line? If you find yourself faced with red flags, the appraisal report generally needs to be revised to produce a credible valuation. MountainSeed reviewers make these revision requests, so our lenders feel free to contact us if they need clarification on why the revisions might have been requested, and how to apply them to the appraisal. On the appraisal sea, we’re basically your commercial property captains. All aboard!