The article “Appraisals are inherently flawed” by Joel Ross published on 4 August 2009 by HotelNewsNow.com is just one more attempt to lay blame for the current real-estate troubles on appraisers, rather than putting it where it rightly belongs: on both borrowers and the lending community that enabled them.
In formulating an appraisal, a hotel appraiser does not create the actions of the marketplace; they reflect the thinking and rationale employed by prudent buyers and knowledgeable sellers. If, at a point in time, some perceive that market to be irrational, an expert appraiser does not correct the market, but instead, reflects such conduct, whether or not in hindsight such activity is deemed rational or not. Past appraisals were not “wrong”—they were just reflective of the frothy market conditions on their date of value.
I believe the author’s commentary is “inherently flawed.” A reputable hotel appraiser’s work is far from “scientific.” It is an art, substantiated by extensive training, years of experience, independence and the ability to distill appropriate market data into value. A professional hotel appraiser is an expert who:
- is exclusively focused on the lodging industry;
- fully understands the prudent operations and ownership of a hotel asset; and
- has daily interaction with hotel investors, owners, operators, brands, lenders, brokers, investment bankers, et c.
An appraisal conclusion is only valid at a single point in time. The market value of New York City property was clearly different on September 12, 2001 as compared with two days earlier.
The author’s claim that “appraisals are based on a set of assumptions that by definition, can’t be known, nor will they prove to be correct except by random coincidence” is baseless. The author fails to recognize that a skilled appraiser’s findings are a reflection of the thinking and/or actions of prudent investors in the market. Does the author mean to imply that the actions of buyers and sellers are also meaningless and based on random coincidence?
A few other points of contention:
1) 10 year projections: No one knows what will occur in the next one minute, never mind 10 years. An expert appraiser’s analysis and findings are identical to the process that knowledgeable buyers, sellers and lenders undertake when they conclude to their own opinion of asset value. Like the investor, an appraiser bases their opinion on extensive market research and analysis.
2) There’s only up: In today’s market, only an incompetent or unethical appraiser would forecast “up” for the near term, no different than what any buyer would consider. Everyone knows hotels are cyclical. During frothy times, when the “there’s only up” psychology is prevalent among active players, this psychology is validated by markets characteristics such as historically high ADR’s and/or sales prices; an expert appraiser must reflect the same “state of mind.”
3) Investors’ perception of risk and required returns shifts over time: Hotel appraisers utilize discounted cash flow analyses with terminal cap rates because that is how lodging debt and equity investors (for that matter, most commercial real estate investors), make their projections. These may, in fact, be “assumption, on assumption, on wild guess,” but if that is how the market behaves, an appraiser must accurately reflect the market. The factors used in such analyses are based on realistic, reasonable and supported assumptions.
4) Within the 10 years, there must be a product improvement plan or a major renovation: Similar to market participants, a hotel appraiser deducts any foreseeable Product Improvement Plan. The PIP may be required either by the brand, or deemed necessary by the appraiser for the asset to remain competitive. When formulating cash flow projections, hotel investors’ account for a 3 percent to 5 percent annual reserve for replacement during the holding period, and a hotel appraiser will accurately reflect the same. Independent studies indicate that the commonly used 4 percent to 5 percent reserve for replacement allocation may not result in sufficient funds for a future PIP requirement, therefore, the appraiser uses a terminal capitalization high enough to account for the need for a PIP upon sale. Terminal cap rates are typically 50 basis points to 100 basis points above the going cap rate to account for both a future PIP and interest rate risk.
5) Most lenders are doing their own underwriting of value and determining their own sense of value: No argument here. Lenders must understand and determine if they are being adequately paid for the level of risk they are taking. Very few lenders are hotel specific, so as generalists, they consider it reasonable, and prudent to rely on the supported analysis and documented opinions of professional hotel industry appraisers rather than on the assertions of borrowers.
The author asserts myriad opinions and commentary of no merit. For example:
• “Internal rates of return tend to decline over time by virtue of the math of discounting.” Correction: Not if the annual cash flows also increase.
• “The appraisals issued in the past several years are totally wrong, so why is any lender going to believe one now? This is how we got into this crisis - investors and lenders believed fantasies.” Correction: Investors and lenders promulgated these fantasies and fed them to appraisers, not the other way around.
• “Lenders believed the ridiculous projections on which appraisals were based.” Correction: Lenders promoted those projections, based on what borrowers, buyers, and other “infallible market” participants were telling them. If an appraiser rejected those projections, lenders would ask: Who knows the market better, you or my big name borrower?
During my 30-year career, I have exclusively focused on appraising hotels. I have authored numerous articles, and always enjoy reading and debating different viewpoints on myriad topics. This is the first time I have ever felt the need to author a letter to an editor about an article that was so egregiously one-sided.
Daniel H. Lesser has specialized in real estate appraisals, economic feasibility evaluations, investment counseling, and transactional services of hotels, resorts, conference centers, casinos, and timeshare properties on a worldwide basis for the past 30 years. He currently serves as the Senior Managing Director-Industry Leader of the Hospitality & Gaming Group at CB Richard Ellis (CBRE). For 11 years prior to joining CBRE, Mr. Lesser founded and led the Hospitality & Gaming Group at Cushman & Wakefield. Mr. Lesser was a member of the original team at HVS International when it was founded, and where he subsequently spent thirteen years expanding the firms practice. Prior to his hospitality advisory and transactional experience, Mr. Lesser held operational and administrative positions with Hilton Hotels Corporation and Eurotels-Switzerland. He can be reached at daniel.lesser@cbre.com.