LESSONS FROM LOSSES IN
COMMERCIAL REAL ESTATE
Errors that Lead to Significant Financial Losses
In Commercial Real Estate Investing and Lending
VERNON MARTIN
Vernon Martin
American Property Research
Lessons from Losses In
Commercial Real Estate
Vernon Martin
American Property Research
Los Angeles, California
©2010 Vernon Martin
4.26.2010
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Lessons from Losses in Commercial Real Estate
TABLE OF CONTENTS
PREFACE ........................................................................................................................... 4
CHAPTER ONE RELYING ON WRONG INFORMATION ...................................... 8
SECTION 1.1
SECTION 1.2
SECTION 1.3
SELLER AND BORROWER MISREPRESENTATIONS ...........................................10
WRONG CHOICE OF DATA...................................................................................30
BAD ADVICE ........................................................................................................33
CHAPTER TWO
ERRONEOUS METHODS OF ANALYSIS ............................... 47
SECTION 2.1 SUPPLY AND DEMAND ANALYSIS .........................................................................47
SECTION 2.2 DISCOUNTED CASH FLOW ANALYSIS ....................................................................53
SECTION 2.3 DEMOGRAPHIC ANALYSIS ........................................................................................70
SECTION 2.4 UNREALISTIC EXPECTATIONS .................................................................................73
SECTION 2.5 ASSIGNING VALUE TO NONTRANSFERABLE RIGHTS ........................................75
SECTION 2.6 ASSIGNING REAL PROPERTY VALUE TO PERSONAL PROPERTY ..................78
SECTION 2.7 CONFUSING REIT PERFORMANCE WITH COMMERCIAL REAL ESTATE
PERFORMANCE......................................................................................................................................79
CHAPTER THREE
SECTION 3.1
SECTION 3.2
LACK OF KNOWLEDGE ..................................................... 81
LACK OF GEOGRAPHIC KNOWLEDGE ................................................................81
LACK OF PROPERTY KNOWLEDGE .....................................................................87
CHAPTER FOUR
CONFLICTS OF INTEREST ..................................................... 95
CHAPTER FIVE
ORGANIZATIONAL FAILURES............................................ 104
CHAPTER SIX INVESTMENT MANAGEMENT ERRORS ................................... 117
CHAPTER SEVEN
PROFILES IN SPECTACULAR LOSSES .......................... 127
CHAPTER EIGHT
POOR ASSET RECOVERY EFFORTS ................................. 131
EPILOGUE ..................................................................................................................... 135
REAL ESTATE TRANSACTION FRAUD PREVENTION CHECKLIST ................. 137
ABOUT THE AUTHOR ................................................................................................ 139
Cartoons
Pages 5, 7, 28. 29, 33, 68, 71, 74, 82, 107 and 122
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Vernon Martin
American Property Research
PREFACE
This book will not make money, nor will my photo sit beside Donald
Trump’s photo in an Airport Hilton ballroom, but some things just need to
be said. Rather than being a roadmap to real estate riches, this book will
only serve as a map of the potholes and the roadside bombs. The road to
riches has been explained well enough by many others.
The primary goal here is to describe what has seldom been described
elsewhere: a detailed analysis of the many different circumstances in which
commercial real estate investors and lenders experience financial losses. It
is not meant to discourage real estate investing or real estate lending, but to
guide it. The premise of this book is how to avoid losing money in
commercial real estate, as I attempt to catalog or classify the failures
witnessed over a 26-year career, most of it working for the lending industry.
As I present these errors and their examples, some readers may ask, “How
could anyone have been so foolish?” to which I respond that these are all
errors that were made or almost made by investors or lenders who should
have known better.
This book is not about cost-cutting trivialities, but about fundamental errors
in research, analysis, due diligence, investment management and placement
of trust in others that can jeopardize a real estate investment. My focus will
be on investment grade commercial real estate, but there are lessons to be
learned about smaller properties and residences, too.
This book is not quite meant to be an academic textbook, although I will be
recycling lecture material I have written for my own university students or
has found its way on to other business school reading lists, including
Wharton. Chapter Two will include analytical methods, including
mathematical proofs to dispel certain misconceptions common in our
industry. To understand these concepts, though, the highest level of math
skill you will need is high school Algebra. If this still intimidates you, be
comforted to know that Algebra has not changed any in our lifetimes.
I have been in a unique position to watch investors and lenders lose money
in real estate over the last 26 years. Beginning my career as an appraiser and
analyst at Jones Lang Wootton in Texas in 1984, at a time and place in
which a commercial real estate mania was about to hit a brick wall, I got to
meet glib real estate developers, lazy “institutional advisors”, dishonest real
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Lessons from Losses in Commercial Real Estate
estate syndicators, brain-dead bankers, clueless appraisers and also a few
people who knew and explained what was going on (not that things have
changed much since then).
During the 1990s I held several management positions at Home Savings of
America, then America’s largest savings and loan institution, and got to
observe the entire lives of many failed commercial and residential loans. I
had the opportunity to travel the nation to visit many failed assets and do
post-mortem analyses, always asking “How could things have gone so
wrong?” I effectively became a real estate and loan autopsist. I call that
episode of my career, “CSI: Home Savings.”
I had a brief, thrilling, but disastrous run as the chief commercial appraiser at
IndyMac Bank, where all the rules of prudent lending were thrown out by
design. There are many lessons to be learned in that bank’s failure,
extending all the way up to Board-level policymaking decisions. My
previous Internet blog on my experience at IndyMac has been the most
popular piece I have written, and I will include it in this book for both
instructional and amusement purposes.
Most recently, I have spent the last eight years in the seamy world of private
and “hard money” lenders serving as lenders of last resort for desperate
property owners with desperate agendas. During this time, I have been
cataloguing every trick used to deceive lenders while studying the subject of
fraud, earning my CFE (Certified Fraud Examiner) credential in 2004.
Desperate borrower
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Vernon Martin
American Property Research
This book is meant for:
 Experienced investors in commercial real estate
 Mortgage lenders seeking to minimize loan losses
 Secondary market investors wishing loan buy-backs from originating
lenders
 Senior management and corporate boards seeking to improve
institutional real estate investment or lending policies
 Government regulatory agencies
 Real estate appraisers, advisors and consultants who wish to improve
the quality of their advice to clients, and
 Attorneys searching for the “smoking gun” in cases of real estate
fraud or negligence.
I have organized the book into general categories in which real estate losses
occur, which are:
1.
2.
3.
4.
5.
6.
7.
Relying on wrong information
Errors in analysis
Lack of knowledge
Conflicts of interest
Failures in policymaking within institutions
Investment management errors
Poor asset recovery efforts
I could add the category, “Failures in due diligence”, but examples of such
failures will be found in most of the other chapters.
Because I have spent the bulk of my career in the lending industry, I will
particularly focus on mistakes often made by lenders.
Unlike a textbook, the chapters do not necessarily need to be read in order,
nor the book read in entirety. Many topics will be independent of each
other. The section on real estate syndications, for instance, might not have
relevance to a lender who specializes in small commercial mortgage loans.
This book, because it is self-published, is also a work in progress, and I will
be editing or updating it every one to two weeks while it is on my web site.
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Lessons from Losses in Commercial Real Estate
For that reason, if readers want to send a copy to their colleagues, it would
be better to refer the link to my web site than to download the .pdf document
for redistribution. For the record, this e-book can presently be accessed at:
www.americanpropertyresearch.com/TheMartinBook
Please understand, too, that this is copyrighted material, even if I may have
provided you with a complimentary copy. You may share it (but not sell it)
with others, but please remember to acknowledge the source, which is:
Vernon Martin
American Property Research
Los Angeles, California
As for the reason to make this alpha online edition of my book
complimentary, there is no profit potential in writing a book on how to lose
money in real estate. The sales from a print edition would probably be less
than the fee from one international consulting assignment. I have also
observed that many real estate investors do not consider the possibility of
error by themselves or their advisors, and the very ones who need to read
this book are the very ones who would not buy it.
By using this free Internet edition to maximize readership, I also hope to get
sufficient feedback to improve the book and make it even more useful,
perhaps eventually justifying a print edition.
“Martin! Mr. Trump says that you’re pooping on the party and
he’s come here to personally fire you.”
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Vernon Martin
CHAPTER ONE
American Property Research
RELYING ON WRONG INFORMATION
“Wherever possible there must be independent confirmation of the ‘facts’”
--Carl Sagan, “The Fine Art of Baloney Detection”,
The Demon-Haunted World
In order to begin right in real estate investing or lending, one must first get
the facts right.
Let us start with one fundamental truth about human nature. People lie.
Why do people lie? People lie to get what they want. Some of them want
your money, your client’s money, your employer’s money, or the
government’s money.
As a part-time academic, I am still waiting to see a Finance textbook that
sufficiently discusses this fundamental flaw in human nature. It seems
almost as if business school students are programmed to believe what they
are told.
Here is a second fundamental truth: The real estate industry does not attract
saints. It may attract sincere people, but mostly people who just sincerely
want to become rich.
Sometimes, when a convicted mortgage broker is led from court in
handcuffs, he or she may say, “But I was making the dream of homeownership
a reality for people who would have never had the chance to live in their own
home!” in a tone of voice so sanctimonious as to make one wonder why
Mother Theresa wasn’t a mortgage broker, too, until one considers that
people with bad credit who lie about income and assets might not actually
deserve homeownership.
How can a liar be detected?
Most of my work is in advising hard money lenders. Sometimes I am asked,
“How did you know the owner was lying?” as if I had the powers portrayed by
Tim Roth on the “Lie to Me” television series. Although I have taken
courses as a fraud examiner on visually detecting clues of deception, the
simple truth is that I usually detect lies by taking the time to verify the
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Lessons from Losses in Commercial Real Estate
information that is given. Looking for facial twitches and “panic blinking”
is a poor substitute for simply doing your homework.
Although one cannot ordinarily conduct a polygraph examination of sellers
or borrowers, I try to informally replicate the polygraph examiner’s methods
by asking “calibrating questions” which establish a base level of honesty.
For instance, having just inspected a cinema for appraisal purposes, I asked
the borrower about the area of the footprint of the building, which he
emphatically stated as 8500 square feet. I already had the assessor’s plat
map indicating only 8180 square feet of site area, including a setback on one
side, and I had previously measured the exterior dimensions of the building
as 60 x 127 feet, indicating a footprint of only 7620 square feet. Thus I
knew that I had an exaggerator on my hands.
To be facetious, another way to tell if a property owner is lying is to watch
to see if his lips are moving.
The neglected art of verification
We live in an extraordinary time that is sometimes called “The Information
Age”. More than ever before, we can verify facts with a few minutes of
Internet research.
For example, a real estate developer claimed to have purchased some remote
California mountain land for $30 million, but the purchase price was
unpublished. In California, Proposition 13 directs county assessors to assess
at market value upon sale; in most cases the purchase price is considered the
market value. The new assessed value is then increased by 2% each year. In
this instance, a quick Internet trip to assessor’s web sites indicated a total
assessed value of less than $14 million two years after this reported
purchase, suggesting that the land had been purchased for closer to $13
million. This fact may seem insignificant until one considers that the phony
purchase price tricked an appraiser into valuing the mountain for $100
million.
A generation ago, such research would have required a time-consuming visit
to a government office. Now it can be done in a matter of minutes by
anyone with an Internet connection. You can hire college students to do
this.
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Vernon Martin
American Property Research
SECTION 1.1
SELLER AND BORROWER MISREPRESENTATIONS
Sometimes a property owner has a problem on his hands, but he would
rather sweep it under the rug and find a sucker to buy him out (or refinance
him with cash out) than to spend extra resources to solve the problem. Let
us catalog some of the ways that these problems are misrepresented:
1. Misrepresentation of occupancy and tenancy
Sometimes it is hard for a property owner to misrepresent occupancy. Retail
centers, for instance, tend to have large glass windows and merchants open
for business during business hours. With mobile home parks, the unit is
either there or not there. On the opposite end of the spectrum are large
apartment buildings and hotels. A buyer or lender inspection needs to be
much more careful to protect against deception about occupancy when there
are many units which are not freely accessible and visible from the outside.
Sometimes it is not practical to fully inspect an apartment complex of
several hundred units. In these cases, it is important for the buyer or
inspector to be in control of the sample selection of the units to be inspected,
so as not to be “steered”, and to select units in different sections of the
property. By “steering”, I mean the practice of preventing access to units
that have been misrepresented as to size, occupancy, or condition. As you
verify that each tenant is there who is supposed to be there you will come to
a point where you can be confident in the rent roll’s representation of
occupancy and tenancy. But wait! There’s more!
It’s the rent, Stupid!
It is important to remember, though, that occupancy per se is not going to
fill your pockets. Rental income is what will fill your pockets. That is why
a property inspection should include some elements of rent verification
when possible and some study of past rent rolls to better understand tenant
histories.
In the financial performance of an income-producing property, moreover, a
non-paying tenant is a worse drag on profit than a vacancy. At least the
vacancy can be promptly filled without having to hire a lawyer.
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Lessons from Losses in Commercial Real Estate
Talk to the tenants
When I am inspecting a unit and a tenant is present, I like to ask “ May I ask
how much you are paying in rent?” Earlier in my career I was afraid to ask
such questions in the presence of the landlord or manager for fear of
offending them. When I started asking such questions, though, protests were
rare, and I was sometimes finding myself surprised by the tenants’ answers,
causing me chagrin in not adopting this questioning policy sooner.
Tenants say the darnedest things
I have learned, though, that the most revealing answers tend to be made out
of earshot of the landlord, as some tenants will feel reluctant to divulge
embarrassing information in front of the landlord. Here are some of the
answers that have alerted me to problems in rental income:
“The landlord is giving me a break because so many of us got laid off.”
“The landlord asked me to sign this lease that says $2500 per month, but he
told me I only have to pay $1800 per month. He just wanted to show the
lease to the bank.”
“I’m not actually paying rent now.”
In inspecting apartment buildings in particular, it is useful to learn a few
words of Spanish. If you are inspecting apartment buildings in the U.S.
Southwest or most major U.S. cities, you will often encounter the Spanish
language barrier. I am not fluent in Spanish, but I find the question “Cuanto
paga de renta cada mes?” (roughly meaning “How much rent do you pay each
month?”) will get me an answer. Numbers in Spanish are easy to remember,
too.
Those who do not yet understand numbers in Spanish may wish to bring a
pencil and paper along for the tenant to write the number down. Written
numbers are a universal language. Also consider that some crowded units
may have subletters who may not know the rent for the entire unit, but only
know their own share. This should become obvious with the number they
give you.
An example of a loss incurred on a fully occupied building
In the early 1990s, Home Savings made a purchase loan on a fully occupied
apartment building in Riverside, California. I was the Major Loans
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Vernon Martin
American Property Research
Appraisal Manager at the time. The loan went almost immediately into
default. As it turned out, the building had been 50% vacant only a short time
before, but was quickly filled when the owner offered free rent, no-moneydown specials to homeless individuals, shortly before he sold it to an
unsuspecting investor, who financed his purchase with a Home Savings
loan. As the buyer quickly discovered, many of the new residents had no
intention of paying rent, and as they defaulted on their leases, the borrower
defaulted on his loan.
The buyer had performed a property inspection and presumably verified full
occupancy. The appraiser I knew to be seasoned and competent. How could
this fiasco have been prevented?
Studying present and past rent rolls
Most professionally managed properties have standardized rent rolls and
management reports that indicate when a tenant moved in and what the
tenant paid each month. In addition to requesting the current rent roll, the
buyer should also request prior rent rolls. These prior rent rolls could
indicate prior periods of high vacancy, as well as free rent specials. It can
arouse suspicion when a large, multi-tenanted property goes from 50%
occupancy to 100% occupancy in a matter of weeks, and the free rent
specials only add to the suspicions. Good management reports will also
indicate collection trends.
Just as importantly, one should request and receive complete lease
documents, including any amendments, in addition to the rent roll. As
tedious as this might be, it is a useful fraud prevention procedure, as rent
rolls can sometimes be inaccurate.
But why stop at the management reports? Tenant files should be examined
in entirety, particularly written correspondence between landlord and tenant.
If you are using a third party, such as an appraiser, to inspect the property, it
should be made clear to the one doing the inspecting that every space and
tenant needs to be accounted for, within the limits of practicality. A lazy
appraiser will often overlook that a tenant is not there, as I have often seen in
my field reviews.
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Lessons from Losses in Commercial Real Estate
In conducting a recent field review of a struggling shopping center in the Las
Vegas area, for instance, I found that the appraiser failed to notice that the
highest paying tenant on the rent roll, a Baptist church, was not occupying
space at the center. Based on the square footage claimed for the church on
the rent roll, it was apparent that the church was supposed to be occupying a
vacant Blockbuster Video store, but anyone could see through the plate glass
windows of this vacant store that there was no seating inside, a prerequisite
for holding religious services.
What if the tenant is not there?
There are situations in which:
a. The tenant has vacated the premises prematurely.
b. A new tenant has not moved in and might not actually intend to.
One should be skeptical of vacancies described as not being vacancies. If the
tenant has left, for instance, it may be claimed that he is still making rent
payments. This should be documented, such as by bank statements. “Credit
tenants”, such as financially sound national retailers, often continue making
their contractually obligated rental payments, but lesser tenants cannot be
expected to do the same.
Likewise, the landlord can claim that a lease has “just been signed” for a
vacant space, but one should be skeptical of tenants who have not yet moved
in. For instance, a large, older medical office building in south Phoenix was
described as being fully leased, but found to be half vacant, with every
vacant suite having a sign announcing a new tenant. Half-vacant, older,
multi-tenanted buildings do not typically go from 50% to 100% occupancy
overnight.
As another example, in an inspection of a multi-tenanted industrial building
in Connecticut, it was found that the tenant paying the highest rent, a
nightclub, had not moved in after 15 months of supposedly paying rent.
When in doubt, request bank statements establishing that the tenant actually
paid rent.
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Vernon Martin
American Property Research
Verification of future tenants
When improvements are only proposed, verifying tenants is trickier.
Developers sometimes stretch the truth, representing letters to prospective
tenants as lease commitments, as in “This letter is to confirm that I will lease
you this space”. There is nothing better than signed leases with real tenants,
and “letters of intent” from prospective tenants can sometimes be relied
upon. To have any credibility, though, the LOI should come from a
recognized credit tenant on company letterhead. I will trust an LOI on
McDonalds letterhead, but not necessarily from an unknown tenant that
cannot be Googled.
Despite these intuitively obvious precautions, a vacant, former Costco
warehouse was purchased for $1,620,000 in 2001 and appraised soon
afterward for $21.5 million – resulting in a $14 million funded loan – with
the assumption that Federal Express, Walgreen’s, AutoZone, and El Pollo
Loco, among others, would be leasing space there, although there was no
documentation of any interest from any of these tenants, nor any
improvements made to the building. None of these tenants ever moved in.
When the landlord pretends to be a tenant
This is also known as the “pocket-to-pocket” lease. As an example, two
developers of a speculative new office building in Phoenix were having
trouble leasing out enough space to satisfy the occupancy requirements of
most take-out lenders, so they wrote leases to themselves creating company
names from their initials. For instance, as Vernon Martin, I could write a
lease to VM Development, Inc. and move in some used office furniture.
One particular clue I look for in detecting “pocket-to-pocket” leases are
unknown tenants signing leases at rental rates obviously above market rates.
Walgreen’s may pay above market rates because of the specialized tenant
improvements they require, but unknown tenants occupying generic office
space should not have a reason to sign a lease at an above-market rate. This
should also give the investor or lender a particularly compelling reason to
find out what market rental rates are.
As an example, a loan was made on a renovated, century-old warehouse
building on a dirt road in Denver based on an appraisal report which
described the building as a fully occupied, class-A downtown office
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Lessons from Losses in Commercial Real Estate
building. The appraised value was $4,250,000. A knowledgeable broker
informed me that the owner had signed a high-rent lease to an entity he
controlled in order to make the building appear fully leased at high rents.
Upon re-inspection, the owner’s space was found to be vacant. The building
was subsequently valued at $1,550,000 seven months after the original
appraisal, relying on market rents for such space.
In addition, any above-market lease in which the tenant has not yet moved
into the space should be viewed quite skeptically.
It is also useful to ask during the inspection, “What does this tenant do?” in
order to sort out possible straw tenants, relatives, in-laws, or VM
Development, Inc.
Verify occupancy and rents with the person in the best position to
provide accurate and objective information
This often means someone who is lower on the totem pole and closer to the
action. One of my favorite ploys is to tell the property owner that I will
conduct my inspection at 10:30 am and then show up at 10 am to speak oneon-one with the property manager. The property managers tend to have
objective reports and may not have yet been instructed to mislead me.
I had a situation with an inner city Detroit apartment building, for instance,
in which the manager gave me correct information, and the owner showed
up 30 minutes later and gave me a fake rent roll with rents being a third
higher. I was able to warn my own client, but this property ended up being
financed by a New York property fund, which has since foreclosed on the
building and is unable to sell it now.
Estoppel agreements
Estoppel agreements signed by tenants are intended to verify lease
obligations and to hold the landlord responsible for any misrepresentations
about the tenancies. I have seen at least one instance, though, in which the
estoppels were counterfeit and the landlord had made a calculated legal risk,
knowing that he was sufficiently bankrupt to be judgment-proof.
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Vernon Martin
American Property Research
2. Misrepresentation of property characteristics
There are a host of unfavorable property conditions that can be
misrepresented by property owners, such as:
Legality of use
An illegal use, a use contrary to zoning laws or building and safety codes,
can be discovered by local authorities, who might then force the owner to
remove the improvement and/or pay for conversion of the space back to
legal use. This can often lead to financial loss for the buyer or the lender.
One example most indelibly printed in my memory was a scam on Home
Savings in the early 1990s. A New York City walk-up apartment building
on a residential street was being acquired by three phony doctors who
claimed that they had the permits to remove all ground-floor, rent-controlled
tenants and replace them with an MRI facility. There was no such zoning
variance approved by the City, but the appraiser never checked for zoning or
permits and used MRI rent comps justifying a much higher potential income
for this rent-controlled residential building. The purchase loan went into
immediate default, with a major loss to Home Savings.
Unknown to the appraiser, these same three “doctors” also acquired a walkup building in the Village with an above-market, “pocket-to-pocket” lease to
a natural foods store they wished to operate in a hard-to-rent basement
space, and this lease was used to support a purchase price well above the
building’s market value. This purchase loan also went into immediate
default.
Legality can often be verified on-line, by a recent Certificate of Occupancy,
or a phone call to the city’s building department.
Some argue that lax code enforcement has made it worth paying full price
for illegal improvements. This may be folly, as unexpected future
enforcement of city codes could jeopardize these illegal uses. All it takes is
one major fire or human disaster to change the political climate for code
enforcement. So the unit is unheated? What will happen to local code
enforcement when a tenant freezes to death in some other unheated
apartment elsewhere in the city?
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Lessons from Losses in Commercial Real Estate
Be alert to clues of illegal improvements. For instance, a studio apartment
without a thermostat, in a building with central heating and cooling, could be
a walled-off master bedroom from another two-bedroom apartment. Some
landlords do this because they can get more rent from a one bedroom
apartment and a studio together than from a two bedroom apartment alone.
Abrupt changes in a roof line or exterior cladding could be a sign of an
illegal addition.
As verifiable as it is, even a property’s zoning can be misrepresented. A
landowner in south Florida who wished to build a community shopping
center claimed commercial zoning. Checking with county officials, the
parcel actually had agricultural zoning with a designated future land use of
commercial, but the only commercial use the county government intended to
approve for the subject site was warehouse use. Whenever in doubt, talk to
the local government departments that make the rules.
There are also independent commercial due diligence services that will
perform a zoning comparison report, and may be worth hiring if there are
any doubts about compliance and the municipal government cannot have its
own representative visit the property. For instance, the fire escape on the
apartment building that you are buying could be not up to municipal code,
and once you take possession you might be required to replace it at a cost of
$100,000.
Availability of utilities and water
Some landowners without access to fresh water or sewers might
misrepresent this. This needs to be verified with the relevant municipality or
private utility company. Property owner claims of receiving water or sewer
service “any day now” also need to be verified.
For those readers in western states, water rights can also be misrepresented.
For instance, a property owner claiming to have rights to a large,
underground aquifer with many potential other users instead had rights to an
underground stream which was only available to a few other potential users.
Water rights tend to be less valuable in thinly traded markets, particularly
when the pace of land development has subsided. Water rights can typically
be verified by an engineer in the state’s Department of Water Resources.
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Vernon Martin
American Property Research
Property size
The larger the property is, the harder it is to verify building area. Relying on
rent rolls or landlord claims of property size can sometimes be risky.
A 17,000 square foot warehouse in Philadelphia, for instance, was appraised
as a 22,000 square foot warehouse. Asked to explain this discrepancy, the
appraiser said he knew the warehouse was 22,000 square feet in area
because the rent roll tenancies added up to that number.
Property managers sometimes create more rentable area than there is
building area. For instance, when I started my career appraising regional
malls, some managers would brag to me about their ability to create extra
rentable area out of thin air, knowing that I was valuing the mall based on its
income stream and not on building area. 25 years ago, when a tenant did
discover the discrepancy and protested that they were paying for too much
space, the mall manager would simply say "We're running at full occupancy
here. You either pay the same rent or else we will find someone else who will."
Today in the U.S. and elsewhere, many regional malls are in a different
negotiating position, with escalating vacancies and struggling retailers.
There exists the possibility that the savvy tenant (such as a major retail
chain) may audit the amount of space, and the tenant may be able to
negotiate the rent downwards, or worse yet, sue the landlord for years of
overpaid rent.
Architectural building plans can be more trustworthy in indicating building
area, but may not reflect change orders that could have changed the area.
Public records are objective, but these can often be inaccurate. Public
records can often understate building area due to unrecorded but permitted
additions, as well as local quirks about excluding certain types of building
area, such as basements. Basements are inherently less valuable space than
ground level space, but can still have value if they bring in rental income.
Measurement
By process of elimination, then, the best way to verify building area is to
measure it. This is not always easy. For buildings with irregular areas, one
trick to simplify the task of measuring is to draw a building sketch and
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Lessons from Losses in Commercial Real Estate
divide the area into rectangles, then add up the area in each rectangle, as
seen in Figure 1. I do not wish to talk down to readers here, but I have met
some MBAs who have never learned this.
FIGURE 1
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Vernon Martin
American Property Research
The building area can be divided up into 10 rectangles, as follows:
22 x 12
=
39.5 x 6
30 x (67 + 39.5)
14 x 4
18 x 2
11 x 31.2
29 x (31.2 + 33.2 -9)
21.5 x 9
10 x 15
30 x 35
TOTAL
264
237
3195
56
36
343.2
1606.6
193.5
150
1050
7131.3 square feet (5931.3 sf above grade)
Property condition
Although the condition of the property will be somewhat obvious at the time
of inspection, the severity of the deferred maintenance can often be
understated. Non-functioning equipment, particularly elevators, may be
permanently rather than temporarily disabled. It is better to order an expert
inspection for any valuable building components, such as elevators, HVAC
systems, or even kitchens.
Some owners may contend that major renovations have occurred since they
acquired the property, renovations that may not be evident. For example, one
apartment landlord in Tulsa claimed to have made $350,000 in recent
renovations, but the property still had original shag carpets, appliances and
HVAC units that dated back to the 1970s. What actually happened was the
previous owner had made a $350,000 cash reduction of the sales price for a
"renovation allowance", but since it was not a cash allowance but a cash
reduction of the purchase price, it did not get spent. If in doubt, politely ask
to see the receipts.
3. Deceptive financial statements
One needs to be familiar with standard property accounting practices in
order to detect unreliable income and expense statements. Whenever
possible, request financial statements prepared by independent accountants,
preferably operating statements for “Year-to-date” and the two previous
years. Even then, the reader must check the footnotes and fine print for any
disavowals responsibility for the accuracy of the numbers.
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Lessons from Losses in Commercial Real Estate
Here are some tricks to watch out for:
a. The numbers are too round.
Professional property management reports are typically exact to two
decimal points, as are utility bills and property taxes. Round numbers for
every line item of income and expenses tells you that actual numbers
were not used.
Rent-controlled apartments are experiencing a high foreclosure rates in
some parts of Los Angeles. Controlled rents are typically uneven and
based on application of legally set limits. For instance, a $500 per month
apartment allowed a 3% increase per year will be $515 the next year,
$530.45 the following year, and $546.36 the year after. A rent roll for a
rent-controlled apartment should have uneven amounts for tenants who
have been in place for two years or more.
b. The numbers are too consistent.
Here is part of an operating statement submitted by a struggling hotelier
who had supposedly “fired” his Choice Hotels franchise. What clues can
we find that the 2006 figures are fictitious?
2005
2006
$3,934,040
722,640
181,778
49,640
$5,637,479
1,035,543
260,488
71,134
181,063
5,069,161
259,463
7,264,108
REVENUE
Rooms
Food
Beverage
Telecommunications
Rental & other
income
Total Revenue
These are some clues:
 Every 2006 line item is the same multiple of the 2005 line item
(1.433). This is a statistical impossibility.
 Management’s report of a 43.3% increase in room revenues alone
would offend common reason, for the loss of the Choice Hotels
Group franchise would have been a severe blow to revenues, being
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cut off from Choice’s extensive reservation system. (Choice
operates Comfort Suites and Inns, Clarion, Quality Inn, Sleep Inn,
and Econolodge hotels.)
 It is unlikely that telecommunication revenues would have
increased 43.3%, as telecommunications revenues have been
universally declining among all hotels as more and more guests
choose to use personal cell phones in lieu of hotel phones.
c.
Not all obligated payments are being made
When tenants get into trouble, they may stop paying escalation income,
expense recoveries, or percentage rental income before they stop paying
their base rent, and some landlords allow them to get away with it,
particularly if they already have the property listed for sale.
d.
The inclusion of non-property-related revenues
Operating statements may sometimes include revenues from other
properties, activities or businesses not being appraised.
The owner of a strip center in Texas supplied deceptive operating
statements that included “capital infusions” as actual income and
included “common area maintenance” (CAM) reimbursements in “base
rents” and as a separate line item of income, therefore double counting
CAM. Also, an unusually high percentage of revenues came from late
fees, which may have been uncollected. As a result of this deception,
reported net operating income had been inflated from $67,000 to
$178,500. (Three of the eight leases were also pocket-to-pocket leases.)
Some owners even pay themselves management fees and include these as
revenues.
Operating statements may also include revenues that cannot be expected
to be consistent. Apartment owners, for instance, typically include “late
fee” income”. The apartment owner in Tulsa, Oklahoma reported so
much “late fee” income that it was apparent he had a big collection
problem. These late fees were probably being accrued, but not collected.
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Lessons from Losses in Commercial Real Estate
Also watch for one-time sources of income, such as a legal award or the
sale of a part of the property. An apartment building owner in Utah
applied for refinancing after an unsuccessful condominium conversion,
representing sales of condominium units as rental income.
A property owner may also be operating a business out of the appraised
property, and the appraiser must be able to distinguish between propertyrelated revenues and business revenues. Here are examples of businessrelated revenues that would not be likely to continue, as they require a
high amount of labor and business or marketing expertise:




Cover charges and liquor sales from a nightclub
Product sales
Food & beverage sales
Services such as valet parking, spa services, or car washing
e. The inclusion of “Pocket-to-pocket” rental income
This was explained earlier in the section about misrepresentation of
occupancy.
f. Failure to include necessary expenses
The owner of a 30-year-old Houston-area apartment property reported
expenses 28% below the market average, a fact that he considered
evidence of his superior management ability, but the property inspection
indicated significant deferred maintenance, with over 200 original
condensing units needing replacement, extensive termite and water
damage to structural wood, and potholes in the parking lot. Skimping on
maintenance only increases the amount of future expenses an investor
can expect to incur.
It is common practice for some lenders to request tax return schedules
relating to the appraised property, something that investors should also
consider doing. Nowadays, having been burnt by counterfeit tax returns,
some U.S. lenders are requiring borrowers to sign and submit and IRS
(Internal Revenue Service) form 4506T, which permits the lender to
contact the IRS directly to receive a copy of the borrower’s actual tax
returns.
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Other methods to determine actual expenses include requesting bank
statements and cancelled checks. One can also compare reported
expenses with expense comparables or expense data from the Institute for
Real Estate Management (IREM), Building Owners and Managers
Association (BOMA), and International Council of Shopping Centers
(ICSC).1 These three organizations slice and dice operating data many
ways, such as by region, by property size, by building age, or by property
type.
4. Deceptive purchase agreements
Sometimes the buyer conspires with a seller to fool a lender (and appraisers,
too) and the purchase contract is one favorite vehicle for this type of
deception.
First ask yourself, “Is this purchase real?” Various studies have consistently
reported that appraisers estimate values identical to purchase prices in 96 to
97% of appraisals, a condition known as “anchor bias”, quite well known to
fraudsters, so much so that creating deceptive purchase contracts is taught in
the many “No money down” seminars held for real estate investors and real
estate salespersons at hotel ballrooms every weekend.
A lender or an investor in a syndicate should also consider the possibility
that the purchase itself is not an arm’s length transaction, but a pocket-topocket transaction, with the buyer purchasing a property that he already
owns. This will be further discussed in the Conflicts of Interest chapter.
A doctor in the Atlanta area, for instance, fooled a lender into
overleveraging an apartment property with the use of a double escrow – an
escrow process in which two purchases are accomplished at one time. Using
an LLC (limited liability company) that he controlled, he bought the
property from the seller for $1,800,000, and then sold the property to himself
for a price of $2,700,000. This latter contract is the one he submitted with
his purchase loan application. He was able to buy the property for no money
down and then practice “skimming”, which is collecting as much as income
as possible while cutting expenses and services, before unhappy tenants
move out, net cash flow becomes negative and he defaults on the loan.
1
www.IREM.org, www.BOMA.org, www.ICSC.org
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Lessons from Losses in Commercial Real Estate
Because he tricked the lender into lending 100% LTV (loan-to-value ratio),
he would lose no money, plus gain all the income skimmed.
In a criminal case that ended in 2009, a Connecticut man, Edward Safdie,
created two LLCs to accomplish the same type of fraud. Operating as 318
Main LLC, he purchased the Inn at Cheshire for $2,350,000 and then
transferred the Inn to Quantum 318 LLC (wholly controlled by himself) at a
much higher price, securing $3,500,000 in loan proceeds, and then another
$1 million in loan proceeds.2 The defrauded bank, Beal Bank, ultimately
foreclosed on the Inn and sold it for $2,450,000, incurring a loss of over
$2,000,000. Safdie was sentenced to 51 months in prison and fined
$1,100,000.
It is not usually possible to prove that a particular purchase transaction is
deceptive or fraudulent, but one needs to be suspicious when the purchase
price is not supported by comparable sales. It is folly to treat a contract
purchase price as prima facie evidence of market value.
Lenders should remove policies of disciplining or harassing appraisers for
“failure to hit the purchase price”. I have been repeatedly scolded by
Imperial Capital Bank and Wells Fargo, for instance, for “failing to hit the
purchase price”, and Imperial was seized and closed in December 2009.
The following excerpt from an escrow document (Figure 2) shows what can
happen behind the scenes. In this particular transaction, a Kansas City
apartment building was being purchased at a price per unit seemingly 50%
above comparable sales, in a particular zip code which often leads the nation
in apartment building foreclosures. By using a fake cash down payment, the
purchase price had been inflated from $3,732,500 to $4,475,000, although
the net cash deliverable to the seller remained the same.
2
“CT Man Pleads Guilty in Commercial Mortgage Fraud’” The Mortgage Fraud Reporter, 1/16/09.
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American Property Research
FIGURE 23
In another case, in which several hundred acres of land in New Mexico were
being purchased at a price seemingly three times as high as similarly zoned
comparable sales, it was observed that the seller had made a transfer of
ownership to an LLC several months before at an undisclosed price.
The buyers had an internet web site advertising services as “transaction
facilitators”, in which they could form a joint partnership with the seller
before officially purchasing the property. This could have explained the
nature of the previous transfer of ownership, making the current purchase
transaction a sham. "Any time there's a facilitator involved it's a red flag, whether
it's a marketing facilitator or a sales facilitator or any kind of facilitator ," says Ann
Fulmer, an executive at Interthinx, the most widely used mortgage fraud
consultants in the residential lending industry.4
Even genuine purchase contracts can still be misleading, with use of seller
concessions, either stated or hidden, such as “allowances for repair”,
“guaranteed rental income” (in excess of actual rental income), seller-paid
closing costs (beyond what is customary) and favorable seller financing.
These techniques are commonly taught in “No Money Down” seminars for
3
Actual escrow document accidentally recovered by the appraiser.
As quoted in “Condo Buyers Allege Flipping Scheme”, Sarasota Herald-Tribune, 12/13/09 by authors
Michael Braga and Chris Davis
4
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Lessons from Losses in Commercial Real Estate
investors and real estate sales agents. Sometimes the concessions are hidden,
though.
Some common techniques to hide seller concessions include:
a) Seller financing which is forgiven in a side agreement. It is
interesting to see letters written to internet legal forums asking for
legal advice on how to accomplish such deception without
accidentally causing the buyer liability for repayment.
b) The hiding of written concessions in an addendum to the purchase
agreement, an addendum that is then excluded from the purchase
contract submitted to the lender or appraiser.
c) Any form of monetary consideration other than cash at closing. For
instance, equity in another property might be offered as
consideration. How is the equity measured, and is it measured by
an objective, competent source?
d) The claim of cash or equity, other than a small earnest money
deposit, that has supposedly been contributed to the purchase
transaction before closing. It would be safer for the investor or
lender to focus on the cash deliverable to the seller at closing,
adjusted by the earnest money deposit (as long as it is reasonable).
The appraiser should be instructed to ignore the purchase price
until after his preliminary valuation analysis. The state of
Maryland even mandates this now. If the initial conclusion of
value is different than the purchase price, this should be the point
in time when the appraiser asks hard questions about the purchase
transaction or else his own analysis.
I recently appraised a golf course in which the seller was providing a
$500,000 cash concession and $2,000,000 in seller financing with a contract
purchase price of $5,700,000. Different purchase contracts had different
interest rates for the seller loan, ranging from 5 to 10%. The net cash to the
seller at closing was $3,200,000, which was not far from my estimate of
value. In this situation, I suspected that the seller financing was a “soft
second” (forgivable financing) meant to inflate the contract purchase price in
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Vernon Martin
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order to mislead the lender and me. Having inconsistent interest rates in the
respective purchase documents was one clue.
Phony offers to purchase
One of the oldest and most transparent scams is to provide a phony written
“offer to purchase”. These offers should not be accepted as bona fide
indicators of market value. In the last three years I have seen a $100 million
offer for raw land on South Padre Island, Texas, a $100 million offer for a
vacant mountain in Lassen County, California, and most recently, a $67
million offer to buy desert land in Cochise County, Arizona. None of these
offers could be justified by comparable sales and listings. What surprises
me most is seeing other seasoned appraisers fall for these scams, as if
professional courtesy demands that all such statements be accepted at face
value.
“But he’s such a fine person”
When I was in banking, there was a developer who tricked our bank into
making a $30 million land speculation loan at a 5% interest rate and 97%
loan-to-value ratio. The loan was supposedly for the purpose of constructing
a parking lot worth $65 million. When I first voiced my doubts about the
developer’s intentions, the loan officers assured me I was wrong because the
developer had just received an “ethics award” from a realtors’ organization.
What could be next -- a humanitarian award from Osama bin Laden?
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Lessons from Losses in Commercial Real Estate
It seems like no coincidence, too, that the only client that ever cheated me
out of a fee was the one who proclaimed his Christianity in each
conversation we had.
“The louder he proclaimed his honor, the faster we counted the spoons”
--Ralph Waldo Emerson
Eighteenth century philosopher Samuel Johnson once said “Patriotism is the
last refuge of a scoundrel.” Let me update Johnson by adding the word
“philanthropy” to the list. Some of the best known “robber barons” of the
19th Century (and at least one from the 20th) became philanthropists.
Bernard Madoff was also a known philanthropist.
The real estate industry often accommodates such paradoxes. When I was in
banking I sometimes had to bear the unpleasant news that we had been
deceived by a borrower, only to hear an admonishment such as “How dare
you question his integrity! Don’t you know he’s chairman of the Pathetic Crippled
Children’s Foundation?” Charity and honesty are not necessarily synonymous.
Conclusion
In conclusion, remember that the three most important things in real estate
transactions are: verification, verification, and verification.
Please promise to use this chapter’s information for good and not for evil.
“Now Martin, before you call this man a liar, I want you to know that he’s
chairman of the Pathetic Crippled Children’s Foundation.”
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SECTION 1.2
American Property Research
WRONG CHOICE OF DATA
Sometimes otherwise accurate data is misused or misinterpreted early on in
the real estate investment or lending decision. In other words, sometimes
the fault is not the accuracy of the data, but that the wrong data was chosen.
When I say “wrong data”, I am not talking about false data, but data that is
not relevant to the real estate decision being considered.
Local research reports from brokers
I often rely on local research reports from Marcus & Millichap, CBRE,
Collier’s or Grubb & Ellis, and have had no reason to challenge their
accuracy. I like the granularity of these reports, allowing me to drill down
into smaller submarkets which may be behaving differently than the overall
metro area. It is important to understand what they are surveying, however.
For instance, you may be considering an investment in office
condominiums, relying on rent and vacancy data from such a survey, not
realizing that the survey was limited to office buildings greater than 10,000
square feet in rentable area. The market you are analyzing may be different
than the one surveyed.
I choose the example of office condominiums because they have become an
increasingly common investment type being marketed to small investors and
because they are usually less than 10,000 square feet in size. In areas with
abundant commercial condo construction, one should distinguish between
condos sold for owner occupant use vs. condos sold to investors. Why is
this difference so important?
Let us examine residential condo markets as an example. Condo markets
governed by owner occupants tend to be more stable, as each condo is
intended to be occupied by the buyer. As long as each owner is financially
solvent, occupancy should remain high.
If one examines the most spectacular residential condo market failures, one
finds markets where many condos were sold to investors rather than
occupants. Some were just trying to ride out the wave of price appreciation
and profit from flipping the property. Others were convinced that the condo
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Lessons from Losses in Commercial Real Estate
could be a reliable source of rental income. The net result in markets like
Florida and Nevada is an extreme oversupply of empty condos.
Commercial condo markets behave in the same manner. Where commercial
condos were built to satisfy demand from investors, rather than owneroccupants, there has been an oversupply built. This data does not usually get
covered in the local broker research reports, which might report the lower
vacancy rates being experienced in the larger office buildings.
One example that comes to mind is Union Hills Drive, an east-west traffic
artery extending from north Phoenix to Peoria, Arizona. Many new office
condos were built along this corridor but may not be surveyed by the local
brokers. A couple of years ago I saw vacancies increasing as condos got
built faster than they could be occupied, and sites in Peoria zoned for
shopping centers were instead being developed with office condo parks.
Jupiter, Florida, is another area where I have seen an excess of office
condominiums built.
Household income data: Focus on the median
For retailers or housing developers, which datum should be used: average
household income or median household income? Average is another name
for the mean of the sample. The median is the number that bisects the
sample into halves. It is at the exact middle of the sample when numerically
ordered.
Median income is typically lower, and it is the statistic relied upon by
retailers, for good reason.
Let us look at the example of Irwindale, California, a southern California
city of 1446 residents, 365 households, a median household income of
$45,000 per year and average income of about $52,000 per year. What
would happen to these statistics if the Bill and Melinda Gates household
moved to Irwindale? Let us assume that Mr. and Mrs. Gates are earning $1
billion per year.
The median household income would change little, perhaps to $45,001, the
next wealthier household on the totem pole.
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Vernon Martin
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The average household income would jump enormously, calculated as
follows:
(365 x 52,000 + 1,000,000,000)/366 = $2,784,098 = avg household income
The average household income in Irwindale would have increased more than
50-fold with the entry of the Gates household.
Which figure would matter more to the local supermarket? Will it sell 50
times as many groceries? Will the carwashes wash 50 times as many cars?
Will 50 times as many homes be sold? I rest my case with these rhetorical
questions.
With few exceptions, the median household income statistic is the one that
retailers and homebuilders rely on.
The average household income may be of more interest to Rolls Royce
dealers, but they could probably get more relevant and granular detail by
getting a count of the number of households earning above $500,000 per
year.
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Lessons from Losses in Commercial Real Estate
SECTION 1.3
BAD ADVICE
Bad advice flows to all levels of the real estate investing industry. Although
I aim this book at sophisticated investors, I want to start by saying
something to the novice investors who might be reading as well as following
the advice of a real estate guru.
The gurus
It is Saturday afternoon, and what could be going on at the Airport Hilton?
Perhaps it is a semi-swank wedding reception? Or could it be a seminar
entitled, “Unfathomable Real Estate Wealth in 3 Easy Steps?” Chances are
the seminar producer is also promoting a book with the same name, or is
charging several thousand dollars per head. “You can’t afford to not attend this
seminar!” (Their words, not mine.)
As I write this book in year 2010, it seems to me that this is now the most
profitable area in real estate – the selling of “get rich quick in real estate”
seminars. These seminars may even be a lagging indicator of the real estate
market, as I notice them more often after the market has become spent.
Except for Donald Trump, the successful real estate investor has no time to
write books and create seminars, nor the desire to spend weekends training
future competitors in windowless hotel meeting rooms with poor climate
control. Anyone who has “the secrets to real estate wealth” would certainly
have no need to share them.
“If I really knew how to get rich quick in real estate, would I be spending all
my time up here and in Holiday Inn meeting rooms?”
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Vernon Martin
American Property Research
When the seminar promoter wants to “partner with you,” be very careful.
Sometimes the purpose of the seminar promoter is to recruit straw buyers to
participate in mortgage fraud.
Other times the promoter will want an advance fee to partner with him, and
results will not be guaranteed.
Another recently publicized scam is called “chunking”, in which the
promoter misappropriates your identity and applies for loans on many more
properties that you think you are investing in.5
I once attended the “seminar before the seminar” by one of these gurus.
Afterwards, I went up to him and asked, “Just between you and me, what
percentage of these people are going to make money using your system?”
Without batting an eye, he said, “2%” and told me that most of the public
had neither the smarts nor the discipline to follow his prescribed methods. I
considered that disclosure refreshingly honest for a seminar promoter.
Two years ago I was attending a Mortgage Fraud seminar sponsored by the
Association of Certified Fraud Examiners, of which I am a member. During
coffee break, some of us found that the next meeting room was hosting a
Robert Allen seminar, and a couple of us crashed the seminar just in time to
learn how to prepare misleading purchase contracts, a subject that I just
covered in Section 1.1 of Chapter 1. We listened dumbfoundedly to his
lesson on how to commit mortgage fraud just before we returned to our own
seminar on how to prevent mortgage fraud.
Guru Robert Allen went through bankruptcy in 1996, reportedly because he
could not come up with the insurance deductible when an avalanche
destroyed a home he was constructing.6 This would seem to cast doubt on
his image as a real estate multi-millionaire.
Those readers who may be following one guru or another may wish to check
the web site of John Reed (www.johntreed.com), an outspoken critic of
Federal Financial Institutions Examination Council, “The Detection and Deterrence of Mortgage Fraud
Against Financial Institutions: A White Paper,” 2009.
6
“ John T. Reed’s Real Estate B.S. Artist Detection Checklist”, www.johntreed.com
5
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Lessons from Losses in Commercial Real Estate
many such gurus. Type in the names and you will get colorful histories on
many of these people--histories of bankruptcy, litigation or criminal charges.
In a nutshell, these seminars mix good advice with bad advice and advice
that could end up landing the novice investor in prison for mortgage fraud.
Sometimes, the gurus are not seminar promoters, but acclaimed advisors
with frequent appearances on the conference circuit.
Advisory firms
Some of these firms serve as holding areas for young people who look good
in suits. I was once one of them. Although I was proud to have a Master of
Science in Real Estate degree, I have since learned that most real estate
knowledge is empirically derived, not academically derived. We knew how
to apply methods of financial analysis, but had little real world knowledge to
assure that the methods were being applied soundly.
If you seek counsel from such firms, just make sure it is from the senior guy,
the one who the firm is named after, and not some kid just out of college.
Yes, you will be told, “But he’s one of our best and he went to the best
schools!” but do not settle. Even then, you may still think you hired the top
guy, but may still be passed down to the junior employee because the genius
who founded the firm often lacks the time to do much of the work. If he
lacks time to do the work, moreover, he will lack the time to properly train
and supervise his staff.
The larger the firm, the less available the genius will be, as he has to spend
ever more time on marketing and speaking engagements to keep the large
advisory ship afloat with business. The demands on his time increase
geometrically, not arithmetically.
It might also be worthwhile to pay a visit to the advisory firm to count the
number of gray hairs as a proxy for the amount of experience of the staff. In
real estate investing, you want advice based on experience.
My advice is to stick to small advisory firms to assure that a senior guy gives
you the attention that you think you are paying for.
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Vernon Martin
American Property Research
I also caution against selecting lazy advisors, those who sit back and take
broker submissions of investment ideas rather than scouring the market for
the best investment opportunities. Ask to see the advisor’s previous
recommendations for other clients, including photos. Is it an office building
without windows on two sides? Is it an older regional mall losing tenants to
a new regional mall nearby? Is it a retail center in a depopulating
neighborhood? Yes, I’ve seen advisors make these idiotic acquisitions for
their institutional clients.
Appraisers
I work as an appraiser in an industry that considers appraisers to be idiots,
for sometimes justifiable reasons.
The main problem with the commercial appraisal profession is that it has
evolved too narrowly and is too insular. The profession suffers from the
“Ivory Tower problem” in its fundamental inability to think like a property
owner or investor.
Most appraisers have no real estate leasing, sales, development or lending
experience, but claim to speak with authority about real estate values. Some
will spend decades working as an appraiser without acquiring many clues.
Considering that appraisers typically work with a definition of market value
in which they estimate what price the property would sell for, a lack of real
estate sales experience is a handicap.
Likewise, how well can appraisers judge the feasibility or cost of proposed
construction if they have never worked in real estate development?
Estimating land value is often a function of estimating the value of the site
as ultimately improved and then discounting back to present value,
deducting all development costs to reach that state of development, but how
well can this be done by people who are not familiar with construction and
development costs?
Appraisers who have never worked at a lending institution will often not
fully understand the needs of a lender client. To them, an estimate of value is
something abstract or academic which differs from the concept of what the
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Lessons from Losses in Commercial Real Estate
property would sell for if placed on the market as of the date of value. “Oh,
no, not that market value!” they will say when the loan experiences early
payment default.
There is often a lack of appreciation for the risks borne by lenders, even
though the appraisal process is fundamentally meant to be a risk
management tool. Some appraisers feel free to err on the high side.
When the loan defaults and the foreclosed asset is sold for well below
appraised value, the lender may ask, “How could you have been so wrong?”
and such appraisers have presented the following excuses:
 “That’s what properties have historically been selling for.”
 “That’s what it would be worth if the protected Banyan Tree wasn’t
there.”
 “That’s what it would be worth when the final tract map is approved,
which is any day now because the borrower sad so.”
 “That’s what it would be worth when the __________is completed
(road, golf course, convention center, etc.).”
 “My estimate of value was based on the rent roll. How was I
supposed to know that the rent roll was different than the leases?”
 “My estimate of value was based on the site having water and sewer.
How was I supposed to know there was no water and sewer?”
In other words, appraisers without lending institution experience often have
no frame of reference regarding the risks of the transaction, including the
risk that the borrower is lying. They have never learned to care about these
things. If the appraiser has never worked at a lending institution, he may
have never seen a loan loss, and he may also have no point of reference to
see how appraisals often miss the mark.
Professional appraiser associations tend to be dominated by independent fee
appraisers, too, which only delays the eventual reform of this profession,
because so many of them hold lenders in disdain, also for sometimes
justifiable reasons.
The present-day appraisal work model, which has not changed in decades, is
20% research and 80% report writing, whereas clients would be better
served with an appraisal work model which is 80% research and 20% report
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Vernon Martin
American Property Research
writing. How much longer must we have to read “Los Angeles is on the west
coast of the United States of America in the western hemisphere of the third
planet from the sun”? Or “Spared from General Sherman’s fiery sweep to
the ocean, Macon, Georgia, is rich in historical tradition?” If these things
must be written, they should at least be tied into the valuation analysis;
otherwise, what is the point?
When taking the Report Writing class of one of the professional
associations, it was constantly reinforced to us that our estimate of value did
not matter, only the documentation of the methods we used to support it. In
other words, the appraisal report does not have to be accurate; it only has to
look good. With such a professional mindset, it is no wonder that appraisers
are held in disrespect.
Another problem with some appraisers is that they have had no training in
microeconomics or finance and may use appraisal methods that controvert
economic laws or accepted financial analysis methodology.
State licensing agencies and professional associations are trying to remedy
the situation by requiring “certified general” (commercial) or designated
appraisers to have undergraduate degrees, but at present, any undergraduate
degree will do, and many, if not most appraisers are career changers with
degrees in irrelevant subjects.
Having witnessed so many failed real estate loans and investments in my
career, I have observed that the process often started with a faulty appraisal.
Here are some common appraiser shortcomings leading to serious losses:
1. The appraiser does not know how to estimate market demand for the
appraised property.
For instance, if the appraiser cannot find comparable sales in the area
of the subject property, he typically just goes to another area to find
comparable sales, failing to consider that there may be a lack of
demand in the subject property’s market area. This is how rural
properties end up being compared with suburban properties and how
suburban properties end up being compared with urban properties.
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Lessons from Losses in Commercial Real Estate
If it is a proposed property, the peril is worse, as most appraisers do
not know how to measure local demand factors, instead assuming
feasibility because “it worked two years ago” or “it worked 50 miles
away.” Even when there are no preleasing commitments or pre-sales,
an appraiser is still likely to tell you that the project is feasible.
Saying that makes everybody feel happy and may result in more
appraisal orders, at least until the client declares bankruptcy.
2. The appraiser relies on outdated comparable sales data when he
cannot find current sales data.
Some will make downward “time adjustments” to older sales data, but
these adjustments are often just pulled out of thin air. The less
cerebral appraiser will reason that if there have been no sales in a
given market in the last two years, that the market value is therefore
the same as two years ago. Nowadays, though, the lack of sales
corresponds to lack of demand, not lack of supply. The next sale to
occur is likely to be at a much lower price.
Worse yet, too few commercial appraisers check to see if current
listings are at prices lower than yesteryear’s closed sales. This is not
even emphasized in appraisal textbooks.
3. The appraiser believes everything the property owner told him
without verifying the facts. Having spent most of my career as a
review appraiser, and even nowadays having to read the appraisals
bought and paid for by property owners and mortgage brokers, I have
been amazed to see some of the most honored appraisers and appraisal
firms fail to detect such misrepresentations.
Unfortunately, appraisers tend to be a weak link in spotting
misrepresentations. In the U.S., appraisers are generally governed by
the Uniform Standards of Professional Appraisal Practice (USPAP),
but this document focuses on areas of analysis, reporting and
reviewing while presenting no standards for the inspection of real
estate and verification of data. USPAP even permits appraisers to
value the property without inspecting it (as long as this is disclosed in
the report).
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Those of you who read appraisal reports in their entirety may have
also noticed the following standard exculpatory clause in the section
of the Assumptions and Limiting Conditions of the report that reads,
more or less, as follows:
“No responsibility is assumed for accuracy of information
furnished by the client.”
This abdication of responsibility personally offends my fiduciary
sensibilities. Such a statement begs the question, “If the appraiser will
not protect the client against inaccurate information, who will?” There is
often no one more uniquely situated than the appraiser to protect
clients against misrepresentations about real estate.
This is an Achilles heel of the appraisal profession – reliance on
inaccurate information from biased parties – with no prospects on the
horizon for universally addressing this inadequacy.
“Assumptions and limiting conditions” generally serve to protect
appraiser from liability rather than protecting the client from
dishonesty of a property owner. Furthermore, the client does
usually see these assumptions and limiting conditions until
appraisal report is delivered.
the
the
not
the
New “scope of work” rules first appearing in the 2006 version of
USPAP can further lessen an appraiser’s accountability to clients, as
most users of appraisals have a negotiating disadvantage with
appraisers in determining the proper scope of an assignment, being
less knowledgeable than appraisers about possible appraisal and due
diligence options. (On one Internet appraiser’s forum, for instance, an
appraiser repeatedly announced her decision to “scope away” the less
pleasant aspects of appraisal assignments, and appraisal work can
sometimes be tedious and unpleasant, whether it is inspecting and/or
measuring large, multi-tenanted properties, or verifying the legality of
improvements.)
For those who order and rely on appraisals, the best defense is to draw
up a required “scope-of-work” for appraisers which require them to
verify essential information, whether it is to inspect a certain
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Lessons from Losses in Commercial Real Estate
percentage of units or to measure the property, and then place this
scope-of-work requirement in the contract for appraisal services. The
major lenders already do this.
4. The appraiser does not attempt to determine if there is a market
oversupply of the subject property’s type.
5. The appraiser does not verify total land area or building area with
public records.
6. The appraiser assumes that buildings with high vacancies will
eventually return to 95% occupancy.
7. The appraiser makes unwise “extraordinary assumptions” (defined by
USPAP as “an assumption, directly related to a specific assignment,
which, if found to be false, could alter the appraiser’s opinions or
conclusions”). Some examples of harmful extraordinary assumptions
I’ve seen have usually related to the construction of another property
or public works necessary for the economic operation of the appraised
property, such as:
 a hotel appraisal that assumed that the a convention center would
be built and completed on schedule next door,
 an appraisal of a community retail center that assumed the
construction of a residential subdivision nearby,
 a subdivision appraisal that assumes that a road would be built to
the property at public expense.
Assuming that other properties get built on time is a risky business.
8. The appraiser relies on “pro forma” projections that differ
significantly from the current performance of the property.
Appraisers have fallen into the habit of assuming that currently poor
operating performance is the fault of management and that new
owners will turn the property around. Experience has taught me that
this is the exception rather than the rule. Buyers usually overestimate
their management abilities relative to the previous management.
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9. The appraiser fails to notice or consider conditions that lessen the
property’s value. Recent appraiser omissions I’ve seen include:
a. A proposed mixed use project that had been planned for five
years had only been 3% preleased.
b. Construction on a luxury hotel/residence project had been
suspended for several months and the hotelier had pulled out of
the project.
c. The going concern that included the real estate was not
profitable, in an industry that isn’t profitable.
d. A regional mall’s anchor tenants were experiencing dismal,
declining sales, and one anchor’s lease expires in a year.
e. A proposed golf destination hotel had access to only one of the
two golf courses it adjoined, and the private course already had
a competing hotel, making it unlikely they would offer access.
f. The terrain was too rugged to be developed. (I couldn’t stand
up straight on the property.)
g. The land did not have water and sewer, and the closest water
and sewer lines were two miles away.
h. The condo-zoned site was in a vacation town which had a fouryear supply of new, unsold condos.
i. The lake next to the land was too polluted to swim or fish in.
j. The largest tenant was missing.
k. The “temporarily-flooded-in-a-rainstorm” land was actually a
permanent swamp. The gravity drains indicated that the owner
had been trying for a while to drain the land.
l. The lakeside land did not have a permit from the Corps of
Engineers allowing for dock or marina development.
m. The developer of an airport parking lot was being sued by the
Airport Authority, who also put up a fence to block pedestrian
access.
n. The property tax exemption was not transferable.
o. The sign at the shopping center advertised “No CAM costs”,
but the appraiser assumed that all leases were triple net.
p. The “sold out”, 20-unit, first phase of a condo project had only
one occupant.
q. The condo community that was supposed to support a selfstorage facility had not been built yet and its completion looked
doubtful.
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Lessons from Losses in Commercial Real Estate
Appraisers specializing in certain property types
There are certain appraisal firms that specialize in certain property types and
often have the most knowledge to offer on that specific property type,
whether it is hotels, or golf courses, or hospitals. Others may specialize in
certain markets, like Mexico. Too often, these specialized appraisal firms
become the paid advocates of the industries they study, and their advice
becomes biased towards the most influential forces in the industry, which
are more likely to be developers and investors than stingy lenders. Check
out their web sites. Are there elated testimonials from real estate brokers,
developers or syndicators? Not on mine, as I strive to serve as the protector
to the lending industry, or at least those lenders who want protection.
My last appraisal assignment of 2009, a proposed hotel and golf resort in
Barbados, may serve as an example. I appraised the property “as is” for $17
million. CB Richard Ellis, who I had no contact with, appraised it for $18
million. The world famous hotel valuation firm appraised it for $50 million.
Selecting an appraiser
Relying on an unknown appraiser’s opinion of value is risky business.
When I was between jobs ten years ago, I spent 6 months in the mortgage
analytics business, and was surprised to see analysts and academics treating
the “appraised value” of the loan collateral to be unquestionable proof of
value, without once considering the problems of competency, pressure, and
bias pervasive in the appraisal profession. It is no wonder that their default
models failed in the great Mortgage Meltdown in recent history.
I approach appraiser selection as I would approach employee selection. The
interview process is considerably scaled down, but it is important to know
the appraiser’s experience and skill with the property type in question. I like
to particularly ask, “How would you appraise this property? What methods
would you use? What type of market research would you perform?”
If you do not feel that you have the competency to evaluate an appraiser,
perhaps it is time to ask yourself if you should be investing or lending on the
property type in question. Taking the risk of engaging an incompetent
appraiser only leads to the blind leading the blind.
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Some who are less confident in their ability to select appraisers turn to
credentials or designations. These can serve as a starting point, but do not
guarantee that the appraiser is competent to appraise each and every property
type. There is no certification or designation or college degree that certifies
an appraiser’s ability to appraise subdivisions, or gas stations, or hotels. If
you were to engage a surgeon to operate on your brain, would you say, “As
long as he’s an MD, that’s fine with me”? You would probably have serious
questions for him about his brain surgery experience.
Once you have established competency, you’re still not home free. Large
appraisal firms often practice “bait and switch”, and the appraiser you think
you hired might instead delegate the work to a junior appraiser. It is ironic
that some appraisal clients insist on a “national appraisal firm”, considering
that they may be less likely to have an experienced appraiser performing the
actual appraisal analysis. I was once one of those junior appraisers.
I counsel my clients to write a contract with the selected appraiser that
requires that him to specifically perform the property inspection and
appraisal analysis. If your appraisal firm tells you that you’re being
unrealistic in making such demands, maybe it’s time to select a different
firm.
When you receive the appraisal report, turn to the Certification section. This
will indicate who actually visited the property and worked on the appraisal
report. If the report is deficient and the engaged appraiser did not even visit
the property, insist that your appraiser live up to the contract.
Competency: Geographic competency vs. specialized competency
Differing consulting assignments require differing types of competency.
Bringing in a residential appraiser from out of state would normally be
illogical in a residential appraisal assignment, where knowledge of local
schools, access to local MLS, and in-depth knowledge of local transactions
would naturally favor the local appraiser.
On the opposite end of the spectrum are property types like regional malls,
where many, if not most of the comparable transactions are in differing
states, and one would want a consultant with a national perspective on the
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Lessons from Losses in Commercial Real Estate
current market conditions governing regional mall sales. Hiring the local
guy might not produce the soundest analysis.
Other specialized property types may also require experts who might not be
available locally.
Golf courses, hospitals, gas stations, condotels,
cemeteries, and even restaurants are not property types that most commercial
realtors or appraisers are trained in, so sometimes an expert needs to be hired
from elsewhere.
Some larger properties may need a larger perspective, too.
Stephen Roulac, for instance, states:
Consultant
“The local expert may know the local scene, but may lack knowledge
of how the local scene fits into the larger context...The local expert
may have no real idea whether out-f-town capital would be interested
or not interested in that market. The local expert may be clueless as
to whether people residing in other places would want to live in that
market, locate a retail store in that market, or put an office in that
market. Relying too heavily on the local expert may be a big
mistake.”7
There are other situations where an out-of-town consultant or appraiser may
also be preferred to a local person because of their independence, such as
when the subject property is in a small community and the local appraiser
does not want to upset the local powers. If your appraisal disappoints Boss
Hogg, he’ll make sure you never work in Hazzard County again.
For instance, my best client asked me to find an MAI to appraise several
hundred acres of land with entitlements for residential subdivision in a rural
county of about 30,000 residents. The county had only one MAI, but when I
tried to recruit him he refused to take on the assignment because he had
already figured out that his estimate of value was going to upset somebody.
The deal was this: several hundred acres which had been listed for sale for
more than 3 years at a price of $4 million were being purchased for $5
million in a very slow market. The buyer was a syndicator, and syndicators
generally make their money in syndication fees (which are proportional to
the acquisition price) and they typically do not contribute their own cash
equity. The MAI had already been offered the appraisal assignment by the
seller and had quickly concluded that the property was actually worth less
7
Stephen Roulac, 255 Real Estate Investing Mistakes, Property Press: San Rafael, CA, 2004, p. 239.
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than $1 million, and if he did an honest appraisal, he would end up being
boycotted in his home county. He turned down the assignment.
My client asked me to do an evaluation, and I estimated a value of $800,000
based on most recent sales and listings. The broker (who was also the seller)
then accused me of being geographically incompetent. This situation could
have easily made a nice newspaper article, such as often seen nowadays,
with an outraged broker saying "I had a bona fide offer of $5 million and the
out-of-town appraiser didn't know what he was doing and appraised it for
$800,000 and killed my deal."
Sometimes, the local consultant is biased by local chauvinism, too. There are
some who cheer their local real estate market much as they would cheer their
local sports team. Some consultants have even suggested that prosperity is a
permanent feature of their community.
Having started my appraising career in Texas in the nid-1980s, I learned
early of the consequences of overbuilding and witnessed an almost religious
faith that God’s invisible hand was there to make Texas real estate
developers rich and exempt from the well established economic laws of
supply and demand. When it all fell apart, along with my job, I relocated to
California and took a position as a commercial appraisal auditor for Home
Savings of America, America’s largest S&L.
Observing that the overbuilding of California lagged Texas by a few years, I
saw the writing on the wall. Among the issues I raised in my audits was the
standard forecasting of 5% vacancy and collection losses for all income
properties, even for those in the latter part of their economic lives, situated in
the shadows of empty new office towers. Being from Texas, I was accused
of geographic incompetence by my audit subjects, to which I responded that
I know overbuilding when I see it. They thought that because they had never
seen commercial real estate prices decline in California, that California was
therefore exempt from the laws of supply and demand. It was me against
several dozen California appraisers. I ended up being right. Every C&I loan
I audited ended up in default, and Home Savings soon ceased new C&I
lending.
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Lessons from Losses in Commercial Real Estate
CHAPTER TWO
ERRONEOUS METHODS OF ANALYSIS
Just as the universe has its physical laws, real estate markets and individual
properties behave according to economic laws. Commonly overlooked or
misapplied economic laws include:
 The law of supply and demand
 Increasing obsolescence over a building’s economic life and its effect
on net income
 The relationship between demographic factors and the demand for
real estate
Also included in my catalog of erroneous analytical methods are false
assumptions concerning property rights and their severability or
transferability.
SECTION 2.1
SUPPLY AND DEMAND ANALYSIS
This is usually covered in Lesson One of your college Economics 101
course, but has frequently been forgotten or misapplied in the real estate
industry.
Back in 1984, I was a graduate student at Southern Methodist University in
Dallas, Texas. By virtue of SMU being a “favorite son” of the Dallas
business community, I was given complimentary free admission to a local
real estate conference on office building development, which was the rage
throughout the U.S. at that time.
Most of the speakers were Texas real estate developers in their thirties and
forties who wore navy blue pinstripe suits and could have been mistaken for
Wall Street investment bankers if it wasn’t for their accents. The theme I
heard constantly repeated was the Dallas area’s phenomenal 5% annual
growth rate in office employment and the rosy future for Texas office
buildings.
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Then the optimistic mood was broken by a speech from an older man
wearing a tan, western cut suit, the type that would look very out of place on
Wall Street. His remarks, to paraphrase, were essentially “Look, guys, this
5% annual growth in office employment is great, but y’all are increasing the
amount of office space by 25% per year, and there’s gonna be a Day of
Reckoning.” That brought home to me the significance of the first lesson
learned in the first lecture of any college microeconomics course –the law of
supply and demand.
At the end of his speech, the silence was deafening. He received not one
question or comment. It was as if he had just told a church congregation that
God doesn’t exist, and not wanting to part with their religion (that God
provides an invisible hand supporting Texas real estate), the audience sat
silently, pretending that he had never spoken. I received the same reaction
once when I delivered a speech on commercial mortgage fraud at the MBACREF (Mortgage Bankers Association Commercial Real Estate Finance)
conference.
To a graduate student who had not yet learned to translate business school
learning into street knowledge, his speech came as an epiphany to me, and
over the next several years I expectantly witnessed an unprecedented
overbuilding of commercial real estate that eventually led to a collapse in the
savings and loan industry and the Texas banking industry.
This time around, in the 21st century, commercial lenders have been careful
not to finance overbuilding of commercial real estate. By necessity they
have to be the ones to gauge commercial real estate markets, because real
estate developers are in the habit of building anything that they can get
financed, knowing that the lender bears most of the risk.
The housing market
Nevertheless, many nations have now had to face housing market collapses,
including the USA, UK, Ireland, and Spain, as a result of residential
overbuilding. Where was the supply/demand analysis this time around? It
was in a small check box on a residential appraisal form, a check mark to
signify if the local housing market was stable, undersupplied or
oversupplied. Those appraisers who checked the “Oversupply” box often
found themselves harassed or losing work.
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Lessons from Losses in Commercial Real Estate
Of course, the oversupply started with the development of new residential
subdivisions, but there was no system for indentifying the prospects of too
much housing inventory until too late (when the foreclosures and auctions
started being advertised). Feasibility was typically justified by the success
of the last subdivision in the area, and no one was measuring the amount of
vacant inventory because it was assumed that new homes would continue to
be snatched up at the same rate as before.
Slightly more than half of my work during the last four years has been the
valuation and feasibility analysis of residential subdivisions and condo
projects, as many developers still want to build as long as they can get
highly leveraged financing, and they will always have a persuasive story
about how their project is different.
Measuring residential oversupply
Traveling to many different areas in the U.S., I try to apply the following
“quick and dirty” rule of thumb to measuring the balance of supply and
demand in a given market. In the U.S. I will typically analyze a market on a
zip code basis (or sometimes two zip codes) and will use RealQuest (product
of First American Core Logic) or Data Express (product of FNC, Inc.) to
quantify the number of residential sales in the last six months, excluding
actual foreclosures (where the bank took possession). Then I go to
www.Realtor.com to find the number of residential listings in the same zip
codes, also recognizing that new home or condo construction is not
necessarily included in multiple listing services. Then I establish a ratio of
supply vs. demand and express it in the number of months (or years) of
unsold inventory.
For instance, if a given zip code had 120 residential sales within the last six
months, and there are 360 listings, then the amount of unsold inventory is
measured in time as follows:
360/120 x 6 months = 18 months of unsold inventory
Most realtors say that a balanced market is represented by an inventory of
three to six months. In the above case, then, it becomes immediately
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apparent that the market is experiencing severe oversupply conditions and is
vulnerable to downward pressure on prices.
When analyzing a condo project, I usually limit my analysis to condo sales
and condo inventory. For instance, in a recent assignment in Chicago’s
Streeterville neighborhood east of its Magnificent Mile (zip code 60611), I
measured a ratio of 1173 listed condos to about 300 condo sales in the last
six months, equivalent to an inventory of almost two years, but there were
also several newly completed buildings for which most of the units were not
yet listed in the MLS. The conclusion reached was that this was a severely
overbuilt condo submarket, and something that had been coming for a long
time..
Monitoring permit activity
This is needed for gauging future competition. Just when the local
oversupply may be drawing down, there could be a new oversupply in the
making.
Measure the possible increase in local inventory on a percentage basis, i.e.
dividing the number of residential permits issued by the number of existing
residential units. Is this percentage increase in synchrony with the probable
rate of household formation?
For commercial real estate, divide the square footage of the permits issued
by the square footage of the existing inventory for a similar comparative
analysis. For instance, will office space permits add 25% more office space
in a market with just 5% growth in office jobs? That would be a prescription
for oversupply.
Shadow inventory from vacant condominiums
Measured vacancy rates in commercial and multifamily rental markets
sometimes fail to consider vacancies created by the new construction of “for
sale” condominiums, even though the nation is experiencing a glut of new
homes and condominiums at present. Traditional thinking typically
separates the “owner occupant” market from the “tenant” market, but there
are spillover effects from the overbuilding of condominiums, both
residential and commercial.
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Lessons from Losses in Commercial Real Estate
An older rental apartment building in a Massachusetts town had been
refinanced only 18 months before at a time when local apartment buildings
were experiencing occupancy rates of 95 to 100%, yet this building had seen
occupancy decline to 70%. In a situation like this, one would normally
reason that the building’s decline in occupancy was due to mismanagement,
but some further market research indicated some other problems with this
market.
A fresh comparable rental survey indicated some surprising changes since
the previous survey. Market rents of $800 per month and $1000 per month
for one and two bedroom apartments had declined to $750 and $850 per
month, respectively. What could have happened?
The answer was an oversupply of unsold condominiums, with an average list
price of $210,000. At an 80% loan-to-value ratio, a 6% fixed interest rate
and a 30-year amortization, the monthly P&I payment would be $1007 per
month for a two-bedroom, 1053 square foot condo priced at $210,000,
indicating that condominium ownership had become price-competitive with
local rental apartments. Smaller condos, more similar to size of the rental
units at the subject property, had sold at prices as low as $89,000 for a 565
square foot unit. Using the same loan criteria, monthly P & I could be less
than $500. That could have been the reason for the falling rents.
Property and Portfolio Research, a national real estate research firm
unaffiliated with mine, reported in MBA Newslink that the apartment
markets seeing the biggest rise in vacancies are the ones experiencing fallout
from the condo boom and bust, such as Orlando, Tampa, West Palm Beach,
Oakland, Las Vegas, and Phoenix.
Commercial condominium overbuilding can also cause havoc, as previously
discussed in the example of the north Phoenix office condos in Section 1.2
of Chapter 1.
It is therefore important to track local residential or commercial
condominium markets, as overbuilding in these condominium markets has
the potential to destabilize rental properties.
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Lack of zoning
Having started my career in Houston, the largest American city to have no
zoning ordinance, I have seen the market chaos that happens when anyone
can build anything anywhere. It is the Principle of Ruinous Competition.
Just when a developer finds a profitable opportunity in a prime location,
others rush in soon afterwards, creating an oversupply. This shortens the
economic life of most property types in unzoned areas. Investors should use
higher capitalization rates to select properties in these areas. Lenders,
likewise, should use higher debt coverage ratios and lower loan-to-value
ratios.
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Lessons from Losses in Commercial Real Estate
SECTION 2.2 DISCOUNTED CASH FLOW ANALYSIS
Discounted cash flow (DCF) analysis relies on a multi-year projection of
income and expenses and an estimated final disposition price and discounts
each year’s forecasted net income and sales proceeds back to a present value
at a desired equity yield rate or internal rate of return. This technique is a
staple of modern finance. DCF analysis was actually invented in the 1930s,
but not extensively used for real estate until decades later.
Lease-by-lease discounted cash flow (DCF) analysis first became
extensively used for real estate investment analysis in the late 1970s. Its
complexity required computer applications for large investment properties
such as regional malls and high-rise office buildings. It was not widely used
at first because existing commercial real estate practitioners of the time had
not been trained in it, did not understand it, or did not have the computer
resources to implement it. The crowning moment for DCF’s new place in
the industry became apparent in the purchase of the Pan Am building (now
the Met Life building) in New York in 1980.
The circumstances were unique, as the financial industry in Manhattan was
experiencing profound innovation at a time when the country's office market
had been stagnating for several years under an "economic malaise' (as
famously defined by Jimmy Carter). If you look at office districts throughout
the U.S., you will typically see no office buildings constructed between
1975and 1980. In 1979 and 1980, though, office space in Manhattan was
being rapidly absorbed and asking rents increased 50% in less than two
years.
Analysts and appraisers using direct capitalization based on the rates of the
1970s were missing out on a market that was taking off. The buyers of the
Pan Am Building used a lease-by-lease DCF model to justify their purchase
price at that time, which equated to a going-in capitalization rate of about
4%. The high valuation was based on rapidly increasing rental rates.
Lease-by-lease DCF analysis had proved itself superior to direct
capitalization methods in quantifying the effects of lease expirations and
rapidly increasing rents on the values of income-producing properties.
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Based on these new circumstances, DCF analysis became all the rage in the
1980s, giving unprecedented employment opportunities to newly minted
business school graduates such as me.
One thing that was not properly understood at the time, though, was that a
DCF model necessarily depends on many, many assumptions that can be
subject to error or manipulation and that the differences in assumptions
could result in wildly varying estimates of value. (Later in this chapter I will
present an example.) Nevertheless, the real estate industry became high on
DCF analysis during the 1980s, and crazy things happened as a result. Even
today, I am not convinced that most investment bankers or financial advisors
understand DCF analysis as it applies to real estate.
The commercial real estate fallout from the 1980s somewhat tarnished the
reputation of DCF analysis, but it is still practiced today and is a useful tool
under the right circumstances, such as when an income-producing property
is encumbered by long-term leases that might not increase a building’s rental
income at the same rate as market forces would dictate. Today’s
commercial leases are shorter than they were a generation ago, so the need
for a DCF analysis is not always required. Three months ago, for instance, I
appraised a regional mall in which almost every lease was expiring in the
next three years, and I decided that a ten-year DCF model would not be
relevant in those circumstances.
When DCF analyses should or should not be used
The main purpose of DCF analysis is to estimate the present value of
irregular cash flows. The most common situations where DCF analysis is
needed are:
 Income-producing properties subject to long-term leases that do not
allow rents to move correspondingly to changes in market rents
 Analysis of new subdivisions and large-scale planned developments
that will take years to develop and sell out, and
 Investments that have no reversion to the owner, such as leasehold
properties.
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Lessons from Losses in Commercial Real Estate
Having previously published and lectured on DCF analysis, I occasionally
receive inquiries from those seeking to apply it to a particular property
investment, and in some cases, DCF analysis is not the appropriate tool.
For example, applying DCF analysis would not be necessary for properties
on short-term leases or in which occupancy one or two years from now
cannot be predicted. Direct capitalization for apartments and hotels, for
instance, would be the superior tool because it would be simpler to use and
understand and less prone to abuse or faulty assumptions. DCF analysis
would provide no benefit over direct capitalization and might actually get
the analysis off-track with faulty assumptions, and so many more
assumptions are necessary for DCF analysis than for direct capitalization.
The exception with apartments might be those subject to restrictions from
LIHTC (low income housing tax credits) which may be allowed major rental
increases at the expiration of the rent restriction period, typically the first 15
years.
DCF analysis is not generally used for properties with regular incomes, such
as triple net lease properties, unless the lease will end soon and the tenant’s
renewal is in doubt. A typical triple net lease property might be a drugstore
or national retailer on a 25-year lease. Investors approach such property
investments as they would evaluate bond investments because of the fixed
returns, and bond investors do not normally construct DCF models.
For those who are either constructing DCF models or else reading others’
DCF models, here are some common errors committed in performing DCF
analysis:
Assuming that long term income growth is as high as expense growth
The relationship between rental growth and expense growth is often
misunderstood, even today. Some analysts apply the same rate of inflation
to both income and expenses, which is not an accurate projection over a
holding period of ten years or more. In examining the long-term operating
history of income properties, expenses always increase faster than revenues
over the life of the building. This is why expense ratios are higher for older
buildings, as is graphically demonstrated in Figure 3. Notice how the line
representing the operating expense ratio for each age subcategory increases
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Vernon Martin
American Property Research
in slope relative to gross income. This is a graphical evidence of expenses
increasing faster than income for income properties.
FIGURE 3
Increasing Expense Ratios as Buildings Age
100
90
Percent of gross income
80
70
Gross Income
Operating Expense Ratio
60
50
40
30
5
15
25
35
Age in years
Data from BOMA (Building Owners and Managers Association)
There is a logical reason for this. As a building ages, it becomes less
competitive and the rate of rental increase slows, while the aging of the
property requires increasing maintenance and capital improvements
expenditures. This is the reality of physical and functional obsolescence.
The natural end of the economic life of a building, of course, is when
expenses finally exceed collectible income. If expenses typically grew no
faster than income, on the other hand, no buildings would become obsolete.
That would be nice for building owners, but the real world does not operate
in that manner.
If this graphical analysis is not convincing, perhaps an algebraic analysis
might be. Here is an exercise I conducted several years ago:
The following are operating expense ratios reported for garden apartments
nationwide in the 2002 edition of the Institute of Real Estate Management
(IREM) Income/Expense Analysis: Conventional Apartments:
1946-1964: 50.6 percent
1965-1977: 47.6 percent
1978-2001: 41.3 percent
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Lessons from Losses in Commercial Real Estate
Take the midpoint of each range, such as 1955, 1971, and 1990, to calculate
respective average building ages in 2001 (when the data was collected) of
12, 30, and 46 years. Then algebraically derive a revenue growth rate that
would correspond to a 5 percent expense inflation given these operating
ratios.
If a 12-year-old building was operating at a 41.3 percent expense ratio and
expenses increased at 5 percent per year, use a financial calculator to solve
for the revenue growth rate that would result in this building operating at an
expense ratio of 47.6 percent 18 years later. At age 12, the building earns
$100 for every $41.30 in expenses. At 5 percent inflation, expenses are
$99.391 18 years later. Divide by 0.476, and the corresponding income
would then be $208.81. Then solve for the rate of return that would turn
$100 into $208.81 18 years later. The solution is a 4.17 percent income
growth rate, not 5 percent.
The difference may seem slight, but projecting 10 years out, the difference
in income between a 4.17 percent growth rate and a 5 percent growth rate
would be more than 8 percent, and the difference in net operating income
could be twice as great or more.
In previous analyses of office buildings, moreover, I have seen faster rates of
obsolescence, in which income grew at an average of about 70% the rate of
growth in rents. These exercises were done before office rents started falling
in the early 1990s.
In evaluating someone else’s cash flow projections, and the rates of income
and expense growth are not explicitly stated, one quick method of
determining if expense growth is projected to increase faster than income is
to compute expense ratios for the first, fifth and final years of the projection
period.8 In most cases, the expense ratios should be increasing.
Cutting corners on lease-by-lease income projections
Sometimes, when projections are made by persons who cannot or will not
perform lease-by-lease DCF analysis (most often done nowadays on Argus
8
Sue Ann Dickey, Reviewing an Office Building Appraisal Report (Scottsdale, AZ: National Association
of Review Appraisers and Mortgage Underwriters, 1987)
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American Property Research
software), the results might superficially appear accurate, but the whole
purpose of a lease-by-lease analysis, which is to quantify the effect on value
of long-term leases and favorable renewal options, will have been defeated.
To determine if lease-by-lease analysis was used or not used, look to see if
annual income estimates increase at a constant rate and then compare these
steady increases with the actual leases. Are there long-term fixed leases that
limit upside potential? Then the increases in annual income should not be
constant and the analyst has not done his job correctly. An example will be
presented at the end of the chapter.
Ignoring the effect of rental concessions
Rental concessions are a reality in current commercial market conditions as
of 2010. In DCF models where rental concessions are a line item separate
from gross potential income, the rapid phase-out of concessions early in the
projection period may distort income growth. In such models, a 5% increase
in market rents as defined by “contract rents” may actually be equivalent to
higher increases in effective rents, although effective rents typically become
the new market rental rates.
Misunderstanding percentage rental income
Percentage rent is extra rent paid by retail tenants when they exceed a sales
“breakpoint”. It is a percentage of sales revenues that exceed the breakpoint.
A “natural breakpoint” is when the breakpoint is computed by dividing the
percentage rental rate into the base rent. For a retail tenant paying a base
rent of $20 per square foot and obligated to pay 5% of sales revenues above
the natural breakpoint, the natural breakpoint would be computed as:
$20 psf/.05 = $400 psf
The tenant would only be obligated to pay 5% of sales above sales of $400
psf, which is about the national average for regional mall sales. If the tenant
only achieves annual sales of $400 psf, he would owe no percentage rent. If
the tenant achieved sales of $500 psf, the percentage rent owed in addition to
base rent would be computed as follows:
(500 – 400) x .05 = $5 psf (in addition to base rent)
58
Lessons from Losses in Commercial Real Estate
When the lease rolls over at a higher rental rate, however, the natural
breakpoint will become higher, and percentage rental income may be
correspondingly reduced in response to higher base rent. For instance,
suppose the above-described tenant has his base rent raised to $26 psf. The
new natural breakpoint would be computed as follows:
$26 psf/.05 = $520 psf
If the tenant is only achieving sales of $500 psf, percentage rent would no
longer be owed.
(500 – 520) x .05 = $0 psf
For this reason, cash flow projections with constantly increasing percentage
rent income should be more closely examined.
Expense recovery income
For fully occupied properties subject to triple net leases, this income
category should grow at the same rate as expenses. In the U.S., retail and
industrial leases are typically triple net.
When a property is encumbered by “gross” leases, such as most U.S. office
buildings, the landlord often pays for the proportional operating expenses
(apportioned by the tenant’s proportion of occupied area) for a “base year”
but obligates the tenant to pay for any additional operating expenses past
that estimated base year amount. This base year can either be an estimate of
coming expenses or simply the actually incurred expenses during the first
year of the tenant’s occupancy.
This base year amount is often called an “expense stop”. For example, the
landlord of an office building signs a tenant at a $14 psf gross lease with a
$6 psf expense stop. Supposing that in the next calendar year of operation,
operating expenses work out to $7 psf, the tenant would then owe as follows
for that year:
$14 psf + ($7 -$6) psf = $15 psf
When the tenant eventually renews his lease, however, he may be given a
new base year expense stop, thereby decreasing expense recoveries for that
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Vernon Martin
American Property Research
tenant in the next year. The resultant effect on buildings subject to gross
leases is that expense recovery income will increase at a lower rate than
operating expenses in that projection period.
Underestimation of vacancy and collection losses
Most software packages for lease-by-lease DCF analysis, such as Argus,
have three components for projecting vacancy losses – a general vacancy
and collection loss rate, “void” periods between tenancies, and a probability
of lease renewal. In considering or reviewing such projections of vacancy,
the following questions should be considered:
 How competitive is the subject property?
 What is the probability of tenant turnover?
 How much competitive inventory will be coming on line at the time of
lease renewal?
 Do the estimated void periods conform to present or expected market
conditions?
The inexperienced DCF analyst may plug in fixed renewal probabilities,
such as 50% or 80%, depending upon the level of optimism he is instructed
to operate under. Because renewal probabilities are so important, however,
they require an extra measure of thought.
For a regional mall, for instance, the landlord typically requires all tenants to
report their sales revenues. On a per square foot basis, these revenues
should then be compared to the rental rate. This is an easy way to spot the
troubled tenants. For instance, when I compare the base rent to the achieved
sales revenues on a percentage basis, I generally consider a tenant in double
digits to be in trouble, or conversely, if the tenant cannot achieve sales
revenues of at least 10 times their base rent, I consider them troubled. This
will vary by industry.
For non-retail properties, whether they are office buildings, industrial parks
or apartment buildings, the analysis may be simpler. It could just be a
matter of summarizing the tenants which are paying rents above market
rates.
60
Lessons from Losses in Commercial Real Estate
Underestimation of expenses
There are certain bad habits common in expense projections, the first of
which is applying a standard rate of inflation to all expense categories
throughout the projection period. The actual operating lives of buildings do
not demonstrate such uniformity in expense growth.
One item that will typically increase faster than consumer price inflation, for
instance, is “repairs and maintenance”. Not only are such expenses subject
to price inflation, but the aging of the building itself will increase the need
for such services and the amount needed.
Think of an aging building as an aging person. In our teens and early
twenties, our maintenance needs are minimal as we enjoy good health and
youthful attractiveness without effort. In our thirties, many of us need to
spend more to maintain youthful attractiveness, whether in the form of
cosmetics, Rogaine, Jenny Craig or expensive gym memberships. In our
forties and fifties, some of us have chronic health problems emerge, such as
obesity, high blood pressure, or heart disease, and maintaining youthful
attractiveness becomes increasingly expensive and complicated. Rather than
remind you of your inevitable decline, however, I will get to the point,
which is if one looked at the cost of human “repairs and maintenance” by
year of age, then it soon becomes obvious that this cost increases faster than
the rate of consumer price inflation.
The same analogy can be made with automobiles.
Another bad habit seen in cash flow statements and projections is the
placement of leasing commissions below net operating income, as if leasing
commissions are not a necessary expense in operating an income-producing
property. As the building ages, the help of outside leasing agents will
increasingly be needed. A new building in a strong real estate market may
be able to rely on in-house leasing or management staff to fill the space, but
as commercial space ages, it increasingly needs all the help it can get in
keeping it occupied.
In the year I write this, year 2010, it has become obvious that most state and
local governments are in financial trouble. This can lead to significant tax
increases in the near future, and property tax increases will particularly
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American Property Research
increase the cost of owning real estate, except where increases are limited by
statute, such as California. Even then, California will have a referendum in
the fall of 2010 to repeal Proposition 13 controls on commercial real estate
assessment.
Naturally, if one is pondering real estate acquisitions or loans in California,
one needs to consider the effect of reassessment upon sale. In California,
property taxes will be based on market value at the time of sale, which is
usually (but not always) indicated by the sales price. Projections of property
tax expenses in California may need to presume a reassessment upon
purchase of the property.
Lastly, the cash flow projections should account for future needed capital
improvements for building components that will inevitably need
replacement, such as the roof, HVAC components, appliances, and carpets.
One cannot predict when each component will wear out, so rather than
projecting a $100,000 roof replacement in, say, Year 8, it is more practical to
include an annual reserve amount, as an expense, which will accumulate to
the amount necessary to replace expensive items with lives shorter than the
building life. Many analysts use 2% of gross income as a replacement
reserve allowance; others may estimate reserves at 25 cents per square foot
or $250 per year for apartments. I am only reporting recent practice here,
not recommending what would be the most appropriate reserve allowances
for your particular building.
Misunderstanding “The Reversion”
A DCF model ends with an estimate of the price the property will sell for at
the end of the projection period. Typically, the net operating income in the
final or subsequent year of the projection period is capitalized to calculate a
sales price which is then discounted to present value at the beginning of the
projection period.
It is important to understand that the property will be several years older at
time of sale and that likely investors, perceiving the shorter remaining
economic life of the building, may apply a higher capitalization rate than
they would have applied several years earlier in the building’s life.
(Exceptions have been made in the recent commercial real estate run-up in
prices.)
62
Lessons from Losses in Commercial Real Estate
The two components of an investor’s required equity yield rate are current
return (AKA capitalization rates for non-leveraged properties or “equity
dividend” or “cash-on-cash” rates of return for leveraged properties) and
capital appreciation. For a newer building, an investor will settle on a lower
current rate of return in expectations of capital appreciation. When the
building is ten years older, however, the expectations of capital appreciation
might diminish, depending upon market conditions, and investors will
typically want a higher current rate of return.
Many analysts today are compensating for this by adding at least 50 basis
points to the ending capitalization rate used to estimate the reversion sales
price. This should depend on the expected economic life of the building.
Some specialized property types may have shorter economic lives because
of the increased possibility of obsolescence. A radiation oncology building,
for instance, might not be needed ten years from now if other cancer-fighting
technologies can do the job better.
As for the reversion, one should fully estimate all the costs of selling the
property. Sales commissions may be as low as 1.5% for major investment
grade properties, but there may be other costs associated with the sale, such
as buyer-mandated repair costs, legal fees, and other seller concessions such
as allowances for interior upgrades, lease-up costs or reserves for tenant
improvement allowances.
The discount rate
The cash flow projections will then need to be discounted at an internal rate
of return. Those readers who are investors will already have your “hurdle”
rates of return, but I find many lenders fooled by DCF analyses for flawed
properties that rely on rates selected from nationally published surveys, such
as Korpacz, that relate generally to investment grade properties. This is not
meant to criticize Korpacz, who I like and respect, but to explain that his
surveys are directed towards institutional investors that invest in high-quality
properties, and that rates for flawed properties should be adjusted upwards.
In addition, during periods of greater risk, desired internal rates of return are
also commensurately increased, and analysts and appraisers need to keep
current with these increased expectations. A recent on-line discussion
between appraisers on residential subdivision discount rates trotted out a lot
of old data, suggesting IRRs of 18 to 22%, when in some cases, 30%
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Vernon Martin
American Property Research
discount rates are being used to compensate for the added risk of large-scale
residential development in severely overbuilt areas.
Unfortunately, published real estate sales data do not include the expected
IRR of the buyer, and the buyer may be hard to reach or reluctant to discuss
such criteria, making it difficult to find appropriate discount rates for one’s
DCF model. Nothing beats interviewing buyers, but when this cannot be
practically done, there may be ways of interpolating an IRR from cap rates
which are part of the real estate sales data.
For instance, the Korpacz survey for regional malls in the first quarter of
2009 involved a mean going-in cap rate of 6.99% and a mean IRR of 9.13%.
If one assumed that net operating income was to grow at a constant rate, the
difference between the mean cap rate of 6.99% and the mean IRR of 9.13%
would imply expected capital appreciation of about 2.14% per year,
computed as follows:
9.13% - 6.99% = 2.14%
In appraising a distressed regional mall several months ago, the most
comparable sales had a mean cap rate of about 12%. If one adds a capital
appreciation rate of 2.14%, this may bring the IRR to over 14%, but one
should also consider that some buyers of distressed malls have rehabilitation
expectations with higher rates of capital appreciation in mind. Otherwise,
what would be the incentive to buy a distressed mall? Regional mall buyers,
I would like to hear from you.
Failure to consider economic cycles
Every DCF model I have seen forecasts uninterrupted growth, but economic
recessions occur in every decade, sometimes even twice. The models of the
1980s failed to forecast the early 1990s recession, and the models of the
1990s failed to forecast the two recessions of the 21st century. This is
another reason why DCF models often give high results.
Inappropriate use of DCF models
Sometimes "Wall Street" investors have insisted on a DCF model for every
appraised property in a portfolio, regardless of the suitability of the
technique, and the resulting DCF models either confirm the direct
capitalization analysis or else greatly exceed the value derived by direct
capitalization because the appraiser constructed a model with faulty
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Lessons from Losses in Commercial Real Estate
assumptions. Apartments and hotels are a good example. Just because the
property is large enough to have its loan securitized does not mean that the
valuation methods should be different. One rule of thumb is: if the property
could be vacant one year from now, a DCF analysis should not be used, as it
would be completely speculative.
Worse yet, there are some who misuse DCF analysis to inflate an estimate of
value, using the methods heretofore described.
Example: Two DCF models
I constructed the following DCF models for an article I did for Real Estate
Review in 1988.9 The first model comes from an actual DCF lease-by-lease
analysis I did for an office building in the mid-1980s. The second model
starts with the same building’s leases and cash flows, but uses various tricks
to inflate the estimate of value while still presenting the illusion of
credibility. The first model estimated value to be $14 million. The second
model estimated value to be $23 million.
ELEVEN YEAR PRO FORMA CASH FLOW PROJECTION
(IN $000)
Year
1
2
3
4
5
6
7
8
9
10
11
2505
2556
2850
2900
2798
2808
3022
3199
3345
3420
3734
663
663
645
667
681
768
746
752
806
869
895
Gross potential income
3168
3219
3495
3567
3479
3577
3768
3951
4151
4289
4429
Less: Vacancy & collection loss
-606
-250
-370
-225
-181
-194
-658
-460
-287
-286
-307
Effective gross income
2562
2969
3125
3342
3298
3382
3061
3461
3793
4002
4322
Mgmt fee
-102
-119
-125
-134
-132
-135
-122
-138
-152
-160
-165
Prop tax
-140
-142
-145
-148
-151
-154
-157
-160
-163
-166
-187
Base rental income
Expense recovery income
Less:
Insurance
-38
-40
-43
-45
-48
-51
-54
-57
-60
-64
-68
Utilities
-585
-614
-645
-677
-711
-747
-784
-823
-864
-908
-953
Other
-287
-301
-316
-332
-349
-336
-385
-404
-424
-445
-467
Reserves
-150
-158
-166
-174
-181
-189
-195
-206
-216
-227
-238
1262
1596
1685
1832
1726
1740
1364
1673
1914
2032
2244
Net operating income
Reversion:
Less: Closing costs @4%
Net sales Proceeds
$2,244,000/.12
18700000
-748000
17952000
Present value of reversion @14%
4842441
Present value of NOI @14%
9118000
TOTAL PRESENT VALUE
Rounded
13960441
$14,000,000
Vernon Martin, “Nine Abuses Common in Pro Forma Cash Flow Projections”, Real Estate Review, Fall
1988.
9
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Vernon Martin
American Property Research
Assumptions used were as follows:
Market rent was inflated at 3.5% per annum from the effective market rent
(net of rent concessions) at the start of the period; most expenses were
inflated at 5%, except for taxes and insurance (2% and 6%, respectively).
The general vacancy and collection loss was estimated as 1.5%, but sixmonth void periods were assumed between tenancies, with a tenant renewal
rate of 65%, resulting in an overall average vacancy rate of 8.5%. Property
taxes were computed as 1% of market value for the first year, inflated at 2%
per annum thereafter until the final year of reversion, in which the property
is reassessed at 1% of market value, similar to what is done by California
property tax assessors. A reserve allowance for tenant improvements and
leasing commissions was based on the forecast of 35% tenant turnover.
By today’s standards, these are not conservative assumptions. If only office
buildings today could be as lucky as to have an average vacancy rate of
8.5% and a 65% tenant renewal rate over a ten-year period!
Same building, deceptive model
ELEVEN YEAR PRO FORMA CASH FLOW PROJECTION
(IN $000)
Year
Base rental income
Expense recovery income
1
2
3
4
5
6
7
8
9
10
11
2654
2787
2926
3073
3226
3388
3557
3735
3922
4118
4324
663
690
717
746
776
807
839
872
907
944
981
Gross potential income
3317
3477
3643
3818
4002
4194
4396
4607
4829
5061
5305
Less: Rental concessions
-149
-233
-61
0
0
0
0
0
0
0
0
Less: Vacancy & collection loss
-606
-174
-182
-191
-200
-210
-220
-230
-241
-253
-265
Effective gross income
Less:
2562
3070
3400
3627
3802
3984
4176
4376
4587
4808
5039
Mgmt fee
-102
-123
-136
-145
-152
-159
-167
-175
-183
-192
-202
Prop tax
-126
-129
-132
-134
-137
-140
-142
-145
-148
-151
-154
Insurance
Utilities
Other
Net operating income
Reversion:
Less: Closing costs @2%
$3,341,000/.085
-38
-39
-40
-42
-43
-44
-45
-47
-48
-50
-51
-585
-608
-633
-658
-684
-712
-740
-770
-801
-833
-866
-287
-298
-310
-323
-336
-349
-363
-378
-393
-408
-425
1424
1873
2149
2325
2450
2580
2719
2861
3014
3174
3341
39305882
-786118
Net sales Proceeds
38519765
Present value of reversion @13.5%
10857379
Present value of NOI @13%
12105174
TOTAL PRESENT VALUE
22963553
Rounded
$23,000,000
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Lessons from Losses in Commercial Real Estate
What are the clues to this possibly deceptive DCF model?
1. Rental income increases at exactly 5% per year, making it doubtful
that a lease-by-lease analysis was performed.
2. The model starts with a market rent assumption not adjusted for rental
concessions, which are deducted and quickly phased out on the line
below. Effective rental rates (net of concessions) are being increased
at a rate averaging 5.6% per year.
3. Operating expenses are inflated at 4% per year. As a result, the
operating expense ratio decreases from 42.9% in the first year to
39.3% in the 11th year, when the operating expense ratio should be
increasing.
4. Expense recovery income is inflated at exactly 4% per year, making it
doubtful that a lease-by-lease analysis was performed.
5. The vacancy and collection loss rate is a standard 5% of gross
potential income, making it doubtful that a lease-by-lease analysis was
performed and void periods between tenancies considered.
6. California property taxes were not based on reassessment upon sale.
7. There are no reserves for tenant improvements, leasing commissions
and capital improvements.
8. The reversion is calculated using an 8.5% capitalization rate instead
the 12% rate used in the first model, and even less than the 9% goingin capitalization rate.
9. The 11th year’s expenses do not account for reassessment upon sale
(California).
10. The model assumes closing costs of only 2%.
11. A lower discount rate is used (13% for the NOI, 13.5% for the
reversion).
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Vernon Martin
American Property Research
“Here’s my plan to increase the value of our real estate
holdings --- Discounted Cash Flow Analysis!”
DCF errors summarized
To conclude this section on DCF analysis, let me re-emphasize certain key
components of DCF modeling that are often misunderstood or misapplied:
 Growth rates for expenses should increase faster than rental growth
rates.
 Failure to perform lease-by-lease DCF analysis defeats the purpose of
DCF analysis and can easily be detected.
 Failure to use “effective rents” (net of concessions) rather than quoted
contract rental rates.
 Percentage rental income should generally increase at a slower rate
than rental income.
 Expense recovery income should generally increase at a slower rate
than rental income when leases are “gross”.
 Vacancy and collection loss assumptions should include a realistic
analysis of each tenant’s likelihood of renewal, based on a comparison
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Lessons from Losses in Commercial Real Estate





of the tenant’s contract rental rate with market rental rates or the sales
revenues earned by the tenant.
Expense categories need to include leasing commissions and reserves
for replacement.
Terminal capitalization rates should be higher than going-in cap rates.
Reversion sales prices need to be adjusted for all likely costs incurred
in a sale of less-than-new property, not just the broker’s commission.
Discount rates need to be appropriate for the quality and risk of
property being analyzed.
DCF models would be more accurate if they included the likelihood
of a recession in any ten-year projection period.
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American Property Research
SECTION 2.3 DEMOGRAPHIC ANALYSIS
Certain forms of real estate, such as residential, retail and self-storage
properties, are quite dependent upon demographic factors.
Population growth vs. household growth
Those forecasting housing demand based on population growth are
sometimes confounded. The most relevant demographic statistic is the rate
of household growth. A baby being born does not create an inherent
demand for a second home to be occupied, but a young man leaving home to
get married does create a demand for another home; he and his wife are
creating a new household.
In these recessionary times population growth and household growth can
actually be opposite. The young man and his wife have a baby, but then
they lose their jobs and have to move back in with the man’s parents. The
population has increased by one, but the number of households has
decreased by one.
Household income
For instance, if one conducts a regression or correlation analysis between
median household income and local apartment rents or housing prices, the
correlation is generally quite high. In other words, rents and prices will be
lower in low income neighborhoods and are a function of what households
are able to pay.
Large retail centers need to rely on a trade area of sufficient population,
disposable income, and population growth to prosper.
These concepts are intuitively obvious, but why are they often violated?
Part of the reason lies in the poor training most real estate practitioners get in
demographic analysis. Among professional real estate associations offering
education, the CCIM Institute seems to be the only one requiring members
to be proficient in demographic analysis, and CCIMs typically work as
commissioned salespersons, not advisors, appraisers or loan underwriters.
Appraisers lack training in this area and often make huge misjudgments as a
consequence. Some misjudgments I have seen include:
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 Valuation of raw timberland in Decatur County, Tennessee for $50
million because of a planned 4100-home, mixed density, luxury
residential development and marina with starting prices of $300,000
for condominiums and detached home prices over $1,000,000.
Decatur County has about 12,000 residents and a median home price
of $65,000. (Having lunch there was like a scene out of Deliverance.)
There was no permit from the Army Corps of Engineers for a marina,
either, and the ACE is generally stingy with such permits.
 A proposed community retail center site west of the Florida Tollway
was appraised at close to $10 psf, but a demographic analysis
indicated less than 50 residents within a one mile radius of the site.
The site was zoned agricultural.
 In the 1980s an enclosed retail mall anchored by JC Penney was built
in Huntsville, Texas, financed by an Arizona savings and loan
institution. A feasibility study considered trade area population, but
no mention was made that many of the residents of Huntsville area are
incarcerated. Huntsville, which was a town of 27,000 residents at the
time, is also home to a Texas state penitentiary and several prison
farms which have together incarcerated up to 5000 prisoners at a time.
“Attention! Prisoners! Let’s go shopping! ”
Image of actor Bob Gunton from “The Shawshank Redemption”, Castle Rock Entertainment
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Depopulation
Investing in older buildings in depopulating areas is a prescription for
failure. The Rust Belt, for instance, has many cities that have lost half their
population in the last 50 years, including Detroit, Cleveland, Youngstown
and Dayton. This usually means increasing vacancies, despite gallant
leasing efforts. Rents are so low that only the lowest cost renovations make
any sense, too. Even then, new space gets built, hastening the demise of the
older buildings.
Of course, there is always somebody forecasting an imminent turnaround in
each city’s fortunes. In 2008, for instance, the median home price in Detroit
was $86,000, which some thought to present a compelling case in attracting
new residents to Detroit (along with the new casinos). Alas, the median
home price today is just $15,000.
Demographic data sources
Many real estate professionals can get demographic data free from their
professional associations, such as CCIM or the Appraisal Institute. LoopNet
has demographic data for each listing, with population and socioeconomic
data for the population within one mile, three mile and five mile radii of the
listed property. If you can find a LoopNet-listed property on the same block
as the property you are evaluating, you can use the demographic data from
that property.
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SECTION 2.4 UNREALISTIC EXPECTATIONS
Misunderstanding scale
The less numerate investor sometimes overestimates the future scale of
growth or price appreciation in the market he has invested in.
Many investors acquire land “in the path of growth” and underestimate the
amount of time that growth will take to reach their property. For instance,
investors are currently seeking to finance a 13,750-home subdivision outside
Benson, Arizona, a 5000-resident community growing at a rate of about 30
residents per year since 2000. Unless outside demand can be induced,
absorption would take about 1000 years at the current rate of household
growth, assuming that all new residents could afford new homes. Most
current residents of Benson appear to be living in mobile homes.
Protection from inflation
At the start of the 1980s, U.S. investors observed that real estate had
successfully served as an inflation hedge over the previous few years. The
high inflation of the times diminished the real (inflation-adjusted) value of
the debt, and rising net incomes and price appreciation made the debt less
onerous. It was thought that real estate was an inflation-beating investment
because equity growth on leveraged properties would exceed the rate of
inflation.
In reality, the increasing income and values at that time were as much a
function of microeconomic factors as a function of price inflation. During
the “malaise” of the 1970s, real estate was not being built, and the U.S.
emerged from the 1970s with a shortage of commercial real estate.
Furthermore, price inflation had driven up construction costs such that any
new space would need to charge much higher rents for the building to be
profitable, which allowed landlords of older, pre-1975 buildings a great deal
of leeway in raising their own rents.
The rapidly increasing rents in existing buildings instigated a new wave of
construction without regard to equilibrium between supply and demand, and
as early as the mid-1980s, the linkage between price inflation and
commercial real estate price inflation had been broken, with rents headed
downward in the Oil Patch states. Contrary to popular belief, the main
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reason for the declines in these markets was not the drop in the price of oil,
but an oversupply of commercial space, the same conditions that brought
down the rest of the nation’s commercial markets a few years later.
Thinking that below-average properties will eventually sell at market
average prices
So you got a great deal on an office building in poor condition, with a leaky
roof, exposed asbestos and a tenant list of unknowns, located in a blighted
industrial neighborhood near downtown. The only way to move this
property’s value from below average to average or better is with a massive
renovation program. Unless you can be assured that you will receive high
rents at high occupancy, the renovation will not usually pay for itself.
The alternative is to just sit on the property and wait for downtown to run
out of space. This has been known to occasionally happen. Ten years ago,
for instance, downtown San Francisco ran out of office space, and
previously vacant Class D office buildings, heretofore limited to fortune
tellers and Alcoholics Anonymous for tenants, became fully occupied with
high-tech start-up firms. That did not last, and central business districts
running out of office space have been the exception rather than the norm.
San Francisco landlord
“Do you foresee me being able to replace you with a higher paying
tenant?.....What?.....Did I say something wrong?”
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SECTION 2.5 ASSIGNING VALUE TO NONTRANSFERABLE
RIGHTS
Sometimes a property owner has extra rights which may add to his own
value-in-use of the real estate, such as:




State or local tax exemptions
Governmental subsidies
Bonus density
Tax credits
An investor or lender needs to determine the transferability of such special
rights by examining the source documents that allow the transferability.
What might create great value for the existing property owner might not be
available to subsequent owners of the same property. If a right cannot be
transferred, it has no market value.
For example, the city of Monument, Colorado, granted lucrative tax
exemptions to a developer for the specific purpose of building a water park.
Although the parcel was being purchased for about $20 million, a local
appraiser appraised the land for $80 million by adding $60 million in
anticipated tax savings. No one argued that $60 million in tax savings were
possible, but the city ordinance declaring the tax exemptions specifically
stated that the tax exemptions were not transferable. A city official
explained to me, “Why should we allow the exemption to be transferred to
someone who doesn’t need it, like Wal-Mart or Home Depot?”
The lender was being asked to lend $20 million based on the $80 million
appraised value, but the definition of market value used in lending (and
appraising) is based on what the property would sell for to another, unrelated
party. If the tax exemption cannot be transferred, than it has no market
value; the value of the property to another owner would be closer to $20
million.
Community redevelopment agencies often create subsidies for developers to
undertake projects in underdeveloped areas, which are euphemistically
relabeled as “Redevelopment Areas” or even “Arts” or “Theater” Districts.
These “Project Funds” often come with many conditions as to use, density or
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aesthetics. Some developers then approach lenders offering these project
funds as additional collateral, but lenders need to determine:
 If the project fund runs with the property rather than the developer,
 If the project fund is transferable upon foreclosure, and
 If the project fund is available for alternative development if the
original project becomes infeasible.
Too often, the answer is “no.” I am even working on a situation now in
which the foreclosing lender would be made liable for repayment of project
funds.
Some redevelopments are often also eligible for federal and state tax credits,
such as the Federal “New Markets”, “Historical Preservation”, or “Low
Income Housing” tax credits which offset Federal income taxes, but care
should be taken to establish that tax credits have already been awarded, as
tax credits are often competitively allocated and limited in supply. For
instance, less than 25% of applications for “New Markets” tax credits
(encouraging qualified investment in economically challenged communities)
are successful in gaining the credits.
Some developers claim value to imminent historic tax credits before their
buildings are officially registered as a historic structure. One developer
claimed to have historic and theater tax credits for a 1950s office building on
the grounds that he intended to convert the building to a parking garage for a
theater one block away. There were no architectural drawings, plans or
specifications to support the intended renovation, either.
Water rights
Water rights can usually be sold, but one must be careful to identify what the
exact water rights are and who can practically use them.
For instance, groundwater rights are quite valuable in the Reno metropolitan
area and can be transferred to potentially hundreds of other users with access
to the underground aquifer.
One investor had the idea of buying two barely profitable golf courses with
substantial water rights, replacing fresh water with effluent water to water
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the golf courses, and selling off unused water rights for a substantial profit.
Most of the participants in this transaction—the investor, the appraiser and
the lender—presumed that these water rights had the same value as Reno
area groundwater rights, but the engineer’s report indicated the water
sources to be surface and underground mountain streams shared by few
other property owners. The market value of these water rights was
substantially less than the value of groundwater rights because the market
for these rights was so much smaller. These streamwater rights could only be
practically used by landowners along these streams.
There are other factors that also go into the valuation of water rights,
including “priority date” (seniority), season of use, location of the water
source, and water quality.
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SECTION 2.6
ASSIGNING REAL PROPERTY VALUE TO
PERSONAL PROPERTY
Real property stays in the same place. Personal property can disappear at
any time. Foreclosing lenders can sometimes find themselves with a hotel or
restaurant without furniture, for instance.
Two years ago I went to South Africa to appraise a game ranch, and found
an active market for game ranches, which were being acquired by super-rich
hunters such as Richard Branson and Howard Buffett (son of Warren). The
particular ranch I went to had thousands of game animals, priced at up to
$25,000 for a white rhinoceros; the hunters must pay for what they shoot.
Prices for game ranches were well above prices for general agricultural land,
but wherein lies the value? The acid test is to ask oneself what the ranch
would be worth without the animals. What would be the source of income?
It became obvious that the value of these ranches was in the animals and not
in the real estate. As my client was a private lender who likes to think
outside the box, I told them that I had acquired a lot of comparable sales of
other fully stocked game ranches, and could estimate the value of a fully
stocked game ranch, but it would be unwise to accept the animals as
collateral without insuring them. Animals can disappear through disease,
theft, poaching, fence breaches or brush fires. It was determined that the
cost of insuring the animals was too prohibitive to make the operation
economical.
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SECTION 2.7
CONFUSING REIT PERFORMANCE WITH
COMMERCIAL REAL ESTATE PERFORMANCE
A REIT is more than just an assemblage of commercial real estate properties
(CRE). It is an enterprise that acquires, operates and disposes commercial
properties, an enterprise in which investors can buy shares entitling them to
dividends. The REIT must distribute at least 90% of Funds from Operations
(roughly equivalent to net operating income plus depreciation) to
shareholders. The chief advantage of investing in a REIT rather than
directly into real estate is the advantage of liquidity, as they trade as stocks.
Another advantage of REIT investing is that the properties that you partly
own are managed by sophisticated operators, whose interests are reasonably
conforming to your own interests as an investor. The REIT, as an investment
vehicle, has considerably outperformed private and publicly traded limited
partnerships specializing in real estate, AKA real estate syndications, for
reasons of transparency and fairness to investors.
One important difference between REITs and commercial real estate in
general is that REITs are traded as stocks and are sometimes subject to
market behavior more synchronous with the stock market than the market
for commercial real estate in general.
The current market situation in April 2010 provides a particularly strong
example of how the two markets have diverged. As I travel throughout
North America and the Pacific for my clients I continue to see declining
commercial real estate markets, with declining occupancies, declining rents,
and declining demand for raw land. (At the same time, I am beginning to
see some residential markets “bottom out” as unsold inventory is being
depleted, but commercial markets typically lag residential markets by a
couple of years.) On the other hand, REIT share prices have been on an
upward run for more than a year now.
What accounts for this REIT/CRE divergence, and what can we learn from
it? These are the possible reasons:
1. REITs tend to own superior quality real estate assets.
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2. REITs now have a high Beta (correlation with overall stock market
performance), which was not the case in the 1990s. Today’s investors
buying REIT shares are more likely to be stock investors than
sophisticated real estate investors, and the increase in REIT share
prices is probably more a vote of equity investors’ confidence in the
economic recovery.
3. Private equity buyouts of some REITs have also fueled optimism
about the prospects for commercial real estate.
4. Rising share prices allowed REITs to tap the markets for equity, thus
diminishing their risk of insolvency. In the recent CRE slowdown, it
is remarkable that General Growth Properties was the only major
REIT to fail.
Failing to observe CRE fundamentals improving, I conclude that the lift in
REIT prices is primarily due to stock market behavior, as rising confidence
in an economic recovery buoys all stocks.
Considering the current average dividend rate of about 3.75% on REIT
stocks, it may even appear that REIT stocks are overpriced on a riskadjusted basis, now that 10-year Treasuries have increased to 3.89% as of
April 9, 2010. Based on the usual risk premiums given to REIT dividends
relative to 10-year Treasuries, the average dividend rate should be about
5.25% rather than 3.75%. Is this risk adjustment no longer warranted? No,
because of declining commercial real estate fundamentals, the risk
adjustment is now more warranted than ever. The REIT dividend rates of
today are mainly reflecting false optimism about a sudden return to price
appreciation.
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CHAPTER THREE
SECTION 3.1
LACK OF KNOWLEDGE
LACK OF GEOGRAPHIC KNOWLEDGE
Few today remember the significance of the Garn-St.Germain Act of 1981.
This is what opened the doors for savings and loan institutions, AKA thrift
institutions, to lend on commercial real estate. Prior to this act, thrifts were
limited to making home loans, but in the deep recession of the early 1980s,
when interest rates skyrocketed to 18%, thrifts found themselves without
loan customers. They noticed the tremendous increase in commercial
mortgage lending at the commercial banks and they wanted part of the
action.
With Garn-St.Germain, there were many new players in the commercial
lending market, and many were small institutions with big ambitions. They
wanted growth, a lot more growth than could be found in their local markets.
To achieve that growth, some made the decision to lend nationally, despite
their lack of experience.
The situation was ready-made for disaster: inexperienced lenders taking loan
applications on properties already turned down by every bank in their home
states.
Take the example of Pima Savings and Loan of Tucson, Arizona. In the mid1980s they took loan applications on marginal properties across the nation.
There was land in downtown Denver they thought to be worth $500 psf, just
as the Denver office market was sinking. There was an unanchored
specialty retail center in Boca Raton composed of unknown tenants, many of
whom were not visible from the street. And then there was the enclosed
mall in the prison town of Huntsville, Texas, as I have previously described.
Needless to say, Pima was one of the many S&L failures of the 1980s.
Another was Western Savings and Loan of Salt Lake City, Utah. They
decided to create a mortgage-backed security with a guaranteed 10% annual
return based on loans on unanchored strip centers and apartment buildings in
the Houston area and Tucson.
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Being called upon to appraise these properties, it seemed to me that the
underwriter had almost gone out of his way to choose the worst properties as
collateral. The strip centers were tenanted mostly by nightclubs and
restaurants, not the most stable of tenants. The Houston area apartments
were cheaply built with Dryvit siding and located in overbuilt, blue collar
suburbs. The apartments on the southwest side of Tucson were inhabited by
armed deadbeats.
As this carelessly selected portfolio rapidly lost value, the underwriter was
promoted to Senior Vice President. Who says that excellence goes
unrewarded? (Commercial mortgage lending is one of the few industries in
which abject failure serves as grounds for career advancement.) Western
Savings and Loan was another casualty of the 1980s.
In Western’s Real Estate Lending Division, excellence never went
unrewarded.
Even Home Savings made mistakes, opening new multifamily loan offices
in new, unfamiliar areas. These new offices were closed as loans defaulted
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rapidly. The Atlanta multifamily lending office had two-thirds of its loans
nonperforming by the end of the first year.
In the latest round of banking casualties, I see others which have
overstepped the bounds of geographic competency. Temecula Valley Bank
was just a community bank in Temecula, California, before it decided to
become a national commercial lender.
Once, when I solicited job applications from commercial appraisers, an
applicant proudly showed me the motel appraisal he did for Temecula
Valley Bank. It was an independent, older motel in Virginia, situated away
from a freeway or CBD, which he compared with franchised motels on the
freeway. The photos showed an empty parking lot. The motel was 3000
miles away from the bank.
Those new real estate investor magazines
I am not speaking here of long established institutional real estate investor
publications, such as National Real Estate Investor, which has improved the
quality of its content and analysis over the years, but a new class of
magazines which market investment real estate nationally or even
internationally to novice or unsophisticated investors.
If one Googles the names of advertisers in such publications, one can often
find a litany of consumer complaints. Litigation against such “false
advertisers” is often complicated by geographic distance or lack of
familiarity with local fraud laws.
The schemes are much the same as a generation ago, when naïve investors
bought Florida swampland or New Mexico desert land sight unseen from ads
appearing in the back of Parade Magazine.
Builder bailouts
For instance, as of January, 2010, there are almost 80,000 vacant homes in
metropolitan Phoenix.10 It is any wonder, then, that these magazines are
Catherine Reagor, “Job Losses Push Back Housing Recovery in Phoenix,” The Arizona Republic,
1/22/10.
10
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crowded with advertisements of Arizona “rental homes” for which the
advertisers promise to find, rent and manage for out-of-state investors?
Even when such homes are sold as leased, what happens at the end of the
lease? There is a name to these scams – “Builder bailouts”. The buyers are
often misled with inflated appraisals while given concessions such as free
condo association dues, cash at closing, and free management services for a
short time.
As an example of a struggling housing developer advertising its own product
as “investment properties” when sales to conventional owner occupants were
not feasible, two years ago a project broke ground in Ogden, Kansas, with
plans to build 2283 investment condos to house the families of soldiers at
Fort Riley. At starting prices of $148,000, the condo prices were beyond the
financial capabilities of most of the enlisted soldiers; the housing allowance
for a corporal, the most common enlisted rank, was just $676 per month.
The developer instead employed a strategy of marketing and selling to outof-state investors. The loan applicant had found this opportunity through
Personal Real Estate Investor Magazine. The most recent web site aerial
photo does not seem to indicate many completed units yet.
International real estate
Working in the Houston office of Jones Lang Wootton, an international real
estate firm, I sometimes received phone calls from our foreign offices,
usually in Asia, inquiring about some Houston property that was being
marketed in their country. These were typically the least desirable
properties, and seemed to fit a pattern, which is this:
The least desirable properties must be marketed the furthest distances
to find buyers or lenders. Good real estate opportunities tend to get
picked off by local investors and lenders.
In the field of international real estate investing and lending there are
sometimes exceptions in countries without homegrown wealth and/or
lending industries to support large-scale development. I’ve been sent to
projects in Fiji and various Caribbean islands, none of which have large
domestic lending institutions.
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Even then, foreign banks have branch offices in these countries and may
have the capacity to evaluate meritorious deals before the opportunities pass
on to my hard money clients, who have no representatives in those countries.
The properties I’ve been sent to visit often turn out to be mangrove swamps
or sugar cane plantations with high hopes of being turned into 5-star resort
developments—in other words, high risk deals passed over by other, closer
lending institutions. (Details can be found on my international blog at
http://internationalappraiser.blogspot.com/)
I have increasingly heard from small private lenders evaluating international
lending opportunities, and I advise any such lender to get competent legal
advice for the country they want to lend in.
There are many obstacles to analyzing foreign markets, starting with the lack
of good quality market information.
For novice investors and lenders, it is important to understand transaction
costs in these countries, too, as they can be much higher than transaction
costs in the U.S. For example, the transfer tax in Jamaica and some other
Caribbean nations is 7.5%, and attorney’s fees often exceed the amount of
the transfer tax in former British Commonwealth nations. For this reason,
lenders should only underwrite at LTV ratios much lower than in the U.S.
Another bit of obvious advice is not to trust unsolicited appraisal reports
from foreign countries. If it was ordered by a property owner or broker,
consider the bias. What also makes the use of foreign appraisal reports
riskier is the considerably lower documentation standards in countries
outside the U.S. and Canada. The reports from other countries, even the
United Kingdom, are much briefer and present much less evidentiary
support for their value conclusions. Some appraisers have designations from
international organizations, but I have seen no indication of ethics
enforcement by those organizations.
I would also caution smaller investors from placing too much trust in
international real estate magazines that take considerable advertising dollars
from real estate developers. You will recognize these magazines from their
hype, written in the same, tired old marketing vernacular used to advertise
miracle weight loss and genital enlargement pill scams—short paragraphs
with frequent bolding, underlining and exclamation marks and stories of
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average Americans living like kings. The results of this misplaced trust may
include overpaying for property or prepaying for properties that never get
developed. It amuses me to see that they still recommend buying condos
“before it’s too late”.
Always seek independent advice.
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SECTION 3.2
LACK OF PROPERTY KNOWLEDGE
Some aggressive investors or lenders overstep the bounds of competency in
selecting the property types they wish to invest in or lend on. Sometimes
they hire advisors or appraisers who themselves lack competency in the
property type. In such situations you have the “blind leading the blind” and
a comedy, or tragedy, of errors.
Land
Let us start with the simplest, yet most complex property type. Sometimes
lenders and less sophisticated investors fail to understand the vast gulf in
value between raw land and finished land, between flat land and hilly land,
or between unentitled land and entitled land.
Dishonest real estate syndicators particularly like land deals, because
unsophisticated limited partners, typically doctors, dentists and lawyers, can
be misled about the value of the land. So can unsophisticated lenders.
The value of the land is a function of the time-discounted value of what can
be developed on it, net of development costs, sales costs, and profit. For this
reason, land is one of the property types most volatile in value, too. Land
can often depreciate 90% in a recession, which always seems to surprise
some lenders who were making 50% LTV land loans.
Any analysis of land, then, must start with an analysis of its highest and best
use and the probability of achieving that highest and best use. Appraisal
textbooks commonly list four factors to consider in judging highest and best
use:




Legally permitted use
Physically possible use
Economically feasible use
The legally permitted, physically possible, economically feasible use
that provides the maximum residual value to the land.
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By the phrase “legally permitted use” some may think only of the zoning of
the land and forget that permission to develop the site is not necessarily a
given. Each parcel of land is governed by a local authority, typically a city
or a county agency, that may have an entitlement process the land owner
must go through to secure building permits. The larger the land parcel, the
more complicated the process.
Unless the investor or lender likes to gamble, it is safer to consider the legal
use as the use which has earned complete approval to build. In some
locales, this may be called “planning approval” or “approved final plat map”
or other similar terms indicating that the local government has granted
permission to develop.
Also be aware that “planning approval” may not be enough if the local
ordinances also require a “public hearing” for final approval. I have
witnessed cases in which a local government approval has been reversed by
a public backlash to a proposed development on the basis of density, view
impairment, increased traffic and noise, or the attraction of “undesirable”
people, such as drinkers, bikers, poor people, AIDS patients, unpopular
religions or unsupervised young people. The public is usually less
politically correct than government agencies.
Those communities with the highest risk of public reversals of planning
approvals often have great disparities in wealth and political viewpoints
among citizens. Some of the poorer counties in northern California, for
instance, have local governments eager for economic development pitted
against wealthy property owners, many of them new, who are more
interested in preserving their secluded paradises than in creating new jobs
for their less prosperous neighbors. These wealthy residents sometimes join
forces with environmental activists, either local or from outside the area.
Also be aware that more than one government approval may be necessary.
If wetlands or waterways are involved, an approval from the US Army
Corps of Engineers may be necessary. If the property is near a coastline, an
approval may be necessary from a state agency regulating coastline
development.
The investor or lender also needs to understand that each community may
have differing amounts of difficulty between “preliminary” or “tentative”
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approvals and “final” approval. For example, Clark County, Nevada has
been very friendly to property developers, and “preliminary” approvals have
been tantamount to final approvals. This is what has precipitated the
overbuilding of Las Vegas.
Contrast Clark County to Tuolumne County, California, where the journey
from preliminary approval to final approval for can involve the following
hurdles that take at least two years to surmount:
 An archaeological study
 A biotic constraints analysis, particularly for the bald eagle, native to
this area.
 A forester’s woodlands study
 Traffic study
 Hydrogeological assessment
 Blooming period survey for special status plants
 An Environmental Impact Report
Consider, also, that those communities promising the easiest path to
entitlements are also the most subject to overbuilding.
All of these subtleties are well known by land developers, but not
necessarily by passive investors or lenders, and that is where the money gets
lost.
Leasehold interests
Loan losses on leasehold interests can be even worse than losses on land
loans, as leasehold value can actually become worthless, unlike land, putting
the entire principal of the loan at risk. At Home Savings, one of our most
interesting loan assets was the International Marketplace in the heart of
Waikiki in Honolulu, Hawaii. For those of you who have visited Waikiki,
this is an open air retail center with many kiosks and at least one large
Banyan Tree.
The International Marketplace was a leasehold property, as is many
properties in Hawaii, with the landlord being the Queen Emma Foundation,
a trust which benefits native Hawaiian people. The ground lease called for
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rent to be adjusted every ten years according to a market value appraisal. In
the mid-1990s, with Waikiki land prices shooting through the roof, the
underlying land was revalued at several times its previous value, and the
new lease payment threatened to bankrupt the borrower. The leasehold
value declined to just a small fraction of the $50 million loan balance. I
have seen other leasehold interests decline to no value at all when lease
payments exceeded net operating income.
Large, single tenant properties
There are many who fail to consider the large difference in value between a
large multi-tenanted building and a large single tenant building, whether it is
retail, office or industrial. The difference in value is partly due to the cost of
conversion to multi-tenant use and partly due to the lack of demand from
other large space users
I have seen former corporate headquarters buildings linger vacant for years
like dead albatrosses. They are only functionally suitable for other large,
single tenant users, of which the supply is small. The cost to convert to
multi-tenant use may take years to pay for itself, and it is difficult to entice
small space users into such a building unless there is a critical mass of other
tenants. Do not use the price per square foot indicated by multi-tenanted
office building sales as an indicator of value for single tenanted buildings.
Likewise, there are many, empty, former K-Mart stores adorning the
American landscape, built during the 1970s and 1980s and now functionally
obsolete for department store use. The value of such retail structures can be
just a fraction of similarly sized, multi-tenanted retail centers.
Rent-controlled apartments
One fault of many rent control ordinances is that rental increases are limited
to increases in the Consumer Price Index, which lags behind the rate of
operating expense inflation at most properties. Beside increases in personnel
and materials costs at rental properties, there is also the problem with the
inevitable deterioration of the building and site improvements (common
areas and parking lot). The combination of all of these items almost
guarantees that operating expense inflation will increase faster than the
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Consumer Price Index, thereby creating a profit squeeze for the property
owner.
LIHTC (Low income housing tax credit) properties
These are very complicated multifamily properties with rent restrictions and
severely reduced liquidity. Operating costs are higher because of the costs of
complying with the restrictions and reporting requirements of the LIHTC
program (as authorized by IRS Section 42) and maintaining the property
according to specified standards. I have seen professional management fees
of 12% of effective gross income. The rent restrictions are often lifted after
the first 15 years of operation, but other traps might still exist, such as:
 Requirements that subsequent buyers be non-profit organizations
 Requirements that the state government approve the sale
If such restrictions exist, the marketability of the property becomes severely
impaired. That being said, I’ve never seen one of these properties actually
sold.
Golf courses
I have watched revenues in this industry decline for the last decade, even
when the economy was improving. In the last six years, I have not appraised
a single, profitable golf course, but this property type still gets traded as if
new ownership is all that is needed and as if the industry will suddenly turn
back to profitability. Many of the buyers are inexperienced in golf course
management, but think that their success in Finance or Law will assure their
success in this difficult business. Many golf course purchases seem to be
vanity purchases, motivated more by social climbing than by economic
fundamentals.
Going concerns
I have seen many loan losses on “going concern” properties in which the
lender failed to distinguish between real property value, business value and
the value of F,F&E (furnishings, fixtures and equipment), the three main
components of “going concern value”. Hotels, restaurants, equestrian
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centers and water parks fit this category. Unfortunately, by the time the loan
defaults, the business value is gone, and by the time the lender takes
possession of the property, the F,F&E is sometimes gone, too.
As a reductio ad absurdum, once there was a loan agent who brought me a
mortgage loan application on a small, owner-occupied Filipino bakery
building. “Just look at these revenues -- $400,000 per year!” he said, as he
wrote up a credit memorandum. “So,” I posited, “Does this mean that we
could foreclose on this building and still sell $400,000 per year of Filipino
wedding cakes?”
Hotels
Home Savings made several loans on Holiday Inns based on their incomes
and appraised values without considering how much of the income and value
came from the Holiday Inn franchise itself, one of the most powerful
franchises in the hotel business. When the early 1990s recession hit, these
hotels, which were independently owned, no longer had the cash flow to
maintain the properties up to Holiday Inn standards, and Holiday Inn
terminated their franchises and forced them to remove all Holiday Inn signs.
This became an opportunity to witness how much difference there was in
value between a “Holiday Inn” and an “unflagged hotel”, stranded without a
national reservation system.
The difference may be narrower nowadays because of internet hotel web
sites such as Hotels.com, Expedia and Travelocity, but brand loyalty and
frequent stayer rewards still create decisive business value to a well-known
franchise, such as Marriott, Intercontinental Hotels Group (Holiday Inn),
Hilton, Starwood, Best Western or Choice Hotels.
An unflagged hotel always has the possibility of becoming flagged again,
but the stumbling block is often the amount of capital investment needed to
return the hotel to franchise-quality standards. Once the borrower is
bankrupt, this is unlikely, and the lender is left foreclosing on a shuttered,
unflagged hotel with deferred maintenance, which it consequently must sell
at a deep discount.
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Restaurants
Many commercial mortgage lenders do not understand restaurant real estate
and most appraisers do not understand them, either. Too often they are
valued on a “price per square foot” basis as if they could be picked up,
transplanted elsewhere, and do the same amount of business. If the lender
does not retain an appraiser with specific restaurant competency, they often
end up with an appraisal report conclusion that reads such as “The
comparables sales ranged in price from $200 per square foot to $1000 per
square foot. Therefore, I reconcile at $600 per square foot. ” Because restaurant
sales are few, the comparables are likely to be all over town, too.
A restaurant is fundamentally a retail property and is thus quite locationdependent. The sounder approach to valuation is an income approach that
focuses on the rental value of the space, using extremely local comparable
rentals. In evaluating comparable rentals, I would even prefer seeing a lease
to a non-restaurant retailer on the same block, adjusted for the amortized
cost to convert to restaurant use, than a triple net lease to the McDonalds at
the Interstate Freeway exit.
I have seen several situations, too, in which overly large, isolated, lakeside
restaurants get overvalued.
For isolated, owner-occupied restaurants, for which no nearby comparable
rentals can be found, I consider that restaurant percentage leases typically
range from 6 to 8.5% of sales for restaurateurs who provide their own
F,F&E, and up to 10% of sales for turn-key facilities. Applying these
percentages to the gross sales of the restaurant in question can give one an
idea of the rental value of the facility.
Equestrian centers
If you have been to a rodeo, you have been to an equestrian center. These
are very labor-intensive operations requiring special expertise. The real
estate is generally minimal, consisting of stables, covered or uncovered
arenas, barns, maintenance buildings, a few offices, and plenty of land.
The revenues of a large equestrian center can be deceiving. A nationally
known equestrian center can achieve $5 million in annual revenues, but it
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should be understood that this revenue comes mainly from a business
operation with a lot of staff. The two leading revenue sources are 1) the
boarding and care of horses, which is labor intensive, and 2) show income,
which is also labor intensive and requires specialized expertise.
Water parks
I was at a conference in 2008 where one speaker extolled water parks as the
hot new real estate investment. When he stopped to take questions I pointed
out that in the first 23 years of my career I was never asked to appraise a
water park or even bid on an appraisal of a water park, but in the previous 12
months, I had been asked in five different instances to appraise proposed
water parks or closed water parks in Colorado, Florida, Tennessee, New
York and California, although I have no known competency in appraising
water parks. I asked if that could be a sign that the water park market could
be “oversaturated”. “No,” he said.
Before a lender or investor becomes blinded by the revenues that these water
parks can bring in, they should also consider that when the water park has
failed as a business, the revenues are gone, and what you are left with is:
 The salvage value of equipment,
 Small concessions buildings that have little retail value, not having
any drawing power for shoppers,
 Man-made lakes that might add value to a redevelopment of the site,
and
 The value of the raw land.
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CHAPTER FOUR
CONFLICTS OF INTEREST
Chapter One discussed how the real estate industry often attracts unethical
people. The reason is a simple one: Real estate is where the money is. The
word “unethical” is a strong one, though, and might mislead the reader into
overlooking situations in which otherwise decent professionals may act
against the interests of buyers, lenders or owners because the system rewards
such behavior without threat of sanctions.
Whether you are a buyer or a seller, your broker may have a conflict of
interest with you, as his remuneration will typically be commission-driven
and he may also want to minimize the amount of effort spent on your behalf.
Lending institutions may have conflicts of interest from their own staff if
staff compensation is variable and dependent upon loan production; such
conflicts can extend all the way up into senior management as I discuss
executive compensation in the next chapter.
Appraisers and institutional advisors that are not subject to commission
compensation may still have other agendas, including the natural human
tendencies to avoid hard work or to avoid displeasing powerful people.
In the final analysis, the root causes of conflicts of interest are how people
are compensated.
Because you may often have to trust your real estate asset or mortgage asset
to third parties, it is important to identify these conflicts of interest and
construct countermeasures. The following are examples of systemic
conflicts of interest resulting in monetary losses in real estate:
Acquisitions recommended by commissioned brokers
It amazes me when investors turn to brokers for investment advice, for the
broker’s inclination is to always advise a purchase. “Now’s the time to buy!”
Sometimes, not investing in real estate is the best policy. That includes most
purchase decisions made in the last three years.
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Professionals recommended by commissioned salespersons
This category includes loan agents on commission. Homebuyers are often
cautioned against hiring a home inspector recommended by the real estate
agent. A truly thorough home inspector is much more likely to be a deal
killer.
Likewise, real estate agents, mortgage brokers and loan salesmen also have
their opinions about who is a “good appraiser,” and you will probably not
find a deal killer among them. If I happen to please such a broker, I make
sure to tell him, “Please don’t recommend me!” 80% of my business is for
wholesale lenders, and I do not want to lose my credibility.
Hiring the broker as the manager
The built-in conflict of interest here is that brokers are more motivated to
sell than to manage, and once your property is mismanaged, you are more
likely to list your property for sale. Look at the advertising of the leading
real estate brokerages. How much emphasis is on sales as opposed to
property management? That demonstrates where their greatest profits lie.
Hidden relationships
When I was at Home Savings of America, I was in charge of an Approved
Appraisers List that covered the nation. As Home Savings ventured into
unfamiliar areas, loan agents often needed me to approve an appraiser for a
new area or property type, and they usually had an appraiser already in
mind. The result was often a biased appraisal by an appraiser who had
already been hired by the borrower or mortgage broker. No rewriting was
needed, other to change the name of the client.
In one particular instance in the Houston area, in which a failed residential
subdivision was re-appraised as a rental property, the developer was not only
a regular client of the appraisal firm, but also a member of the appraisal
firm’s Advisory Board, as indicated by the resume submitted as part of his
loan application. The appraiser made many false statements, including:
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 Only 60% of the homes had to be leased to low income tenants.
(100% of the units were required to be set aside for low income
tenants.)
 All three and four bedroom units within a three-mile radius were
100% occupied. (The rental survey performed by the junior appraiser
indicated a 16% vacancy rate.)
 Misstating the age of the comparable properties and then making
upward adjustments.
Then, there was the sin of omission – the subdivision was adjacent to the
smelly petrochemical refineries of Pasadena, Texas, an unpleasantness that
was not apparent until my field visit.
Real estate syndications
The field of real estate syndication started innocuously enough several
decades ago. A few affluent local friends would perceive a profitable real
estate investment opportunity and pool their resources to acquire a certain
property with income-generating or appreciation potential. One of these
friends might have been a real estate developer who was consequently
elected to be the general partner in a syndicated limited partnership. For
actively managing the syndication, he was paid fees and/or his equity
contribution requirements reduced or eliminated. Everyone knew and
trusted each other and worked together for their common good. This is the
way real estate syndications were supposed to work.
As far back as the early 1980s, some syndications morphed into another,
more malevolent form, as I witnessed in Texas. The general partner was
typically a successful developer who would have had no problem receiving
100% LTV (loan-to-value) financing from a Texas bank or S&L for most
anything he wanted to do, as was common in Texas mortgage lending in the
early 1980s. When commercial real estate values started to decline, though,
these savvy real estate entrepreneurs instead touted their successful real
estate experience in order to reel in large numbers of limited partners to form
a syndicate. The limited partners were typically doctors, dentists, airline
pilots or lawyers -- wealthy, but not financially astute. These new types of
public real estate syndicates were chronicled by SMU professor William
Brueggeman in his widely used textbook, Real Estate Finance:
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In an operation of this kind the syndicate general partners share
few of the risks. They may have originally bought [the property]
through another business entity and sold it to the syndicate at a
profit. Through another company which they own they may
receive substantial remunerations for management services.
Above all, as the general partners, all earnings and capital
gains not contracted away to the limited partners accrue to their
benefit…This has been a matter of increasingly grave concern
to state and federal securities sales regulators. [7th edition, 1981]
As commercial real estate markets sank, syndicates often made the general
partners richer while making the limited partners poorer. “Syndication”
became a somewhat tarnished word. Real estate authors and professors
David Ling and Wayne Archer of the University of Florida later explained
typical abuses in their Real Estate Principles text:
The syndicator can use his or her information advantage to take
unfair advantage of the investors. For example, the syndicator
may “carve out” large upfront fees that reduce the amount
invested in the enterprise. Moreover, if the syndicator’s return is
“front-loaded,” this may reduce his or her incentive to maximize
the value of the syndicated assets through aggressive property
management...Just say no to unsolicited syndication offers from
individuals with whom you are not completely comfortable. We
wish we had followed this simple rule a time or two in the past.
[2005]
In the last two years I have witnessed major real estate purchases by
syndicated real estate partnerships at above-market prices. To skirt federal
and state securities laws, they conducted “private placements” which allow
them to escape SEC scrutiny (although the SEC cannot prevent syndicators
from charging outrageous fees, any way). The conflicts of interest were
sometimes disclosed, however, in the "private placement memorandum", a
voluminous, catch-all legal document which discloses everything their
attorneys tell them to disclose, in the moral equivalent of “fine print”. Many
states have Securities Acts requiring syndicators to disclose material
information about their offerings, including disclosure of the risks of the
investments, the source of repayment for the investments, the payment
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history of prior investments, and financial information about the issuers of
the investments.
In one Texas syndication, for instance, the general partners purchased a
piece of land from themselves, on behalf of the syndicate, at a $20 million
profit after a one year holding period, in a market with a growing inventory
of large land parcels for sale at much lower prices. In addition to the $20
million profit, the general partner and its affiliates earned fees of about
$3,300,000 in selling commissions, $500,000 in wholesaling fees, $800,000
in placement fees, $600,000 in reimbursement of offering costs, $350,000 in
underwriting fees, and $5,200,000 in reimbursement of offering and
organization expense fees. This represents over a $30 million profit on a
property that probably lost value since its purchase as the demand for
residential land waned.
These types of syndicates are not necessarily confined to the United States,
either, and are increasingly taking on an international flavor. I have
witnessed Canadian syndicators, for instance, misbehaving in Arizona and
Costa Rica, exploiting Canadian and British limited partners.
What is also worrisome is that such syndicators are applying for mortgage
financing in an industry where most of the loan underwriters are either too
young or too forgetful to remember the abuses of the past. The purchase
price agreed to by the syndication is often treated as prima facie evidence of
market value by lenders and appraisers, and the loan is consequently
underwritten based on the inflated purchase price. The consequences to
commercial mortgage lenders and limited partners can be catastrophic.
Case study in real estate syndication fraud
This real-life situation involved a 50-year-old Indianapolis warehouse and a
fraudster named Ed Okun, recently sentenced to a 100-year prison term.
Okun established a company known as the 1031 Tax Group LLC, which
managed and operated “Qualified Intermediaries” acquired by him.
A Qualified Intermediary (QI) is a company or entity used to facilitate 1031
exchanges (named for section 1031 of the IRS tax code). The QI receives
and holds sale proceeds from a real estate investor wanting to defer capital
gains taxes on the sale by transferring the original cost basis from the sold
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property into another property. Under Section 1031 of the Internal Revenue
Code, the investor must identify the property to be exchanged within 45 days
of the sale and must close on the purchase of the exchanged property within
180 days in order to realize the tax benefits. The QI holds the sales proceeds
from the sold property until the investor completes the exchange and
acquires a qualified property.
Okun specialized in organizing private, tenant-in-common (TIC)
syndications to acquire new properties to be exchanged. A TIC syndicate is
a passive investment vehicle limited to 35 or fewer qualified investors who
pool their resources to acquire larger properties beyond the reach of most
smaller investors.
Under U.S. tax law, a TIC qualifies for a 1031 tax deferred exchange
treatment. Because of its size, such a syndicate is considered “private”, not
“public”, and is thus not subject to scrutiny by the U.S. Securities and
Exchange Commission. Okun had another company, called Investment
Properties of America (AKA IPofA), which served as the general partner in
these syndicates, managing the property and promising to distribute returns
to the limited partners, who were passive investors. Per his web site
(www.FreeOkun.com, as in “Please free Mr. Okun from prison”), Mr. Okun
claimed expertise in identifying, acquiring and turning around distressed
commercial real estate.
Okun, doing business as IPofA, managed several such syndicates. I was
contacted by the leader of 20 aggrieved investors in one such syndicate.
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They claimed to have lost all of their investment in the syndicate’s
acquisition of the Park 100 Industrial Building in Indianapolis.
This building was a two-story, single-tenant warehouse containing 459,000
square feet of area, built in 1959. The local tax assessor described the
condition of the building as “fair” (between “average” and “poor”). The
building was acquired by IPofA for $12,650,000 in December 2004 for
IPofA West 86th Street, LLC from 5201 West 86th Street, LLC. The 20
aggrieved investors were the limited partners in this syndicate.
LLCs are often used to cloak non-arm’s length transactions. Each U.S. state
has a Secretary of State’s office that publishes the officers of the LLC. In
this case, the Indiana Secretary of State’s office had the following document
concerning the seller of the warehouse, 5201 West 86th Street, LLC:
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Okun’s signature was on the bottom of the Articles of Organization page.
The Park 100 Industrial Building had already been acquired by Okun, doing
business as 5201 W. 86th St. LLC, for $3,300,000 in November 2001. The
new syndicate, in which Okun was the general partner, was thus acquiring
Okun’s own property for $12,650,000 three years later, giving Mr. Okun a
$9,350,000 profit on this aged warehouse property and a return on
investment (on a free and clear basis) of close to 300%.
The investors were informed that the warehouse had just been leased to an
entity known as Brickyard Properties, LLC, at an annual rental rate of $2.15
per square foot, triple net. Per the lead investor, Brickyard was a subtenant
in a master lease to IPofA 5201 LeaseCo, a shell company formed by Ed
Okun. The lease document promised a $1 million lease incentive to be paid
to Brickyard “upon successful syndication of the property”. They occupied
the property for about a year, but never paid rent.
All of the information used to mislead the limited partners was also used to
mislead the appraisers, 2 MAIs from a nationally known brokerage, who
appraised the property for $12,650,000, the stated purchase price.
As Okun’s assets had already been seized, the investors wanted to also sue
the appraisal firm, a subsidiary of a deep-pocketed national brokerage.
Unfortunately, the appraisal was done for a lender, not the investors, and the
legal doctrine of privity precluded any fiduciary duty or liability to the
investors. The lender, perhaps suspecting foul play, elected not to fund this
transaction.
Lessons to be learned about real estate syndication
1. Learn to use the resources of state “Secretary of State” offices to identify
who is on each side of each transaction, whether it is the purchase and
sale or an important lease.
2. Hire an independent appraiser or advisor to evaluate the deal.
3. Be careful with investing in private syndications, as these are more prone
to abuse than public syndications, which are (allegedly) scrutinized by
the SEC.
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4. Read every document carefully. This means the Private Placement
Memorandum, purchase and sale document, and lease documents. Few
investors do.
5. As Ling and Archer stated in their textbook, “Just say no” is prudent
policy for dealing with unfamiliar syndicators.
Conclusion
The main lessons from this chapter on Conflicts of Interest are:
 Rely on professionals without a vested interest in the transaction.
 Do not rely on referrals from self-interested parties to the transaction.
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CHAPTER FIVE
American Property Research
ORGANIZATIONAL FAILURES
Sometimes an organization devoted to real estate investment or lending is
dysfunctional. For instance, there exists the famous “institutional
imperative”, when institutions copy the mistakes of other institutional
investors without question. Subprime lending comes to mind. “Surely
Lehman Brothers knows what they are doing, right?”
Wrong decisions are also made as a result of failures in processing
information, incentivizing employees and management, establishing checks
and balances, or instructing and monitoring staff.
The larger the
organization, moreover, the greater the inertia to keep on doing things the
way they were always done, which can be disastrous during changing
market conditions.
The power of inertia
Inertia is a concept in Newtonian physics. An object in motion stays in
motion. The poster child for the destructive power of inertia could be
General Motors prior to its bankruptcy. There is a tendency for companies
that have grown large and successful to self-congratulate and stay the
course, telling themselves, “We must be doing something right.” This can
blind an institution to the need for change.
For instance, Home Savings was once the General Motors of the savings and
loan industry in terms of size and dominance. When they assigned me to
manage the multifamily loans appraisal staff, I was introduced to a concept
called “The Home Savings Way”. Much of it was good, such as:
 requiring the appraiser to measure apartment square footage
 the meticulous keeping and updating of records on comparable rental
properties in the markets we served in California, Chicago and New
York City
 meticulously adjusting comparable rentals for differences in
amenities (landlord paid utilities, parking, security, pools,
concessions, etc.)
 attention to needed reserves for future-needed capital improvements
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There were also some weaknesses which had been passed down through
time much as aboriginal tribes pass down their history, religion and science.
The most egregious weakness was the habit of never rating building
condition as less than average. This was a policy instituted when the
appraisers were managed by loan managers incentivized to maximize loan
production. It was hard to end this practice when I became manager, even
with the support of senior management, as the appraisers were hesitant to
throw away their tribal religion, AKA “The Home Savings Way”.
Later, when I was charged with the revaluation of collateral for problem
loans, I got to see firsthand the consequences of never rating a building as
being in less than average condition. In the various neighborhoods I visited,
I sometimes had difficulty in finding the address of our problem property,
but if I looked for the property in the worst condition, it would surely be the
Home Savings REO. Tens of millions of dollars were lost lending on “the
worst properties in the neighborhood”.
I felt that my staff, as highly trained as they were, had become insulated
from standard appraisal practice, as most had begun their appraisal careers at
Home Savings and had never worked elsewhere. I tried to hire outsiders for
new appraiser positions, but many found themselves tormented and scorned
as heretics and violators of “The Home Savings Way”. It was hard to turn
around their managers, too, as most had never worked anywhere else but
Home Savings. I, myself, sometimes felt like an embattled outsider.
The point I am making here is that an institution needs to constantly reevaluate investment policies, underwriting policies, or valuation policies or
be at risk of failing to adapt to changing markets.
Failure to allow the flow of vital information
Larger organizations need to be particularly mindful of information
bottlenecks that block the flow of vital information to those involved in the
real estate investment or lending decision process.
As an appraiser, I have observed that one of the most common omissions in
the information received from clients is the preliminary title report. The
preliminary title report is often the first piece of information alerting me to
financial distress at the property to be appraised, including tax liens,
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mechanic’s liens, notices of default, and legal judgments. Why would a
lender not want the appraiser to have this vital information?
For raw land and development parcels, the feasibility analyst or appraiser
should also know where the utility easements lie, as their location can
interfere with the optimal development of the site.
More importantly, the title report will also disclose other major obligations,
such as special tax assessments. I remember IndyMac Bank taking a $2
million loss on a subdivision in Lehi, Utah because it never provided the
appraiser with a preliminary title report, which would have disclosed a $2
million special assessment from the city of Lehi to fund infrastructure
development.
Appraisal management errors
The Appraisal Institute recently conducted an analysis of 35 recently failed
banks and found that nearly two-thirds had been previously cited by federal
bank examiners for appraisal problems.11
Of the 35 Federal Deposit Insurance Corporation Inspector “General
Material Loss Reviews” of failed banks nationwide, 22 contained concerns
or unheeded recommendations from previous reviews regarding appraisal
practices. These results were analyzed from Material Loss Reviews
conducted by the FDIC Inspector General in 2009 and 2010. Examples of
such concerns included: “Failure to obtain current appraisals or perform
adequate appraisal reviews”; “Bank frequently relied on stale appraisals”;
“Inadequate control of the lending function, including appraisals”; and
“Poorly explained upward adjustments to the appraisal values.”12
As an appraiser I have been at both the managing end and receiving end of
institutional appraisal policies. Some shortsighted policies can lead to major
risk management problems and financial losses. Here are the most notable
errors that I’ve seen:
Allowing loan origination staff to select or harass real estate appraisers
As a former bank appraiser, I have witnessed objective appraisals changed
or undone by interference from loan origination personnel and senior
executives with compensation linked to loan production. The independent
appraiser who has never worked at a financial institution may have
11
12
Appraiser News Online, Appraisal Institute, 2/3/10
Ibid., 2/3/10
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confusion as to who is in charge, and might change the appraisal report at
the request of an executive perceived as having a higher rank. At IndyMac
Bank, for instance, I was merely a vice president as the chief commercial
appraiser, but the loan salespeople had “regional vice president” or “senior
vice president” titles that served to confuse the fee appraisers.
I have performed many independent appraisal reviews for Imperial Capital
Bank, for example. The fee appraisers serving them were often fooled by
deceptive purchase contracts and phony rent rolls. When my appraisal
review failed to support the purchase price, I would typically get a phone
call from some loan manager, which would go like this:
“Hello, Mr. Martin. I am the regional grand poobah for commercial loans at
Imperial Capital Bank, and I have to say you’re the worst appraiser I’ve
ever seen. You couldn’t even hit the purchase price!”
Imperial Capital Bank was seized and closed by the federal government on
December 18, 2009.
Mr. Martin, as Imperial Regional Grand Poobah for Loan Sales I have to
say that you’re the worst appraiser I’ve ever seen!
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Executive compensation
In the mortgage industry meltdown of 2007-2008 it could be asked why so
many of the best and brightest financial minds were so wrong again so soon
after the savings and loan fiasco of two decades ago?
It’s the compensation, Stupid!
One explanation is that financial executives were gaming the system in
response to perverse executive compensation systems commonly used by
public companies.
Earnings can often be booked at loan origination, regardless of loan
soundness. During the good times, these unsound loans can be sold off to sit
in mortgage pools or portfolios as ticking time bombs, to be dealt with long
after the senior executives have received their bonuses and exercised their
stock options. It would be difficult for such executives to not follow such a
compelling enrichment scheme.
As recently reported on CBS’s Sixty Minutes, for instance, Herb and Marion
Sandler safely and soundly managed World Savings for years before finally
succumbing to such temptation, receiving millions of dollars in the sale of
their moribund institution to Wachovia Bank, so badly damaged that the
federal government had to force its sale to Wells Fargo.
The two other largest savings and loan institutions in the U.S., IndyMac and
Washington Mutual, were respectively seized by the FDIC in July and
September of 2008. I had the curious misfortune to briefly work for each.
Both were fast-growers who were rewarded by Wall Street with high priceearnings multiples and soaring stock prices. Those in the mortgage lending
business know, however, that such rapid growth is inconsistent with prudent
lending.
IndyMac was a particularly good example of a “Pump and dump” operation.
As their chief commercial appraiser, I was not permitted to reject any
appraisal reports, all of which were ordered by self-interested loan officers
on commission, not by me. Loans were funded prior to my review. After
funding, the chief lending officer would personally visit my office and
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angrily insist that I promptly approve the appraisal report used to justify the
loan.
After a few months, senior management reached the conclusion that I was
never going to approve certain biased appraisals supporting eight-figure loan
amounts, and I was terminated and replaced with someone chosen by the
loan origination staff. I was later told that at the time of IndyMac’s seizure,
53% of its construction loans were in default.
Many mortgage-lending institutions rewarded their CEOs and COOs with
incentive-based compensation that dwarfed their annual base salaries and
encouraged them to do whatever was necessary to increase the stock prices
of those institutions. Stock prices moved in tandem with reported earnings.
IndyMac CEO Mike Perry, for instance, had an annual salary of one million
dollars per year, but his incentive-based compensation (bonuses and stock
options) was many times as high. Perry earned over $32 million by selling
IndyMac stock from 2003 to 2007, in addition to performance bonuses
which were typically 75 to 100% of his base salary.
An IndyMac press release on September 22, 2006, “IndyMac Signs LongTerm Contract with High-Performing CEO, Michael Perry,” plainly explains
the radical difference in future (year 2007) compensation to Perry under
various scenarios, with his total compensation limited to $1,250,000 for EPS
growth of less than 5%, but compensation of $8,943,000 for EPS growth of
17%. With a compensation structure like this, it was no wonder why rapid
growth was pursued at all costs.
Making and selling bad loans would the easiest way of meeting such a
financial goal. One of the class action complaints against Perry, Daniels vs.
Perry et al, filed January 27, 2009 in the US District Court’s Central District
of California, Western Division, is a compelling read, quoting dozens of
employees about shockingly unsound lending practices.
Kerry Killinger, CEO of Washington Mutual, was also paid a base salary of
$1,000,000 in Washington Mutual’s last full year of existence, and he was
incentivized with stock options that brought his total pay package to more
than $14 million. The New York Times reported that he received $38.2
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million in performance pay ($7.6 million in cash and the remainder in stock)
between 2005 and 2008. WAMU”s mortgage-related losses of $8 billion in
2007 and 2008 wiped out all of its earnings in 2006 and 2005.13
Franklin Raines, the CEO at Fannie Mae, received $52 million in
compensation between 1999 and 2004, with $32 million from an incentive
plan generating big bonuses for Fannie Mae achieving certain performance
yardsticks, such as 15% annual growth in earnings. Mr. Raines was accused
of falsifying the reported earnings to gain his bonuses and was therefore
terminated, leading to a $9 billion profit restatement covering years 20012004.
Why would shareholders allow senior executives to work against their
interests in this manner? Part of the reason is that many of the shareholders
are institutions, too, that had incentivized their managers in the same way,
i.e. chasing short-term profits at the expense of long-term solvency.
Examining the executive compensation schemes of other institutions and the
ultimate results might make one think twice before calling these dethroned
mortgage industry leaders “irrational” or “incompetent”. It seems that they
have very rationally and competently lined their own pockets.
INDYMAC BANK
The following is a blog I published on an internet appraiser’s forum the
weekend after IndyMac Bank was seized by the federal government in 2008.
Some readers may ask how the story could be so rich in detail six years after
I was fired by IndyMac. The answer is that I kept an office diary. For
anyone else who finds himself trapped in a corrupt organization, I
recommend this practice, as an honest person will surely find himself under
attack while employed at a corrupt institution.
The blog
“I first became acquainted with IndyMac (IMB) through OTS appraisal examiner
Darryl Washington, MAI. Darryl used to examine my appraisal department each
year when at Home Savings of America, which was acquired by WAMU in 1998.
“After Huge Losses, a Move to Reclaim Executives’ Pay”, New York Times, February 23, 2009
13
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During the summer of 2001, I had a chance encounter with him at a jazz concert.
I asked him what he had been up to, and he told me that he had just completed
the first examination of IndyMac Bank, which had just received its savings and
loan charter only a year before. He said, ‘Vern, they could use a guy like you.’”
“Several weeks later I saw the chief commercial appraiser position for IndyMac
Bank posted on Monster.com. I responded with a cover letter that started with
“Darryl Washington of the OTS suggested that I contact you….” Apparently, that
was the right way to start the letter. IMB’s chief credit officer called me soon,
asking “do you know Darryl Washington?’ I said “Yes, he examined my
department annually at Home Savings.” His next question was “Do you know
how to deal with him?” I assured the chief credit officer that I was used to dealing
with the OTS and Darryl and that I could get IMB into compliance with OTS
appraisal regulations.”
“After 3 interviews, IMB wanted me to start right away, because the OTS was
returning in November. I started on 10/15/01 and had a month to familiarize
myself with their commercial lending practices until the OTS showed up.”
“At the end of my first week, there was an urgent need to field review an
appraisal of a subdivision in the Sacramento area. I went up there on the
weekend, but also took along some other recent appraisal reports from the
Sacramento area. One of the other appraisal reports concerned me. A residential
subdivision had been appraised as “80% complete”, but when I visited it, it had
only been rough-graded, probably no more than 15% complete. “
“When I returned to the office on Monday I asked who the construction inspector
was for that region. I was told that there were two inspectors for the Sacramento
area; one was CEO Mike Perry’s father and the other one was Mike Perry’s
father-in-law. The loan officer on the deal was Mike Perry’s younger brother,
Roger, who had recently been hired. His previous experience had been as a cop.
Thereafter I heard of favoritism towards relatives of Mike Perry and “FOMs”, and
the chief credit officer advised me to take special care of Mike Perry’s brother.
(“FOM” was IndyMac jargon for “Friend of Mike”.)”
“I reported my Sacramento findings in a private memo to the chief credit officer,
who then distributed it to the senior managers at the construction lending
subsidiary known as the Construction Lending Corporation of America (CLCA).
The senior credit officer from CLCA, the manager who most resembled Tony
Soprano, was the one to call me. He asked “Are you sure you saw what you said
you saw?” in a rather chilling manner. He said he had been on site with Roger
Perry and had seen things differently.”
“After that call, I asked the chief credit officer why CLCA’s senior credit officer
would want me to recant my report. He told me that the senior credit officer
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received sales commissions for every loan made, which seemed to me like a
blatant conflict of interest.”
“All appraisals were ordered by the loan officers from a list of approved
appraisers maintained by LandAmerica. I was not allowed to order appraisals,
but I recognized many names on the LandAmerica list as well known, reputable
appraisers. What I began to observe, however, was that loan officers were
learning which appraisers were more “flexible” than others. My areas of concern
were extraordinary assumptions, lack of feasibility analysis, and false information
given to appraisers.”
“As an example, I read an appraisal of a vacant, former Costco warehouse which
had been purchased for $2 million several months before, but was appraised for
$17 million based on a fabricated rent roll composed of tenants that had never
signed a lease or a letter of intent. Only one tenant actually moved in. I told the
loan officer that I could not accept the appraisal report, as it was hypothetical. He
wanted me to approve it, any way, with the understanding that no funds would be
disbursed until the prospective tenants could be verified. I told him that I wasn’t
going to approve a hypothetical appraisal. The loan was funded, any way.”
“My only substantive encounter with CEO Mike Perry was in November 2001. I
was summoned late to an impromptu meeting of senior executives in the board
room. When I arrived, the meeting was already underway. The tone of the
meeting was very different than senior executive meetings at other companies I
had worked for. Mr. Perry, a man in his thirties, was spinning ideas and
executives who were 10 or 20 years his senior were behaving like ‘yes men’,
competing to agree with his ideas. There were lots of raised hands and
enthusiastic participation. He seemed to be enjoying this, in a megalomaniacal
way.”
“Then he turned to me with an idea. He asked me if I, as the chief commercial
appraiser, had the regulatory authority to change the discounted cash flow
models in each subdivision appraisal, which might have the effect of changing
appraised values. I said that I could possibly do it, but why? He smiled and said
"Don't housing prices always go up?" (Was he really too young to remember the
early 1990s?)”
“I told him that it wasn’t a good idea, because we were already hiring competent
appraisers who had more local knowledge than I had. Unless I could show that
their analysis was flawed, it would be inappropriate for me to change the
appraisals. That answer seemed to anger him. At the end of the meeting, the
chief credit officer tried to introduce me to him, but he turned his back on me.”
“I later learned that Mike Perry was hired as CEO of IndyMac at the age of 30
when it was spun off by Countrywide. He had been an accountant at
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Countrywide and a protégé of Countrywide founders David Loeb and Angelo
Mozilo.”
“When the OTS arrived mid-November, my review duties were handed over to
LandAmerica. I was to spend full time responding to findings from OTS examiner
Darryl Washington. In the ensuing month it became increasingly obvious that the
main reason I was there was to refute OTS findings and serve as window
dressing for an institution that scoffed at or was wholly ignorant of federal
regulations. Many, if not most, of the senior executives had come over from
Countrywide, which was an unregulated mortgage bank.”
“One of the craziest violations of OTS regulations was underwriting loans based
on appraised values well above purchase prices. For example, a prominent
Sacramento developer purchased a piece of land for $18 million, a price most
reasonably supported by the comps, but it was appraised and underwritten at a
value above $30 million, the rationale being that this developer added value to
the property just by buying it. This does not satisfy the USPAP and federally
accepted definition of market value, however. The appraisal firm was the same
one used for the supposedly 80% complete subdivision.”
“I was present at several confrontational meetings between the OTS and FDIC
examiners and CLCA executives. It seemed that IMB was intent on refuting every
finding and using me towards that end. I was criticized for not arguing enough
with the examiners.”
“After the examination was over, there was an unsolicited appraisal report waiting
for me on my desk. A piece of land next to an airport had recently been
purchased for $24,375,000 and was almost immediately appraised for more than
$65 million based on the owner’s plans to build an airport parking lot. This was
three months after September 11th, 2001 and average parking lot occupancy at
this airport had declined from 73% to about the low fifties. The appraisal lacked a
sales comparison approach and its feasibility analysis was based on preSeptember 11th data. The feasibility analysis was done by the same consultant
who caused the city of Los Angeles to lose millions on the parking garage at
Hollywood and Highland [Kodak Theater]. The appraisal was done by an
unapproved appraiser who had previously caused my previous employer, Home
Savings, to set up a $17 million loan loss reserve on a hotel he appraised for
$450 million and the loan defaulted within a year”
“The report was delivered less than a week after it was ordered by the IMB loan
officer, leading me to suspect that it had already been completed for someone
else, most likely the borrower. I told CLCA executives that I could not accept the
report and that I considered it to be biased. I tried to get the appraiser to change
the report, but he immediately called the chief lending officer, who must have
then instructed him to ignore my request.”
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“Despite my stated objections to the appraisal report, the chief lending officer told
the Loan Committee that I had ordered and approved the appraisal, and they
funded a $30 million loan. Thereafter, there was sustained pressure on me to
approve the report. I responded that I would have to write my own report, since
the original appraiser would not make changes. This bought me time. Meanwhile,
the airport, who had previously owned 80% of the parking spaces in the area,
was suing the developer and erected a fence to keep people from walking from
the parking lot to the terminals.”
“The chief lending officer also pressured me to accept another unsolicited
appraisal of a Sacramento-area subdivision. This report was based on an
“extraordinary assumption” that a road led to the subject property. When I went
up to Sacramento to see the property, there was no road.”
“In January I went to Sparks, Nevada, to review an appraisal of the last phase of
a condominium project. The first phase, with condos on the golf course, was a
success, but the last phase was on the opposite side from the golf course and
actually sloped below grade. The appraiser made an $8000 downward
adjustment for each unit, and I questioned whether $8000 was adjusting enough.
That provoked warnings from several executives, including the chief credit
officer. The developer was buying the land from David Loeb, IndyMac’s
Chairman of the Board (and co-founder of Countrywide), and I was warned that
challenging this deal could get me fired.”
“Soon after, the chief credit officer came to my office with a representative from
human resources to announce that my initial 90-day probation would be
extended for another 90 days, as CLCA executives had complained about my
lack of cooperation with them. The HR rep had a look of horror on her face the
whole time he delivered this message.”
“I finally finished my own airport parking lot appraisal report in late March, the
same week that the Bush Administration laid off most of the OTS examiners. I
don’t know which event precipitated my termination. My appraisal of the airport
parking lot estimated the stabilized value at $37 million in year 2003 and the
value upon completion as $31 million in 2002. These appraised values were
considered insufficient to support the $30 million loan.”
“IMB gave me two weeks’ notice of my impending termination and offered me
$25,000 severance pay if I turned over all documents and signed a nondisclosure agreement. I told them that state law required me to keep records of
all of my appraisals and reviews, and that $25,000 was not enough. After a few
days of seeing that I was not cooperating, I was summoned to a final meeting
with the chief legal officer and “chief people officer”. A written statement indicated
that I was being terminated for having a “communication problem”. I asked for
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examples of my communication problem, but none were presented. (I later
recounted, during a deposition, that I was left alone with the chief legal officer for
a few minutes of awkward silence. I then asked him, “Doesn’t it bother you that I
am being fired for a communication problem without any evidence against me?”
He said, “Not at all.” This cracked up my attorney.)”
“After the meeting, I was escorted back to my office by a large security guard to
collect my personal belongings, and then I was escorted out of the building, with
my toothbrush in my left hand and my toothpaste in my right hand.”
“During these last days I contacted OTS about the abuses going on at IMB and
said I had documentary evidence. They flew in to Burbank to meet me and they
debriefed me for a couple of hours. They were upfront about how the flow of
information had to be one way, from me to them, and not vice versa. I had to call
my friends at IMB to find out how OTS was responding. The OTS paid a special
visit to IMB and called for an internal audit to investigate my allegations. The first
audit was considered a whitewash, and the OTS called for a re-audit.
Interestingly enough, there was even a document produced that supposedly
indicated my approval of the appraisal of the ‘80% complete subdivision’.”
“The second audit corroborated most of my allegations and the OTS called for
certain personnel changes. The president and senior credit officer of CLCA were
ousted; the chief lending officer had his loan approval privileges removed.
Chairman of the Board David Loeb suddenly and coincidentally retired at the
same time. He died 5 months later.”
“Interestingly enough, at about this same time, I read in the press of IMB
receiving a “corporate governance” award from some organization, for having an
impartial and effective board of directors.”
“I had an excellent attorney. Besides suing for wrongful termination, he showed
me that I could actually sue for discrimination. Many states, including California,
have laws that prevent discrimination against employees who are upholding
public policy, which was the very reason that got me fired. Other bank appraisers
should take note of this. USPAP and OTS appraisal regulations are public
policy.”
“In interrogatories sent to IndyMac during the litigation, they were once again
asked to demonstrate evidence of my ‘communication problem’. The only
evidence provided was a memo from me about a borrower ‘trying to deceive us’
and a memo from a loan officer complaining that I actually called Union Pacific
Railroad concerning one of his deals, a subdivision being built close to a railroad
right-of-way. I was told by the loan officer that the track was no longer used, but
Union Pacific disclosed to me that it was still being used once a day during the
evening hours.”
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“Interestingly enough, in the six months of unemployment and underemployment
which followed my termination, I rented many videos, one of which was “The
Insider”, the real-life story of Dr. Jeffrey Wygand, who blew the whistle on the
tobacco industry to Sixty Minutes and was also fired, coincidentally, for having a
‘communication problem.’”
“Most of this information is already publicly disclosed in my lawsuit, filed 7/15/02
in Los Angeles Superior Court, Case Number BC277619, for anyone wanting
further details. As for the results of that lawsuit, the only thing I can legally say is
that ‘the matter has been resolved to the mutual satisfaction of both parties’.”
The aftermath of the blog
In September 2008 I was summoned to the former Pasadena, California,
headquarters of IMB by criminal investigators from the FDIC and US Postal
Service. I brought photographs and documents and my office diary. They
debriefed me for over an hour.
Since then, other former IMB employees have also been debriefed by the
same investigators plus the FBI.
There have been no indictments yet.
I had phone interviews with Wall Street Journal, New York Post, and
National Public Radio, but with the failures of WAMU, AIG, Lehman
Brothers, Fannie Mae and Freddie Mac soon afterwards, my story became
no longer newsworthy.
Some have asked who my attorney was. My lead attorney was Lawrence J.
Lennemann, who was assisted by his wife, Erin Lennemann, also an
attorney. In 2008, they relocated from California to Overland Park, Kansas.
I highly recommend them for their competence and ethics.
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CHAPTER SIX INVESTMENT MANAGEMENT ERRORS
For this chapter, I will make a distinction between the term “property
management”, which generally connotes the management of an individual
property, and the term “investment management”, which usually connotes
the management of a number of properties and a more macro-level approach
to property management, including sourcing, performing due diligence,
acquisition, financing, leverage, ongoing income maximization strategies,
tax avoidance, and ultimate disposition. “Property management” is what
Uncle Earl and Aunt Mildred do at their small apartment building.
“Investment Management” is what Jones Lang LaSalle does with a $41
billion global portfolio of properties.
The field of property management has been studied and written about
extensively, and it is beyond the scope of this book to describe the field of
professional property management and all of the errors that can possibly be
made. I will therefore concentrate on macro-level issues concerning real
estate portfolios.
Let us start with acquisitions:
Falling for the “Dog and Pony Show”
A good real estate investment should almost sell itself. Good location, good
occupancy, good condition, growing economy—these are self-evident
property attributes that need no sales pitches.
Then there are properties that need all of the BS capabilities of professional
spin doctors. As an appraiser, I can almost measure the desperation of the
owners by the length of the presentations they force me to sit through and
the number of spin doctors they hire to convince me of a conclusion that I
would have otherwise considered improbable. I become particularly
skeptical when the presentation starts to feel more like an abduction. I have
been a prisoner in real estate developer’s vehicles for up to four hours.
I just returned from an assignment in Costa Rica, for instance, to value a
remote, beach-adjacent parcel which was intended to be developed with a 5star hotel and tourist hospital. The owner hired the most famous consultants
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to justify the feasibility of a 5-star hotel and a tourist hospital. Two different
appraisers had been hired to estimate the value of the raw land at $26
million. The biggest problem I saw, though, was the lack of paved road
access, something that was never addressed in the less-than-objective
feasibility studies. The nearest paved roads were 35 minutes away, and the
rugged terrain of Costa Rica can cause flash flooding and road washouts
during the six-month rainy season, making this location accessible only to 4wheel drive vehicles, and occasionally inaccessible altogether.
Imagine coming home from surgery over these bumpy roads to the nearest
international airport, 90 minutes away, which also raises another issue.
Medical tourism is a growing industry, but successful tourist hospitals are
typically located near international airports and not in the wilderness. There
is also the issue of staffing in this remote area. Where would be medical
professionals come from and where would they live?
In my valuation assignments, I voraciously study listings and also found the
same property listed for sale for only $5,500,000, casting doubt on the $26
million appraised value.
Consultant Stephen Roulac described a “Golden Palomino” effect behind a
poor acquisition decision made by an executive who became smitten by a
golden palomino he was allowed to ride on, followed by outdoor barbeques
and campfire songs.14
I was similarly treated once when I was sent to South Africa to value a game
ranch. My very gracious hosts treated me to an afternoon safari expedition
and a night at a charming hunting lodge, including a delicious barbeque with
fine wines. The buyers had a bold plan to turn the ranch into an
international tourist destination and I was certainly charmed by the setting
and wanted to share their vision. As previously mentioned, though, I found
most of the value to be in the animals, and not the land.
The most suspicious dog and pony shows are the ones in which I am driven
to the “comparable properties” first before being shown the property I am to
evaluate. In one excursion in Louisiana, for instance, I was driven to
successful “campsite” developments (their term for marina residential
14
Stephen Roulac, 255 Real Estate Investing Mistakes, Property Press: San Francisco, 2004, p. 105
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developments) for more than two hours before being shown the subject
property, a swamp. As I stood about 18 inches over the Houma Channel,
they insisted I was 10 feet above it. As I looked down at the gravity drains
they emphatically told me “This is not a swamp!”
Excessive leverage
National Real Estate Investor recently conducted a poll which asked the
question, “What factors have contributed most to the current state of the
commercial real estate industry?” The most common answer was “the
excessive use of leverage.” Lenders should particularly take notice, as they
are the ones providing the leverage. A highly leveraged property that is
foreclosed upon creates minimal loss for the property owner but significant
loss to the lender. This is what has almost brought down our financial
system.
Many lenders underwrote at loan-to-value ratios that were too high for the
asset class that served as collateral. Some asset classes devalue much further
than conventional income properties, particularly land and leasehold
interests.
The value of land is basically a residual of its ultimate value as improved
minus the cost and time to develop it to that state. During the recent
homebuilding frenzy, agricultural land was often rezoned for residential use,
and subdivision developers bid up prices to ten or more times the underlying
agricultural value.
It stands to reason, then, that when the highest and best use of the land
changes back from residential development to cattle grazing, the value of the
land will consequently decrease by 90% in those cases. I am indeed
encountering many geographic areas where land prices have dropped by
90% or more. Despite the known volatility in prices for land, though,
typical land loans were underwritten at a loan-to-value ratio of at least 50%.
In instances where land values have dropped by 90%, then, a 50% LTV ratio
becomes a 500% LTV ratio.
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Ignoring the bottom line
Some investors forget that a real estate investment is fundamentally a
business. They may overlook a property-specific pattern of declining
revenues or net income by focusing on external benchmarks such as
“percentage of replacement cost” or “percentage of previous appraised
value”, blinding themselves to a losing investment.
For instance, for about the last year I have been encountering novice
investors in golf courses, yet every golf course I have appraised in the last
six years has been unprofitable. Each profit and loss statement shows the
same pattern of declining revenues and negative net income (even before
debt service). The entire industry has been in decline for the last decade,
long before the current recession started. Some investors have perceived
this industry downturn as a special opportunity to buy golf courses cheaply,
but is the decline in the golfing industry temporary or permanent? Are
novice investors naïve in expecting a sudden resurgence in demand for
golfing or are they overconfident in their ability to turn around an
unprofitable business? These questions serve as natural lead-in for the next
topic:
Tolerating negative cash flow in expectation of appreciation
Novice real estate investors often like to start with rental homes. In southern
California, the novice investors often gravitate towards areas of abundant
and cheap new homes, such as the Antelope Valley (Lancaster, Palmdale,
Rosamond, Quartz Hill) and the Coachella Valley (AKA the Palm Springs
area). The achievable rents often fail to cover ownership costs, i.e. debt
service, taxes, insurance and maintenance, but the novice investors take
comfort in the price appreciation of their residential investment, blind to the
bubble they are forming in synchrony with other such investors. They
tolerate negative cash flow because they are confident that the appreciation
in the value of their rental home will more than compensate them for their
interim losses in the end.
In the end, the bubble bursts, and these novice investors are stuck with rental
homes that are no longer new, suffering the typical wear and tear of rental
properties, and unable to find quality renters. Many find themselves
overextended and unable to service the debt. This is why foreclosure rates
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are often highest in housing markets with a high proportion of rental homes,
such as Las Vegas, Nevada, or the lower income communities of the
Coachella Valley (such as Indio or Cathedral City).
I once made the mistake of presenting the example of Indio in my Real
Estate Valuation class at Cal State LA. One student came from a family that
just happened to be heavily invested in rental homes in Indio, and she took
my example to be a personal insult to her and her family, so much so that
she filed a complaint against me to the department chairwoman and dropped
my class. I wonder how her investments are working for her now, in year
2010?
Allowing tenant incompatibility
Properties particularly oriented towards an upscale market can damage their
prospects and annoy their existing tenants by bringing in incompatible
tenants. A new office building in Houston, for instance, leased its ground
floor space to a vocational school that specialized in training students to be
security guards. At first thought, one might think this would make the other
building tenants feel more secure, but when one actually sees the type of
people that a security guard school attracts, loitering in the lobby, shouting
and smoking, it is easy to imagine why the other building tenants felt less
safe, instead.
Staying at a family-friendly timeshare resort in Waikiki a couple of years
ago, I noticed a “Coyote Ugly” copycat saloon on the ground floor. Such
bars are popular in Florida and Texas with Spring breakers, bikers and drunk
women, but this Waikiki resort catered to families and honeymooners. The
owner of the bar, “Coyote Willy”, was having trouble attracting enough
lowlifes to keep him in business, so he elected to stand outside his bar,
inebriated, harassing passersby who were not going into his bar. “C’mon,
Baby, I know you can speak English,” I heard him say to a woman near me.
This type of behavior only scares away the families and the decent people
who would otherwise want to stay at this resort.
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Incompatible tenants: Professor Martin and Coyote Willy
Failure to diversify
Single-property investors often have no choice, but large investors who put
too many eggs in one basket only multiply the risk. One investor that comes
to mind is Shashikant Jogani, who was once California’s largest landlord, as
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disclosed in a Forbes Magazine article from the early 1990s. Forbes
discovered him by accident when someone was researching as to who was
California’s biggest water user. Mr. Jogani, as he has publicly disclosed in
court documents, “began investing in residential apartment properties in and
around Los Angeles County. By 1989 he owned properties having a fair market
value of $375 million and a net equity of $100 million. Because of an economic
recession that started in the late 1980s and continued into the mid-1990’s,
Shashi faced defaults and foreclosures on valuable properties…By the mid1990’s, the equity in Shashi’s real estate holdings had fallen from $100 million to
a negative $50 to $70 million.”15
As I recall, Jogani’s multifamily portfolio was particularly concentrated in
LA’s San Fernando Valley, which took a double hit from the early 1990s
recession and the Northridge earthquake. There were 16 earthquake deaths
in one of his buildings, no fault of his own, but he was sued any way,
because he was the owner at the time.
It seemed that Mr. Jogani magnified his bad luck by concentrating
excessively in San Fernando Valley multifamily properties. Geographical
and asset class diversification would have tempered his financial losses.
By expanding his geographic limits a few more miles, he would have found
that multifamily properties in Glendale, Pasadena and the San Gabriel
Valley would have held up better in the recession and earthquake.
Balancing his portfolio with retail or industrial properties might have even
offset his losses in an improving commercial sector at the time. Consider
that the some of the characteristics that make one asset class attractive can
also be present in other asset classes, too, characteristics such as location,
economic growth, demographics, favorable development rules,
infrastructure, neighborhood aesthetics, availability of utilities, construction
resources, and a generally improving economy.
Relying on post-transaction monetary guarantees from the seller
“Guaranteed rental income for the first two years” is a seller promise that
should be interpreted as a sign of weakness, not security, because an
15
Shashikant Jogani v. Haresh Jogani, et al..California Court of Appeals B181246, Los Angeles County
Superior Court No. BC290553
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adequately performing rental property does not need to be sold with any
such guarantees. It is almost tantamount to saying that Year 3 is going to be
a crapshoot because tenants are currently so hard to find. Do not be surprised
to see that the property’s previous asking price has been inflated to more
than cover the amount of these guaranteed rents.
Failures in capital budgeting
As explained in Chapter 2, a building is a depreciating asset with short-lived
components that will need replacement before the entire structure is retired.
When investors over-leverage their properties, there is sometimes little or no
cash flow to take care of problems that will naturally result from the
building’s aging. A highly leveraged property may not be able to provide
the cash flow to take care of a sudden need for a new roof or new HVAC
units or unanticipated acts of nature.
When there isn’t enough money to fix the roof, for instance, the problem can
compound itself if not remedied in time, as water is a potent destructive
force. Water leaking into the building can cause mold and rot and damage to
tenant furnishings and equipment.
Deferred maintenance can also scare away decent tenants.
If the acquired building has vacancies, tenant improvement allowances may
be necessary to fill the vacancies. These are typically expected by tenants in
office and retail buildings. Investors also commonly underestimate leasing
costs, either in terms of commissions to outside brokers, the amount of staff
hours needed in showing space, or the typical delays that happen before the
space is occupied by a rent-paying tenant.
Emphasizing tax deductions rather than financial profit
Bear in mind that this is a much rarer mistake today than it was in the early
1980s, when losing real estate investments could generate attractive tax
deductions, particularly with the 15-year residential and 19-year commercial
ACRS (accelerated cost recovery system) depreciation schedules first
instituted by the Economic Recovery Tax Act of 1981, and then taken away
in the 1986 Tax Reform Act. Many investors in money-losing properties
and tax shelters got blindsided when the TRA of 1986 limited passive real
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estate losses and increased the residential depreciation period from 15 to
27.5 years and the commercial depreciation period from 19 to 39 years. I
recall an immediate 10 to 15% decline in commercial real estate values as a
consequence of the change in tax laws.
New government policies often have unintended consequences that
encourage behavior that would otherwise be uneconomical. My favorite
historical example is when the French colonial government of Vietnam, in
an effort to reduce the rat population, offered bounties for dead rats. The
enterprising Viet people confounded their shortsighted colonial masters by
building rat farms for profit.
In the future, there may be new tax laws that distract investors from
investing for profit and tax shelters may re-emerge, thereby provoking
public outcry about loopholes, followed by Congressional reversals that will
once again leave tax shelter chasers with money-losing real estate
investments.
Insufficient time budgeting
I see a lot of this, considering that 88% of my work is for bridge lenders,
also known as hard money lenders. Many investors apply for financing too
late, particularly if they have looming deadlines to complete deals. Complex
deals might spend months in a commercial bank loan committee, forcing the
borrower to find expensive bridge financing in the mean time. A bridge loan
can cost up to 8 points, with a double digit interest rate. Wait a minute.
Why am I telling you this? Bridge lenders are my firm’s lifeblood. Go
ahead and dawdle.
1031 exchanges also force buyers into hurried decisions. The new property
that will be exchanged for the previous property needs to be identified
within 45 days of sale of the previous property, and the purchase of the new
property must be closed in 180 days. This timeframe has forced many
investors into overpaying for properties and/or skimping on due diligence.
One appraiser-scholar has measured that 1031 buyers pay an average
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premium of 8% over market value16, and the time limitations are the most
likely cause.
Failure to consider liquidity
Commercial real estate is among the most illiquid of investments. Investors
and lenders need to consider exit strategies for properties in thinly traded
markets. Liquidity can become a significant complicating factor in small
communities, overbuilt markets, or thinly traded property types, such as
radiation oncology buildings or modern media storage backup facilities.
Lenders need to underwrite on such properties mindful of the extended
marketing times for such properties.
Barrett A. Slade, Ph.D. , “Conditions of Sale Adjustment: The Influence of Buyer and Seller Motivation
on Sale Price,” The Appraisal Journal, Winter 2004, pp. 50-56.
16
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CHAPTER SEVEN
PROFILES IN SPECTACULAR LOSSES
The following recent events present interesting case studies of the principles
discussed in the previous chapters. These losses can truly be described as
“spectacular”, exceeding $1 billion in each example. I will discuss
Stuyvesant Town/Peter Cooper Village in Manhattan and the Credit Suisse
syndicated loan fiasco concerning major resort properties in the western U.S.
(Yellowstone Club, Lake Las Vegas, Tamarack Club, et al).
1. Stuyvesant Town/Peter Cooper Village
The largest real estate foreclosure in U.S. history, these two postwar
apartment communities, with a total of 11,250 apartments, were together
purchased for $5.4 billion in 2006 in a syndication organized by Tishman
Speyer, who reportedly kept a $100 million equity interest in the deal; there
was also $4.4 billion in first and mezzanine financing. The purchase price
equated to $480,000 per apartment in two complexes that were built in the
1940s. 73% of the units had rents restricted by New York’s Rent
Stabilization Ordinance, and the average rent for a one-bedroom apartment
was about $1300 per month at the time. At the time of purchase, market
rents on one-bedroom apartments, once renovated, were estimated to be
$3200 to $3500 per unit.
The loans were underwritten not according to present income but according
to pro forma income expected in 2011, five years hence. Net operating
income was expected to triple in five years! The plan made some sense, as
Tishman reportedly planned to more actively manage the property than
previous owner MetLife, and thought rents could be raised through
renovation and the eviction of illegal tenants, estimated to occupy about
1000 units. MetLife previously had a plan to convert the units into luxury
apartments, but found itself legally confounded by tenant litigation.
Enterprising New Yorkers sometimes pretend to keep possession of
apartments with restricted rents while subletting to other unrelated parties.
Tishman planned to aggressively raise rents on these illegal subletters. One
problem, though, was that under the Rent Stabilization Ordinance, stabilized
rents below $2000 per month are not eligible to be raised to market value,
and most of the units were earning less than $2000 per month.
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My personal observation is that New York is a very litigious city; I have
been threatened with lawsuits just for calling up buyers or sellers and asking
them what they paid for their properties. MetLife had already been stymied
by tenant lawsuits, so Tishman should not have been surprised that its
aggressive rental increase program also attracted a class action lawsuit on
more than 4000 units. The courts judged $200 million in rental increases to
be illegal and awarded $4000 per renter.
Besides ruinous legal expenses, the financial industry meltdown had hit the
New York apartment rental market hard, and market rents were falling.
Asking rents on one bedroom apartments now start at $2255 per month, not
including a $500 move-in bonus.
The first mortgage loan was underwritten at a 1.7 debt coverage ratio based
on pro forma Year 2011 NOI, and considering the mezzanine financing, the
debt coverage would have still been 1.2 in 2011, but actual first year debt
coverage in year 2006 was only .48! What this meant for equity investors
was years of red ink before the property could earn positive cash flow.
When the projections became unattainable, there was no more reason for the
investors to hold on to the properties, and the lenders took possession.
A rating agency has preliminarily estimated market value of less than $2
billion, meaning a potential loss of about $2.5 billion for the consortium of
lenders which include Wachovia (now Wells Fargo), Merrill Lynch (now
Bank of America), and the Government of Singapore Investment
Corporation (holder of a $575 mezzanine loan on the property, now
worthless).
2. The Credit Suisse resort loans syndication
Whereas the Stuyvesant deal seemed to be conceived through sincere
optimism and miscalculation of risk, the Credit Suisse loan syndication
appeared to be conceived in bad faith. Credit Suisse (CS) is Switzerland’s
second largest bank.
Per Bankruptcy Court Judge Ralph Kirschner:
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“In 2005, Credit Suisse was offering a new product for sale. It was
offering the owners [developers] of luxury second-home developments
the opportunity to take their profits up front by mortgaging their
development projects to the hilt. Credit Suisse would loan the money
on a non-recourse basis, earn a substantial fee, and sell off most of
the credit to loan participants. The development owners would take
most of the money out as a profit dividend, leaving their developments
saddled with enormous debt. Credit Suisse and the development
owners would benefit, while their developments—and especially the
creditors of their developments—bore all the risk of loss. This newly
developed syndicated loan product enriched Credit Suisse, its
employees and more than one luxury development owner, but it left
the developments too thinly capitalized to survive. Numerous entities
that received Credit Suisse’s syndicated loan product have failed
financially, including Tamarack Resort, Promontory, Lake Las Vegas,
Turtle Bay and Ginn [Sur Mer].”
The most famous resort to fail in this loan syndication scheme was
Montana’s Yellowstone Club, home to such rich and famous residents as
Bill Gates, Dan Quayle, Bill Frist and Tour de France winner Greg LeMond.
Tamarack is located in Idaho, Lake Las Vegas is in Nevada, Promontory is
in Utah, Turtle Bay is on Oahu, and Ginn Sur Mer is located in the Bahamas.
From a valuation and underwriting point of view, the most shocking part of
the scheme was how CS dictated that the appraisal company, Cushman &
Wakefield (C&W), use an unorthodox appraisal methodology called “Total
Net Value”, which basically ignored the time value of money in estimating
the present value of each of these resort developments. Such developments
were going to take years to sell out, but future revenues were not discounted
for time. The “total net value” methodology merely subtracted the costs of
development without respect to the timing of revenues.
Investors naturally expect to be paid a rate of return for deferred profits, so
the “total net value” methodology did not come close to the standard
definition of market value used in the U.S. Its whole purpose seemed to be
to inflate the appraised value and thus justify a higher loan amount.
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Prior to CS’s involvement, Cushman & Wakefield had appraised
Yellowstone Club, a 13,600-acre private ski resort community in Montana,
for about $400 million. CS instructed C&W to revalue Yellowstone Club
several months later using “total net value” methodology, and the appraised
value shot up to over $1 billion. The developer, Tim Blixseth, was not even
required to spend the resulting $375 million loan on the project, and in a
recent lawsuit by Yellowstone Club residents, Blixseth and his wife were
accused of diverting $209 million to themselves before filing for bankruptcy
protection in November 2008. The suit was reportedly settled for $39.5
million.
On July 17th, 2009, the foreclosed Yellowstone Club was sold for $115
million to Cross Harbor Capital Partners. The loan loss was therefore about
$260 million. Add to this the likely loan losses on Lake Las Vegas,
Tamarack, Ginn Sur Mer, Turtle Bay and Promontory, and losses are likely
to exceed $1 billion.
The Yellowstone Club/Lake Las Vegas/Promontory/Turtle Bay/Ginn Sur
Mer/Tamarack syndicated loan fiasco is thus another prime example of the
abuses of “syndication” in which the syndicator (in this case, CS) does not
keep “skin in the game.”
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CHAPTER EIGHT
POOR ASSET RECOVERY EFFORTS
The field of “asset recovery” as defined today in the commercial real estate
industry relates more to the repositioning and disposition of failed assets
than recovering all monies lost. Most attempts at commercial asset recovery
are tepid at best. Money is being left on the table.
For instance, in the commercial mortgage loan servicing industry, a
defaulted non-recourse loan to a single-purpose entity, such as an LLC or
LP, is considered a dead end in collection efforts. Servicers do not typically
consider or investigate fraud or malpractice among the parties involved in
the making of the bad loan, such as:





False statements made by borrowers
False statements made by sellers to the borrowers
False statements made by mortgage brokers
Collusion by appraisers
Title insurers knowingly providing title insurance for fraudulent
transactions
 Escrow agents misrepresenting cash down payments and failing to
record improper disbursements at closing
 Malpractice by property inspectors
Denial isn’t just a river in Egypt
Loan servicers are not typically trained in fraud detection or prevention and
they labor under a tunnel vision mindset of standardized work processes. I
have occasionally followed up on foiled attempts at fraud against my clients
by finding out if a loan was funded by another lender. In those cases where
the loan was funded and then defaulted and a loss was incurred or likely to
occur, I then contacted the lender to inform them that they may have been a
victim of fraud. I recommended that they have their attorneys contact me.
Not one lender followed up on this information.
The field of asset recovery is still in its infancy in this regard, as once the
true extent is known of the fraud and negligence contributing to the recent
failure of commercial real estate markets, aggrieved investors and lenders
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will be seeking more aggressive solutions than appointing property receivers
and listing the failed asset for sale.
One step in this direction is identifying behavior that is criminal. It takes a
human being to commit a crime, and a human being, unlike an LLC, cannot
dissolve himself and disappear, but can be legally pursued for criminal
behavior.
Moreover, securing criminal prosecution of a fraud by
government entities may reduce the expenses of civil litigation and their
financial burden on the victim, and a criminal conviction can also add to the
speed and success of the civil litigation by enabling “summary judgment”
without a trial. Summary judgment requires agreement on the facts of the
case, and a criminal conviction removes all doubt.
Seeking criminal prosecution is easier said than done, however, when DA
and US Attorney offices are stretched to their limits in staffing resources.
One fellow CFE, Hugo Holland, an assistant district attorney in Shreveport,
recommends a strategy of persuading the DA to offer a plea deal of
probation and no restitution to guilty fraudsters, thereby setting them up for
civil litigation and a quick summary judgment. Civil judgments are
apparently easier to collect than restitution.
Title 18 of the U.S. Code is a useful place to start, and it is loaded with
useful fraud statutes, such as:
Chapter 47
Fraud and False Statements
Section 1001
Statements or entries generally
This is the broadest of the fraud statutes, as it basically states that in any
matter under the jurisdiction of the federal government, whoever knowingly
and willfully:
1. falsifies, conceals, or covers up by any trick, scheme or device a
material fact;
2. makes any materially false, fictitious or fraudulent statement or
representation; or
3. makes or uses any false writing or document knowing the same to
contain any materially false, fictitious or fraudulent statement or
entry shall be fined or imprisoned under Title 18.
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Section 1002
Possession of false papers to defraud the United States
Section 1005
Bank entries, reports and transactions
Section 1007
Federal Deposit Insurance Corporation transactions
Section 1014
Loan and credit applications generally
Section 1031
Major Fraud Against the United States
Section 1032
Concealment of assets from conservator, receiver or
liquidating agent of financial institution
Section 1037
mail
Fraud and related activity in connection with electronic
Chapter 63
Mail Fraud and Other Fraud Offenses
Section 1341
Frauds and swindles
Section 1343
Fraud by wire, radio or television
Section 1344
Bank Fraud
Section 1345
Injunctions against fraud
Used against those who intend to violate banking laws
Section 1348
Securities Fraud
Used against corrupt real estate syndicators
Section 1349
Attempt and conspiracy
These mail and wire fraud statutes are more often used in federal fraud
prosecutions, partly because they are broad enough to cover just about any
fraud and also pack a powerful punch in sentencing, allowing sentences of
up to 20 years in prison. Almost any real estate fraud is a wire fraud or mail
fraud. These statutes allow U.S. postal inspectors to help in investigations
which may otherwise lack staffing resources. For instance, a postal
inspector assisted in my debriefing in an investigation of IndyMac Bank.
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Chapter 73
Obstruction of Justice
Section 1510
Obstruction of criminal investigations
Setion 1516
Obstruction of Federal audit
Section 1517
Obstructing federal examination of financial institutions
Section 1519
Destruction, alteration, or falsification of records in
Federal investigations and bankruptcy
Seeking legal help
There are certain law firms specializing in aggressive asset recovery from
parties that have willfully caused you or your organization financial losses in
real estate. Up until now, most of them have focused on residential
mortgage fraud, but similar methods can be applied to commercial real
estate losses, too.
As in any litigation strategy, the costs always need to be measured against
the likely benefits. For instance, Ed Okun the syndicator is serving a 100year sentence and all of his assets are depleted, making further litigation
against him pointless.
Here are a couple of law firms specializing in asset recovery litigation:
Rachel Dollar
Smith Dollar PC
Santa Rosa, CA
(Rachel is the publisher of www.mortgagefraudblog.com and actively cosponsors mortgage fraud conferences.)
William Rudow
Rudow Law Group
Baltimore, MD
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Lessons from Losses in Commercial Real Estate
EPILOGUE
The subject of financial losses in commercial real estate merits thousands of
pages of discussion. There are numerous areas that I have not touched, such
as income tax consequences, location selection, and property management
strategies. The other limiting factor in writing this book is that I have had
only 26 years of experience in this industry.
Chapter One was a lesson on soliciting accurate and relevant information for
making a real estate investment or lending decision.
Chapter Two demonstrated errors in analysis that resulted in significant
financial losses, including the misapplication of commonly used investment
analysis techniques.
Chapter Three demonstrated the folly of those who tread into unfamiliar
areas, whether the unfamiliar area is another geographical area or else an
unusual property type.
Chapter Four demonstrated that conflicts of interest have the capacity to
compromise investment strategy.
Chapter Five demonstrated how organizational behavior sometimes
contributes to financial losses with self-defeating employee incentives and
informational bottlenecks.
Chapter Six demonstrated that investment management practices can also go
wrong, bringing down a whole real estate investment program.
Chapter Seven presented some of the most spectacular commercial real
estate losses in recent history.
Chapter Eight was an exhortation to improve asset recovery efforts when
financial losses occur to fraud or gross negligence.
This is hardly a comprehensive list of all the things that can go wrong in
commercial real estate investment, but I think this list goes well beyond the
existing literature. I hope that you, the reader, will put this information to
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good use and that the dreaded words, “Real Estate Crisis”, will never have to
be used again in our lifetimes.
Vernon Martin
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REAL ESTATE TRANSACTION FRAUD PREVENTION
CHECKLIST
(Items checked “yes” increase the propensity for fraud.)
PURCHASE CONTRACT









Does it not include all addenda and paragraphs referenced in the document?
Are there missing signatures?
Is there seller financing?
Is the seller financing at a favorable rate or allows loan forgiveness?
Is there reason to suspect that the buyer and seller are related parties?
Was the property listed at a lower price than the contract price?
Does the contract include allowances that reduce cash to the seller?
Are there third parties providing cash to the seller?
Is there consideration in lieu of cash to the seller at close of escrow?
yes
___
___
___
___
___
___
___
___
___
no
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
PROPERTY HISTORY





Has the property transferred ownership recently?
Has the property traded more than once in a short time span?
Has the property been listed for sale for more than a year?
Are there delinquent taxes or other liens on the property?
Is the property on the CERCLA SuperFund web site?
APPRAISAL











Was the appraisal ordered by someone with a vested interest in the transaction?
Is the appraiser not on your institution’s approved list?
Does the appraiser have any disciplinary actions against him/her?
Does the appraiser's client list consist mostly of developers or brokers?
Was the report was done prior to being engaged by your institution?
Did appraiser not confirm borrower's statements with supporting documents?
Is the estimate of value based on hypothetical conditions?
Has the appraiser made extraordinary assumptions?
Has the appraiser relied on pending sales or offers to purchase?
Did the appraiser not analyze the preliminary title report?
Do comparable sales involve the same borrower or broker?
___ ___
___ ___
___ ___
___ ___
___ ___
___ ___
___ ___
___ ___
___ ___
___ ___
___ ___
PROPERTY CONDITION




Is there evidence of significant deferred maintenance?
Are any of the improvements not covered by permits?
Is the property not the same size as represented by the borrower or appraiser?
Have alleged renovations not been completed?
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
OPERATING INFORMATION








Are the borrower's financial statements not supported by tax returns?
Are the financial statements inconsistent with the leases?
Does the borrower admit to filing false tax returns?
Are revenues or expenses inconsistent with similar properties in the area?
Is there unexplained “other income”?
Have certain revenues been double-counted?
Are revenues received for services that are not normally billed?
Have capital infusions or payments between owners been counted as income?
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CONSTRUCTION





Did the borrower not provide plans or specifications?
Did the borrower not provide signed leases or else LOIs on company letterhead?
Are the proposed improvements inconsistent with the zoning of the site?
Are there no permits for the construction?
Does the construction inspector have a vested interest in the transaction?
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
___
OCCUPANCY





Are the tenants listed on the rent roll still there?
Were parts of the property not available for your inspection?
Does the property have a history of high vacancy?
Were you able to verify rents with tenant estoppel agreements or interviews?
Is stated occupancy consistent with number of parked cars in the parking lot?
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Lessons from Losses in Commercial Real Estate
ABOUT THE AUTHOR
Vernon Martin is the principal and founder of American Property
Research, a real estate advisory and appraisal firm in Los Angeles, and has
been a practicing commercial appraiser since 1984 and a Certified Fraud
Examiner (CFE) since 2004. Mr. Martin has served as the chief commercial
appraiser at three national lenders and also teaches Real Estate Valuation
part-time at California State University, Los Angeles. He has studied at the
College and the Graduate School of Business of the University of Chicago
and received his Master of Science in Real Estate degree from Southern
Methodist University’s Cox School of Business. Inquiries may be sent to
vm@americanpropertyresearch.com.
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