While I do not normally comment on the news, a recent article in The WallStreet Journal caught my attention as it relates to the CRE market. In - Examnier: Lehman Torpedoed Lehman- the Journal reports among other things that a court appointed examiner found that "Lehman improperly valued its real-estate assets". What makes me shake my head about this is that so was everyone else and by the way, they still are. Not only this, but the FDIC is enabling and encouraging the practice among community banks holding real assets. I cannot comment on the other allegations in the article, but it appears that the $30m report provided a nice scapegoat for the crisis.
How can this be:
It is based in the fact that the industry is reliant upon appraisals for valuations of underlying hard assets. It is the classic social psychological phenomena that occurs when no one knows the value so what do they do but ask the expert. Where does the expert get their value. there are three methods, income approach, comparable approach, and replacement approach, which are then reconciled. For income producing assets the income approach is given the most weight and so this is where I will focus. I will briefly point out that the comparable approach is simply looking at what everyone else has done in the past. In a dislocated market, where there are very limited comparables to choose from and the past comparables are from an overheated market, there is very limited relevant usefulness. The replacement approach is a straightforward approach to what it would cost to rebuild a structure today, but it will not give an acurate market valuation. Please note that I have nothing against appraisers or appraisals under normal market conditions. I am simply pointing out that their are serious limitations to their usefulness in dislocated markets.
The income approach:
The income approach relies heavily on on picking the right capitalization rate. Many appraisers construct their cap rate based on formulas utilizing current interest rates and other factors. The problem in a dislocated market is the fact that most will not go far enough in their assumptions and will overvalue properties.
The result:
Anecdotally, I am seeing banks taking properties they own to market based on appraisals and being unable to sell because the 7 offers they receive are well below that number. Basically, the market is telling us what the value is but we do not want to hear it, so if we ignore it it will go away. In many cases the banks are upset at the appraisers because they would be leaving themselves open to regulatory and shareholder scrutiny if they actually sold at the market value. In steps the FDIC. If the FDIC takes over a failed bank that currently has property on their books at appraised value X but the market values it at X-100, then the FDIC is shouldering the liability and allowing the bank to hold the property at appraisal value X on the books. The bank has less incentive to liquidate the asset due to the backstop, and holds it on its books at an inflated valuation.
