Charlie Dixon, ASA
President/Owner, CD Valuation Services, Inc.
Abstract: Lenders who regularly review appraisals for collateral loans are looking for specific issues, such as adequate and reasonable support for market analysis, including support for cost approach when used, and discussions of how the lives used—normal and remaining useful lives in particular—influenced and supported the opinion of value. This article addresses the importance of scope of work in appraisals for financing at liquidation values and for those with fair rental calculations, and end of lease or residual values (residual forecasting). This article was guided by interviews with many of my clients in the Commercial Bank Finance and Equipment Leasing profession who generously contributed their time and insight.
What are some of the issues that bankers, leasing agents, and other reviewers see with liquidation appraisals provided to them? Lack of support is the most common issue brought up, especially the lack of support for market analysis or for cost approach. Rarely did the finance professionals mention issues relating to the income approach, even though the income approach is a viable approach in many situations. Another related and important issue for financial professionals is inadequate discussion of normal useful lives (NUL) and remaining useful lives (RUL) and the process by which appraisal reports conveyed and supported the opinions.
A good understanding of the scope of work (SoW) is the key to solving the appraisal problem and the start of the assignment. USPAP defines scope of work as the type and extent of research and analyses in an appraisal or appraisal review assignment.[i]
The assignment review process (verbal or written understanding) between lender and appraiser is most important. Both the Association of Machinery and Equipment Appraisers (AMEA) and the Equipment Appraisers of North America (EANA) require all assignment agreements to be (must be) in writing. The EANA states that the agreement must be “… approved and signed by all contracting parties before the assignment starts.” The Principals of Appraisal Practice and Code of Ethics (ASA, v111820), Article 4.6 states, “It is good practice to have a written contract between the appraiser and client, covering objectives and scope of work, time of delivery and amount of fees. In certain circumstances…”
[i] USPAP: 2020-2021 Uniform Standards of Professional Appraisal Practice, The Appraisal Foundation, p. 5. The 2020-2021 edition of USPAP is effective through December 31, 2023.
What is the appraisal problem to be solved? Is this a minor assignment with few and “typical” assets or a more complex assignment with special purpose assets, an oil refinery, chemical plant, pharmaceutical plant, or other? Are there special parameters or assignment conditions (such as the ability to inspect the assets) which will determine the How, What, Where, and When of the appraisal problem?
Often overlooked, not discussed, or just taken for granted, is a deeper look into the appraisal problem to be solved and the SoW necessary to solve it. For example: an appraiser provided with a lender’s request for proposal and scope of work, may understand that the lender requires an opinion of orderly liquidation value (OLV). Within the lender-provided definition of value may be a requirement relating to a specific marketing time.[i] Possibly, this is a standard line in all requests for proposal letters from that lender (assignment condition, possibly boilerplate?). Some definitions of value sourced by others use marketing time terminology such as “typically 120 days” or a “120-day market value.” The appraiser, experienced with this type of asset(s), may have other ideas about the marketing period due to the type of asset it is. As a special purpose asset, will a brief period of time potentially limit the recovery amount and hence have a negative effect on the opinion of value?
[i] VME: Machinery & Technical Specialties Committee of the American Society of Appraisers, Valuing Machinery and Equipment: The Fundamentals of Appraising Machinery and Technical Assets, 4th ed., American Society of Appraisers (Herndon, Virginia: 2020), Glossary, “market level,” p. 542.
Within the SoW, what is the level of inspection, such as a visual walk around or is more depth expected: Is the appraiser expected to start up equipment and put it through test procedures and/or reference lube oil samples?
Does the appraisal report discuss who will be responsible for the cost to disassemble and prepare assets for removal (if necessary)? Is this cost borne by the buyer, seller, or lender? Could these additional costs influence how much a buyer will pay (what is his/her ceiling)? Will these costs influence the comparables and hence the opinion of value?
The appraiser needs to recognize these issues, discuss with the lender/client, and agree on a relevant SoW to account for this or any other condition. Would the lender want to know your opinion of these issues? These issues are best discussed before the acceptance of the appraisal assignment.
It is also common to start an assignment with an agreed SoW and find in the process of completing the assignment that adjustments should be made to that SoW. The SoW Rule states, under Scope of Work Acceptability, Comment, that “Determining the Scope of Work is an ongoing process in an assignment. Information or conditions discovered during the course of an assignment might cause the appraiser to reconsider the scope of work.”[i]
Summarizing the SoW might also include disclosure of research and analysis not performed.
Pertaining to this are the relevant USPAP Reporting Standards Rules. For example, Standards Rule 8-2(a)(x)[ii] states that at a minimum an Appraisal Report must provide sufficient information to indicate that the appraiser complied with the requirements of [the Development Standards Rule] by
(1) summarizing the appraisal methods or techniques employed …
(5) summarizing the information analyzed and the reasoning that supports the analysis, opinions, and conclusions, including reconciliation of the data and approaches
Appraisers must determine the appropriate approach and clearly communicate why and how that approach, or those approaches, are used in the appraisal. The appraiser must also state the reason(s) for excluding an approach if any have not been developed.
A leasing group related issues with appraiser’s utilization of the cost approach. While the appraiser(s) relied heavily upon the cost approach, the report(s) lacked discussion and support of the various forms of depreciation. Typically, appraisers consider the three standard forms of depreciation[i] which are then applied to the replacement or reproduction cost new of the subject asset to determine market value.
What the leasing group wanted to know is if or how the cost approach is supported by recognized (published) age life, depreciation tables and indexes. Or is there analysis of comparable items sold in the marketplace from which one can determine levels of obsolescence and apply that data? It is important to these intended users how, or to what level, are physical depreciation, functional obsolescence, and economic obsolescence discussed and supported?
[i] VME, p. 48-49.
Lenders noted that comparable analysis is sometimes not well discussed or explained. Reviewers sometimes see statements such as “I have researched the relevant markets,” or “In my analysis, I may have removed the buyer’s premium.”
These statements are vague. The Scope of Work Rule states that an appraiser must:
Vague or boilerplate type statements do not comply with the Scope of Work Rule. The reviewer will instead think about the elements of CAARR: Complete, Adequate, Accurate, Relevant, Reasonable, as well as USPAP SR8-2(a)(x) discussed earlier.
Other review issues arise when the appraiser utilizes market sales or classifieds (advertisements) and applies that data to opinions of liquidation value with no discussion of how adjustments were made. How did the appraiser adjust from a fair market sale to (get to) a forced liquidation value? Are prices asked (rather than sold costs) reasonable comparables?
[i] USPAP, p. 13-14.
No interviewees brought up the income approach, even though the income approach is a viable approach in many situations, such as refineries, pharmaceutical and chemical plants, steel mills, hospitals, convalescent facilities, and apartment complexes. These facilities may have income that can be allocated to a single process, the complete facility, or a single asset, such as an individual process line, a forging press, or items such as a piece of construction equipment contracted out on some form of rental or longer-term lease agreement. Think of companies like United Rentals, Sunbelt Rentals, Penske Truck Leasing and Idealease.
Especially for Real Property (RP), the income approach is a well-recognized method and typically a necessary approach which may support the analysis and credibility. Machinery and Equipment reviewers (M&E) see statements such as “The income approach is not relevant because no data was supplied,” or “It is difficult to allocate income to individual assets,” or “The market approach is the most relevant approach used by machinery and equipment appraisers.” However, are these factors analyzed and then discussed in the report? What is the support (which is reported as often lacking)?
With M&E / PP assets, income may be derived from equipment in a rental center (United Rentals, Sunbelt Rentals). Oil refiners and Pharma chemical plants derive income from raw materials processed to finished product sold. Valuation analyses may be completed utilizing cash flow, discount, and cap rates, or present worth of future benefits. Simply put, the investment decision is predicated upon the present value of future benefits and the Income Approach may be applicable.
RP lenders had few review issues and noted they were satisfied with most appraisals received. However, when issues were brought up, it was generally a lack of comparable sales analysis and/or illogical comparable(s) used.
Comparable analysis includes recognition of major real estate factors such as building square footage, land size, living/dwelling units (how many) in apartment complexes, convalescent and senior citizen facilities, bed count, hospital rooms, departments and modalities, mall retail space and store fronts, etc. An example of an illogical comparable is an industrial building with heavy-duty floors, heavy electric service, and overhead bridge cranes while the comparable cited is a simple warehouse, not climate controlled and with no extra or any heavy-duty services. What adjustments were made and how were they calculated and applied?
Equipment leasing and financing professionals are interested in fair rental calculations, and end of lease or residual values (residual forecasting). Their lack of support issues hinge primarily on the report not explaining concerns such as how the appraiser produced an opinion of value for a future opinion five years out? Another issue is an appraiser not reading the specific lease agreement and so utilizing an incorrect definition of value. Lease agreements can be vastly different from one firm to another, and it behooves the appraiser to review the lease document prior to starting an assignment.
Reviewers noted a lack of explanation and support for age/life analyses, normal useful life, remaining useful life, economic useful life estimates, and calculations. Intended users want to know where the data comes from. Are data sources cited? How is this information conveyed and supported within the appraisal report?
While appraisal mythology suggests that few lenders are interested in the support of opinions or the nuts and bolts of the appraisal, and only look at the bottom-line, my interviews suggest that most lenders are interested in the appraisal process. Some lenders have in-house reviewers or review departments who are interested in the analysis and support of opinions. Dodd/Frank legislation requires financial institutions to have appraisals reviewed by independent third parties, whether in-house or from outside. [Bold added to emphasize independent, impartial, and non-biased.]
A common misunderstanding between a lender and an appraiser might sound like this:
Lender: “As we talked on the phone, I thought the appraiser knew exactly what I was asking for and what I needed.”
Appraiser: “I thought the lender knew what was involved and how I was going to do it, and that is exactly what I gave her.”
A better way to conclude liquidation appraisals for financing is by providing more relevant and meaningful reports.
How do appraisers analyze and draft their reports to be more relevant and meaningful? USPAP, while sometimes referred to as “the minimum standards,” is not limiting in the sense of the Scope of Work and how much relevant and supporting information an appraisal report includes.
The objective of USPAP requirements, as illustrated by the Preamble and the Scope of Work Rule, is a clear, concise, relevant, and meaningful appraisal report.
The purpose of the Uniform Standards of Professional Appraisal Practice is to promote and maintain a high level of public trust in appraisal practice by establishing requirements for appraisers. It is essential that appraisers develop and communicate their analyses, opinions, and conclusions to intended users of their services in a manner that is meaningful and not misleading.[i]
[i] USPAP, p. 1.
Comment: Appraisers have broad flexibility and significant responsibility in determining the appropriate scope of work for an appraisal or appraisal review assignment... Credible assignment results require support by relevant evidence and logic.[i]
Disclosure Obligations: The report must contain sufficient information to allow the client and other interested users to understand the scope of work performed. The information disclosed must be appropriate for the intended use of the assignment results.[ii]
Charlie Dixon, ASA, CSA, is accredited as MTS and ARM. He is a USPAP Certified Instructor (personal property) through the Appraisal Qualifications Board (AQB) of the Appraisal Foundation, was awarded the George D. Sinclair Award for Professionalism, and served ASA as local chapter president and internationally on the Machinery & Technical Specialties (MTS) Committee and MTS Discipline Governor. He is currently on the ASA Educational Foundation and Board of Examiners (ARM) and is co-editor of the ARM e-journal. Charlie is also a Certified Senior Appraiser of the Equipment Appraisers of North America (EANA) and is the EANA Appraisal Review Chair. Email: cdixon@cdvsinc.com