There were three especially interesting issues that we discussed at various points throughout the classroom sessions. 

First, we spent a fair amount of time reviewing the 2006 USPAP changes and attempting to identify their more relevant implications for assessing and interpreting an appraisal report.  I think it’s fair to say that we reached the following conclusions:

§         It is perhaps even more important now to thoroughly understand the appraiser’s scope of work, especially since the appraiser is not required to detail the scope of work in a single section of the appraisal report but, rather, may provide some or all of the scope of work at various points in the report.

§         As a result, the client should take care to specify in its engagement letter to an appraiser that the scope of work must be stated clearly in a single section of the appraisal report and clearly labeled as such.

§         Because specific and binding requirements have now been eliminated, the responsibility for the quality of work rests even more heavily on the appraiser.  That is, with sets of specific and binding requirements abolished as requisite components in an appraisal, the appraiser has – by force of circumstance – more discretion in deciding what to include or not include in an appraisal that will provide credible results.  Consequently, it seems even more important that the client thoroughly review and assess the final product.

§         However, time will tell if these conclusions are valid.  It’s hard to break old habits, so current appraisal reports may look and read like past appraisal reports with only minor changes in the use of customary terminology.

Second, we examined current cap rates in various markets in relation to stated yields on other investments.  I should note that there was wide geographical representation among the participants, so we had the luxury of first hand knowledge in numerous real estate markets.

In theory, a cap rate for an income producing property with no expectation of price appreciation should be higher than the yield on a less risky investment, such as the yield on a Baa corporate bond, by some risk factor that will vary by property.  If investors expect price appreciation, then the cap rate should decrease in relation to the yield on a Baa corporate bond, if we may use the yield on a Baa corporate bond as a reference point.  In fact, the cap rate should fall below such a yield if the price expectations are sufficiently robust. 

As a result of our discussion, I think we felt comfortable with the following observations:

§         In markets where the cap rate exceeded the current yield on a Baa corporate bond (approximately 6.28% at the time of our session) by more than 400 basis points, property prices were actually decreasing.  We would expect this, since the yield from the cash throw-off from the property – captured by the cap rate – must be high enough to compensate for the expected decrease in asset value.

§         In markets where the cap rate was 200 to 300 basis points above the yield on a Baa corporate bond, there was generally little expectation that property values would increase – certainly not in the foreseeable future.  We would also expect this, since the cash throw-off from the property is the sole component in the investor’s yield on his or her investment in the property.  And the yield on a relatively high-risk investment should certainly exceed the yield on a less risky corporate bond.

§         In markets where the cap rate was equal to or below the yield on a Baa corporate bond, there was general evidence of continuing appreciation in property values. Again, this falls in line with our expectations.  The cash throw-off from properties in this market environment represents one of two components in the overall yield.  It can certainly hover below the yield on a less risky investment if the upside price potential is sufficient to offer the investor a yield on this riskier investment that he or she would require.

Third, we examined the relationship between investor leverage and the yield from property price appreciation via a series of computations.  As you would expect, the greater the investor’s leverage, i.e., the less his or her equity investment in the property and, therefore, the greater the lender’s, the less the amount of property appreciation necessary to provide some rather substantial yields from appreciation alone.  You might, for example, consider an income producing property valued at $2,000,000.  Calculate the different yields to the investor from property appreciation of just 5% over a single year if the investor had contributed a) $400,000 toward the purchase price, b) $600,000 toward the purchase price, or c) $800,000 toward the purchase price.  Use the same interest rate and amortization period for all three scenarios.  You might be surprised with the results.  We were.