Scope of Work: Desktop Review vs. Inspection
You are asked to review an appraisal of a 20-year-old office building. The original appraiser performed an interior inspection and noted that the building’s HVAC system is original and may need replacement soon. The appraiser estimated a replacement reserve of $0.25 per square foot per year in the income approach. The review engagement is a 'desktop review' per the client’s instructions, meaning you will not inspect the property. The client is a life insurance company considering a $5 million loan; the appraised value is $8 million. The building is 50,000 square feet and is 90% occupied with leases rolling over in the next three years. The market for office buildings in this area has been declining, with vacancy rates rising from 10% to 15% in the past year. The original appraiser used a 5% vacancy rate and a 7% cap rate, which are at the optimistic end of the market. The client wants to know if the appraisal is 'safe' for lending purposes.
1. What are the scope of work considerations for this review, and how do they affect the reviewer’s ability to assess the appraisal?
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Scope of work considerations:
USPAP Scope of Work Rule: The reviewer must determine an appropriate scope of work for the review. The client has requested a desktop review, but the reviewer must decide if that is sufficient given the assignment’s risk. The reviewer should consider the property type, loan amount, market conditions, and the original appraiser’s findings.
Reliance on original inspection: Since the reviewer will not inspect, they must rely on the original appraiser’s description of the property. However, the reviewer should assess whether the original inspection was adequate and whether the physical condition issues (HVAC) were properly considered.
Market data verification: The reviewer can verify market data (vacancy, cap rates) through third-party sources. The reviewer should check if the appraiser’s 5% vacancy and 7% cap rate are supported. Given the market decline, these may be optimistic. The reviewer can use published surveys, broker reports, and online databases.
Lease analysis: The reviewer can review the rent roll and lease terms if provided. The reviewer should assess whether the appraiser’s income projections are reasonable given the rollover risk.
Physical condition: Without an inspection, the reviewer cannot verify the HVAC condition or other physical issues. The reviewer may need to qualify their opinion or recommend an inspection if the physical condition is material. The replacement reserve of $0.25/SF may be insufficient if HVAC replacement is imminent; the reviewer can compare to industry benchmarks.
Limiting conditions: The review report should state the scope and any limitations. The reviewer’s opinion of the appraisal’s quality may be qualified by the lack of inspection.
Client’s needs: The client wants to know if the appraisal is 'safe' for lending. The reviewer should address the risk factors (market decline, rollover, physical condition) and whether the appraisal adequately reflects them.
2. How should the reviewer evaluate the original appraiser’s assumptions about vacancy, cap rate, and replacement reserves?
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Evaluation:
Vacancy: The appraiser used 5%, but market vacancy has risen to 15%. The subject is 90% occupied (10% vacancy), so the appraiser’s 5% may be optimistic even for the subject. The reviewer should check if the appraiser explained the lower vacancy (e.g., strong tenant base, long leases). Given the rollover risk, a higher vacancy allowance may be warranted. The reviewer should compare to market data and conclude whether 5% is supported.
Cap rate: 7% is at the optimistic end. With rising vacancy and declining market, cap rates may be expanding. The reviewer should check recent sales of similar office buildings to see if 7% is reasonable. If market cap rates are 7.5-8.0%, the appraiser’s 7% may overstate value. The reviewer can use published investor surveys or talk to market participants.
Replacement reserves: $0.25/SF is low for an office building with original HVAC. Typical reserves are $0.20-$0.50/SF, but if HVAC replacement is imminent, a higher reserve or a one-time capital expense should be considered. The reviewer should assess the HVAC’s remaining life and cost. Without inspection, the reviewer may rely on the appraiser’s description but should note the potential understatement. The reviewer can check industry standards (e.g., BOMA, IFMA) for reserve benchmarks.
Overall: The reviewer should determine if the appraiser’s assumptions are reasonable and supported. If not, the reviewer should state how they affect the value. The reviewer may conclude the appraisal is not 'safe' due to optimistic assumptions and recommend a revised appraisal or additional analysis.