New Appraisal Method Could Limit Lending

New Appraisal Method Could Limit Lending

If you‘re not a real estate appraiser, you’re probably unaware of a major catastrophe looming that could effectively eliminate all types of hotel financing, making it all but impossible to either build or sell a hotel. Under potential new governmental lending regulations, hotel appraisers will be forced to utilize an appraisal methodology that will lower their hotel valuations by as much as 40%, forcing borrowers to finance significantly less of their acquisition prices at greatly inflated interest rates. While this topic is somewhat technical, I will attempt to describe the issues in simple terminology.

From a valuation perspective, hotels consist of four components: land; improvements (building); furniture; fixtures and equipment (ff&e); and business. The business component consists of various intangibles like specialized management expertise, brand affiliation and reputation. When a typical mortgage lender makes a loan on a hotel the collateral for the loan can only be the real property components that are the land and improvements. Most lenders cannot consider the ff&e and the business components as collateral. The same considerations are true when a property tax assessor values a hotel for assessment purposes — the assessed value only includes the real property components: the land and improvements.

Up until 10 years ago, hotel appraisers used one methodology for valuing the real property component (known as the Rushmore approach) that was fair to owners looking for both mortgage financing (high real property component) and a reasonable property tax assessment (low real property component). Everything was in balance.

The situation has recently changed and the balance has moved toward favoring a property tax perspective where a low real property component valuation is beneficial. Several real estate appraisers specializing in valuing hotels for property tax appeals came up with a revolutionary methodology that essentially shifts a significant portion of a hotel’s overall value from the real property components to the ff&e and business components. This has become a boom to their hotel property tax business because they have been able to achieve huge decreases in their client’s assessed values. In addition to developing this highly biased methodology, they have supported it through authoring numerous articles, textbooks and seminars — many of which have been sponsored by the Appraisal Institute where these members hold high-ranking positions. Up until now, no one has been overly concerned with this lopsided appraisal methodology because it was applied only to property tax appeals.

However Houston, we now have a problem. With the recent real estate lending bubble and the collapse of many financial institutions, government regulators are looking for ways to reduce the risk of another crisis. One of these approaches is to limit the value of the collateral that a hotel lender can consider when they make a mortgage loan. Thus, if regulators force appraisers to use this new methodology, which greatly lowers the value of a hotel’s real property component, they can significantly reduce the amount of money a hotel lender is able to provide to hotel borrowers.

Let me provide you an actual example showing the potential magnitude of this issue on the hotel lending industry. The following is data from a tax appeal of a Marriott hotel where I appeared as an expert witness for the tax assessor testifying against one of the developers of this biased methodology, who appeared on behalf of the property owner. The methodology used by this appraiser is called the “business enterprise approach” because it creates an inordinately high business value. The methodology used by most hotel appraisers is called the “Rushmore approach.” The subject property was a Marriott hotel located in New Jersey, just outside of New York City. On the date of value, the Marriott was enjoying 81% occupancy at a $128 average rate. The property was situated on a major interstate highway and was in good physical condition. The overall value had to be at least $125,000 per room.

Without going into technical details as to the differences in the business enterprise approach and the Rushmore approach, the following table shows how both approaches allocate the total value among the various components:

Utilizing the business enterprise approach, the value of the real property component represents only 36% of the hotel’s total value or about $45,000 per room. Under the Rushmore approach, the real property component is 60% of the hotel’s total value or a much more realistic value of $75,000 per room. If banking regulators force appraisers to utilize the business enterprise approach when appraising for mortgage financing, then all hotel loans would be approximately 40% lower than what they are now! Good news for bank regulators, horrible news for hotel owners.

Needless to say, many hotel appraisers have rejected the business enterprise approach as being highly biased toward appealing property taxes and are rallying to get the Appraisal Institute to back off their support of the business enterprise approach and recognize the significantly greater consequences of completely shutting down hotel mortgage lending.

By the way, the New Jersey tax court that heard the Marriott case totally rejected the business enterprise approach in favor of mine. ( Credit, Steve Rushmore)

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