A couple of weeks back, I published a blog post about excess rents. For that blog post, I interviewed Stephen Roach, MAI, SRA, AI-GRS, who recently wrote an article that appeared in The Appraisal Journal, the leading trade publication for commercial appraisers throughout the world. On the surface, the post appeared to be just another boring article about appraisal techniques used by commercial appraisers. The post seemed to be innocuous. It wasn’t.
Mr. Roach’s article and the post that followed were the equivalent of offering the red pill in “The Matrix” to the financial community, providing its participants the opportunity to face an uneasy truth about past commercial appraisal methodology and lending practices in the banking industry.
Following the Great Recession, President Obama signed into law the “Dodd–Frank Wall Street Reform and Consumer Protection Act,” commonly referred to as “Dodd-Frank.” This act brought sweeping changes to the financial industry, including the commercial appraisal profession. Among the reforms, Interagency Appraisal and Evaluation Guidelines issued by the Office of the Comptroller of the Currency, the Federal Reserve Board, the FDIC, and others stipulate that the impact of intangible assets are to be accounted for in the appraisal of commercial buildings. Of equal importance, these asset classes must be treated differently in the underwriting process by lenders.
Many of the assets now held by banks as collateral consist of smaller commercial buildings occupied by businesses that have an intangible value component (e.g. those with excess rent, hotels, convenience stores, restaurants, funeral homes, etc.). If the sampling of commercial appraisals I’ve seen on many of these buildings in the past is typical, much of the intangible value has been mistakenly attributed to the value of the real estate.
If that’s the case, it’s likely that the portfolios for a number of banks are significantly undercollateralized, undermining their soundness, at least as far as regulators are concerned. If the methodology proposed by Mr. Roach becomes widely accepted within the lending and commercial appraisal communities, the reserve requirements for banks could increase significantly, forcing them to meet those requirements with future profits.
This prospect of being required to increase reserve requirements is what has some banks running scared, at least that’s what I’m hearing on the street.
But what’s your take? As always, I’d be interested in hearing your feedback.