By Scott RobinsonIs there a bubble forming in the U.S. commercial real estate market? Some investors and analysts seem to think so.
And the nation’s bank regulators apparently share those concerns. The federal banking agencies in December warned they “have observed substantial growth in many CRE asset and lending markets, increased competitive pressures, rising CRE concentrations in banks, and an easing of CRE underwriting standards.” Their statement notes that CRE asset and lending markets are experiencing substantial growth and that competitive pressures are contributing significantly to historically low capitalization rates and rising property values.
The joint memorandum recommends that member banks mitigate their risks, including “implementing processes for reviewing appraisal reports for sufficient information to support an appropriate market value conclusion based on reasonable market rental rates, absorption periods, and expenses.” It also said that during 2016, supervisors from the banking agencies will pay special attention to potential risks associated with CRE lending.
Fortunately, designated appraisers are well trained to assist banks in understanding CRE risks and to avoid contributing to asset bubbles. Their qualifications—particularly high quality education, peer review and demonstration of knowledge requirements—prepare them to support and defend their work. This kind of rigor can be particularly valuable when facing challenging valuation assignments.
Besides hiring designated appraisers to assist in risk mitigation, lenders also should engage in appropriate appraisal review procedures. Appraisers with a review designation from the Appraisal Institute have the knowledge and skills needed to satisfy issues related to due diligence and risk management often requested by lenders.
Based on expertise from the Appraisal Institute, designated appraisers will look for several possible indicators of a CRE bubble:
- Rate of return associated with a property type, economic characteristics of tenants or users are not typical and tend to be very low. For example, capitalization rates may be very low or indicate negative leverage, which is often a sign of speculation.
- Buyers become emotionally involved and act irrationally, contrary to the market value definition.
- Prices increase at a faster rate than rents.
- Rates of return decrease below long-range trends.
- Prices rise while rents and net incomes remain stable or are declining.
- Traditional buyers are replaced by new ones. “Everyone” starts to invest in real estate.
- The number of transactions increases.
- Shorter marketing times.
- Average days-on-market decreases.
- Very few expired listings.
- An increase in the number of properties remaining vacant after purchase.
- Condominium conversions become more common.
- The number of persons employed in the real estate sector (real estate sales, mortgage lending) significantly increases.
- Rents increasing faster than the ability of tenants to pay.
- Sales prices above affordability of users.
It can be difficult to spot a bubble market when in the midst of one. That’s why a designated appraiser can be such an asset to a lender in mitigating risk.
SCOTT ROBINSON, MAI, SRA, AI-GRS, is a Salisbury, N.C.-based real estate appraiser and the 2016 president of the Appraisal Institute, the nation’s largest professional association of real estate appraisers.