Cap Rate News

Sub prime Appraisal Meltdown
by Warren K. Hoppke, SRPA
 www.AppraiserValues.com

We have heard allot about the Sub prime Mortgage Meltdown, however, nobody has asked the question, "What about all the fraud and inflated appraisals" generated by aggressive sub prime lenders that will cause a Sub prime Appraisal Meltdown.

The Mortgage Lender Implode-O-Meter (http://ml-implode.com/) which tracks  U.S. lenders that have "imploded" or are on their ailing/watch list has now risen to 102 major U.S. mortgage lenders that have been affected in some way by subprime loans.

As the industry unwinds the layoffs will grow and will include many in house staff review appraisers along with major appraisal management companies. I just received an email from a large appraisal management company stating that they will let you know when and if they will be able to pay their appraisers for all of the appraisals prepared for many of the subprime lenders that are going under. Looks like appraisers get the short end of the stick again. It happened in the late 1980's during the Savings & Loan crisis and is happening again. Who says history does not repeat itself.

In the early 1990's many appraiser E & O insurers were sued by lenders trying to recoup their loan losses of the 1980's. Does history repeat itself, it sure looks that way. Get ready for E & O insurance meltdown and E & O insurance rates to go through the roof as a result of all those inflated appraisals. Appraisal meltdown will happen in late 2007, 2008, and 2009 as lenders again blame the appraisal industry. Whose fault is it really? State licensing agenies for lack of enforcement and allowing thousands of unqualified appraisers into the industry. The lender pressure to perform those endless value checks required by most all mortgage lenders pushing valuations to the upper outer most stratosphere. Or is it the overly aggressive lenders greed for killer profits which are sold to greedy Wall Street investors and Hedge funds.

Many of the residential and commercial review appraisals I have performed during the last 6 months have been on extremely inflated appraisals. One in particular in the Los Angeles County area was over inflated 200%. Another in the Orange County area was over inflated by 150%. You ask does the same fate await the commercial subprime market?

Let’s take a look. Yes, the commercial subprime market has been marketing 100% to 125% LTV loans for the last several years. Cap rates have been rapidly moving down to all time lows due to investor demand on expectation that rents will continue to rise and appreciation will continue. Small to medium sized commercial property prices have been increasing rapidly. Debt service coverage ratio’s do not exist any more or have moved to all time lows as a result of negative cash flows. A negative cash flow is suppose to be a trade off for expected future appreciation.

Most all of the sub prime small to medium size commercial properties have negative equity dividend rates. Most are on variable rate loan products and many borrowers could not support the negative cash flow generated by extremely inflated prices. For example, total consumer debt now stands at $7.4 trillion, almost double what it was at the beginning of 1990 according to Anna Bernasek Fortune Magazine. This could have negative consequences for many mom and pop commercial property sub prime investors. When the market turns many of these people will lose there properties to foreclosure. If interest rates go up cap rates will go up and prices will fall. Even if interest rates do not go up investors will demand substantially higher yield spreads. Wall Street investors will want to be compensated for the perceived risk rising out of the subprime housing sector which is now spilling over into the CMBS commercial market in the form of tighter credit standards.

You say, what will make rates go up when the economy is doing so well. Larry Kudlow of CNBC says we have a goldilocks economy. Well, stagflation for one and a credit crunch for the other. The subprime market is already starting to tighten its lending standards with higher down payments and higher rates to offset the risky lending practices perceived by investors in CDO's according to Fitch Ratings which provides ratings on commercial debt obligations. As reported in Yahoo News Fitch reports defaults on commercial mortgages originated this year could be up to 15 percent higher. Moreover, the housing market is weak and unemployment from the housing and sub prime melt down will increase. The bottom line, a slow down is in the works and it will hit commercial property late next year as credit standards tighten, rent expectations do not materialize, and appreciation rates flatten or go negative.

Moreover, the Bush Administration has recently started a new trade war with China by imposing tariffs on some imports. Additionally, sanctions on tainted products such as cat food, toothpaste, etc. will start a round of trade barriers on imports. This could start a continuation of the decline in the dollar possibly pushing up rates here. Notwithstanding, even if all other economic factors remain equal, tightening credit standards and investors demanding higher yields due to the overall increase in perceived risk in captial markets will send cap rates upward.  

In the long run the ultra low Cap Rates cannot be sustained over a typical 10 year holding period. When the market turns and interest rates edge up and or as price appreciation levels off or declines a price correction will send a message to overvalued commercial properties in the form of higher cap rates.

Appraisal meltdown in commercial real estate will be the result of over inflated appraisals utilizing discounted cash flow spread sheet assumptions that indicate unrealizable continued high long term income growth rate expectations, understated expenses, and understated going out cap rates. Discounted cash flow projections like these will never materialize over a 10 year holding period and therefore will cause appraisal meltdown in the sub prime market.

As a result, get ready for the commercial appraisal meltdown as lenders begin to sue appraisers to recoup losses for overvalued commercial appraisal valuations.

AppraiserValues.com provides residential and commercial review appraisal services for financial institutions, private money investors, law firms, and governmental institutions.