Bullish CMBS Appraisal Sparks Questions

The appraisal of an extended-stay hotel portfolio collateralizing a $570 million mortgage that was securitized last week has raised the eyebrows of investors.

 

Blackstone acquired the portfolio from Clarion Partners for $800 million in August. But the Cushman & Wakefield appraisal cited by lenders J.P. Morgan and Deutsche Bank valued the properties at almost $100 million more.

 

The valuation gap is unusual. When real estate has just changed hands, the appraised value typically mirrors the purchase price. The issuers of securitizations, in turn, use that value to determine the leverage ratio of the mortgage on the properties. Because the high Cushman valuation increased the denominator, the stated loan-to-value ratio was lower than it would have been if the purchase price was used. Some investors view the higher valuation as an example of an ongoing slide in loan-underwriting standards.

 

The loan was the senior portion of a $675 million floating-rate debt package that J.P. Morgan and Deutsche originated on Aug. 12 in conjunction with Blackstone’s acquisition of the 47-hotel portfolio. The two banks securitized the senior loan last week via a stand-alone deal (BLCP 2014-CLRN), with the investment-grade classes pricing in line with the dealers’ asking prices.

 

In addition to its $800 million purchase, Blackstone incurred $35.1 million of closing costs and funded $10.1 million of upfront reserves, bringing its total outlay at the closing to $845.2 million. Blackstone has also indicated that it plans to spend $63 million on renovations over four years.

 

The securitization documents cite multiple appraised values that Cushman provided on July 1 at the behest of J.P. Morgan and Deutsche. The brokerage supplied valuations based on whether the hotels were appraised individually or were sold to a single buyer willing to pay a premium to buy in bulk. Cushman said the "as-is" value was $833.7 million on a one-by-one basis and $885.1 million on a portfolio basis.

 

The brokerage also supplied "hypothetical" appraised values that factored in "all planned capital dollars" that Blackstone will put in reserve to upgrade the properties. Using that hypothetical standard, Cushman valued the portfolio at $844.8 million on a one-by-one basis and $896.3 million on a portfolio basis.

 

Of the four potential valuations, J.P. Morgan and Deutsche chose the highest. As a result, the loan-to-value ratio highlighted in the deal documents was 63.6% — or $570 million divided by $896.3 million — on the senior debt and 75.3% on the overall debt package. By contrast, had Blackstone’s actual $800 million purchase price been used, the leverage ratios would have been 71.3% and 84.4%.

 

While it’s possible that Clarion left a lot of money on the table by selling the 5,908-room portfolio to Blackstone at a below-market price, real estate pros say that seems highly unlikely, given that both companies are sophisticated institutional investors and that Clarion conducted a broad-based auction via a major brokerage, JLL.

 

Instead, investors contend, the use of the most-optimistic appraisal is another sign that commercial MBS issuers are pushing the envelope on credit quality. They view the use of hypothetical valuations as akin to "pro forma" underwriting, under which lenders make credit decisions based on projected increases in property cashflows, rather than in-place income. The use of pro-forma accounting was widespread as the CMBS market was peaking in 2007 and contributed to the subsequent crash.

 

 "They call it a ‘hypothetical’ appraised value — that in itself should be a red flag," said one investor. "If you want to know what the true LTV is, you might want to use the actual purchase price."

  

J.P. Morgan, Deutsche and Cushman declined to comment on why the appraised value was so much higher than Blackstone’s purchase price. Blackstone and Clarion also had no comment. But the boilerplate fine print in the preliminary prospectus for the securitization effectively warns investors that the cited valuations may have little connection to reality. "Information regarding the appraised values of the Properties is presented in this offering circular for illustrative purposes only and is not intended to be a representation as to the past, present or future market values of any of the properties," the prospectus says.

 

Other recent stand-alone securitizations that financed the acquisitions of properties or portfolios cited appraised values that were equal or close to the purchase prices. Some examples: 

• A Related Cos. partnership bought two office condominiums at Time Warner Center in Manhattan from Time Warner for $1.3 billion (plus $35 million of closing costs). Lead manager Deutsche cited a Cushman appraisal of $1.3 billion (COMM 2014-TWC).

 

• A Mark Karasick partnership bought the leasehold interest in the Mobil Building in Manhattan from Hiro Real Estate of Japan for $900 million (plus $59.5 million of other costs). Lead manager Morgan Stanley cited a Cushman appraisal of $900 million (MSC 2014-150E).

 

• Blackstone acquired two hotel portfolios from separate sellers — an OTO Development partnership and special servicer CWCapital — for a total of $503.6 million, plus $14.7 million of other costs. Lead manager J.P. Morgan cited a combined appraised value of $513.6 million (JPMCC 2014-BXH).

Leased fee, fee simple. Who cares? Your regulator.

"Fee simple" and "leased fee"? What's that about and why does it matter?

Don't get distracted by the term "fee simple". It sounds strange because it's a vestige of middle-age, English common law. For purposes of illustrating the point, let's (over)simplify. Assume, for the sake of this conversation only, that fee simple is a rough translation for "ownership".

Example
Here's an example. Your borrower owns an office building. So, in other words, your borrower is the "landlord" to several office tenants under standard office leases. The tenants occupy the building. The landlord, in general, does not.

It might be common in real estate circles to say that your borrower owns the "fee", and that the handful of tenants that occupy the building own a "leasehold" interest -- a fancy way of saying they rent space.

Now assume that your bank is considering making a loan to this borrower. The loan will be secured by the borrower's interest in the office building. You are ordering the appraisal. What interest should you ask the appraiser to value?

What does it mean to appraise the "Fee Simple"?

It's a natural reaction to say "fee simple" -- after all, your borrower is not renting the property from someone else. They own it.

But here's what will happen if you do that. In valuing the property under the income approach, the appraiser will perform market research and use accepted methods and techniques to determine the appraiser's opinion of market rent. In other words, the appraiser will come up with an opinion as to the rent that your borrower could get if they leased space in the building today -- or, more precisely, as of the effective date of the appraiser's opinion of value. Then, the appraiser will use that opinion of market rent to value the building, more or less ignoring the current leases.

Below-market rents highlight the distinction

But what if some or all of the tenants in the building signed long-term leases 10 years ago, and still have 10 years left on their leases? What if those tenants are "credit" tenants (e.g., big, successful public companies with low risk of default) and as a result have sweetheart deals, even in light of today's real estate environment? Well, in that case, the appraiser's opinions about the "market rent" don't bear a resemblance to the cash flow that's actually coming in the door based on the specific terms of those leases. If you want the appraiser to dig through the terms of those leases, the rent roll, and other information and use the actual numbers in the income approach, then you need to order "leased fee".

What if I order it the "wrong" way?

In most cases, if this gets mixed up, it's just a misunderstanding. But getting this wrong can cost time and money. If you order a fee simple appraisal, the appraiser may not think to ask you about leases and rent rolls. He may assume there isn't a lease in place. Then, if you suddenly ask him why he didn't consider the lease, or if the appraiser runs into a tenant on his site visit, you could have an issue. The appraiser may have to go back and review leases and rework his income analysis. It pays to get this right up front.

(Aside from the regulatory issues discussed below, it's not "wrong" to order a fee simple appraisal for a building with tenants. There may be very legitimate reasons for wanting to know the market value of the building using the prevailing market rents and ignoring the specific leases in place. For example, it may be that the leases in place have above-market rent. In that case, a fee-simple appraisal may serve as a means of stress-testing value in the event those tenants were to default and the landlord was forced to re-rent the space. But you should understand what you're ordering. And the appraiser should take care to clearly explain in the report which interest he or she is valuing.)

Does my regulator care?

When you're dealing with a property with below-market rents, it might be tempting to view this distinction as an opportunity to influence value. You may be confident that your borrower's "good for it" and looking for a way to get the property to "appraise out". If you order a "fee simple" appraisal, you could take advantage of the market rents, even though your borrower's locked into below-market rents. But don't do it. Your regulator is paying attention.

Each of the prudential regulators requires that appraisers report appropriate deductions and discounts, and that includes, specifically, for properties with below-market rents. Refer to Appendix C in the December 2010 Interagency Appraisal and Evaluation Guidelines. There you'll read:

"For properties subject to leases with terms that do not reflect current market conditions, the appraisal must clearly state the ownership interest being appraised and provide a discussion of the leases that are in place. If the leased fee interest is being appraised and contract rent is less than market rent on one or more long term lease(s) to a highly rated tenant, the market value of the leased fee interest would be less than the market value of the unencumbered fee simple interest in the property. In these situations, the market value of the leased fee interest should be used."