With the unprecedented, rapid rise in interest rates, financial institutions must grapple with the growing impact on commercial real estate appraisals. The approach an appraiser uses to determine capitalization (cap) rates of non-owner-occupied properties can create artificially low cap rates based on what existed a year or two ago. Loan officers, appraisal reviewers, management at financial institutions and borrowers or investors need to understand how an appraiser arrives at a cap rate calculation because of the potentially significant impact on value, lending terms and an investor’s rate of return.
Rapid Rise in Interest Rates Shape Cap Rate Calculations
In a low-interest-rate environment, cap rates tend to be lower as investors can get the same returns despite paying higher prices than when in a higher interest rate environment. However, as interest rates rise, investors become more risk-averse and demand higher returns, leading to an increase in cap rates.
Due to rising interest rates, certain methods appraisers use to determine a property’s value may artificially lower the calculated cap rate. If an appraiser uses, or heavily weights, market extraction, also known as sales comps, to determine the value, it can completely ignore the current environment of high interest rates and instead use figures from a much lower interest rate period. The challenge for appraisers is reconciling these higher cap rates with their comparisons from a year or two ago. This discrepancy in cap rates can lead to differences in property valuations and potentially impact loan underwriting.
Financial institutions must develop strategies to review appraisals that use lower-than-market interest rates, stretched amortization terms or rely on comparable sales from periods when interest rates were lower when determining the cap rate. Personnel who perform in-house evaluations, particularly for larger loans at renewal, must also be aware of the appropriate assumptions and techniques when determining whether an existing appraisal is still valid.
Cap Rate Calculation Scenario
Consider the following scenario: a retail property produces a net operating income (NOI) of $100,000. Just a year and a half ago, the appraiser assumed your financial institution would want a 1.20x debt service coverage (DSC) ratio at an interest rate of 4% on a 25-year amortization, with an 80% LTV. The cap rate would be 6.1% using a direct capitalization, lender’s yield approach, the property valued at $1.645 million and the loan would be $1.316 million with excess collateral of $329,000. Fast forward to the present and substitute an interest rate of 8.5% and an amortization period of 20 years, with all else equal. The cap rate would be 10%, the property valued at $1 million and the loan would be $800,000.
Now assume that a borrower came in with a contract to purchase the property for $1.645 million. Your financial institution ordered an appraisal, but the appraiser ignored the change in interest rates, the tightened amortization terms and used comps from a year and a half to two years ago to determine the cap rate remained at 6.1%. Your institution makes a $1.316 million loan, believing they are at an 80% LTV when they are looking at the potential loss of $316,000 the day the loan is made.
At some point in this scenario, there needed to be a tough but necessary conversation with the investor or borrower regarding the current reality surrounding increased interest rates and decreased risk tolerance. The appraiser likely felt pressure to justify the current contract as reflective of the market, which can easily be accomplished with comps from a year and a half ago. This combination has the potential to lead to future charge-offs for the institution and losses for the investor.
Next Steps to Address Cap Rate Discrepancies
To navigate these challenges, financial institutions need to stay informed about current market conditions and adjust underwriting standards accordingly. This may include reassessing risk models, considering different approaches to determining cap rates and conducting thorough due diligence on property valuations.
Communication between appraisers and appraisal reviewers helps ensure accurate and reliable property valuations. Appraisal reviewers should provide feedback and guidance to appraisers based on market conditions. In some cases, a reviewer might not know pertinent information, such as DSC ratios, that loan officers or loan decision-makers have access to. Communicating key underwriting metrics to the reviewer is important as finding a disconnect between the stated value of a commercial real estate property and acceptable DSC ratios may be a factor the reviewer can use to question the calculated cap rate.
Your institution may also benefit from leveraging technology and data analytics tools to enhance your understanding of market trends and property valuations, such as Microsoft Fabric, which includes Power BI. Fabric offers additional data tools as an all-in-one analytics solution for in-house use. Working with an experienced managed services provider can help you design and connect dashboards to sources of raw data, such as comparable sales, rental income, vacancy rates and other factors that influence cap rates. Alternatively, you could engage commercial real estate research platforms such as CoStar or risk management services like RMA.
The Anders Banking and Financial Institutions team understands the issues facing lenders and what to look for in appraisals when conducting loan reviews. Learn more about how we can help your institution, and the associated costs, by requesting a meeting with an advisor below.
