As with the millions who subtract pounds and add inches to their dating site profiles, it’s very tempting to push values.
By John E. McNellis, Principal at McNellis Partners, for The Registry:
If you’re in real estate, if you’re developing or simply investing in property, you’re in the business of borrowing money. And if you’re a serial borrower, you have a chore to do every January: You must prepare your personal financial statement for your bankers.
Unlike the reporting requirements for public companies, financial statements for individuals are simple (at least in concept): a balance sheet that lists all liabilities and assets, deducts the one from the other, thereby producing a statement of net worth.
Broadly stated, real estate liabilities are as objective as your body temperature; reporting them is easy, a matter of faithfully recording numbers. If you list the year-end balances on all of your commercial and private loans, credit cards, taxes due, etc., you’re home-free. Besides, you might as well be accurate and complete; loan balances are easy to verify by curious credit departments.
Assets are another story. Valuing property is more subjective than judging a cake-baking contest. Think about it: Appraisers use three different approaches to evaluate a commercial property—replacement cost, income capitalization and comparable sales. While less voodoo than, say, oh, psychology or economics, appraising is still as much art as science.
Frank appraisers will admit their methodologies are worm-holed with judgment calls. And since they’re working for the lenders, these dispassionate professionals have zero interest in over-valuing your buildings. While they usually come up with a value that won’t kill the deal, they seldom give you a penny more than you need.
Properly viewed, there’s a distinct upside to this. If you use your lender’s appraised value for your assets, neither your judgment nor honesty is likely to be questioned. In short, that third party appraisal provides a safe harbor for your valuations.
It may not be unfair to posit that every investor in America is hell-bent on growing her net worth every year and that the easiest way to do this is to goose her numbers a little bit (as opposed to developing a successful new project). As with the millions who subtract pounds and add inches to their dating site profiles, it’s very tempting to push values. While choosing a property value that can only be achieved — like a summiting of Everest — at a brief moment in time may not be outright fraud, it’s still kinda dumb.
Why? Your bankers are smart. If they think you’re bullshitting them on simple reporting requirements, how much are they going to trust you when it hits the fan?
What do we do with our financial statements? We carry our properties at the bank-appraised values until long after the original appraisals have become meaningless. And when we do eventually abandon outdated appraisals, we value our properties based on a capitalization rate worse (about 100-125 basis points) than the market rate; that is, we under-value our properties. (My long-time partner Mike Powers gets all the credit for this approach.)
This fiscal conservatism has a couple obvious benefits and one obscure one that hopefully you’ll never enjoy. First, nothing makes a banker feel cozier than a low-ball valuation. Second, when the next recession arrives, you won’t have to whack your net worth by 10 to 20 percent, because you’ve already baked that nasty dip into your numbers.
Finally, if there’s the slightest chance you might divorce someday, consider this: If you plant your financial statement atop Mt. Everest, your spouse’s divorce lawyer will wave that statement in court and demand half. When you say whoa—the market crashed, the recession hit—that $25 million net worth you posted a couple years ago is now a mere $10 million, your hurting spouse won’t believe a word and the already ugly process will only get worse. You will be faced with answering that age-old legal question, “Were you lying then or are you lying now?” This has happened to two of my friends.
Let’s put this suggestion into perspective. I asked a friend whose net worth starts with a “b” how he values his buildings on his financial statement. He said he lists his properties at their depreciated book value, regardless of their current market value. This approach means that if he bought an office building thirty years ago for, say, $1 million, he reports it today on his financial statement at $500,000 to account for his depreciation…even though the building’s fair market value may be $20 million. This is the financial statement equivalent of Jeff Bezos flying stand-by on Jet Blue.
While marveling over this approach’s jaw-dropping conservatism, I pointed out that he could never figure out his net worth from such a statement. He replied, “If you know how rich you are, you’re not that rich.” By John E. McNellis, for The Registry.
The fatal flaw of meal-delivery unicorns. Read… Meals on Broken Wheels: Uber Eats, GrubHub, DoorDash & Postmates
Enjoy reading WOLF STREET and want to support it? You can donate. I appreciate it immensely. Click on the beer and iced-tea mug to find out how:
Would you like to be notified via email when WOLF STREET publishes a new article? Sign up here.
In a business that is dependent on credit , does it make sense to limit your borrowing power by underestimating your assets?
The implications of this article,I.E. that real estate developers are financially conservative is ridiculous.
Re-read the article before making silly statements like this. What the article says is that when you borrow money for a project, it’s the BANK’s appraisers that value the project, and they do it on their terms, not your terms. After you owned the property for a while, and it’s funded and everything, it’s up to you to value the property on an annual basis for your own balance sheet (unless you want to refinance the property). That’s what this article was about, and where valuing a property conservatively comes in.
The article stated the obvious fact that appraisal is an art. There is nothing to prevent a developer from going to another bank if he thinks that his properties are appraised too low. I would argue that few developers would accept the so called “ conservative valuation” except in times of economic distress.
The part about minimizing asset values in divorce bothers me a great deal. Although probably not illegal , it implies deception in regard to any divorce settlement.
The fact that this article is about private real estate makes it irrelevant to almost all of your readers. Public real estate developers want to maximize their stock value and they do so not by conservative valuations but often by NON-GAAP accounting rules
If the developer who wrote this article sold his company, does anyone really think that he will sell for anywhere near “conservative valuations”
The fact that this article is about private real estate makes it Relevant, not irrelevant, to most of [this blog’s] readers.
Like the stock market, in real estate there’s speculation, and there’s investing. People tend to get the two mixed up, but the thrust of the article is based on investing, particularly long-term investing by readers who own property other than their primary residence. The author may otherwise have interest in development and speculation, but this particular article is addressed to conservative private investors.
Highly leveraged public company developers hoping to inflate the value of their stock are not the primary or majority audience of this blog or this article.
During a divorce your spouse can have the property reappraised. So that logic doesn’t work.
Yes, of course, SOP. But those are third-party appraisals — likely his-and-hers dueling third-party appraisals — and not the value derived at in a moment of RE braggadocio. I think that was the gist here, in terms of the divorce paragraph.
I think the point that RC may have been making (awkwardly) is that a *lot* of real estate financiers (but not the author of the post) make their fortunes by pyramiding debt based on very aggressive upward revaluations of existing building collateral, so they can get the next greater loan, and do it over and over again.
That is one part of how we get real estate bubbles.
The author is absolutely right about valuation (collateral or otherwise) being a very imprecise art – where we part company may be in our appraisal (so to speak) about the RE industry’s average disposition towards overly aggressive valuations.
And…a not inconsequential number of lenders (at least historically) tend to turn a blind eye – even though their loans make up 60 to 70 pct if the project costs (developer sourced equity making up the rest).
Why do banks go along with aggressive upward revaluations?
The small reason – lending fees.
The big reason…they are only in the *second* loss position – if the pjt goes BK and is sold at a loss in foreclosure, the developer equity losses everything before the bank loses a penny.
So, aggressive loan to own type banks sorta love delusionally optimistic developers pyramiding loans on aggressive upward revaluations of existing collateral (within reason) – when the whole thing unravels (after helping to create a bubble) the banks own the collateral and don’t have a lost a penny (unless price fall is greater than the entirety of developer equity – which, historically at least, was rare).
CRE is actually just a simplified version of securitization (historically at least) – 2 risk tranches instead of 5+.
The specifics of any deal are of course much more complicated – but the essential logic of “waterfall” loss progression (equity eats it first – in its entirety) holds.
This is why banks are around a lot longer than developers…
In this or another post, you may want to talk about first vs. second (or subsequent) loss positions in leveraged investments (I discuss them below to little notice…).
The fact that co-investors/co-creditors may not have equivalent risk of loss is absolutely key in this age of vastly increased debt/securitized investments.
I don’t think most civilians understand/appreciate how tranching alters the risk/reward equation for what would appear to be co-creditors and how the segmented marketing to creditors with different return goals/risk tolerances has allowed debtors to significantly expand their borrowing.
Tranching maybe goes back 30 to 35 years – but has only really gone bonkers in the last 20 – with the rapid inclusion of trade receivables (auto loans, etc).
I don’t think the topic and its impact has been discussed in public enough for it to sink in.
You might be able to change that.
I think I discussed this topic many times when discussing MBS, CMBS, CLOs, and the like … that there are tranches that take the first loss, and that, if losses don’t exceed a certain level, the top tranches remain unscathed. Hence the range of credit ratings from triple-A through C among the tranches of a CLO that is backed by junk-rated loans.
But true, I have not written an entire article on it. It was more like a one-paragraph explanation in the broader context of CLOs or CMBS.
I think he meant he was conservatively valuating his “assets” so that he could not or wouldn’t get overleveraged in his borrowings.
Think about the Asian crisis. You read stories about Thai business people selling their Rolexes for almost nothing. You don’t want to be in that position.
Peasants who think that a Rolex makes them something, well……
One of the wealthiest men in Europe just wears one those crappy plastic watches and laughs at ‘status’ symbols.
If you know how rich you are, you’re not that rich.
I just keep cash flowing these puppies and don’t pay much attention to ‘values’
since value will change tomorrow
you make your money on BUY – then cash flow crap out of it
Who is the better business writer, John McNellis or Wolf Richter? I will defer this matter for now. I still can’t decide Ginger or Mary Ann…
When I took my accounting courses back in the day, that is how they taught it.
“This approach means that if he bought an office building thirty years ago for, say, $1 million, he reports it today on his financial statement at $500,000 to account for his depreciation…even though the building’s fair market value may be $20 million.”
You evidently skipped the part on depreciation recapture and the associated tax.
That only happens if/when you sell.
And plenty of ways to offset.
Real estate appreciates because the value of land appreciates. If it’s worth $20M, then why would you not account for $19.5M of the land’s value on the balance sheet?
Because accounting is based on verifiable and autible facts and inputs. Like inventory, accounts receivable, interest owed on debts, etc.
Like the last time the land/building was purchased or sold would, by definition, be its market value.
Accountants are not real estate speculators deciding on the value of something based on non facts. On a yearly basis.
Book vs market value.
Now, the business could get an expensive appraisal done every year. But, why would they? Just added cost for no reason. And if an average business needs an up to market value of their office building to make the books look good, there is much more going wrong.
And yes, I have worked in businesses that have buildings and land purchased 50 years ago. And it can get skewed.
But imagine it the other way.
Note: I am not an accountant.
I agree with the sentiment. However, for a business there is a chain of people who handle the numbers and their bonuses and promotions depends on improvement in those numbers. They dont care about your bankers, or the irs or the sec as long as what they are doing isnt criminal or timely consequences otherwise. Unless we start rewarding people for honest work, this idea will remain just that a sentiment.
Valuing property conservatively is an investing norm but everybody knows that isn’t the real value, especially divorce lawyers. The better story is about quick and easy ways to evaluate the market value of a given property when prospecting. These methods are what separate real investors from the rest of us.
If you know an area well, especially the taxing structure, you can calculate an on the fly value. This is what you need to know to decide how correctly the property is valued for sale, and whether you keep looking or make an offer. The tax valuation may not work in every area but local investors know what to look for where they invest.
My personal opinion is you can’t go wrong being close to Neiman Marcus or Saks.
Smack yourself on the head and stay away from investing in real estate.
A clearly-written and practical article.
That’s why I measure net worth in cash only.
cash only would be OK if only for worth going to the woods asap,,, and, in that case, only if the cash is in silver, gold, platinum, etc… though IMHO bullets would likely be worth more than precious metals at the ‘time in point’ when the most likely ”serious interrupter” AKA sun surge, etc., again IMO the most likely global interrupter does actually occur.
although, in fact, I AM a big fan of Iamafar most of the time, just slightly less a fan of him or her behind Wolf,, in this case, he or she failed to provide enough information.
Ok that’s fair. Unless your belongings are extremely liquid, it’s hard to tell what you’re really really worth. Chances are you have to rely on some (maybe sleazy) appraiser. Stocks and bonds needed for liquidity can be valued a lot less after sales. Even gold, silver, bitcoin have to be sold and converted to cash before you can use it to settle or pay most debt.
My family is going through two probates at the same time now. There are lots of prime commercial properties with no debt involved. How do you think the judge will partition this? My bet is liquidation by selling into cash, then distributing the proceeds net of tax and probate fees.
I am partial to cash not because today’s interest is high. In fact they’re too low. I just think that cash is the ultimate form of payment and distribution. Makes dying a little easier for the inheritors. I am not joking here. I was seriously ill but miraculously survived without paralysis. I liquified my belongings, and am already in the process of giving as much as I can to my kids. I’m living proof of staying liquid. Cash is not trash.
I would ask why are you in probate at all with these significant assets?
Long ago this should have been mitigated.
Plus with the proper amounts of life insurance to offset costs/taxes.
The very old ones died without a will. They inherited many commercial lots from their parents. I just happen to be an heir to both of them.
My dad told me I should not count the value of my home as my net worth. He suggested I should only consider my investable assets as net worth.
Ben Franklin wrote, “A house with two chimneys burns more fuel than a house with one.” The more home I keep, the greater will my expenses be.
Franklin also wrote, “Vessels large may venture more, but little boats should keep near shore.”
Understating assets on a bank loan application is not bank fraud.
The county property taxes are based on their assessment of value. In my experience, this is market value.
In BC (Canada), the tax assessment is the first step for sussing out property worth, especially for a private sale. However, it is almost always quite a bit below market value.
Folks that contest their assessment always lose. My brother did this once. He has a nice house on 5 acres of oceanfront. He contested his assessment a few years ago and the Regional District (think county but bigger) came around, left his valuation alone, and raised the value of everyone else’s property in his neighbourhood. Ouch.
I have always been a firm believer in undervaluing assets, not because I am or am not borrowing money for investments, but because I never ever want to start buying into the borrowing/pyramid game. What I have I own, and as such, there is no way I will ever lose it.
I would never be able to talk my wife into borrowing money, anyway. Win win.
Good article. Very interesting comments.
Thanks to California’s old Proposition 13 (Jarvis-Gann), the assessed value of my home significantly lags its market value.
Great article. A few comments:
1. Your goal as a borrower is essentially to find a dumb banker. Dumb bankers will consider your “net worth” when making a loan. Sad but true, especially as one is starting out
2. A halfway intelligent banker will back into your annual net income and divide it by your net worth to gauge the cap rate/roi/yield. Sadly. Most bankers are too stupid to do this
3. Although one can obfiscate and make this hard to do with k-1’s, non income producing assets etc. a reasonable banker can still use rule #2
4. The Billionaire using their depreciated book value is ALREADY a billionaire! Whether they get a smart or dumb banker is irrelevant. They will get the money. Their net free cashflow is going to be at least 30Million per year.
Assuming you are managing pension money, your job and GOAL is to BS and fluff the “Independent” appraisal. Check out CIM group with CALPERS values or VISTA EQUITY portfolio company valuations moving by 100M+ in less than a few months. These guys are playing the same game as the private RE guy bs’ing his values.
Sadly, Calpers AND the local property tax authority are more than happy with the fraud. Why? Everyone gets paid amd the pensioners et. Al continue living in lala land
At the end of the day, all that matters is real, unadjusted, legitimate GAAP earnings. There are real, legitimate players out there- but many others -MANY- That are fluffing values based on “adjusted” earnings etc. In fact, it seems there are more bs schemers than the latter
Andrew’s comment really brought back memories when I was mortgage shopping 30 years ago.
The Credit Union loans manager quickly moved beyond my pay stubs and bank accounts and started asking about our vehicles, toys, etc. I started to laugh because we drove crap. I asked if she was kidding?
They were trying to up our borrowing amount and all I wanted to use was my net pay and use the 1/3 rule. No wonder debt is king, and some kings have the most debt.
Back in the Eighties, I was a Realtor in CT. Real estate was in a huge bubble, much like today. In early 1988, house prices began to drop, starting in the Greenwich area, the same area where the boom started. Days on market (DOM) was 18, and it started growing. Sales dropped off, and I explored other ways to make a living. I took the two State of CT appraiser courses. That didn’t help. Appraisers were being laid off, not hired. Prices plunged to about half of peak values. CT is not a financial backwater nor was it dependent on one employer. It was a total fire sale. After it hit bottom, it took ten years to return to 1988 peak values. Ten years. Reversion to the mean is a MF.
I have been wondering about all of the realtors in the bay area. I haven’t been in the market long enough to understand the trend but it feels like there are awfully few sales going around at the moment. How are realtors surviving if the pie is shrinking?
Psychology isn’t magic. I am a practicing licensed social worker. I attended school for a long time and have a decade of practice to do what I do well. The fact that the author doesn’t understand my field doesn’t make it magic. He may be right about real estate. I don’t know, that is his field, but his random remark about psychology is dead wrong and frankly frustratingly unoriginal.
I didn’t notice it on first read but yeah, he didn’t need to go there to make that point.
Don’t take it badly, our whole financial system is built on perception of values. This would make you the expert. We believe, therefore it is so, until reality intervenes.
I’m very interested in how a developer is investing in the age of dead and zombie malls. Is your business immune because of where you invest? Have you shifted to another RE segment/area? How do you value CRE in an environment where millions of square feet are not earning a cent?
There are many videos online of endless empty commercial centers, especially in CA. They show the evidence but never dig deeper to show whose money is carrying the load. I think there’s a lot of investor money buried in these places but nobody ever goes into detail. Do you dare?
John’s retail properties are mostly strip malls, rather than mega malls. If you put a grocery store in a strip mall, plus a Starbucks, a sandwich place or two, a nail salon, a cleaners, etc. they might do pretty well.
There are still millions of square feet of dead strip malls all over CA. They are all being supported by some entity. Most of the videos never touch on the topic of how these dead strip malls affect nearby residential RE as well. A bunch of dead strip malls in an upscale town is detrimental to homes, but this is never discussed.
Actually — and this is a bit of behind the scenes info — John and I have a long-drawn-out disagreement on the brick-and-mortar retail meltdown. You know my position on it. He thinks it’s overblown.
We don’t disagree on much, as far as I can tell, but that’s one place where we disagree.
But I do agree with him that grocery stores and service locations (hair salons, nail salons, cafes and restaurants, cleaners, etc.) can keep a well-placed strip mall in decent shape.
But there are other strip malls that have turned into zombies, as you pointed out.
There is a little mall down the street here with a Safeway in it, and a Walgreens, a cleaners, a Chinese restaurant, a 24-hour fitness, etc. It has a few smaller vacant spaces, including one that had long been a bank branch and is now closed. But they’re working on the inside, redoing it. So maybe they found a tenant. But that mall has quite a bit of traffic and seems to be doing OK.
Who is paying for the taxes on all the vacant properties? Who can afford the luxury of paying exorbitant taxes, fees and insurance of vacant properties? Banks? Someone is holding a bag of CRE I believe.
To more directly reply to your topic: Vacant stores (not in malls but along streets, including neighborhood streets) in San Francisco have become such a problem that the City has imposed fees on landlords that keep stores vacant. The City has been under pressure from neighborhoods to do something about that.
All this article points out is the absurdity of the US tax system.
The “depreciation” noted is how tax payments are reduced; the absurdity is that the building itself has reduced in value.
This is highlighted when the building is sold – the “losses” are suddenly disappeared even if the purchase valuation has not changed.
Secondly, whether deliberately or not, the use of old appraisals inflates the cap rate of the property in question. Even undervaluing market cap rates by 10% or 20% might not offset this, particularly if underlying valuations have increased significantly. In particular, this discrepancy expresses itself as rents.
For example: let’s take a $1M building with 5% cap rate and 5% per year appreciation (Zillow says home prices increased 4.8% annually since 2012).
Starting rent is $50K a year. In 10 years, assuming rents keep pace with property valuation, rents become $81.4K per year
Property value becomes $1.63M, but the property is carried at $354K (9.8% per year depreciation).
Cap rate at the original value is now 8.14% – but utterly false.
Cap rate at the depreciated value is 23%
The ownership has taken $646K in tax offsets to income – that’s at least $200K in cash savings at the nominal 35% tax rate.
Total collected rent over this time would be a shade under $630K – even subtracting 1% of building actual valuation for maintenance costs (which are also deductible), net cash flow would be $500K plus the $200K tax deduction plus $550K in underlying appreciation.
The most important thing I have learned in my RE investment career in regards to seeking advice is ask this question first?
Did your father gift you your properties? There are completely different strategies in whether or not you are part of the lucky sperm club or if you actually have to go out and make your own money. Wealth preservation by people with no debt should not be giving advice to people that need to strategically leverage to grow net worth.