Appraisal Institute of Canada
By David Babineau, AACI, P.App, Fellow
The purpose of this article is to provide some clarity in regard to a challenging appraisal problem – the valuation of distressed property, while the intent of the article is to prevent the appraiser from becoming more distressed than the property he or she is asked to value.
Let’s start by trying to clarify what the term ‘distressed property’ means in the context of real estate appraisal. According to the Business Dictionary (businessdictionary.com), a definition of the term ‘distressed property’ is as follows:
Property that is under a foreclosure order or is advertised for sale by its mortgagee. Distressed property usually fetches a price that is much below its market value.
As appraisers, I believe you would agree that the preceding definition provides a concise description of a typical forced sale situation in Canada – or does it?
In Canada, when a borrower defaults, the ‘power of sale’ process is most often employed by lenders. From an appraiser’s perspective, this process differs from a ‘foreclosure’ in two important aspects. First, ownership of the property does not change hands until the property is sold in a power of sale proceeding, whereas the lender becomes the owner of the property as a result of foreclosure. Second, any extra money from the sale of the property goes to the homeowner in a power of sale situation, while the lender has the right to keep any extra money (proceeds in excess of the unpaid loan, arrears and expenses) in a foreclosure action. The distinction between the power of sale process and a foreclosure may have some important liability implications for appraisers, but more about that later.
Going back to the definition of ‘distressed property,’ there is one important point that should stand out to every appraiser reading this article, “Distressed property usually fetches a price that is much below its market value [emphasis added].” If this definition is accurate, then the appraisal of a distressed property calls for a valuation that is different from market value and it is critical that a reader of the report understand that this is the case.
According to 2014 edition of the Canadian Uniform Standards of Professional Appraisal Practice (CUSPAP), an acceptable definition of ‘market value’ is as follows:
The most probable price, as of a specified date, in cash, or in terms equivalent to cash, or in other precisely revealed terms, for which the specified property rights should sell after reasonable exposure in a competitive market under all conditions requisite to a fair sale, with the buyer and seller each acting prudently, knowledgeably, and for self-interest, and assuming that neither is under undue duress.
As most of us are aware, this definition may be expanded by adding the following:
Implicit in this definition are the consummation of a sale as of the specified date and the passing of title from seller to buyer under conditions whereby:
Therefore, if the appraisal of a distressed property is to provide an estimate of value that is less than ‘market value,’ what terms and/or conditions have been altered or are omitted from the preceding expanded definition?
Perhaps the following definitions from The Dictionary of Real Estate Appraisal (Fourth Edition) may provide some answers to this question:
The price paid in a forced sale or purchase, i.e., a sale in which a reasonable time was not allowed [emphasis added] to find a purchaser or the purchaser was forced to buy.
A sale involving a seller acting under duress [emphasis added].
Although the preceding definitions were written in the context of the foreclosure process, they still provide some valuable clues as to how the valuation of a distressed property in a power of sale proceeding may differ from an appraisal where the sole purpose is to estimate market value.
Referring again to the definition of market value contained in the 2014 version of CUSPAP, we find that some of the conditions that expand the definition may not be met. Due to the fact that the seller may be acting under compulsion or duress, they may not be ‘typically motivated’ in a power of sale proceeding. Also, a reasonable time may not be allowed for exposure in the open market.
So, what do you do when you receive a call from a lender or their representative asking you to prepare an appraisal of a property in forced sale circumstances? What do you do if the lender or their representative requests you to estimate a value based on a 30- 45-day sale period, when the typical exposure period in the marketplace is 180 days?
The recommended first step would be to refer to the relevant edition of CUSPAP. The 2014 edition of CUSPAP can be found at: https://www.aicanada.ca/canadian-uniform-standards/
In the current version of CUSPAP, you will find a definition of value (Definition 2.63), which contains the following note:
Value expresses an economic concept. As such, it is never a fact, but always an opinion of the worth of a property at a given time in accordance with a specific definition of value. In appraisal practice, value must always be qualified, e.g., market value… liquidation value, investment value, rental value, or other.
Remember that the definitions are considered to be an integral part of CUSPAP; as such an appraiser must provide a specific definition of the value that is being estimated. Therefore, if you are asked to prepare an appraisal of a property with the purpose of estimating a value other than market value, you must include a relevant definition of the value you are estimating.
So, hopefully you now understand how the power of sale process may impact the standard definition of market value and that it is incumbent upon you to provide an alternative definition of value in an appraisal where you are estimating a value other than market value. But what are some best practices to employ when you are asked to provide a ‘forced sale value?’
This last point leads us back to how appraisals prepared in a power of sale proceeding may have some important liability implications for appraisers. Remember that, in a power of sale situation, the owner of the property is entitled to any extra money from the sale. Therefore, an appraiser is advised to use caution and carefully explain what value he or she is estimating in the appraisal and how that value may differ from market value. Although you may have been engaged by the lender or their representative and have clearly identified them as the only intended user, it may not prevent the owner of the property attempting to sue an appraiser for any ‘shortfall’ between market value and the amount received as a result of the power of sale proceedings. However, if you follow the suggested best practices, it should mitigate this risk to an acceptable level.
For further information, you are encouraged to read a Professional Excellence Bulletin entitled ‘Appraisal for Foreclosure Purposes,’ which can be found under the Professional Liability Insurance tab at www.aicanada.ca
While the methodology you employ in an assignment where the purpose of the appraisal it is to estimate ‘forced sale value’ may vary due to the availability of data and other local market conditions, the following course of action provides a suggested roadmap that a reasonable appraiser might follow:
In summary, the appraisal of distressed properties does present appraisal challenges. However, there is demand for this type of work in the marketplace and it can be rewarding. If appraisers follow the suggested best practices and employ relevant methodology, they should be able to complete assignments where the purpose of the appraisal is to estimate value in a forced sale situation with greater confidence and limited risk. In turn, this should minimize the challenges and maximize the rewards.
The Appraisal of Real Estate, Third Canadian Edition, Canadian Property Valuation. Winnipeg: 2010. Vol. 54, Issue 4: p.2.2