Are your appraisals able to withstand the probe of audits, credit and risk management reviews, or litigation? To find the answer, ask the following questions: Do the appraisals adequately convey the methods used, data analyzed and value appraised? Does the scope of work statement support the intended use of the appraisal? Is the proper premise of value employed? Is the definition of value appropriate for the intended use of the appraisal?
Appraisals should conform to the Universal Standards of Professional Appraisal Practice (USPAP) and the Standards and Code of Ethics of the American Society of Appraisers (ASA). These define the minimum standards and tasks an appraiser must perform to properly complete an appraisal, which includes specifying the name of client, date of appraisal, effective date of appraisal, scope of work, intended use, derivation of definitions, extraordinary assumptions, limiting conditions, equipment description, the three approaches to value, intended user(s), intended reader(s) and a signed certification page. Following these standards provides validity to the structure of the appraisal.
In many valuation disputes, opposing council attempts to discredit the lessor’s appraiser and/or appraisal on the basis of appraisal date or the qualifications of the appraiser. Strictly following USPAP and ASA Standards and Code of Ethics helps establish the credibility required in court or an arbitration case. Additionally, auditors typically review methods used and specific data analyzed. A properly documented appraisal, with references and examples of data used and considered, is more likely to pass muster with government regulators and financial auditors.
Most leasing companies’ bottom lines depend on residual value realization. How good are your appraisers at forecasting residual values? Do they have the necessary training and experience? Do they understand the equipment market in which they are forecasting? Do they understand the implications of build rates and technology, which can impact future values? And finally, are they aware of pending regulations that may threaten residual value for certain equipment types?
Previous on-the-job experience is critical to accurate residual value forecasting. For example, I received training in residual value forecasting from Robert G. Clark, former president of Pepsico Leasing, and chairman and CEO of International Capital Equipment (ICE). The training was rigorous and used real life situations. Since ICE was a residual value guarantor, missed residuals could seriously affect company financials. Since the residual value guarantees issued by the company were in the form of “puts,” we spent considerable time analyzing equipment and market, and developing trade data covering many years of a given market segment.
A thorough education reveals that residual value can be affected by a myriad of variables including currency exchange rates, maintenance, utilization, regulations, health of the domestic and global economy, location of the equipment, changes in technology over time and overall population of the asset type and model.
To adequately understand the nuances of residual value analysis, membership in trade associations is highly desirable and recommended as associations provide residual value forecasters and appraisers with inside information that can affect a given industry and specific types of equipment. Consider the impact of noise regulations on aircraft values, clean engine technology on truck and construction equipment values, clean air regulation on the electric power generating industry and changes in trailer and container length standards or railcar capacities.
Regulatory changes that affect residual values are usually publicized years in advance. That’s why equipment lessees attempt to push this risk on the lessor, which is fine if the lessor understands the impact of impending regulatory changes.
Avoid Leasing Rookies
Most errors in residual valuation are caused by low fee or free leasing rookies who do not adequately understand the leasing concept and the nuanced effects that an equipment lease can have on value, including maintenance and return provisions. Other common errors include ignorance of the industry using the equipment and overlooking pending regulatory changes or technological advances, which leaves over- or under-stated future values.
Some audits have uncovered the disturbing three call method, in which three individuals provide free and off-the-cuff opinions of residual value for a certain model of equipment based on minimal information. This violates the appraisal code of ethics. While some guesses are reasonable, many are not. In one audit, I discovered a seven-year-old high-speed letter inserter with a residual value appraised over 35%. Nothing could have been further from the truth! The audit revealed the estimate was provided by an oil field specialist.
Engage someone who is familiar with the asset, the market, and equipment leasing and related documentation. This could have a major impact on value.
Ensure USPAP Compliance
One of the major issues to consider is the importance of USPAP compliant work. Currently, regulated financial institutions and government-funded banks are required to use USPAP compliant appraisals. Auditors and inspectors are noting the use or nonuse of USPAP compliant valuations and appraisals in bank fundings and leased equipment residual value positions. Some auditors view attempts to avoid using USPAP compliant appraisals as acts of omission or commission. Both have negative connotations. Insist upon USPAP compliant appraisals, which should be able to withstand audits as well as legal and credit reviews.
Demand Historic Data
There are three approaches to value: market, cost and income approaches. When using the market approach it’s important to ask your appraiser, “What is the basis of your value?” Hopefully, the answer is more than an opinion or past experience. Quality appraisals are based on, and display, important data that is considered, used and analyzed as part of the appraisal process. This focus gives the client some understanding of the value being appraised, and third parties can observe the value levels at which certain types of equipment sell. For example, does comparable equipment usually sell for $1 million or $500,000? This helps to establish a credible appraisal — the more data, the better.
The cost approach is based on depreciated replacement cost new. The appraiser must explain the source of replacement cost new, how economic useful life was determined, how technological obsolescence was factored in, and finally, how adjustments were made for economic obsolescence. Inutility may come into play here, which occurs when an asset’s productive capacity is lesser or greater than the facility in which it works.
Finally, the income approach to value can be highly advantageous, especially for end-of-lease contests in which two to three appraisers are employed to set the purchase option price for a leased asset. In one recent case, the income approach recognized an additional 50% of value for a process line versus using the cost approach alone. Truthfully, many appraisers do not perform the income approach to value because they cannot correctly employ it, and it cannot be used in some instances. When it can be used, appraisers should properly value the asset based on the discounted cash flow method.
Understand Appraisal Types
As consumers of equipment valuations and appraisals, equipment finance companies and banks must understand the type of appraisal they need. An appraiser can often set a scope of work based on the intended use of the appraisal.
Should the appraisal be performed to determine replacement cost new, fair market value, orderly liquidation value or forced liquidation value? Should the value premise be in place or in exchange? The value must fit the intended use. Replacement cost new appraisals are appropriate for insurance purposes. However, ad valorem, financing, residual valuation, bankruptcy and various forms of litigation require fair market value, orderly liquidation value or forced liquidation value. Each intended use of an appraisal has an associated type of value, and the appraiser must be able to determine and guide the client to the correct type of value for the purpose at hand.
Consider Exit Strategies
Equity funds, large lessors and other companies will sometimes ask for net orderly liquidation value or net auction value. In these cases, an appraiser must be able to determine the costs of sale, including security, rent, utilities, taxes, management, mechanics, clean-up, equipment prep, shipping, rental equipment, remarketing fees and commissions.
Does your appraiser have the experience for this? Does he or she understand the business enough to estimate variables? This is where appraisers with firsthand exit strategy experience provide real value. Such analyses mitigate major surprises to the lien holder, and may also be applied in bankruptcy work.
Clients must evaluate the qualifications of each appraiser considered for an engagement. First, verify professional accreditations from major appraisal organizations, such as the ASA and the Royal Institution of Chartered Surveyors (RICS). Can the appraiser demonstrate reaccreditations at regular intervals? Ask for a copy of the appraiser’s current USPAP certificate. Sometimes USPAP certificates are issued by other major appraisal societies such as the Appraisal Institute and registered with the state.
Finally, does the appraiser have a proper educational background? Does he or she have an engineering, science or economics degree? While a science or economics degree is not required to perform the appraisal, it may indicate the candidate’s ability to thoroughly understand and apply the work at hand.
A simple search can reveal whether the appraiser is engaged in the industry and employed by a member company of a relevant trade association. Is he or she a member of the trade associations? If so, is he or she a mining trade association member who is attempting to appraise business jets?
How many years of experience does the appraiser have? Does the appraiser appear knowledgeable? Can he or she speak and write well? Some appraisers with 10 years of experience have the equivalent of one year’s experience because their work lacks depth or variety. Others seem to have more experience than their years in the industry would imply.
Leasing companies and banks can take many steps to improve the validity of their appraisals. Scrutinizing the appraiser’s qualifications and methods can help avoid common valuation mistakes, maximize residual values and ensure appraisals withstand audits, reviews and potential litigation.