| ‘Hocus-Pocus’ #1 | |
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By Tim Connor |
2/17/2003 |
Part 1
A 9-month Camas investigation reveals how dubious appraisals allowed the Cowles family to reap at least $25 million in excess profits in the RPS garage transaction.
A 9-month Camas investigation reveals how dubious appraisals allowed the Cowles family to reap at least $25 million in excess profits in the RPS garage transaction.
How The City Bought the Cowles Garage
NEW EVIDENCE REVEALS how appraisal abuses in the River Park Square garage transaction helped create tens of millions of dollars in hidden public subsidies for Cowles real estate companies.
"All right. Maybe I'm not making myself very clear," said Cowles attorney Les Weatherhead.
He was in the midst of a lengthy deposition in the River Park Square securities fraud case. It was April 24, 2002, and the witness was Spokane appraiser John Evans.
"Am I correct to understand that if you had read the Walker report and you had been persuaded that it was hocus-pocus, that it was nonsense, am I right in thinking that you would never have produced the [appraisal] report?"
The real estate appraisals for the RPS garage and the Cowles-owned land beneath it are the foundation of the public/private partnership that now mires Spokane in the worst financial and political crisis in the city's history. A nine-month investigation by Camas Magazine senior editor Tim Connor raises new and more serious questions about the propriety of those appraisals.
This three-part series is based on information that has become available since our original report, "Secret Deal," came out two-and-a-half years ago. Subsequently released documents, depositions taken for the RPS securities fraud case, and recent Camas interviews show why Weatherhead's question, and the way Evans answered it, are so important. -Ed.
In the spring of 1995, Dennis Beringer, real estate manager for the city of Spokane, was told to figure out how much an expanded River Park Square garage would be worth to the city. Beringer's superiors wanted to know how much of Spokane's money they should spend on the facility as a way to help Betsy Cowles redevelop her family's downtown shopping center.
From the city's point of view, the purpose of the Cowles mall was to revitalize Spokane's decaying urban core. By all accounts, everyone in city hall was enthusiastic about the public/private partnership.
Because he was worried about downtown's future, Beringer, too, was an enthusiastic supporter of the project. But by this time the city had already decided to do more than buy the garage. In a controversial decision, the city agreed to pledge five years' worth of Spokane's future federal Housing and Urban Development (HUD) block grants to secure a $22.65 million loan to help the Cowleses refurbish their mall. The size of the loan was so large that it took up all of Spokane's existing loan capacity under the HUD Section 108 program.
Now the anchor tenant, Nordstrom, was demanding a renovated garage. So the city stepped up to the plate again. Spokane could sell revenue bonds to finance the transaction. But how much should the city pay the Cowleses for the garage and still have a reasonable expectation that garage revenues, alone, would pay off the bonds?
Beringer considered historic earnings and the planned renovation. He concluded the city could afford to pay the Cowleses $15 million for the garage.
Beringer's number matched what the developer was requesting at the time. In a June 1, 1995 memo recently discovered by Camas, Cowles attorney Duane Swinton sent a proposal to former city bond counsel Roy Koegen. Swinton said that the existing garage and a planned new section could be built "at a total cost of approximately $12 million." A week later, the developer's PR firm, Rockey West, issued a press release announcing it would cost the city $14 million to buy the garage at the new mall.
Then-city councilman Joel Crosby, a commercial realtor with an accounting degree, balked at those numbers. Like other city officials, Crosby supported the development, but he wanted to make sure the garage could pay for itself once the city bought it. "It would probably justify a $12 million investment," Crosby told Camas in 2000, "and that was pushing it to the edge of the envelope."
"What I clearly recall," Beringer said in a recent interview, "was that Joel was constantly calling me, and talking to me, and coming to my office asking me how I got to certain numbers within my estimate."
Beringer met with his predecessor, Jim Simpson, to go over his work.
The $15 million was "probably on the high side," Simpson told Camas in a recent interview. "I thought it would pass the test, but it was generous."
Beringer remembers that, except for Crosby, the city council was "thrilled with the $15 million."
The city's official records validate the accounts of both Beringer and Crosby. Spokane's participation in the River Park Square public/private partnership was launched on June 12, 1995 with the city council's unanimous support. Through revenue bonds authorized by Resolution 95-74, the city would put up a total of $15 million to buy the garage. But this sum had to cover bond issuance costs as well as the purchase price.
Resolution 95-74 would not be the last word, though.
Joel Crosby left office in December 1995. "A month or so later, I saw Orville [Barnes]," Crosby says. Barnes was a member of the council's finance committee and, by all accounts, the council's lead player on RPS because of his experience in commercial real estate and property management. "He said, 'We're up to nineteen, twenty million.' I was stunned. He [Barnes] said, 'We just kind of got to do it to make it work.' "
Why was the city changing its course so drastically?
Developer's Appraiser Advises the City
Thus far, nothing has been found in city documents that explains why the city abandoned the bond limit set forth in Resolution 95-74. The indications that the terms of the transaction were changing, and that the RPS developer was determined to receive more money for the garage, begin to appear in notes and memos in late March of 1996. A pivotal meeting took place on March 21, 1996 at which Barnes, River Park Square project manager Bob Robideaux, and a host of senior city staff members assembled to discuss the new urgency surrounding the project. Dave Mandyke, a city public works director who would rise to the position of assistant city manager during the formation of the RPS project, was one of those present. His notes included the handwritten entry: "15-20M PARKING GARAGE." On the next line, Mandyke wrote, "DEREK ZIMMER PARKING GARAGE APPRAISER."
This reference is to the appraiser hired by the developer. Beringer and former city finance director Pete Fortin say Zimmer worked with Robideaux in pushing city officials to do a new appraisal of the garage using the "investment approach" to value.
By then, March 1996, Beringer knew, "Betsy Cowles was not happy with my number of fifteen million."
Asked how he knew that, he replied: "Bob Robideaux basically said the developer was not going to accept my value, no matter what the council said, no matter what the council voted; the fifteen million dollars was not acceptable."
In a typical real estate transaction of this type, sellers and buyers commission their own appraisals. Ordinarily, these are confidential between appraiser and client and are the foundation for negotiations. If appraisals are shared, as is sometimes the case to advance negotiations, it is as a mutual exchange. That arm's length relationship didn't exist at River Park Square.
In the RPS transaction, the buyer (the city) let the seller (the developer) tell it to perform questionable appraisals that benefited the seller by inflating the purchase price. In a highly irregular move, the prospective buyer then turned its appraisals over to the seller for the seller's review before negotiations were concluded. The seller then used the inflated appraisals to bargain for a higher price, to which the buyer (acting through a non-profit corporation organized by the seller) ultimately agreed.
Beringer had forcefully advocated the "income appraisal" approach - the standard method for appraising the market value of income-generating properties. An "investment appraisal" would be much more speculative and volatile, more akin to trading on commodities futures. Yet this is exactly what Zimmer prescribed, using the city's low interest bond rate as the "discount rate."
City records show that by the end of March 1996, Beringer recommended that Spokane hire two appraisers to independently evaluate the garage. He says he hoped they would help him convince the council that the standard income approach to value was the more appropriate method for the city to use.
In a March 18, 1996 letter to Robideaux, Zimmer laid out the recipe for the investment value appraisal that the developer wanted the city to commission. To address expected ethical questions, Zimmer included excerpts from the authoritative Uniform Standards of Professional Appraisal Practice (USPAP) which seemed to condone the approach he was recommending.
At the heart of the investment value appraisal method is what's called the "discounted cash flow" (DCF) analysis. In the mathematics of the DCF analysis, the "discount rate" functions as an interest rate and is, in fact, primarily based on the interest rate the buyer would usually pay to borrow money. The less a borrower (the property buyer) has to pay in interest, the greater the potential for making a profitable use of the borrowed funds. This is because more money will be left over as profit after the money is paid back. The higher a project's potential for profit, the greater its potential "investment value."
From the standpoint of Zimmer's client, his proposal was a brilliant move - if the city would agree to it. Setting the discount rate based on the city's less expensive money would significantly increase the "investment value" of the garage. The sole beneficiary of this maneuver would be Cowles real estate companies. This was the irony deeply embedded in the RPS deal. It was use of the city's access to cheap money that would cause the appraisers to put a higher value on the garage. The resulting added "value" would be harvested by the seller-the Cowleses-while the city and garage bondholders would bear the additional risks. What Zimmer's idea came down to was that Spokane would have to pay several millions of dollars more for a garage purely as a result of the city's willingness to pay for it with low-interest municipal bond proceeds.
Zimmer's letter to Robideaux was passed on to the city and later to the city's appraisers. Conspicuously absent from Zimmer's USPAP excerpts is the pertinent USPAP caution: "Because DCF analysis is profit-oriented and dependent upon the analysis of uncertain future events, it is vulnerable to misuse."
In the end, the city gave in to the Cowleses and used the investment appraisal they wanted. But how did that happen? How was the city convinced to use an unconventional and controversial appraisal method that went against the advice of its own real estate manager? The answer is sealed behind the closed doors of a Spokane city council executive session.
Former city finance director Fortin remembers a meeting with Robideaux, Zimmer, Beringer, and the city's contract appraisers, "in which Robideaux and Zimmer tried to convince us that the investment method was a valid method to use in this instance. And the appraisers felt that it was just one of many. So we had an executive session with the council in which the various methods were described, as I recall by Dennis [Beringer] and [then-assistant city attorney] Stan Schwartz. And at that point, the council said we should use the investment method." The city's appraisers were so instructed.
In what was apparently a "what's-good-for-Cowles-real-estate-is-good-for-Spokane" kind of moment, Spokane's top decision-makers decided to take the developer's advice about how much to let the developer charge the city for the garage, over the advice of the city's own real estate manager.
According to Beringer, that was the meeting at which Spokane's direction in the RPS development fundamentally changed. "I had been saying turn right, turn right," says Beringer, meaning the city should do a standard income appraisal. "At that meeting the city decided to turn left."
With this fateful turn, Spokane began its grim march through political chaos and litigation caused by the garage's financial collapse. These newly emerging facts surrounding the garage appraisal controversy suggest that city officials made willful decisions to suspend their fiduciary responsibilities to their citizens. The new evidence adds weight to the charge of former Mayor John Talbott and his special counsel for RPS, O. Yale Lewis, that city officials engaged in a civil conspiracy with the developer to divert public money for private purposes.
What the City Told Its Appraisers to Do
Appraisals are opinions of value. The canons of professional appraisal standards are the principles of scrutiny, probity, and disclosure. They dictate the appraiser's evaluation of how assets and liabilities affect a property's worth. The underlying assumption in this process is that clients act in their own best interest. The RPS garage appraisal turned that assumption upside down.
The city's appraisers worked for a client - the prospective buyer - who insisted on subordinating its own interests to those of the seller. Among other things, this resulted in instructions from the city to its appraisers that made it difficult, if not impossible, for them to obey the standards of their profession. Consequently, the City of Spokane's orchestration of the appraisals was part of a larger process. Ultimately, this was a process through which the city endorsed transactions and contracts transferring tens of millions of dollars in cash and lease terms to Cowles real estate companies over and above the sums that could have been supported by appraisals done in strict conformance with contemporary appraisal standards.
(In court documents, the city is now arguing that terms of the garage transaction were the result of either "mutual mistakes" or that the city was duped by its partner, the Cowleses. The facts behind the appraisals, and the appraisal process, don't support either contention.)
The city's two appraisals of the River Park Square garage were conducted simultaneously by John Evans and David Auble (of Auble & Associates), and Daniel Barrett. Evans/Auble and Barrett were given explicit instructions by the city to use the "investment value" method, which included "discounted cash flow" (DCF) analysis.
Two key factors govern DCF analysis: the discount rate and the projected revenue stream used to calculate investment value. The discount rate is the more volatile of the two.
Even though Evans/Auble and Barrett were instructed to use this method, industry standards and ethical guidelines required that they scrupulously examine and make adjustments for any unsubstantiated optimism in revenue projections. Moreover, the DCF method would normally allow the appraisers, working with their client, to add interest points to the discount rate in order to account for the risks they saw. As tables deep in the bowels of Barrett's report indicate, a shift upward of even a single percentage point in the discount rate causes the investment value of the garage to drop by millions of dollars. Thus, if the discount rate used in the city's appraisals had been adjusted to account for the risks the appraisers identified, it could easily have dropped the "investment value" of the garage right back to the same market value Beringer and Crosby had calculated in 1995.
"You and I would not have done this deal, based on the information that was available at the time the appraisals were done."
--Spokane MAI Appraiser Dan Barrett
Under the terms of the appraisal assignment, however, the appraisers had no such discretion. They were told to use a discount rate of 7.75 percent. They were told they could not adjust the rate upward to account for the risks they identified. This 7.75 percent rate was significantly higher than the 6.25 percent Zimmer was advocating. But, as Barrett's report indicated, it was still lower than the 10 percent to 12 percent interest a private investor would have received from a commercial bank at the time-even if a commercial bank would have been willing to make such a risky loan.
In appraiser Barrett's view, the risks to Spokane were so daunting that they likely would have frightened off a typical bank lending officer.
"You and I would not have done this deal based on the information that was available at the time the appraisals were done," Barrett told Camas in a recent interview.
The resulting appraisal reports are layered with paradox. Although ostensibly the city's appraisals were conducted to benefit the city in its negotiations with Betsy Cowles, they heaped benefits upon the developer at the city's expense. DCF analysis is inherently profit-oriented. In their depositions for the securities fraud case, both Dan Barrett and John Evans admit that their "investor" client, the city, was not interested in making a profit on the garage. Instead, the "profits" created by relying on the appraisals would go to Cowles real estate companies. Why would the client be using a profit-oriented appraisal method when it wasn't interested in making a profit? Their reports are completely silent on this question. In depositions and interviews, the appraisers say they don't know.
The other key factor in DCF analysis is projected revenues. The appraisers were ordered to base their assessments on certain assumptions. Here the appraisals run afoul of the letter and spirit of professional appraisal requirements. Particularly glaring was the blind acceptance of the now-discredited revenue projections of Walker Parking Consultants, the acceptance of which led directly to a gross overstatement of the garage's "investment value."
Over the objections of many knowledgeable observers, Walker predicted many more customers would pay higher rates to patronize the garage than historic data supported. Critics like Bob Glatzer, who once managed River Park Square and who later served as a director of the public agency that manages the new garage, warned from the beginning that Walker's projections were unbelievable. Such warnings were ignored. (They turned out to be accurate. Now, Walker's wild errors are a key element in the garage's insolvency.)
The ethical guidelines of the Appraisal Institute and the Appraisal Foundation call for independent scrutiny and evaluation of numbers like the Walker projections. The city's appraisers - who carry the prestigious MAI designation, for Member of the Appraisal Institute - nevertheless agreed to instructions that thwarted their independence and invited distortions of their work. They were clearly uncomfortable with these instructions, but the objections they raised in their reports were surprisingly muted.
Beringer says he was immediately skeptical of the 1996 Walker projections and shared his skepticism with Walker's lead analyst, John Dorsett. Dorsett, Beringer says, assured him of Walker's credentials and the firm's confidence in its numbers. Beringer quickly learned the appraisers shared his own deep concerns about the reliability of the Walker forecasts.
Said Beringer: "I specifically told both appraisers, 'Whatever objections you have, whatever concerns you have, I recommend you put them in your report. Because I have no control over the negotiations [between the city and Cowles representatives]. I have no control over the process of investment value. I have no control over the stipulations given to you. I have no control over the discount rate given to you. Whatever you're unhappy with, you see it as a red flag for you, put it in your report. Just that simple. Do that.' "
Barrett's red flags were planted much more prominently than those of John Evans and David Auble. For example, Barrett underscored the word "not" in pointing out that Walker's report assumed the garage operator "will not participate" in the funding of a parking validation program.
"This may not be a reasonable assumption," he noted, adding later: "The prudent purchaser of this investment would recognize this as added risk and compensate in some manner for the uncertainty."
Barrett also reported that he viewed the Walker income projections from cinema parkers as "optimistic."
"Not many investors would be willing to put money at risk," he noted, "where so little is known about one of the primary sources of investment income."
Even with these red flags, Barrett produced his 90-page report using the Walker numbers. He did, however, take an unusual step. Rather than giving just one investment value number, he provided three. His "best case" number used the unaltered Walker projections. It put the investment value of the garage at $30.8 million. His "worst case" number cut in half the projected income from moviegoers and resulted in an investment value of $22.2 million. (As things turned out, even this number overestimated actual revenues by 75 percent.)
A close reading of Barrett's report shows he put little if any stock in his "best case" number. It was there to represent what the investment value would be if he followed the city's instructions to the letter. But this "best case" $30.8 million is the only number Barrett provided that can justify the $29.8 million Betsy Cowles later insisted she should receive.
The Auble & Associates report provided only one number for the investment value of the garage-$27.6 million.
The way John Evans and David Auble handled the Walker numbers is difficult to reconcile with the USPAP standards and the AI Code of Ethics. The standards clearly require that appraisers accept full responsibility for the key inputs into their value opinions. Even if a projection comes from another source or contractor, like Walker, the appraiser must still carefully review the work and vouch for the numbers.
It was even more important that they do so in this particular assignment. Among the cautions Cowles appraiser Derek Zimmer left out of his March 18, 1996 letter that addressed ethical requirements were the USPAP's emphasis on two basic rules. They instruct appraisers not to commit significant "errors of omission or commission" in their work or "render appraisal services in a careless or negligent manner." Observing these rules is important, the USPAP cautions, "because of the potential for the compounding effect of errors" in the volatile DCF analysis used for investment value appraisals.
Yet, except for one minor adjustment (the average length of stay for retail parking customers was adjusted downward by a half hour), the Auble report relies exclusively on the Walker income projections. It warns that the higher parking rates forecast for the garage-a key premise of the rosy Walker numbers- is "a major assumption, but one that has been specified by the client." Because these same projections don't account for the cost of parking validation, the Auble report also warns, "revenue may be overstated." Yet, in the next sentence, and without explanation, the appraisers report they "have assumed" the issue will somehow be addressed "to assure there is no income shortfall from the projections herein."
USPAP prohibits using such assumptions to calculate value unless they've been verified by the appraisers. By following the city's instructions, and lending their MAI credentials to their appraisals, Evans and Auble appear to have violated Appraisal Institute standards. This is because they failed to independently verify the reliability of the Walker revenue projections.
Appraisal industry sources say the use of investment value appraisals by public entities is extremely rare. As Camas reported in June 2000, at least two experienced MAI appraisers who learned of the RPS garage appraisal plan at a meeting in city hall in April 1996-John McFaddin and Mike Sprute-quickly objected to its propriety. The two veteran appraisers say they could see no purpose for the city to depart from market value in appraising the garage for a public purchase.
A federal banking law cited by McFaddin and others reinforces his and Sprute's objections to the garage's non-market value appraisals. The law is known as FIRREA. It stands for Financial Institutions Recovery, Reform and Enforcement Act. Passed in 1989 after the savings and loan crisis, its purpose was to crack down on appraisal industry abuses that created property overvaluation of the sort that took place at the RPS garage.
McFaddin's point that FIRREA requires market value appraisals on all transactions involving federal funds raises an important question. Whether it was legal or not, why would the city insist on using a risky appraisal method that is barred by federal rules designed to protect U.S. taxpayers?
Continued...
To download Swinton's June 1, 1995 memo, click here.
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