cba chief credit officers symposium - … cco 11-5-10.pdf · cba chief credit officers symposium...

David Rosenthal, MAI,FRICSPresident & CEO

CBA Chief Credit

Officers SymposiumNovember 5, 2010

“An analysis conducted by the Appraisal Institute of failed banks showsthat nearly two-thirds had been previously cited by federal bankexaminers or had ongoing appraisal administration problems,highlighting a significant weakness in many struggling financialinstitutions.”1

1 Appraisal Institute

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The FDIC Inspector General cited examples:

• “Failure to obtain current appraisals or perform adequate appraisal reviews.”

• “Bank frequently relied on stale appraisals.”

• “Inadequate control of the lending function, including appraisals.”

• “Poorly explained upward adjustments to the appraisal values.”2

2Appraisal Institute

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• Per FDIC DRR, “Market conditions are so moribund in many markets that it is difficult for appraisers to appropriately project into the future or even find recent comparable sales. ”

• “Appraisals may be outdated in 90 days; whereas, in a reasonable market a 12 month period is acceptable.”

3 Information provided by FDIC Division of Resolutions & Receiverships (DRR)

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• Dodd-Frank Act? No, only addresses residential appraisal, not commercial appraisal.

• Proposed Revision to Interagency Appraisal and Evaluation Guidelines of 1994?Not yet published, and no projected timeframe for publication.

• Interagency Appraisal and Evaluation Guidelines (1994)?Yes, still in effect.

• Interagency Policy Statement on Prudent Commercial Real Estate Loan Workouts (October 2009)?Yes, Section III.C. addresses “Assessing Collateral Values”

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4 Published October 24, 1994 by FRB, FDIC, OCC, and OTS

Background

Title XI of FIRREA required each agency to adopt regulations regarding the preparationand use of appraisals by federally regulated financial institutions.

Supervisory Policy

Examiners will review an institution’s appraisal and evaluation policies and procedures,considering the institution’s size and real estate concentration.

Reviews will include examination of:a. Appraiser qualification criteria, including checking for conflicts of interestb. Individual appraisals or evaluations for regulatory compliancec. Individual appraisals or evaluations for reasonableness

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Appraisal and Evaluation Program

Each institution’s board of directors is responsible for reviewing and adopting policiesand procedures that establish an effective real estate appraisal and evaluation program.

The program should:

1. Establish selection criteria for who performs appraisals and evaluations;2. Monitor ongoing performance of appraisers and evaluators;3. Provide for independence of appraisers and evaluators;4. Identify the appropriate appraisal for various lending transactions;5. Establish criteria for evaluations;6. Provide for timely delivery of appraisal and evaluation reports;7. Assess the validity of existing appraisals or evaluations to support subsequent

transactions;8. Establish criteria for obtaining appraisals or evaluations for transactions that are

otherwise exempt from the agencies’ appraisal regulations;9. Establish internal controls that promote compliance with these standards.

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Who May Perform Appraisals and Evaluations?

Each institution should establish criteria for selecting, evaluating and monitoringappraisers and evaluators.

The criteria should ensure that:a. The selection process is non-preferential and unbiased;b. Individuals selected have appropriate education, expertise and competence to

complete each assignment;c. Individuals selected are capable of rendering an unbiased opinion;d. Individuals selected are independent with no ties to the property or the transaction.

In addition:• Appraisers must be engaged directly by the institution or its agent.• One institution may use an appraisal prepared for another institution provided that

it conforms to all appraisal regulations.

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Five Minimum Standards for an Appraisal

Each appraisal must:

1. Conform with USPAP.

2. “Be written and contain sufficient information and analysis to support theinstitution’s decision to engage in the transaction.”

3. “Analyze and report appropriate deductions and discounts for proposed constructionor renovation, partially leased buildings, non-market lease terms and tractdevelopments with unsold units”.

4. “Be based upon the definition of market value set forth in the regulation”.

5. “Be performed by State-licensed or certified appraisers”.

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Appraisal Options:

• Complete Appraisal?

• Limited Appraisal?

• Departure Provision?

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Appraisal Options:

• Complete Appraisal – No longer part of USPAP.

• Limited Appraisal – No longer part of USPAP.

• Departure Provision – No longer part of USPAP.

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Appraisal Reporting Options:

A. Self Contained Report – “Provides the most detail.”

B. Summary Report – “Presents the information in a condensed manner.”

C. Restricted Report (now Restricted Use Report) – “Provides a capsulized report withthe supporting details maintained in the appraiser’s file.”

“The agencies believe that the Restricted Report (Restricted Use Report) format will not be appropriate to underwrite a significant number of federally relatedtransactions due to the lack of sufficient supporting information and analysis in theappraisal report.”

“However, it might be appropriate to use this type of appraisal report for ongoingcollateral monitoring of an institution’s real estate transactions and under othercircumstances when an institution’s program requires an evaluation.”

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Evaluations

According to the Minimum Standards an Evaluation should:

1. Be written;

2. Include the preparer’s name, address, signature, and the effective date of theevaluation;

3. Describe the real estate collateral, its condition, its current and projected use;

4. Describe the source(s) of information used in the analysis;

5. Describe the analysis and supporting information, and;

6. Provide an estimate of the real estate’s market value, with any limiting conditions.

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According to a letter dated January 14, 2010 from the Board of Governors of the Federal Reserve System, the Federal Reserve has taken the following positions regarding the use of Broker Price Opinions (BPO’s) by federally insured banks:

• “…a BPO does not satisfy the definition of an appraisal in the Board's appraisal regulation. Therefore, a regulated institution would not be able to utilize a BPO to originate a loan secured by commercial real estate when the loan requires an appraisal in accordance with the appraisal regulation.”

• “…a BPO does not provide sufficient detail on a commercial property's condition, occupancy, and use to meet the guidelines' requirements for an evaluation.”

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Portfolio Monitoring

“Institutions should also develop criteria for obtaining re-appraisals or re-evaluations as part of a program of prudent portfolio review and monitoring techniques, even when additional financing is not being contemplated.”

Options to Consider:

1. New appraisal from a new appraiser (USPAP Compliant)

2. Update appraisal from the same appraiser (USPAP Compliant)a. Without incorporating the prior reportb. Incorporating the prior report by attachmentc. Incorporating the prior report by reference

3. New appraisal in a Restricted Use Report format (USPAP Compliant)

4. Evaluation

5. Broker price opinion

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5 Published October 30, 2009 by FRB, FDIC, OCC, OTS, and NCUA

When Should Valuations be Updated?

• Each institution should have its own policies and procedures that dictatewhen collateral valuations should be updated as part of their ongoingcredit review.

• Consideration should be given to changes in market conditions ordeterioration of a borrower’s financial condition.

• Institutions are responsible for reviewing current collateral valuations(appraisals or evaluations) to ensure that their assumptions andconclusions are reasonable.

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When Should Valuations be Updated?

New appraisals may not be necessary when an internal evaluation:

a) appropriately updates the original appraisal assumptions to reflect current market conditions, and

b) provides an estimate of the collateral’s Fair Value for impairment analysis.

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Fair Value vs. Market Value

“Fair Value” is defined in the FASB ASC Master Glossary, as:

“the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”

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“Market Value” is defined6 as:The most probable price which a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller, each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus.

Implicit in this definition is the consummation of a sale as of a specified date and the passing of title from seller to buyer under conditions whereby:• buyer and seller are typically motivated;• both parties are well-informed or well-advised, and acting in what they consider their best interests;• a reasonable time is allowed for exposure in the open market;• payment is made in terms of cash in U.S. dollars or in terms of financial arrangements comparable

thereto; and• the price represents the normal consideration for the property sold, unaffected by special or

creative financing or sales concessions granted by anyone associated with the sale.”

6 12 C.F.R. Part 34.429g0: 55 Federal Register 3496, August 24, 1990, as amended at 57 Federal Register 12202, April 9, 1992; 59 Federal Register 29499, June 7, 1994)

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Market Value in a collateral valuation and Fair Value in an impairment analysis are based on similar valuation concepts.

They may differ in various situations such as:

a) If they are based on different dates of value and market conditions have changed since the initial date of value,

b) If the property use or physical characteristics have changed since the initial date of value, or

c) If they are based on different underlying assumptions.

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When estimating Fair Value of CRE for FAS 157 purposes, what if anything, should be deducted from Market Value “As Is”?

Per Panel One: Fair Value is equal to Market Value “As Is” less:• Selling costs (commissions, etc.)• Holding costs - Discount for extended exposure time (over

1 year)• Refurbishment costs to make the property marketable• Past-due property taxes

Per Panel Two: Fair Value is effectively the same as Market Value, “As Is”, with no deductions.

7 Based on interviews of two different panels of regulators from FRB, FDIC, and OCC

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What Should a New Valuation Address?

For CRE loan workouts, a new or updated appraisal or evaluation should address current project plans and market conditions.

It should analyze whether there has been material deterioration in any of the following:

• The performance of the project,• Market conditions for the location and property type,• Variances between current actual conditions and original appraisal

assumptions,• Changes in project specifications (e.g.- changing a planned condominium

project to an apartment building),• Loss of a significant lease or take-out commitment, or• Increases in fallout of pre-sales.

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Documentation for the Market Value of the collateral should demonstrate a full understanding of:

• the property’s current “As Is” condition considering the property’s Highest and Best Use, and

• other relevant risk factors affecting value.

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CRE collateral valuations often contain more than one value conclusion and could include:

• “As Is” Market Value• Prospective “As Complete” Market Value• Prospective “As Stabilized” Market Value

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“As Is Market Value” is defined8 as:

“The estimate of the market value of real property in its current physical condition, use, and zoning as of the appraisal date.”

8 The Dictionary of Real Estate Appraisal, 5th ed. (Chicago: Appraisal Institute), 2010

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“Prospective Opinion of Value” is defined9 as:

“A value opinion effective as of a specified future date.

…Frequently sought in connection with projects that are:• proposed, • under construction, • under conversion to a new use, or • those that have not yet achieved sellout or a stabilized level of long-term

occupancy.”

9 The Dictionary of Real Estate Appraisal, 5th ed. (Chicago: Appraisal Institute), 2010

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Which Value Conclusion to Use?

Institutions should use the Market Value conclusion (and not Fair Value) that corresponds to the workout plan and the loan commitment.

• For example, if an institution intends to work with the borrower to get aproject to stabilized occupancy, then the institution can consider theProspective “As Stabilized” Market Value in its collateral assessment for creditrisk grading, after reviewing the reasonableness of the appraisal’s assumptionsand conclusions.

• Conversely, if the institution intends to foreclose, then the institution shoulduse the Fair Value (less costs to sell) of the property in its current “as is”condition in its collateral assessment.

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What Do Examiners Look At?

Examiners will analyze collateral values based on the following:

• An institution’s original appraisal or internal evaluation,• Any subsequent updates,• Additional information, and • Relevant market conditions.

An examiner should review the appropriateness of the major facts, assumptions, and valuation approaches in the collateral valuation and in the institution’s internal credit review and impairment analysis.

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When reviewing the reasonableness of the facts and assumptions associated with the value of an income-producing property, examiners should evaluate:

1. Current and projected vacancy and absorption rates,2. Lease renewal trends and anticipated rents, 3. Effective rental rates or sale prices, considering sales and financing

concessions, 4. Timeframe for achieving stabilized occupancy or sellout, 5. Volume and trends in past-due leases, 6. Net operating income of the property as compared with budget

projections, reflecting reasonable operating and maintenance costs, 7. Discount rates and direct capitalization rates.

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Examiners should give a reasonable amount of deference to assumptions that were recently made by qualified appraisers (and, as appropriate, by the institution) as long as they are consistent with the discussion above.

Examiners also should use the appropriate Market Value conclusion in their collateral assessments.

• For example, when the institution plans to provide the resources to complete aproject, examiners can consider the project’s Prospective Market Value andthe committed loan amount in their analysis.

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What If Examiners Find Weaknesses in the Valuation?

If weaknesses are noted in the institution’s supporting documentation or appraisal or evaluation review process, then examiners should direct the institution to address the weaknesses, which may require the institution to obtain a new collateral valuation.

However, if the institution is unable or unwilling to address these deficiencies in a timely manner, then examiners will have to assess the degree of protection that the collateral affords in analyzing and classifying a credit.

This may result in examiners making adjustments, if applicable, to the collateral’s value to reflect current market conditions and events.

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Should Examiners Challenge Valuation Assumptions?

Examiners are generally not expected to challenge the underlying valuation assumptions (including discount rates and capitalization rates) used in appraisals or evaluations when these assumptions differ only in a limited way from norms that would generally be associated with the collateral under review.

The estimated value of the underlying collateral may however, be adjusted for credit analysis purposes when the examiners can establish that any underlying facts or assumptions are inappropriate or when they can support alternative assumptions.

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Key Valuation Definitions and Concepts

The Policy Statement also provides definitions and discussions of the following key concepts for valuation of income producing real estate:

• Discount Rate and Net Present Value Approach• Direct Capitalization (“Cap” Rate) Technique• Differences between Discount and Cap Rates• Selecting Discount and Cap Rates• Holding Period versus Marketing Period

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10 Based on interviews with representatives from FRB, FDIC and OCC.

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When and How Often Should Banks Order New or Updated Appraisals?

• Banks should have their own in-house policy.

• When a collateral-dependent loan is classified as impaired and put on non-accrual.

• Regulatory preference is to see re-appraisals every 6 months.

• Once an appraisal is over a year old, it makes regulators uncomfortable to see it relied upon.

• This can vary by institution based on the health of the institution and the bank’s concentration in CRE loans.

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What is a reasonable basis for projecting absorption of units in For Sale projects (lots, houses, condos)?

• Should be based on current actual sale activity.

• Use a stark assessment of current market conditions.

• Should not be factoring in projections of improving market conditions.

• Actual activity should be revisited and re-analyzed quarterly.

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Disposition or Liquidation Values

• Infrequently developed in appraisal reports.

• Market supported deductions vs. “rule of thumb” approach.

• Not needed for regulatory purposes.

• Can be useful to help banks solve their business problems.

• Current appraisals are more important to regulators than appraisals with DV or LV.

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FAS 114 Impairment Analysis

An FAS 114 discounted cash flow analysis:

• Must be thoughtful with market support for assumptions.

• Must not just assume refinance or extension at maturity.

• The term of the cash flow analysis is discretionary for the bank, based on their analysis of the likely scenario(s).

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Appraisal Review Process

• A bank’s appraisal review process must be clear and well documented.

• All appraisals must be reviewed either internally or externally.

• The appraisal review process should be risk-based:o Smaller or more conservative loans may be fine with a lighter internal

review.o Larger or riskier loans require a robust review.

• Compliance reviews are not sufficient; a review should include the reviewer’s opinion of the value conclusion.

• Banks should be tracking appraised values vs. actual recoveries from sales of REO.

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Background:• 54 townhouse condo units within a 75 unit project.• 21 units have been sold to private homeowners.

• 54 units are currently rented as apartments.

Appraisal Problem:• Market Value at Highest and Best Use• Is Highest and Best Use as condo or apartment?

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Condo Considerations:• Relocation costs to remove existing tenants• Refurbishment costs• Pricing• Absorption rate• Phasing?• Rental income during sell-out

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Apartment Considerations:• Real estate taxes – assessed based on individual units• Operating costs – HOA fees, construction defect insurance• Project is controlled by HOA• Discount for fractured project?• Premium for eventual exit as condos?• Impact on cap rate?

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Conclusion:Highest and Best Use was as apartment

Valuation Considerations:• Real estate taxes higher than typical apartment• Operating costs higher than typical apartment• Lack of management control due to HOA• Discount for fractured project: Yes, per broker survey• Premium for eventual exit as condos: No, per broker survey

condo exit was too far in the future.• Impact on cap rate: Considering higher expenses, per

broker survey, increase typical cap rate by 50-100 bps

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Background:• 3 tenant, 100,000 sf retail center• Dark 60,000 sf retail space (former grocer)

Appraisal Problem:• Market Value at Highest and Best Use• What is Highest and Best Use of the dark space?

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Considerations:• Street access to dark space is only on narrow frontage side• 6 other dark retail big boxes in immediate market area• No demand for 60,000 sf space• Demand exists for smaller spaces with much less depth

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Alternate Uses Considered:• Keep vacant until demand returns for 60,000 sf space• Divide space into 2-3 long narrow spaces• Divide space into shallow frontage spaces, leaving rear

space with limited access/visibility• Scrape vacant building and rebuild or hold until market

returns

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Conclusion:Highest and Best Use was to divide front half of space into 2-3 shallow depth retail spaces and convert rear half of space into storage use

Valuation Considerations:• Demising costs for subdividing the space• Lease-up time and cost for leasing front retail spaces• Market demand and income potential for rear storage use• Required entrepreneurial profit• Market cap rate and discount rate for the proposed mixed use

development (retail and storage)

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Background:• 2 tenant, CTU industrial building in business park• New tenant signed a 5-year lease 6 months ago and was paying

rent, but never occupied the space• Other tenant (a gym) had a short term remaining and

needed to expand (wanted to take over leased but vacant space)

Appraisal Problem:• Market Value at Highest and Best Use• How to treat new space that was leased but not occupied?• How to treat gym space?

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Considerations:• Could not determine why new tenant had not occupied, or

what their plans were• Not enough parking to support gym expansion (higher parking

requirement for gym use)• Very low market demand for space• Both tenants were at market rent

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Valuation Scenarios Considered:New tenant:

• Occupies and honors lease• Does not occupy and breaks lease• Negotiates for rent reduction

Gym tenant:• Renews in existing space• Leaves on expiration, for larger space• Negotiates CUP with city to allow expansion on site

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Valuation Considerations:• Uncertainty and high risk to new tenant lease• Uncertainty and high risk to gym tenant renewal• City would not commit regarding possible CUP for gym• Low demand for space if either or both vacate

Conclusion:Per survey of market participants, value property at market rents (same as contract) with high vacancy rate and cap rate 100 bps above stabilized cap rate to account for risks

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Background:• 20 acre site in outlying area• Fully entitled for large lot, residential subdivision• No off-site or on-site improvements

Appraisal Problem:• Market Value at Highest and Best Use• Did the entitlements have value?• Were the entitlements worth protecting?

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Considerations:• Glut of foreclosed houses in the area• No current demand for new development• No financing for new development• Future demand would likely be for smaller houses on smaller

lots

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Valuation Scenarios Considered:• Residual analysis on entitled residential development• Sales comparison analysis

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Valuation Considerations:• Residual analysis yielded negative residual land value• Sales comparison analysis and survey of market participants

showed buyers were long term land-bankers• Current entitlements may not represent future Highest and Best

Use

Conclusion:Entitlements had no value and were not worth protecting. Market Value was value as raw land based on $/sf.

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Background:• 86,000 sq. ft., good quality CTU Industrial Building in conforming

industrial neighborhood• Four years ago, owner increased office space to 38% GBA• Offices cut up into “mini-suites” as small as 100 sq. ft.• No typical “Executive Suite” services other than shared

conference rooms• Building now leased to 44 “mom and pop” tenants • Leases were all short term or month-to-month

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Appraisal Problem:• Market Value, “As Is” • Did current use represent Highest and Best Use?

Considerations:• Office suites <500 sq.ft. - 38% vacant, rents $2.25-$2.65/sq.ft.• Office suites >500 sq.ft. - 18% vacant, rents $2.00-$2.25/sq.ft.• What was Market Rent for office mini-suites? • Industrial units were fully occupied • Most sales of similar industrial buildings were to owner-users

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Valuation Scenarios Considered:

• Current use as multi-tenant, mixed-use office and industrial• Conventional industrial building, less conversion cost

Conclusion:Market Value to an investor based on current use was similar to Market Value to an owner-user (less conversion cost) as a conventional industrial building.

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Speaker’s Biography

David Rosenthal, MAI, FRICS has over 27 years of commercial real estate appraisal experienceworking with lenders, equity sources, attorneys, and public agencies. Prior to co-founding Curtis-Rosenthal, Inc. in 1983, he worked at Security Pacific National Bank as a corporate banker. Hehas an MBA from the Kellogg Graduate School of Management at Northwestern University, anda BS in finance from the University of Florida. He lectures on real estate at UCLA and LoyolaMarymount University, and is a frequent author for commercial real estate publications. His“Economic Update Report” is a regular feature on www.RENTV.com.

Subscribe to Rosenthal’s Economic Update Report by contacting him at:

[email protected]

310-215-0482www.curtisrosenthal.com

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