Financial Lending Notes
March 4, 2009

When To Reappraise Commercial Real Estate

Declining real estate values over the past couple of years have impacted financial institutions in many ways. One effect that may be particularly troublesome for banks is the declining value of commercial real estate held as collateral to secure income property loans where the source of repayment is the property itself.

As a result, the federal regulatory agencies are putting increased emphasis on the need for banks to reexamine the current market value of such property by reappraising the property based on new, more realistic assumptions. The value of such property directly impacts the calculation of the adequacy of a bank's allowance for loan and lease losses (ALLL) and testing for loan impairment as directed by FAS 114, another reason for regulatory concern.

Proposed New Interagency Appraisal Guidelines

In response to heightened concerns over collateral appraisals and credit quality, the federal regulatory agencies issued for comment in November proposed Interagency Appraisal and Evaluation Guidelines that reaffirm supervisory expectations for sound real estate appraisal and evaluation practices. The guidelines help clarify risk management principles and internal controls for ensuring that banks' real estate collateral appraisals are reliable and support their real estate-related transactions.

The interagency guidelines would replace the 1994 Interagency Appraisal and Evaluation Guidelines by incorporating recent supervisory issuances and reflecting changes since then in industry practices, uniform appraisal standards and new technologies. They would apply to all of a bank's real estate lending functions, including both commercial and residential.

The proposed guidance offers an expanded discussion of portfolio management techniques and circumstances under which an institution should update real estate collateral valuations, as well as more detail on the regulators' expectations for an independent appraisal and evaluation function. They also include more explanation of the regulators' minimum appraisal standards and revisions to the Uniform Standards of Professional Appraisal Practice (USPAP).

A Structured Process

Given these new proposed guidelines and the tremendous uncertainty of today's credit environment, banks should have a structured process in place for monitoring the value of commercial real estate held as collateral and ordering reappraisals when necessary. Examine collateral and loans in the following order of priority:

1. Troubled loans backed by questionable real estate collateral that has likely declined in value.

2. Marginal loans backed by questionable real estate collateral that has likely declined in value.

3. Good loans backed by marginal real estate collateral that may have declined in value.

Re-appraisals obviously cost money, so use your best judgment in determining what types of commercial real estate may need reappraising. The value of a warehouse in south Florida probably hasn't changed significantly in the past year or two, for example, but the value of a condo or apartment building there almost surely has. Also consider the size of the loan (is it material to your institution?) and the loan-to-value ratio.

How to Order Appraisals.

In addition, regulators are now insisting that banks segregate the ordering of appraisals. In other words, an individual who is independent of the lending decision must order and evaluate the appraisal - someone in credit administration, for example. This person must be knowledgeable about appraisals, maintain a list of approved appraisers, and select from this list an appraiser with appropriate expertise (e.g., by type of property and market area) and knowledge.

You should note that a technical review may be required on larger credits - i.e., those that are material to your bank- that goes beyond just making sure the appraisal conforms to USPAP standards. Such a review would test key assumptions, such gross potential rent, vacancy factor, operating expenses, cap rate, etc.

Please contact me via phone at (404) 420-5670 or via email at ptuley@pkm.com if you have any questions or concerns.

 

Compliments of:

Porter Keadle Moore, LLP (PKM) is a full service accounting firm based in Atlanta, Georgia. PKM offers audit, tax and systems services to clients throughout the country. The firm focuses its efforts on companies registered with the Securities and Exchange Commission (SEC), community banks, the insurance industry, technology and life sciences companies and the real estate/construction industry.
 

To discuss this article contact Pat Tuley, CPA with Porter Keadle Moore, LLP at ptuley@pkm.com.

Pat has over 23 years of experience in public accounting. He has worked with clients ranging from individuals to international Fortune 50 companies in a variety of tax consulting and compliance areas. He is most active in the real estate and banking industries, serving numerous clients across the Southeast. Pat has led PKM’s tax practice since 2003. Prior to joining PKM he was a partner with KPMG, where he spent 17 years of his professional career.

 
Regulators Clarify Banks’ Roles and Responsibilities

Late last year, federal regulatory agencies issued a joint statement emphasizing the “prudent role that bank lending practices play in promoting the nation’s economic welfare.” The agencies encouraged banks to work together with regulators to ensure that the needs of creditworthy borrowers are met, specifically by:
  • Providing credit in a manner consistent with prudent lending practices, and continuing to ensure that they consider new lending opportunities on the basis of realistic asset valuations and a balanced assessment of borrowers’ repayment capacities.
  • Maintaining a strong capital position by ensuring the adequacy of their capital base and focusing on effective and efficient capital planning and longer-term capital maintenance.
  • Engaging in appropriate loss mitigation strategies and foreclosure prevention by working with existing mortgage borrowers to avoid preventable foreclosures, as well as mitigate other potential mortgage-related losses.
  • Reassessing the incentive implications of their compensation policies to ensure that they are aligned with the long-term prudential interests of the institution.
 

Tim provides accounting and auditing services to financial institutions as well as clients in the construction, service, technology/life sciences and manufacturing/distribution industries. He routinely works with companies registered with the Securities and Exchange Commission; privately-owned companies and S Corporations. He has experience with Initial Public Offerings (IPOs), Mergers and Acquisitions, Sarbanes-Oxley compliance and internal control consulting. You can contact Tim at tmessman@pkm.com.