Real Estate Valuation: Beyond the Basics Hosted by WebEquity July 2012 Q&A WebEquity Solutions hosted a complimentary Webinar for community banks on Real Estate Valuation: Beyond the Basics presented by representatives from Wipfli CPA and Consulting firm. We received excellent questions on the topic from our audience, and our speakers have published their answers for your benefit. For a recording of the live Webinar and/or a copy of the presentation visit: www.webequitysolutions.com/webinars/library Q: Regarding the appraisal exception for business loans less than $1,000,000, we have a lot of business borrowers who separate their real estate ownership from their operations. For example: Entity A owns the real estate, while Entity B operates the business and pays rent to A via the cash flow of the business. A and B are both managed and owned by the same person. Does a $750,000 loan (for example) to Entity A, secured primarily by the real estate, require an appraisal (versus an evaluation)? I m assuming this is a typical business retail sales, manufacturing, professional services, etc. that are unrelated to real estate. A: The guidelines for the business loan exemption look to the source of repayment, which cannot be rental income derived from the property or sale of the property. We would, therefore, recommend that the structure of your transaction clearly demonstrate, perhaps through a guaranty or co-borrowing relationship and supporting formal lease agreement, that the primary source of repayment is the cash flow from the business operation. A loan to a standalone, single-asset real estate investment entity may otherwise not meet the definition of a business loan where the source of repayment is not dependent on the sale of or rental income from the property and would then not be an exempt transaction. Q: Regarding documentation at the time of renewal or subsequent advance, assuming an appraisal would normally be required (i.e., a $1,000,000 loan), how much is needed to verify that the previous appraisals remain adequate? Do we need a full evaluation (property inspection, comparable sales analysis, etc., as appropriate to the property) to prove its validity, or is it sufficient to complete a statement similar to prior appraisal has been reviewed and found to continue to be representative of the property and its market? A: Your financial institution should establish criteria for assessing whether an existing appraisal or evaluation continues to reflect the market value of the property and therefore remains valid. Your criteria may vary depending on the property type, market, and nature of the transaction. Guidelines indicate your credit file documentation should provide the facts and analysis supporting your conclusion that the existing appraisal or evaluation continues to reflect the market value of the property. The statement you propose should be further supported by facts and analysis sufficient to allow subsequent reviewers to draw the same conclusion. Q: Is there any condition where an appraisal or evaluation is NOT required on a criticized asset? For example, if the bank-owned balance is less than $50,000? A: A loan modification involving a limited change in the terms of a note or loan agreement and that does not adversely affect the institution s real estate collateral protection does not rise to the level of a new real estate-related financial transaction for purposes of the agencies appraisal regulations. An automated valuation model or other technique may be sufficient to demonstrate an understanding of the collateral risk. If the modification is in keeping with safe and sound lending practices and your alternative collateral valuation method is reliable and an acceptable practice for your institution, an appraisal or evaluation may not be required. Webinar Q&A Real Estate Valuation: Beyond the Basics www.webequitysolutions.com 1
Q: Where can I get more information on the Review Committee for the appraisal and evaluation reviews? We are a very small institution. A: The committee or team approach is something we have seen in practice as a means of providing the element of independence when the originating loan officer has performed the valuation and credit analysis. The originating officer must then abstain from directly or indirectly approving or voting to approve the loan. The appraisal and evaluation review team may consist of one or more commercial lending professionals or other qualified management, staff, or a board member. Smaller institutions are expected to implement safeguards and prudent practices when absolute lines of independence cannot be achieved. Q: If a prior evaluation/appraisal has increased in value and thereby increases your collateral position on a loan that you are either renewing or even rewriting, would you have to do a new appraisal/evaluation? Your collateral position would actually be better than a previous appraisal/evaluation, so I would think just a notation on an acceptance of a prior appraisal/evaluation that your value increased would be sufficient instead of having to go through the expense and time of doing a new evaluation/appraisal. What would you have for an opinion? A: Institutions are allowed to use an existing appraisal or evaluation to support a subsequent transaction in certain circumstances. It is important for your institution to establish the criteria for assessing whether an existing appraisal or evaluation continues to reflect the market value of a property and then to document the facts and analysis supporting your conclusion. A new appraisal or evaluation is necessary if the originally reported market value has changed. Interestingly, the guidelines are mute as to whether the change needs to be positive or negative. Q: In the state of Wisconsin, loans are readily cross-collateralized legally. For example, Loan A for $200,000 is written today secured by property A. Next month, we advance a new loan B of $200,000, secured by property B. Even if the A/A and B/B loan to values are acceptable, we consider this as one global relationship for collateral purposes with a loan to value of (A+B)/(A+B). Because of this, are we required to aggregate the loan amounts for application of the appraisal threshold, functionally requiring our threshold to be calculated on a relationship basis versus a transaction basis, or can we rely on the size/purpose of the transaction itself? A: Appraisal and evaluation requirements are transaction based. In the scenario described, you have two unrelated transactions for appraisal and evaluation purposes. One cautionary note, however: There should not be a pattern of multiple exempt transactions secured by a single property or properties in an attempt to circumvent appraisal requirements. You would certainly want to decide (perhaps in your loan or appraisal policy) at what point you would require an appraisal. Q: Is an appraisal required for a non-owner-occupied, single-family house if the repayment is dependent upon rental income, given the loan amount is less than $1 million? A: Assuming the loan amount is greater than $250,000, yes, an appraisal is required. If $250,000 or less, an evaluation is required. Refer to Appendix A of the Appraisal and Evaluation Guidelines. Q: Do you have any recommendations of training outlets that we could send potential evaluators to and examples of good evaluations? A: Risk Management Association has a course on income-producing property valuation and one on interpreting and understanding appraisals. The Appraisal Institute offers a wide variety of courses including some geared toward reviewing appraisals. Your state banking association may have courses available; the Wisconsin Bankers Association offers a webinar on reviewing and interpreting commercial real estate appraisals Webinar Q&A Real Estate Valuation: Beyond the Basics www.webequitysolutions.com 2
Q: We have been using a broker price opinion performed by an outside agent in that market area. The OCC recently reviewed this practice and approved this use of a BPO on our extensions and modifications. Please advise. A: A BPO is not by itself an appraisal or evaluation, but it could be used for monitoring the collateral value of an existing loan when deemed appropriate. Refer to Appendix D, Glossary of Terms, of the Appraisal and Evaluation Guidelines. Q: What is an automated valuation method? A: A computer program that estimates a property s market value based on market, economic, and demographic factors. Hedonic models generally use property characteristics (such as square footage and room count) and methodologies to process information, often based on statistical regression. Index models generally use geographic repeat sales data over time rather than property characteristic data. Blended or hybrid models use elements of both hedonic and index models. Refer to Appendix D, Glossary of Terms, of the Appraisal and Evaluation Guidelines. Q. Please tell us more about the need for independence when ordering an appraisal. Can the loan processor order the appraisal for the loan officer? A. For both appraisal and evaluation functions, an institution should maintain standards of independence as part of an effective collateral valuation program for all of its real estate lending activity... An institution should establish reporting lines independent of loan production for staff who administer the institution s collateral valuation program, including the ordering, reviewing, and acceptance of appraisals and evaluations. For a small or rural institution or branch, it may not always be possible or practical to separate the collateral valuation program from the loan production process. If absolute lines of independence cannot be achieved, an institution should be able to demonstrate clearly that it has prudent safeguards to isolate its collateral valuation program from influence or interference from the loan production process. (Section V, Independence of the Appraisal and Evaluation Program) An institution should use written engagement letters when ordering appraisals, particularly for large, complex, or out-of-area commercial real estate properties. An engagement letter facilitates communication with the appraiser and documents the expectations of each party to the appraisal assignment. In addition to the other information, the engagement letter will identify the intended use and user(s), as defined in USPAP. Refer to Section VI, Selection of Appraisers or Persons Who Perform Evaluations, and Appendix B, Engagement Letters, of the Appraisal and Evaluation Guidelines. Q. How do you consider foreclosure sale prices in doing appraisals and evaluations? A. The effect of foreclosure sales will vary by market and property type. Factors to be considered may include the number of foreclosure sales for the property type; the number of similar, competing properties available; and the rate of absorption for these properties. A single foreclosure sale among recent comparable sales may represent an aberration for which an adjustment can be supported. A single foreclosure sale where no recent and comparable sales can be found may signal a much greater negative effect on the market. Q. When stating an exempt transaction, does this mean less than the $250,000 and $1,000,000 levels? A. Yes, and any subsequent transactions that are considered exempt as well. Refer to Appendix A, Appraisal Exemptions, of the Appraisal and Evaluation Guidelines. Webinar Q&A Real Estate Valuation: Beyond the Basics www.webequitysolutions.com 3
Q. Is it acceptable for an appraiser to perform a leased fee estate appraisal using market rents and estimated expenses instead of actual rents and expenses that are available? A. The estimate of market value should consider the real property s actual physical condition, use, and zoning as of the effective date of the appraiser s opinion of value. Prospective market value opinions should be based upon current and reasonably expected market conditions. When an appraisal includes prospective market value opinions, there should be a point of reference to the market conditions and time frame on which the appraiser based the analysis. Refer to Section VIII, Minimum Appraisal Standards, of the Appraisal and Evaluation Guidelines. See also USPAP Statement 4, Prospective Value Opinions. Q. Regarding comparables, if the appraisers are having problems finding good comps, how are bankers supposed to? Also, have the examiners demonstrated reasonableness as well when reviewing evaluations? A. As we indicated in our presentation, use the best available sales comparables, whatever that may be for your particular market. Examiners may differ in their approach and conclusions, but we find that most examiners understand the current environment and will recognize a reasonable effort. Q. I have two questions. Does your information regarding evaluations apply equally to home equity loans as opposed to just first mortgage refinance? Is it acceptable to use the lower of the FMV from the tax bill and the AVM to determine value as an evaluation method? A. The information presented regarding appraisal and evaluation guidance addresses all real estate-secured loans. A valuation model that does not address the property s current actual physical condition as well as the economic and market factors would not be acceptable. However, institutions should establish policies and procedures for determining an appropriate collateral valuation method for a given transaction, considering associated risks. Q. Should the site inspection be completed by the person writing the evaluation? A. A site inspection is not required to be completed by the person writing the evaluation; it is the responsibility of the person writing an evaluation to describe the method used to confirm the property s actual physical condition and the extent to which an inspection was performed. Q. We offer five-year balloon loans for our in-house residential real estate loans. When the balloon is due, we do an extension of the note and mortgage for the next five-year term. (This is basically for the ability to adjust the rate). Do we need to do an updated evaluation upon the renewal of the balloon? A. With no increase in the principal amount and a compliant, original appraisal on file, the subsequent transaction you describe is likely an exempt transaction, subject to the requirements for an evaluation. Q. Where does one go to find all the details on comparables as outlined in the evaluation? A. The information available to your financial institution may depend on your market. There may be information available on recent sales within your market via the Internet. Your local real estate brokers and appraisers may be able to provide resources on comparable properties, but you should also see the Internet resources at the end of the presentation for potential sources of sales data. Q. What would be a good cap rate to use for income approach evaluations? A. There is a wealth of available information on cap rates, but a conversation with a local appraiser may give you an indication of a range of cap rates for the specific property type you are evaluating as a starting point. Webinar Q&A Real Estate Valuation: Beyond the Basics www.webequitysolutions.com 4
Q. My question is related more to the workout/problem credit valuations. Can the bank ever ask for something other than market value such as liquidation value or disposition value particularly for a property where the market value may be based on an extended marketing time (years) and if the bank does take the property back for repayment but will not want to hold the property for an excessive amount of time? A market value appraisal or evaluation may not be a realistic amount that the bank can recoup. A. While the appraisal and problem credit guidance focuses on market value, you can ask the appraiser to also provide a liquidation value as a part of the overall appraisal report. Q. How is the Mortgage Constant calculated? A. MC = i/[1- (1/(1 + i )n )] MC = Mortgage Constant i = Mortgage interest rate n = Number of periods equal to the term of the loan Q. If making multiple, separate (not cross-collateralized) loans to the same borrower, all being under $250,000, is it acceptable to use evaluations for each property? A. This is a situation where evaluations are all that the agency guidelines require; however, your loan policy may address the need for an independent appraisal on aggregate extensions of credit to a single borrower in excess of a certain dollar amount. Q. Can you share some of the websites to help in obtaining comp sales for evaluations? A. We have provided a variety of websites with general market information as well as sales data for specific markets. Q. How can a loan officer complete any evaluation forms and have them be considered independent? A. The interagency guidance recognizes that it may not always be possible in a small or rural institution or branch to separate the collateral valuation program from the loan production process. The institution is responsible for demonstrating it has prudent safeguards, if absolute lines of authority cannot be achieved, to isolate the collateral valuation process from the loan production process. A lending officer who ordered, performed, or reviewed an appraisal or evaluation must abstain from any vote or approval involving loans secured by properties on which he or she was involved in the collateral valuation. Q. Please address abundance of caution when it is appropriate. Thanks. A. There are limited applications for an abundance-of-caution exemption. A careful reading of the entire guidance on this topic is necessary in making a decision to exercise this exemption. Please refer to Appendix A, Appraisal Exemptions, 2. Abundance of Caution. Q. How can anyone other than an appraiser provide market value? It is my understanding that appraisers are the only persons qualified to provide market value. A. The agency guidance on evaluation content calls for an estimate of the property s market value in its actual physical condition, use, and zoning designation as of the effective date of the evaluation. Webinar Q&A Real Estate Valuation: Beyond the Basics www.webequitysolutions.com 5
Q. Under your slide titled Is the Original Appraisal Compliant, you have a bullet point ordered independently on behalf of the lender. If the original appraisal was ordered by and addressed to the lender does this mean the appraisal does not meet minimum standards? I find this on many of the appraisals that predate 2011. A. The slide would have been more appropriate if stated as ordered independently on behalf of the lending institution. It was not intended that lender would refer to the lending officer, but rather to the financial institution. Q. Should an appraisal contain more than just the comparable approach (i.e., income or cost approach)? A. Under USPAP, the appraisal should contain any approach to value, whether cost, income, or sales comparison approaches) that is applicable and necessary to the assignment. Your financial institution is also responsible for obtaining an appraisal that contains sufficient information and analysis to support its decision to engage in the transaction. Therefore, discussion with the appraiser and your engagement letter should outline your needs and expectations. Q. You talked about a leased fee valuation when a property is leased below market. What about when contract rent is above market? According to the Appraisal Institute, a leased fee valuation is required WHENEVER there is a lease. What do you think? A. The interagency guidelines address the minimum requirements for federally regulated institutions. Keep in mind that appraisals are to comply with USPAP as well. Considerations on which ownership interest(s) should be included in the appraisal report may depend on the specific property, such as whether leases are long or short term, expectations upon expiration of leases in place, current and future use of the property, etc. Q. As an appraiser who is employed by a bank, I complete evaluations, appraisals, and reviews. There are times when I have access to information, such as loan amounts and LTV, that we wouldn t ever tell a fee appraiser. If I complete an evaluation or appraisal, and I already knew some of this information about a property, is that considered a violation of independence? A. You can expect examiners to review steps taken by an institution to ensure that the persons who perform the institution s appraisals and evaluations are not subject to conflicts of interest and that standards of independence include isolation from influence by the institution s loan production staff, whether by reporting lines or other safeguards. Access to information would not automatically prevent you from performing an objective engagement in conformance with both the interagency guidelines and USPAP. Q. We have a small credit staff, and in most cases we do not receive the appraisal until after the credit is approved. In these cases, every officer has approved the credit. How do we maintain review independence in these cases? A. With a smaller institution, you may need to have a lender abstain from a credit decision in order to remain independent when performing an appraisal or evaluation review. You can discuss options with your primary regulator as well. In addition to independence in the review of an appraisal or evaluation, the review guidance clearly states, As part of the credit approval process and prior to a final credit decision, an institution should review appraisals and evaluations to ensure that they comply with the agencies appraisal regulations and are consistent with supervisory guidance and its own internal policies. The appraisal guidance also indicates the institution s real estate appraisal and evaluation program should provide for the receipt and review of the appraisal or evaluation in a timely manner to facilitate the credit decision. Refer to Interagency Appraisal and Evaluation Guidelines, IV. Appraisal and Evaluation Program, and XV. Reviewing Appraisals and Evaluations. Webinar Q&A Real Estate Valuation: Beyond the Basics www.webequitysolutions.com 6
Q. Significant confusion arises from the FDIC s interpretation of interagency guidelines on Transactions That Require Evaluations ; specifically, the business loan threshold of $1,000,000. The PowerPoint slide references owner occupancy; however, isn t the appraisal exemption based on the repayment source? Has the FDIC provided any further guidance or clarification regarding business loans that require appraisals? In the webinar, the Wipfli slide provides that an appraisal is required on new, real estate-secured transactions over $250,000 or over $1,000,000 to an owner-occupied business not dependent on sale or rental income of the property. Should this read:... is dependent on the sale or rental income of the property? A. The basic appraisal threshold for all real estate-secured loans is a transaction greater than $250,000. There is an exemption up to and including $1,000,000 for a business loan when the sale of or rental income derived from the real estate is not the primary source of repayment. In order to apply the exemption, the institution must determine that the primary source of repayment is operating cash flow from the business. The typical scenario is an owner-occupied property or where the pledged real estate is owned by an LLC of the business or the business owner. If the exemption does apply, an evaluation is required. Q. It appears the bank needs to obtain a new evaluation, if appropriate, no matter what the circumstances (i.e., renewal or refinance) due to the statement, A subsequent transaction may be supported by an evaluation when there has been no obvious and material change in market conditions or physical aspects of the subject property. In other words, we just can t simply renew a loan citing a previous evaluation or appraisal because it s almost certain that most, if not all, real estate values dramatically declined due to this unprecedented recession; therefore, the bank would be required to perform an evaluation. Is this the proper interpretation? A. Part 323.3(a)12(b) states, For a transaction that does not require the services of a state-certified or licensed appraiser under paragraph (a)(1), (a)(5), or (a)(7) of this section, the institution shall obtain an appropriate evaluation of real property collateral that is consistent with safe and sound banking practices. I would interpret that to mean an evaluation is required for any transaction where an appraisal exemption applies, whether in times of market stability or volatility. Q. My question has to do with evaluations. My department is in charge of reviewing evaluations that are completed to make sure they are done correctly and competently. We have been receiving more and more excuses that no one is able to find comparables for the evaluations, even though we keep a very extensive listing of comparable sales, so my department was wondering your feelings that if they are unable to locate comparables, engaging a restricted-use appraisal would be the next step to ensure that the proper valuation is being achieved? A. The inability to find comparables may relate to a lack of recent sales or a lack of sales considered to be comparable to the subject property. We tried to stress that the best available sales comparables are what should be used and that adjustments will need to be made accordingly. The same would be true if the problem is with the type of property being dissimilar. The evaluation analysis can also consider whether there are similar properties listed in the market but not selling, a situation that might suggest current market values have dropped below the listing prices. If a restricted-use appraisal is completed, it can be included as supporting documentation for your evaluation. Q. Two of our offices make agricultural real estate loans; we have no one who would feel comfortable performing an agricultural real estate appraisal review, other than the three agricultural lenders in our offices. Of course, this would be a conflict due to them being the lenders and/or their lending authority required to approve the loan request that prompted the appraisal. A. Both appraisal and evaluation functions require standards of independence as part of an effective collateral valuation program. An institution can achieve independence through lines of authority, segregation of underwriting and loan production personnel, or other appropriate safeguards. Small or rural institutions or branches may need to demonstrate that they have prudent safeguards in place to isolate their collateral valuation from influence or interference from the loan production process. If, for example, a loan officer s expertise is required to perform an evaluation, that lending officer should abstain from any vote or approval involving loans on which he or she ordered, performed, or reviewed an appraisal or evaluation. Webinar Q&A Real Estate Valuation: Beyond the Basics www.webequitysolutions.com 7
Please contact Kevin Graff, Senior Manager Loan Review, at kgraff@wipfli.com or Cynthia Brzeski, Senior Specialist Loan Review, at cbrzeski@wipfli.com, or call 800.486.3454 for more information. View Webinar See a recording of the Real Estate Valuation: Beyond the Basics Webinar at www.webequitysolutions.com/webinars/library. The answers in this document were prepared by: Kevin Graff, Senior Manager Loan Review and Cynthia Brzeski, Senior Specialist Loan Review from Wipfli. For more information please contact Kevin at kgraff@wipfli.com or Cynthia at cbrzeski@wipfli.com, call 800.486.3454 or visit www.wipflicom. About WebEquity Solutions WebEquity is the proven leader in on-demand lending software. More than 750 financial institutions and 20,000 lending professionals use WebEquity to automate and streamline their lending process and reduce operational costs, while making more uniform and profitable credit decisions. The company offers financial institutions a distinct advantage with a single solution that works for all loan types, an on-demand model that provides centralized, anywhere access, and the flexibility to configure the system so it fits their lending practices. WebEquity is endorsed by the Independent Community Bankers of America as the ICBA Preferred Service Provider for commercial lending software. For more information call 800-264-0787 or visit www.webequitysolutions.com. Need Additional Information? WebEquity Solutions Mallory Eccker 800-264-0787 ext. 3 WebEquity Solutions LLC 1314 Douglas Street Suite 1000 Omaha, NE 68102 800-264-0787 www.webequitysolutions.com Webinar Q&A Real Estate Valuation: Beyond the Basics www.webequitysolutions.com 8