Appraisal Review and Regulatory Issues in the Current Banking Environment

1. Appraisal Review and Regulatory Issues in the Current Banking Environment A Bank Reviewer Appraiser’s Perspective

2. Topics • Brief History of Regulatory Environment • Most impactful issues with the regulations • “Best Practices” for Compliance • Appraisal Review • Specific Examples from Real Appraisals

3. Brief Regulatory History • New “Interagency Appraisal & Evaluation Guidelines” as of December 2, 2010 • Previous guidance issued in 1994 with updates on specific topics • 12/2/2010 combines everything and emphasizes common themes

4. Important Points • Collateral is an important component of credit decision. • Independence of persons ordering, performing, and reviewing appraisals and evaluations. • Focus on appraiser selection based on competency. • Value Definitions and Scenarios. • Expanded Evaluation Requirements. • Appraisal or Evaluation Required? • Depth of Review/Evaluation • Quick Compliance Suggestions

5. Important Component of Credit Decision • The collateral valuation program is an integral component of the credit underwriting process and, therefore, should be isolated from influence by the institution’s loan production staff. • A review of valuation information is an essential component of sound credit administration and is mandated by the Dodd-Frank Act.

6. Reviewing appraisals and evaluations before engaging in a loan transaction ensures the value conclusion is reliable and enables financial institutions to make informed credit decisions, manage credit risk, and meet supervisory requirements. • Loan repayment sources: • Borrower • Guarantor • Collateral • Refinance from another lender

7. Independence of Process • Appraisers must be independent of the loan production and collection processes and have no direct, indirect or prospective interest, financial or otherwise, in the property or transaction. • USPAP requires disclosure • Interagency Guidelines simply don’t allow it.

8. Not Independent Independent

9. Very Important Thing to Note: • “Communication between the institution’s collateral valuation staff and an appraiser or person performing an evaluation is essential for the exchange of appropriate information relative to the valuation assignment.” • Source: Interagency Appraisal & Evaluation Guidelines, Page 21 of 70

10. “An institution should not directly or indirectly coerce, influence or otherwise encourage an appraiser or a person who performs an evaluation to misstate or misrepresent the value of the property.” • Source: Interagency Appraisal & Evaluation Guidelines, Page 21 of 70

11. After April 1, 2011, an institution must report non-compliance with USPAP to state appraiser boards • Must also file a Suspicious Activity Report (SAR) with Financial Crimes Enforcement Network (FinCEN) when suspecting fraud • Factual errors are major trouble, differences in opinion are more difficult to pursue.

12. Appraisals from Other Financial Institutions • Appraisal must meet the Bank’s quality standards (and of course be compliant with USPAP & FIRREA) • Must be still valid with respect to changes to the property and market since date of value • Should confirm: • Appraiser was engaged directly by the other bank • Appraiser had no direct, indirect, or prospective interest, financial or otherwise, in the property or transaction • Cannot accept readdressed or altered appraisals with intent to conceal original client

13. A borrower can inform the lender that a current appraisal exists, and the lender may request it directly from the other institution • No “assignment letters” for appraisals from other financial institutions required.

14. Appraiser cannot be engaged by borrower. • Independence is compromised when: • a borrower recommends an appraiser or person to perform the evaluation • loan production staff selects a person to perform the appraisal or evaluation

15. Engagement letters • Provides paper trail. • Lenders should use written engagement letters when ordering appraisals, especially for large, complex or out-of-area commercial properties. • Note: Appraisal Institute offers samples. • Also, appraisers should have their own.

16. Preparing Customers for Appraisals • Let customers know: • An appraiser will be calling them to set up an inspection • They will request information needed to complete the assignment, which may include: • Site plans • Building plans • Capital expenditures (in recent years and planned) • Historical income and expense statements (3 years + YTD) • Rent rolls • Leases • Title work • Previous appraisals • Purchase agreement (if applicable)

17. Expectations for Appraisers • In most cases, it’s a good idea for appraisers to contact the customer within a few business days of engagement. • If they are going to be late, notification to the client should occur as soon as possible. • Learn the regulations to add value to your customers, by catching things that could get them in trouble. • Value-in-use example.

18. Resolving Appraisal Deficiencies • What can and cannot be asked of an appraiser: • Can: Consider additional info. about the subject or comps • Can: Provide additional support for the value • Can: Correct factual errors • Cannot: Instruct or require the appraiser to make substantial changes • If still not resolved, what options do we have? • Reject the appraisal and order a new one • Rely on an appraisal review completed by an appropriately licensed appraiser, that includes a value opinion – must comply with USPAP Standard 3 • Adjust underwriting criteria

19. Focus on Competency • “The person selected possesses the requisite education, expertise, and experience to competently complete the assignment.” • Source: Interagency Appraisal & Evaluation Guidelines, Page 22 of 70

20. Reviewer qualifications • Not required to be a state licensed or certified appraiser • Must be independent and competent • Let the appraisal stand on its own merit, aside from the specific qualifications of the appraiser.

21. Value Definitions and Scenarios An appraisal report must: • Conform to USPAP. • Be written and contain sufficient information and analysis to support the institution’s decision to engage in the transaction.

22. Analyze and report appropriate deductions and discounts for proposed construction or renovation, partially leased buildings, non-market lease terms, and tract developments with unsold units. • Be based on the definition of market value set forth in the appraisal regulation. • Be performed by state licensed or certified appraisers.

23. In regards to #4 from Previous Slide: • Value opinions such as going-concern value, value in use, or a special value to a specific property user may not be used as market value for federally related transactions. • An appraisal may contain separate opinions of such values so long as they are clearly identified and disclosed. • 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.

24. Expanded Evaluation Requirements • BPO, AEMV, CMA are out, when by themselves. • Also, must consider actual physical condition.

25. What is an “evaluation”? “A valuation permitted by the Agencies’ appraisal regulations for transactions that qualify for the appraisal threshold exemption, business loan exemption, or subsequent transaction exemption.” • See page 31 (of 70) of the Interagency Guidelines 12-2010.

26. How do the various “valuation products” fit into a banks collateral • program? • BPO, AVM or other methods may be tools used by a bank for portfolio monitoring, etc. • BPO’s, AVM’s, etc. cannot be used as an “evaluation” because they most likely don’t comply with all of the provisions for development and content of an “evaluation”. • AVM or other methods/ technological tools may be used in the preparation of an “evaluation”, but probably will need additional information/analysis in order to comply with all of the provisions of the Guidelines.

27. Who can do evaluations? • Need not be a licensed or certified appraiser, but must be competent • When done by an appraiser, USPAP applies. See Advisory Opinion 13 (2010-11 Edition). • Also see AI Proposed Guide Note 13

28. Appraisal or Evaluation Required? • A Real Estate Evaluation is Required When: • „A new real estate-related transaction is $250,000 or less, • „A new real estate-related transaction is a business loan of $1 million or less and the sale of or rental income derived from real estate is not the primary source of repayment, or • A real estate-related transaction involves an existing extension of credit at the lending institution, provided that: • There has been no obvious and material change in market conditions or the physical aspects of property that threatens the adequacy of the institution’s real estate collateral protection after the transaction, even with the advancement of new monies; or • There is no advancement of new monies, other than funds necessary to cover reasonable closing costs.

29. A Real Estate Appraisal is Required When: • „A new real estate-related transaction exceeds $250,000, unless another exemption applies, • A lease is the economic equivalent of a purchase or sale of leased real estate, or • „The banking supervisor requires an appraisal be obtained.

30. A Real Estate Appraisal is Not Required When: • „A lien on real estate is taken as an “abundance of caution,” • „A loan is not secured by real estate, • „A lien has a purpose other than the real estate’s value, • „A new business loan is $1 million or less and the sale of or rental income derived from real estate is not the primary source of repayment, or • A renewal, refinancing, or other subsequent transaction of an existing extension of credit where an evaluation is permitted.

31. Following are Examples of Decision-Making Process for Appraisal/Evaluations(There are separate handouts that show them in bigger font)

34. Depth of Review/Evaluation – Should be Prioritized by Risk • “The institution should consider the risk, size, and complexity of the transaction and the real estate collateral when determining the appraisal report format to be specified in its appraisal engagement instructions to an appraiser.” • See page 28 (of 70) of the Interagency Guidelines 12-2010.

35. Although the Agencies’ appraisal regulations allow an institution to use an evaluation for certain transactions, an institution should establish policies and procedures for determining when to obtain an appraisal for such transactions. For example, an institution should consider obtaining an appraisal as an institution’s portfolio risk increases or for higher risk real estate-related financial transactions, such as those involving: • Loans with combined loan-to-value ratios in excess of the supervisory loan-to-value limits. • Atypical properties. • Properties outside the institution’s traditional lending market. • Transactions involving existing extensions of credit with significant risk to the institution. • Borrowers with high risk characteristics.

36. Quick Suggestions: • Can’t afford to have staff appraisers? • Outsource at least some reviews – maybe the most complex properties. • Outsource some evaluations as well. • Don’t use same appraisers multiple times on the same property year after year. • Don’t be penny-wise and pound-foolish. You get what you pay for. • Leverage your appraisers for data and information. • Make it a standard practice to bounce questions off other qualified appraisers – but keep it confidential. • Rate appraisers for timeliness, quality and responsiveness.

37. Appraisal Review • How bank reviewers are scrutinizing collateral • Real vs. Theoretical • In-place vs. Proforma • Provide useful data (not just opinion) • Convince me. • Why banks are scrutinizing collateral • Primarily regulatory and accounting reasons • Some genuinely care about the collateral component to their loan.

38. Appraisal Review • Of course, there are those banks out there who are in “Extend and Pretend” mode, trying to ride-out the storm until things calm down. • A low appraised value, even if it is undisputable, can cause the bank to incur a write-down, and impact capital reserves. • To avoid this, they will: • Delay getting new appraisals as long as possible • Go back to an original appraiser who appraised it in the peak of the market. • Look for less experienced, less competent appraisers who are hungry for work.

39. Appraisal Review • Errors in appraisals can be from: • Time/effort issues • Not enough fee • Not enough time (client or appraiser’s fault) • Competency - very tricky • Ethical lapses – usually involves some kind of coordination/cooperation with lender, consciously or subconsciously.

40. Suggestions: • Read the appraisal, follow the logic. • Check the math (at least the most important sections). • Tests of reasonableness. • Watch out for giant leaps in assumptions. • Think about it as if you were going to buy the property. • Who knows, as a lender, you may end up owning it one day…

41. General Warning Signs: • Spelling/formatting errors • Leaps of faith • Core assumptions at extreme ends of a range • Questionable or insufficient comp data • Presence of “hedging” words (e.g. “say…”) • Contradictory logic • Failure to apply tests of reasonableness • Value equal to, or exceed costs? • Value reconciled w/current or historic selling/listing activity?

42. Market Analysis section Red Flags • Meaningful or meaningless? • Market participant interviews? • Request that the appraiser include a section of the report summarizing interviews of market participants (realtors/brokers, developers, city officials, etc.) about not only the market in general for the subject property type, but also the specific marketability of the subject property itself.

43. Information related directly to the subject property? • Important to be bouncing ideas off other market participants, including other appraisers, to make sure they aren’t missing anything. • To a certain extent, appraising consists of consensus building, between the appraiser, the client, and also brokers, developers, borrowers, etc.

44. Cost Approach Red Flags • Replacement Cost - does it appear reasonable? • Depreciation – have all forms been accounted for? • Physical (age) • Functional (over- or under-improvement) • External (market forces) • Entrepreneurial Incentive – is it included? Is it adequate? • Without it, why would anyone build it? • In current market, very rare that cost equals value.

45. Sales Comparison Approach Red Flags • Arbitrary, unless there are “smoking gun” comps. • Pay attention to range of sale prices per unit (both unadjusted and adjusted). • The target should most often harden. • Use of old, incompletely reported, poorly analyzed or not truly comparable sales. • Dramatically different tenant profiles. • Fee Simple vs. Leased Fee • Inconsistency in adjustments.

46. Income Approach Red Flags • Direct Capitalization vs. Discounted Cash Flow. • Stabilized Income vs. Non-Stabilized Income. • Rate = Risk • Fee Simple vs. Leased Fee • Which represents the true “as-is” value of the subject property? • Considerations for above- or below-market contract rent? • Asking Rents vs. Actual Lease Comps • Full burden of expenses shown?

47. Reconciliation Section Red Flags • Should lead reader to conclusion. • Watch for inconsistencies in approaches to value. • They should rarely be that far off. • If they are, then there should be a logical, reasonable explanation.

48. Examples from Real Appraisals

49. Example 1 • Summary of Three Approaches to Value for a purchase of an existing, fully functional retail building, to be renovated for a unique, special use: • Cost Approach - $865,000 ($192.22/SF of GBA) • Sales Comparison Approach - $860,000 ($191.11/SF) • Income Approach - $635,000 ($141.11/SF) • Final value conclusion - $860,000 ($191.11/SF) • FYI, total project cost = $862,050 • Of which, $327,080 is renovation costs. • Or is it $202,000?

50. Example 1 • Summary of Three Approaches to Value for a purchase of an existing, fully functional retail building, to be renovated for a unique, special use: • Cost Approach - $865,000 ($192.22/SF of GBA) • Sales Comparison Approach - $860,000 ($191.11/SF) • Income Approach - $635,000 ($141.11/SF) • Final value conclusion - $860,000 ($191.11/SF) • FYI, total project cost = $862,050 • Of which, $327,080 is renovation costs. • Or is it $202,000?