REAL ESTATE COLLATERAL VALUATION

1. REAL ESTATE COLLATERAL VALUATION Jon Eagar, Senior Examiner FDIC March 12, 2008

2. Why do we obtain appraisals? • Provides independent assurances that property’s value is consistent with the loan request • Key concept: Independent valuation • Ensures that bank has sufficient protection to cover loan balance in event of a default • Provides independent assessment of project viability • To confirm condition and location of property

3. Regulations and Supervisory Guidelines • Appraisal Regulations and Guidelines in the United States • Title XI of Financial Institutions Reform, Recovery, and Enforcement Act of 1989. For FDIC supervised banks, the rule is enacted by Part 323 of the FDIC Rules and Regulations • USPAP. Uniform Appraisal Standards. Developed by appraisal industry, and is referenced by the bank regulation. • Part 364 of FDIC Rules and Regulations • Class Discussion: Regulations in other jurisdictions

4. Fundamental Principles • Independence • Minimum standards • Fully supported and transparent valuation process • Bank controls over the process

5. ELEMENTS OF CONTROL SYSTEMS • Written appraisal policy • Appraisal reviews • Independence in the process • List of approved appraisers

6. INCOME PROPERTY • Primary reliance on Income Approach, but usually also includes Sales Approach and Cost Approach • Typical Methodology • Potential Gross Income • Less: Expenses, Maintenance Costs, and Vacancy Allowance • Net Operating Income • Capitalization Rate • Net Operating Income divided by Cap Rate = Estimated Value • Is there a sale associated with this transaction?

7. Simple Example • Office building with 9,500 square feet office space • Average location • Building was constructed five (5) years ago • Good lease history (average 95% occupancy) but most of the current leases will soon expire.

8. Potential Gross Income

9. Adjustments to Gross Income • Expenses • Capital Expenditures and Management Costs • Vacancy Allowance

10. Capitalization Rate • Rate of return required by lenders and investors for this type of property • When combined with net operating income, the cap rate can be used to derive a market value • Net Income / Capitalization Rate = Indicated Market Value • $100,000 (per year) / 0.09 = $1,111,111 • Underlying the Cap Rate are a loan component and an equity component • Loan Component: interest rate available for this type of project • Equity Component: return that an investor requires for this project • Class Discussion

11. Valuation Using the Income Approach

12. Valuation Using the Income Approach

13. Residential Property • Generally based primarily on Sales Approach, although may be some reliance on Cost Approach. Only minimal reliance on Income Approach. • The Sales Approach is based on comparable sales (comps) of similar properties. Primary consideration for the bank regulator: • Overall similarity of the comparables to the subject property

14. Residential Property

15. Residential Construction Loans (single unit) • Similar to residential (primary reliance on Sales Approach) but value is estimated “when completed”. • Important to look at Cost Approach • Bank might need to take back the property before it is completed. • Red Flag: Appraised value significantly exceeds Cost Approach

16. Land Development orNew Construction of Multi-Family • Loan Purpose: to purchase land and fund improvements which allows borrower to sell individual lots/units. • Income Approach and Cost Approach are critical. Cost Approach indicates what it will take to complete the project. Should be similar to borrower’s budget. • Market value is not the sales price of individual units multiplied by number of units. Should be based on discounted cash flow approach which considers costs, absorption rates (sales time), marketing costs, profit margin, etc.

17. Other Considerations • Examiner familiarity with local conditions, real estate trends, prices, other factors that may impact real estate values. • Visit the property • Historical record of sales for this property. • What if there aren’t comparables due to unique features of the property?

18. Final Thoughts • Appraisals are an estimate of market value, not a precise science • Examiners need to assess the underlying assumptions • Evaluate the bank’s overall appraisal practices and system of controls • Should we be concerned about appraisal practices in current environment?