COMMERCIAL REAL ESTATE: APPRAISALS & CASH FLOW …COMMERCIAL REAL ESTATE: APPRAISALS & CASH FLOW ANALYSIS . Richard A. Hamm . President & Owner . Advantage Consulting & Training .
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COMMERCIAL REAL ESTATE: APPRAISALS & CASH FLOW ANALYSIS
Richard A. Hamm President & Owner
Advantage Consulting & Training Huntsville, Alabama
advantagecons@bellsouth.net 256-503-5591
August 1-3, 2019
1
CRE Cash Flow and Appraisals
August 2019
Richard HammAdvantage Consulting & Training
advantagecons@bellsouth.net
Objectives/Agenda
Distinguish between “CRE” and “C&I” loans
Properly develop cash flow of an income-producing property and use it to derive debtservice coverage (DSC), value estimate andloan-to-value (LTV Conduct/evaluate stress-testing of a project at
the transaction level
Identify key inputs and factors that influencecapitalization (“cap”) rates
Identify key appraisal issues and regulations Appendix (Time Permitting): Identify non-financial CRE
lending risks
Terminology: C&I and CRE Loans
Commercial & industrial loans (C&I) sometimes involve RE Various call report and other loan coding
systems flag these loans as “CRE” if there is enough RE collateral, regardless of purpose
Business loans where operating cash flow is PSOR but RE is collateral should be effectively considered C&I ________________ usually is applied to
C&I loans secured by RE such as manufacturing plants, warehouses, offices, retail stores, etc
Terminology: C&I and CRE Loans (cont.)
True CRE loan depends on rental income or planned RE sales as the primary source of repayment (PSOR) __________________ usually describes
income-producing, investment or other true CRE loans
Liquidation (by bank, unplanned) is SSOR for both
3
Terminology: OO and NOO Loans
With OO loans, most of land and improvements (50%+) will be utilized by owner
Directly via same entity
Indirectly via entity with substantiallycommon ownership
Usage test can be based on
Space occupied
Rental income
Similarities and Differences in Commercial Loans
Business financial statements and/or tax returns
Monitoring/ Reporting
Primarily fixed, some floatingPrimarily floating, some fixed
Interest Rates
Long-term (amortization 15-20 yrs., maturity 3-5 yrs.)
Short-term (AR+INV) Medium-term (EQ)
Structure/ Amortization
RE + FixturesNon-RE (AR, INV, EQ)
Collateral
Liquidation of RE CollateralLiquidation of non-RE collateral
SSOR
Cash flow from operationsPSOR
NOO REOO REC&I
Developing Property NOI & CFADS
CRE cash flow measures: NOI (net operating income) and CFADS (cash flow available for debt service) Old-fashioned net income + depreciation (a non-cash expense) +
interest expense (to avoid double-counting with interest as part of debt service) for historical NOI Start with earnings before interest, taxes and depreciation and amortization
(EBITDA)
Then adjust for capitalized expenditures to get historical NOI
Then adjust expenses (some smoothed, some imputed) to get pro-forma or projected NOI
More adjustments, primarily for distributions or unusual income or expenses, to get CFADS, historical and pro-forma
Ignores most business balance sheet sources and uses of cash (direct method cash flow used for C&I businesses), because Land/building likely only significant asset
Loan/mortgage likely only significant liability
Underwriting Variables
Basic steps to NOI (bankers and appraisers) and CFADS (bankers)
1. Develop gross potential income or gross rents, historical and pro-forma Not provided by tax returns
Need rent roll or property configuration # units x rental rate per month x 12 months
Awareness of unusual lease terms Events of default by landlord
Events of default by tenant
Cotenancy clauses, etc.
Underwriting Variables (cont.)
2. Develop _____________________ vacancy
Also not provided by tax returns
Start with gross potential income developed above
Then subtract your
“gross rents” or
“rents received” from
top line of tax return
Example blank
Form 8825
on page 15
Underwriting Variables (cont.)
When using tax returns, bankers work backwards
to determine historical vacancy
“Rents Received” on Schedule E
“Gross Rents” on 8825Gross Effective Income
Less: Vacancy
Gross Potential Income
Tax Return Data
(Schedule E or Form 8825)
Customer Data and
Bank NOI Worksheet
Underwriting Variables (cont.)
3. Develop ______________ vacancy
Three factors to consider
1. __________ levels and trend of the property (non-construction and where data available)
2. ____________ levels and trends/conditions
3. ______________ minimums/guidelines
Blindly sticking with historical levels and/or policy guidelines are traps to avoid
___________________ occurs when occupancy of subject property reaches “market” levels (100% – market vacancy)
Underwriting Variables (cont.)
Keep in mind, there are two types of vacancy
1. __________________ (unit is empty)
2. __________________
Late or no payment
Check bounces (credit or collection loss)
Rent concessions or give-aways
Appraisers use phrase “vacancy and credit loss”
7
Differentiated Underwriting Guidelines – Example Grid
15%10%5%Min Vacancy Factor
24 months24 months36 monthsMax Construction Term
85%85%85%Max FDICIA LTV
20 years20 years30 yearsMax Amortization
5 years5 years5 yearsMax Loan Term
0.70x0.70xNAMin Pre-Leasing/Pre-sales
1.30x1.35x1.20xMin DSC
20% (10%)25% (15%)15% (5%)Min Equity (Cash)
80%80%85%Max LTC
75%75%80%Max LTV
Multi-Tenant Office Building
Unanchored Shopping Center
Apts >100 Units** Example Only **
Underwriting Variables (cont.)
4. Impute pro-forma management fee
Usually at 4-6% (use going rate in property’s market) of net rents in pro-forma, even if no actual fees paid in historical data
NOT to simulate costs if foreclosure occurs
Banker is not making a liquidation analysis
Recognizes that a large portion of purchasers will not self-manage
Exception: residential rental properties where self-management is prevalent
Underwriting Variables (cont.)
5. Historical maintenance and repair costs Most costs will be expensed in current year and shown
on Schedule E or Form 8825
Tax and accounting rules may require some costs to be capitalized onto balance sheet, then depreciated or amortized over several years
If improvement extends useful life of property, it should be capitalized
This is very subjective, however, leaving room to fully expense cost in year made, especially if customer wants to defer taxable income
Underwriting Variables (cont.)
6. Create pro-forma _____________________
Sometimes called reserves for replacement
Usually impute in pro-forma column at 2-3% of gross potential income, with 5% often more appropriate in medium to smaller properties
Pro-forma amount may be higher due to property age, historical trends or observed need for deferred maintenance
Historical costs tend to fluctuate greatly, so pro-forma in an estimate of expected, average, ongoing annual expenditures over time
9
Underwriting Variables (cont.)
6. Create pro-forma maintenance reserve (cont.)
Assessed even in first years of new properties
“Sets aside” cash flow annually for big ticket repairs down the road
Usually not funded or escrowed, unless required by
Lender due to significant deferred maintenance
Government programs, such as state affordable housing
Underwriting Variables (cont.)
May be assessed as a one time expense
May create material cash flow change from year to year, requiring multi-column NOI analysis or discounted cash flow (DCF)
Obvious improvements needed to render property lease-able (in purchase or renovation situation)
New paint or carpeting
Integrity of roof (leaks)
Potholes in parking lot
Underwriting Variables (cont.)
7. Operating expenses Historical expenses generally come from customer
data or tax returns
Both NOI and CFADS exclude depreciation expense and interest expense
Pro-forma expenses generally based on high point of recent history or obvious trend
Generally inflation neutral, because cap rate used with pro-forma NOI (to make value estimate) does not have a direct time value of money component
Sometimes based on “rule of thumb” per square foot, per unit, per bed or % of rents
Underwriting Variables (cont.)
8. Optional: Create pro-forma re-lease and rollover reserve
Ongoing cost to attract tenants or get lease renewals over time Marketing and advertising
Leasing commissions (commercial tenants)
Minor tenant improvements (TIs) related to renting or re-leasing space
More common in larger properties in larger markets
Generally not funded, but assessed at 1% or less of gross effective income
11
Underwriting Variables (cont.)
9. Result/subtotal: NOI
Pro-forma NOI used to ____________________
Pro-Forma NOI Estimated Cap Rate
“Missing link” in most analyses by bankers
Value estimate and loan amount used to determine ______________________________________
Pro-forma NOI can be reduced by 10%, divided by
Estimated cap rate increased by 0.5% or 1.0%
Result: stress-test value estimate
Stress-test LTV: Loan amount divided by stress-test value estimate
Underwriting Variables (cont.)
10. Adjust NOI for distributions to owners, other items not in NOI or at unusual levels; result: CFADS
Appraisers generally stop at NOI as cash flow measure
Not concerned about DSC
Distributions to owners, other non-real estate pass-through items (such as interest income) generally do not affect market view of NOI
Common items that may affect CFADS
Distributions found on Sched. K-1s or business tax tax return Sched. M-2, net of any contributions
Other cash items found on Schedules K, M-1 or M-2 of business tax return and not already used within NOI
The actual management fee
Adjust back to $0 (if mgt. fee imputed for NOI, but self-mgt. makes sense for this borrower)
Adjust back to above-market fee charged by borrower, if for NOI you adjusted the fee down to a market level
Underwriting Variables (cont.)
10.Adjust NOI to get CFADS (cont.) CFADS used by bankers to determine debt
service coverage (DSC)
DSC = CFADS Annual Debt Service Tested against guideline ( 1.25x)
Stress-Test DSC: Combining a higher annual debt service (by increasing interest rate +2% or +3%) with a lower CFADS (by factor of 10-15%)
Adjust/increase interest rate, even if fixed rate in place for 3-5 years- New rate at end of 3-5 years is unknown
Underwriting Variables (cont.)
Summary: For transaction-level stress-testing, at minimum, most banks
Interest rate and CFADS
DSC
Hopefully 1.0x or higher
NOI and cap rate
Value
LTV
Hopefully 100% or lower
13
Preferred Worksheet Format
Shows historical data along with underwriting or pro-forma column that is not necessarily next year, but a representative year in the short-term
In most medium-to-smaller-sized properties, data can be compiled on dollar basis, similar to tax return or financial statement data
For larger properties, data is often expressed on per-square-foot basis
Some bankers include more advanced calculations (for larger loans), such as
Supportable Loan Amount (DSC-based and LTV-based)
DSC Breakeven points (for interest rate, rental rate and/or vacancy rate)
Case Study: Smith Apartments
Customer has reached five-year balloon on an original $850,000 loan at 7.0% fixed interest rate
Seeking to renew $650,000 outstanding at 6.0% fixed for three more years on 10-year amortization
Your bank’s vacancy underwriting guideline for apartments is 10%
For ease of calculation, use a 10% cap rate at the appropriate place
Annual debt service for the renewal will be $86,600
Stress-test annual debt service will be $94,600
Case Study: Smith Apartments Step one: calculate gross potential income from rent roll:
Bldg A has 8 two-BR units that rent for $400 per month Bldg B has 4 two-BR units that rent for $400 per month Bldg C has 4 one-BR units that rent for $325 per month Bldg D has 12 one-BR units that rent for $325 per month Bldg E has 12 one-BR units that rent for $325 per month
Step two: calculate historical NOI & CFADS for 2018 Case data on page 16, worksheet on facing page, page 17
Step three: complete the pro-forma column Step four: compute DSC and stress-test DSC Step five: develop value estimate and loan-to-value (LTV)
using a capitalization rate (“cap” rate) work in small groups – if you are not experienced in this
process, partner with someone that is
Case Study: Smith Apartments
Step one: calculate gross potential income from rent rollA-2BR _____________ = $_________
B-2BR _____________ = _________
C-1BR _____________ = _________
D-1BR 12 x $325 x 12 = 46,800
E-1BR _____________ = __________________________________________________
Total Possible Annual Rents $_________
Case: Tax Return Information for Oak Trace Apartments
Form 8825 (attached to various business tax returns: Form 1120, Form 1120S and Form 1065)
Name: Smith Apartments, LLC (data compiled from three separate tax returns, shown here in one consolidated chart)
1 Name and physical address of each property Type-Enter code 1-8 see page 2 for list
A Oak Trace ApartmentsHuntsville, AL 35811
Rental Real Estate Income
2 Gross rents 2
Rental Real Estate Expenses
3 Advertising 3
4 Auto and travel 4
5 Cleaning and maintenance 5
6 Commissions 6
7 Insurance 7
8 Legal and other professional fees 8
9 Interest 9
10 Repairs 10
11 Taxes 11
12 Utilities 12
13 Wages and salaries 13
14 Depreciation (see instructions) 1415 Other (list) >
15
16 Total expenses for property
Add lines 3 through 15 1617 Income or (Loss) from property
Subtract line 16 from line 2 17
Form 1065 U S Return of Partnership Income
Schedule L - Balance Sheets per Books 12/31/2015 12/31/2016 12/31/2017 12/31/2018(active rows only)
1 Cash
9a Buildings and other depreciable assets
9b Less: accumulated depreciation
11 Land (net of any amortization)
14 Total assets
16 Mortgages, Notes Payable in less than 1 Yr.
19b Mortgages, Notes Payable in 1 Yr. or More
21 Partners' capital accounts
22 Total liabilities and capital
Schedule M-2 - Analysis of Partners' Capital Accounts
1 Balance at beginning of year2 Capital contributed: a. Cash
b. Property
3 Net income (loss) per books4 Other increases (itemize)
5 Add lines 1 through 4
6 Distributions a. Cashb. Property
7 Other decreases (itemize)
8 Add lines 6 and 7
9 Balance at end of year
10,00064,000
125,600
39,000
122,100
42,000
164,600
3,1001,500
45,000
4,000500
44,70014,200
9,8002,800
46,7009,2009,7003,000
45,000
2
Fair Rental Days
365
Personal Use Days
0
600
164,100
3,2001,600
140,500
3,100
86,000
26,000
14,000
184,000
894,000
93,000
86,000
53,000
74,00010,000
48,000
26,000
18,000
237,000
845,000
93,000
2,900200
60,3007,0009,1002,400
2016 2017 2018166,500
3,7001,600
300
779,000894,000 845,000 812,000
42,000
106,00010,000
64,000
135,00013,000
96,000
39,000
13,000122,000
10,00096,000
93,000
753,000 688,000 623,000 564,000
48,000 64,000 96,000 122,000
331,000 661,000
88,000
779,000
701,000
86,000
812,000
93,000
25,000 30,000
978,000 978,000 987,000 992,000794,000 741,000 286,000
REAL ESTATE LOAN UNDERWRITING WORKSHEET
Date of Analysis: _________ << oldest most recent >>
Year 2016 2017Source tax return tax return (customer prepared, tax return, etc.)
NET OPERATING INCOME (NOI) and CASH FLOW AVAILABLE FOR DEBT SERVICE (CFADS)Gross Potential Income $166,800 $166,800 100% 100%
Vacancy 300 2,700 % %
GROSS EFFECTIVE INCOME 166,500 164,100
Management Fees 0 0 % %
Maint.Exp.& Repairs//Reserve 7,300 9,200 %Capitalized Expenditures* 0 5,000 %
Insurance Expense 2,900 3,100Utilities Expense 2,400 3,000Property Tax Expense 9,100 9,700Other Expenses or Reserves** 5,500 5,400
TOTAL EXPENSES 27,200 35,400 % %
NET OPERATING INCOME $139,300 $128,700 % %
Distributions, Other*** 10,000 10,000
CASH FLOW AVAIL FOR DS $129,300 $118,700
DEBT SERVICE COVERAGE ANALYSIS
Cash Flow Avail. For Debt Serv. $129,300 $118,700Total Annual Debt Service**** $91,700 $91,700 $91,700 $86,600
DSC (x) 1.41 1.29
CFADS x 90% $116,370 $106,830Total Debt Serv.@ Int.Rate+2% $103,400 $103,400 $103,400 $94,600
Stress Test DSC (x) 1.13 1.03
LOAN-TO-VALUE ANALYSIS
Most Recent Appraisal Date 03/22/2013 Value $1,064,000 LTV 61%
Pro-Forma NOI (from above)Est. Current Cap Rate 10%
Pro-Forma NOI x 90%Est. Current Cap Rate + 1% 11%
Notes:*Calculated using [(incr.) decr. in net bldgs. & depreciable assets, from Sched. L] - depreciation expense ** Excluding interest exp. & depreciation; can include release or rollover reserve, etc.***Distributions net of any contributions; other cash items from Schedule K, M-1 or M-2 if not used within NOI**** Usually test historical CFADS against historical debt service; can test against proposed debt service
CUSTOMER or PROPERTY: Smith Apts. LLC/Oak Trace__
Pro-Forma
%
Stress-Test Est. Value
Current Est. Value
Current Est. LTV
Stress-Test
Est. LTV
(Rev. 12/2013)
LOAN AMOUNT: $650,000
Stress-Testing at Transaction Level Grid Example #1
1.011.031.051.081.10(10%)
.90.92.94.96.98(20%)
.95.971.001.021.04(15%)
1.071.091.111.141.16(5%)
1.121.151.171.201.230%
CF –
2.0%1.5%1.0%0.5%0.0%
Interest Rate +DSC(target =1.2x)
Stress-Testing at Transaction Level Grid Example #2
78%75%71%68%65%(10%)
88%84%80%77%73%(20%)
82%79%76%72%68%(15%)
74%71%68%65%61%(5%)
70%67%64%61%58%0%
NOI –
2.0%1.5%1.0%0.5%0.0%
Cap Rate +LTV(target =80%)
Cap Rates Oversimplified
Appraisers have several methods for developing cap rate Most dominant is ________________ from comparables
Also popular are ____________________
More academic is _____________________ which is a great way for us bankers to conceptualize
Example, using Smith Apartments caseFunding % of
Portion Deal Cost Factor
Loan 80% x 9% = 7.2%
Equity 20% x 15% = 3.0%
Total 100% 10.2% cap rate
Cap Rates Oversimplified (cont.)
Example, using large apartment complex in nearby cityFunding % of
Portion Deal Cost Factor
Loan 90% x 7% = 6.3%
Equity 10% x 10% = 1.0%
Total 100% 7.3%cap rate
Tables above substitute a market-based loan interest rate (five yrs., fixed) for mortgage constant Similar numbers, move up and down together, but loan rate
easier for bankers to derive on a daily basis
Cap Rates Oversimplified (cont.)
Bands of investment or mortgage/equity method
1. Helps frame your understanding of cap rate levels and their reactions to market forces
2. Explains why larger, investment-grade projects have lower cap rates (those you are likely to read about)
3. Helps you determine where investor return demands are today (starting point) and will likely react to changes in the economy
Example: Where is your market? (next slide)
Cap Rates Oversimplified (cont.)
Where is your market today?
Funding % of
Portion Deal Cost Factor
Loan 75% x __% = ___%
Equity 25% x __% = ___%
Total 100% 12.0%cap rate(from a recent appraisal of similar property)
21
Cap Rates Oversimplified (cont.)
Importance of developing a database from appraisals to begin to track cap rates over time
Importance of general movements in interest rates, since the loan cost and the investor return are critical factors
Appraiser cap rates generally lag actual market by six months
Cap Rates Summary
Ideally, market extraction (from comparables) is balanced against bands of investment (and even lender’s yield or market/investor survey) for appraiser’s cap rate conclusion
NOI Actual Sale Amount = Cap Rate
NOI Actual Sale Amount = Cap Rate
NOI Actual Sale Amount = Cap Rate
From Comparables Cap Rate
Final Cap Rate Conclusion
From Bands of Investment Cap Rate
Cap Rates Summary (cont.)
Cap rate is simply an income multiplier
Similar to price/earnings (P/E) ratio for common stocks based on earnings per share (EPS)
Example
Stock Price = P/E Multiple $200 = 10.0x P/E
EPS $20
NOI = Cap Rate (%) $20 = 10% Cap Rate
Prop. Value $200
Cap Rate DataMay 2012 March 2016
Real Capital Analytics: all property types, deals valued $10 million +,
under contract or closed in last 12 months
$5.0
$5.2
$5.3
$6.0
$7.9
$8.3
$8.7
$10.1
$11.4
$11.6
$13.5
$16.0
$17.5
$18.3
$20.1
$23.0
$24.6
$36.3
$38.1
$88.7
Volume $B
6.9%Tampa20
6.4%Portland19
6.7%Raleigh/Durham18
6.9%Orlando17
6.5%Austin16
6.4%Philadelphia Metro15
6.6%Houston14
5.9%San Diego13
6.4%Phoenix12
6.3%Denver11
5.6%Seattle10
6.8%Atlanta9
6.5%Dallas8
6.3%South Florida7
6.1%Boston6
6.3%Chicago5
6.0%DC Metro4
5.8%SF Metro3
5.5%LA Metro2
5.4%NYC Metro1
Cap RateMost Active Markets
Cap Rate Data (March 2016)
Cap rates just above 5% and close to “Triple B” bond yields “Baa” (Moody’s) in chart at left Good risk proxy (Green
Street)
“RE not cheap anymore” Foreigners bought net $57B of
US RE in 2015 Compared to average of $3B
last five years (Green Street)
Update: Baa at 4.59% at 5/23/2019, vs. 5.19% at 11/19/2018 and long-term average of 7.35%
Appraisal Process Overview
__________________ of ordering and reviewing of commercial appraisals and evaluations In most cases, ___________cannot order or review
appraisals, and cannot prepare evaluations Bank does not have to (should not) follow a “blind draw” of
appraiser selection, as most banks do for residential
Thresholds requiring appraisals ($ size) Situations exempt from appraisals (still need valuation)
Evaluation by bank staff (sometimes an appraiser) Validation, factors to consider when using an existing
appraisal and bring it forward Both approaches have detailed formats/content information in
the 2010 guidelines
Approaches to Value (Brief Definitions)
1. ____________
Estimate of cost to reproduce the building and improvements
Deducts estimated depreciation
Adds the value of the land
2. _____________
Direct sales comparison of similar properties (comparable sales, or “comps”)
Similar location, financing terms, property condition and use
Approaches to Value (Brief Definitions, cont.)
3. __________ 1 – Rental Income, Direct Capitalization
Estimated or known rental income at market rates
New projects may require a stabilization period
Deducts projected vacancy
Deducts operating costs
Excluding
Depreciation
Interest expense
Including
Management fees
Replacement or maintenance reserves
Capitalizes annual NOI to arrive at value conclusion
25
Approaches to Value (Brief Definitions, cont.)
3. ______________ 2 – Discounted Cash Flow
Discounted value of future property sales
Commonly used with land acquisition and development (A&D) loans where lots are sold
Also used for other projects where absorption (selling pace) is important, such as condominiums
Unsold units typically appreciate at market rates
Future net cash flow (sales less various costs) discounted (time value of money) in multiple periods
Unit sales usually assumed to be straight-line, but can be seasonal or more desirable to least desirable
Appraisal Process Overview (cont.)
Replaced or Deleted:
Interagency Appraisal and Evaluation Guidelines –1994
Joint Statement “Independent Appraisal and Evaluation Functions” – 2003
The 2006 Revisions to USPAP
Left in Place:
Financial Institutions Reform Recovery Enforcement Act (FIRREA) Title XI – 1989
Interagency FAQs on Residential Tract Develop-ment Lending – 2005
FAQs on the Appraisal Regulations – 2005
December 2010 Interagency ____________________
2010 Interagency Guidelines (cont.)
Guidelines, not outright regulations (2018 FAQs) No deadline for implementation, up to your primary
regulator Depends on complexity and nature of RE lending activities, risk
profile and business model (2018 FAQs, page 4 of 14)
Re-affirmed and clarified independence of appraisal/evaluation program Retained prudent minimal safeguards for small/rural institutions
Selection of appraisers and evaluators (my word) Emphasis on selecting appraiser competent for
both property type and geographic market Section on appraiser qualifications Less emphasis on “non-preferential and
unbiased process” or going down a list Competency may go beyond USPAP
standards and/or credentials
2010 Appraisal Guidelines (cont.)
Document has appendix materials that can be updated Appendix A further clarifies RE-related transactions
that are exempt
Appendix B covers use of analytical methods or technological tools in developing an evaluation
Appendix C (new from proposal) clarifies minimum standards for analyzing and reporting appropriate deductions/discounts for discounted cash flow (DCF) appraisals
Appendix D is a glossary of terms
27
Minimum Appraisal Standards
1994 Guidelines wording/2010 Guidelines new wording
1. Conform to USPAP, unless sound banking requires stricter standards
Example: USPAP allows appraiser to value property he/she has direct or indirect financial or other interest in, regulations do not
2. Written report plus sufficient information to support value conclusion
Correct report format for transaction complexity
3. Analyze and report discounts and deductions for Proposed construction or renovation
Partially leased buildings
Non-market lease terms
Tract developments with unsold units
Minimum Appraisal Standards (cont.)
4. Based on market value as set forth in regulations Going concern value, value in use and other special values can
be reported, if properly disclosed and identified, but do not qualify
Must consider property’s current physical condition, use and
zoning
If construction or renovation, clear “as is” value and identification
of conditions used to determine prospective market value upon
completion and/or stabilization
5. Performed by state certified or state licensed appraiser plus commensurate
Education and experience
Knowledge of property type and specific property market
Minimum Loan Amount Requiring an Appraisal Raised to $500,000 (April 2, 2018)
Proposed rule in Sept. 2017 suggested $400,000
Actual $250,000 had not been changed since first 1994 Interagency Appraisal Guidelines
Increase to $500,000 from $400,000 would Further reduce the regulatory burden
Reduce number of transactions subject to FIRREA
And not pose a threat to safety and soundness
Does not apply to residential (next slide)
Proposal in late 2018 to increase residential to $400,000
Other Regulatory Comments: FFIEC
Other agencies (HUD, VA, Dept. of Ag. Rural Housing) involved in residential mortgage market and the GSEs (Fannie Mae and Freddie Mac) have authority to set appraisal requirements for loans they originate, insure, acquire, or guarantee, and generally require a certified or licensed appraiser regardless of value of the loan
Based on 2014 HMDA data, at least 90% of residential mortgage loan originations are not subject to Title XI appraisal regulations, but majority of those are subject to the appraisal requirements of agencies or GSEs FFIEC (Federal Financial Institutions Examination Council, a
joint effort of the Federal Reserve, OCC, FDIC and NCUA) Joint Report to Congress, March 2017, page 28
2018 FAQs Result: Regulations
“Superseded” (page 2 of 14) 2005 Interagency FAQs on Residential Tract Development
Lending 2005 FAQs on the Appraisal Regulations
“Heavily emphasized” “The real estate lending standards”
OCC: 12 CFR Part 34, subpart D Fed: 12 CFR Part 208.51 and Part 208, Appendix C FDIC: 12 CFR Part 365, subpart A, Appendix A
March 2016 Interagency Advisory on the Use of Evaluations in Real-Estate Related Transactions (“Evaluations Advisory”)
Addressed ag properties, using appraisals ordered by another bank, and more
More on Market/Comparables
What is the most important consideration in selecting comparable sales? _________________
Appraisers are essentially observers of buyers’ actions. Identifying the typical buyer underpins all other factors with comparable sales. This limits the properties that truly compete against the subject for such a buyer. The other factors serve to then refine the comparables.
Think of a large, 400-unit apartment complex – the potential purchasers are likely to be regional or national players, even REITs. This affects how the other comparable factors (location, physical characteristics and date of sale) are used.
Appraiser Governance Summary
Uniform Standards of Professional Appraisal Practice (USPAP), governed by The Appraisal Foundation [www.appraisalfoundation.org]
The Appraisal Institute (professional association with 24,000 members) provides designations and The Appraisal Journal [www.appraisalinstitute.org] Member of the Appraisal Institute (MAI)
Senior Residential Appraiser (SRA) residential
Senior Real Property Appraiser (SRPA)
Two big issues: competency and independence
State licensing and CPE requirements
Types of Reviews – Three Levels
Administrative review of all appraisals Compliance checklist
Technical review of larger credits In addition to the compliance checklist
Size limits sometimes larger for owner-occupied or C&I
Test data used in income approach
Examine comps and adjustments
By more qualified person than administrative reviewer
Third party review of largest and “complex” Usually by a licensed appraiser
Can use USPAP Standard 3
Three Levels of Review – Sources
FAQs on Appraisal Regulations, March 2005 (p. 6) Should all appraisals undergo a
compliance review? ________, prior to final credit decision ___________ or narrative format Certain reports reviewed more closely to assess technical
quality based on risk, size, etc.
Can a loan be approved subject to receipt of appraisal? Yes, but final approval cannot occur until review and
acceptance of report
Three Levels of Review (cont.)
2010 Interagency Guidelines, page 33 of 70 An institution’s policies and
procedures for reviewing appraisals and evaluations should: Address the reviewer’s
Independence Educational and training qualifications Role
Reflect a risk-focused approach for determining the depth of review
Establish a process for resolving any deficiencies in appraisals and evaluations
Set forth documentation standards for review and resolution of noted deficiencies
Three Levels of Review (cont.)
Setting dollars limits, such that 60-70% of CRE-secured loans
$250,000+ get admin. review only 30% get further technical review
Appraisals done for other banks At least one for each appraiser on approved list as year
unfolds (for purpose of updating approved list) Higher limit for CRE-OO (C&I)
10% get thorough, third party review
Based on “80/20 Rule” where largest 20% of loans by number will account for about 80% of the portfolio’s total dollars
Two Community Bank Portfolios
Total Outstanding $72.8 million $643.8 million
Total # of Notes 226 3,319
Total 20% of Total Notes 45 664
Cumulative $ in Top 20% $51.7 million $477.4 million
Top 20% Share of Total $ 31% 74%
Size of Note at 20% Cut $496,000 $186,000
Appraisal Guidelines Summary/Issues
1. Evaluations must be performed by independent person and reviewed
2. Emphasis on both USPAP compliance and appraiser certification not being sufficient in some cases
3. Market value (appraisals and evaluations) must address current use, conditions and zoning
4. Wording about using an appraisal prepared for another bank adds element of care
5. Tightening of abundance of caution exemption
GSB Online Courses on CRE (2019)
Starting Oct. 15, two 4-part classes (each class has 6 total hours) CRE Appraisals: Reviewing &
Interpreting
CRE Cash Flow: Analyzing Income-Producing or Rental Real Estate, Plus Global Cash Flow Issues
Starting Nov. 26, one 3-part class (4½ total hours) Monitoring & Updating RE Values:
Using RE Cash Flow & Other Resources Beyond Initial Underwriting
Instructor Information
Richard Hamm has been training bankers for 28 years, designing and delivering courses specializing in commercial lending and credit, including portfolio and risk management, commercial real estate (CRE) and appraisals, plus general banking topics such as selling and negotiating skills, and director training. His clients include:
National associations such as the American Bankers Association (ABA)and the Risk Management Association (RMA)
Regional banking schools such as the Barret School of Banking –Memphis, the Graduate School of Banking – Wisconsin, the SouthwesternGraduate School of Banking – Dallas, the Graduate School of Banking atColorado and the Western States School of Banking
State banking and community banking associations in nine states
Individual banks
Based in Huntsville, AL, he has owned/operated Advantage Consulting & Training for 14 years, after a 22-year banking career including senior positions in lending and credit, plus president through formation and acquisition of a community bank.
He has BS and MBA degrees from the University of Alabama.
Appendix (Time Permitting): HVCRE
Years ago, bank capital levels were easy to monitor Simple formula Min. Req. Equity $ Total Assets $ x Capital %
Several rounds of Basel Accords later, bank assets are risk-weighted Banks wanted this, since many assets are much less risky
than loans However, regulators brought off-balance sheet risk exposures
into the formula, such as undrawn lines of credit and standby letters of credit
Result: More complicated formula, and most banks ended up holding just as much capital as before
Also, most loans remain 100% risk-weighted
HVCRE (cont.)
As part of “correcting” banks after the recent recession, regulators decided that certain types of construction loans would have a 150% risk weighting if they are Non-residential Non-agricultural purpose Non-community development oriented And where borrower has not put 15%+ cash equity into deal (based
on “as completed value”), and loan agreement does not require equity to remain through completion of construction
Simple idea, intended (?) to mimic strict rules for equity in the secondary market for residential mortgages, but has greatly complicated loans in two categories Expansions of successful, mature rental properties Owner-occupied CRE
Further, “as completed value” presents appraisal issues
Proposed Revision: HVCRE to HVADC
Will apply to ADC loans that are Non-residential
Non-agricultural purpose
Non-community development oriented
Regardless of equity %, capital risk weighting (RW) will be 130%
Banks with profitability models are finding that 150% RW requires a 0.5%-0.6% increase in loan pricing to maintain ROE or profitability With 130% RW, pricing increment more like 0.3-0.4%
Appendix (Time Permitting): Non-Financial CRE Loan Risks (Beyond Cash Flow, DSC and LTV)
Non-Financial CRE Loan Risks
Qualitative, CRE-specific risks Completion risk
Refinancing risk
Re-lease or rollover risk
Market cycles
Physical plant
Ongoing property management
Lender’s challenge Which of these risks apply to your transaction?
How do you mitigate the applicable risks? Not always strong DSC, low LTV or other financial
aspects/strengths
Construction/Completion Risk
Definition: Failure to complete construction According to original plans and specs
On time
Within budget
Some SOLUTIONS Separate, licensed and qualified general contractor
Bonding of gen. contractor or 10-15% standby letter of credit
Customer equity injected first, before loan draws
Adequate contingency in budget
Assignment of construction contract
Draws and 3rd party inspections
Refinancing Risk
If your bank chooses not to renew, project can’t be financed elsewhere
Previous permanent commitment is not honored or can’t perform
Some SOLUTIONS Underwrite as if you keep the loan to full payout
Conduct normal lending due diligence
Develop your CRE network
Re-Lease or Rollover Risk
Definition: Initial term of lease(s) shorter than proposed amortization (“overhang”)
Some SOLUTIONS Tenant “invests” in finish out
Location, location, location
Periodic inspections for upkeep
Develop your CRE network
Market Cycles
Loan matures/balloons or project fails at bottom of cycle
Some SOLUTIONS Conservative LTV limits
Outside (non-CRE) strength of sponsor
Portfolio diversification
Physical Plant
Unusual or trendy style becomes obsolete
Limited alternative uses
Some SOLUTIONS Stick with “vanilla” styles
Be boring, boring, boring
Know that “beauty is in the eye of the beholder”
Ongoing Property Management
Property is not adequately maintained, serviced or cleaned
Some SOLUTIONS Periodic inspections
Talk to tenants
Professional management in place
Develop your CRE network
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