How lenders' distressed assets are appraised can impact the overall market

Carl Streck, principal, MountainSeed Appraisal Management

As published in Scotsman Guide's Commercial Edition, June 2012.

The recent financial crisis brought to the fore how important it is for commercial mortgage brokers to stay on top of the factors that can impact current and future property values. These factors include issues that impact the lending environment as well as the actual property itself. With this knowledge and understanding, mortgage professionals can be prepared to deal with today’s market challenges and brace themselves for future industry fluctuations.

One of the issues that will impact the market this year and the next several years is the expiration of shared-loss agreements (SLAs) made at the height of the property boom between the Federal Deposit Insurance Corp. (FDIC) and financial institutions. The FDIC entered into these agreements to incentivize acquisitions by guaranteeing 80 percent coverage of projected losses on acquired assets for an effective five-year window. For any institution involved in an SLA in the peak years of 2007 and 2008, this means that window will be closing in the next 24 months, and the trend will continue for many years to come.

In most cases, the end of an SLA means that the acquiring banks will be required to absorb the full losses tied to their commercial real estate portfolios. They must, therefore, have a precise value for their commercial property assets to make any strategic business decisions related to their portfolios before the SLA window closes.

In addition, in many cases, banks may not able to sell assets below the valuation received from an independent third party. This creates a difficult situation for the acquiring banks, the FDIC, and the broader commercial and residential real estate markets, because there will be pressure on the acquiring banks to sell assets before an SLA expires. When some of those assets transact, they have the potential to create lower data points for appraisers when valuing similar properties — which could mean further depression in overall commercial property values.

In distress

Although distressed property is certainly not a new concept, the recent recession has put it into a completely different context. As recently as 2006, most banks did not have clearly assigned special-assets groups or departments because there simply wasn’t an overwhelming demand for that specific service.

At the height of the recession, the FDIC took action with SLAs to facilitate a rapid consolidation within the industry. As a result, volumes of accounts and portfolios exchanged hands, and banks that experienced influxes found themselves suddenly in possession of billions of dollars of distressed commercial accounts. At the same time as these acquisitions, there was an increase in defaults on commercial mortgages, causing land values to plummet.

In the past two years, financial institutions have begun to realize substantial losses on their assets. There were large impairments — estimated at between 30 percent and 60 percent in development and construction loans — from what the bank was owed to what, ultimately, the market value of the property was.

The high number of portfolios acquired by banks coupled with a depressed real estate market will result in varying levels of loss for nearly everyone involved. By some estimates, many banks may see an additional loss of 30 percent to 50 percent of their other real estate owned (OREO) book values this year, because these banks are carrying property within those portfolios at 50 percent of the original cost. Banks then may see additional losses, because the land is trading as low as 10 percent of the loans in some instances, and commercial real estate and distressed properties continue to trend in a fashion similar to what the industry saw in the past two years.

Commercial real estate is extremely expensive to carry, and it would be a mistake to think that a valuation performed even a few years ago is substantial enough to project future values. The FDIC defines the life of an appraisal as varying based on market conditions and property type, and says it is affected by the volatility of the local market, availability of financing and inventory of competing properties.

Because of the inconsistency of the commercial real estate market, it is imperative to the health of a financial institution to have an accurate and current valuation of its assets, so it can be well-informed of its position and aware of any potential losses. Banks therefore are likely to seek portfolio valuations that are clearly defined and managed with as few disparities and distortions as possible, which will help mitigate any potential losses.

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