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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   June 2012

Keeping Tabs on Property Values

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

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.

"Without the proper instructions, property information and appraisal type, the report that is returned to the bank can carry what appear to be mistakes and even value issues, but in fact, the main issue was the way the appraisal order was placed."

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. 

A measured process 

One instance in which an appraisal is typically ordered is when a loan becomes real estate owned (REO) by the bank. The issue — and it’s rapidly growing — is that land was being appraised this past year slightly lower than its value in 2010. Questions should be raised in terms of quality and compliance when there are immense differences in property valuations from one year to the next. This underscores why choosing the correct appraiser, and being diligent and clear in the engagement process, can be the most important decision a bank can make. 

One of the most overlooked areas in a financial institution’s appraisal process can be presenting the appraiser with the correct information in the engagement process — this information governs the entire appraisal and is critical to an appraisal’s accuracy. Getting the proper instructions at the onset is an issue that appraisers across the country have with the appraisal process done internally at banks and with appraisal management companies. Without the proper instructions, property information and appraisal type, the report that is returned to the bank can carry what appear to be mistakes and even value issues, but in fact, the main issue was the way the appraisal order was placed. 

Banks must have a basic mandate of valuation and appraisal guidelines that will help them adopt and review policies and procedures. The primary formula for any institution engaging in the valuation process is to make sure there is a policy in place, review its compliancy within revised guidelines and then ensure practices match those policies, as well as regulatory requirements.

Structured independence

Banks reduce the potential likelihood of any complications in the valuation process by having structural separation between the collateral valuation team and the loan-production team. 

The loan-production staff usually includes anyone responsible for generating loan volume, including: lending, loan originators, frontline approval personnel and their supervisors/subordinates (at least one level up and one level down). Additionally, employees compensated via bonuses for processing or approving loans, or the amount of loans generated, should be disqualified from the collateral-valuation department.

Through the regulations made recently, there is a consistent theme that every person who helps to develop approved appraiser lists and who orders and reviews appraisals and valuations should be isolated on the collateral-valuation team in terms of to whom they report and how they are compensated.

When the collateral-valuation team has been identified and isolated from the loan production team, an appraiser can be selected. Institutions should limit the authority to select appraisers to its collateral-valuation team or its appraisal management company. 

• • •

It is imperative for financial institutions with commercial real estate portfolios to address potentially damaging components within their accounts, particularly in view of the expiration of many SLAs. In addition, by implementing  in-house procedures or employing a qualified outside appraisal company to handle the valuation process from start to finish, banks potentially can minimize financial losses on their commercial real estate portfolios and position themselves to emerge in better fiscal health overall.

All these issues will eventually impact the overall commercial real estate industry, and commercial mortgage brokers and professionals must be aware of emerging trends as they continue to change and shape the lending landscape. 


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