Community Banking Advisor: Setting the Value of Real Estate Collateral

Abstract:   Influenced by the real estate crises of the last decade, bank examiners today want to know that banks are following all rules and guidelines for their valuation programs for real estate collateral. This article discusses interagency guidelines and the importance of program independence, selection criteria for valuators and appraisal standards.

When did your bank last review its valuation program for real estate collateral? Bank examiners today, still influenced by the real estate crises of the last decade, want to know that your institution is following all relevant rules and guidelines.

Interagency Guidelines are Key

Start your evaluation by revisiting the kingpin of any valuation program, the Interagency Appraisal and Evaluation Guidelines. They apply to appraisals and evaluations for all real estate–related financial transactions originated or purchased by regulated institutions, whether for the institutions’ own portfolios or as assets held for sale. The guidelines cover residential and commercial mortgages, capital markets groups, and asset securitization and sales units.

Most transactions valued at over $250,000 require appraisals, though certain transactions — listed in Appendix A to the guidelines — are exempt. In addition to the exclusion for transactions at or below the $250,000 threshold, the exceptions include business loans secured by real estate for less than $1 million whose source of repayment is from other than the rental income or sale of the real estate. Also, extensions of existing credits, loans not secured by real estate, and transactions guaranteed or insured by the U.S. government are generally exempt from the appraisal requirement.

The exemptions are limited, so be sure to scrutinize transactions to determine whether risk factors or other circumstances make an appraisal necessary. Some exempt transactions require a less formal evaluation.

Effective Programs are Independent

Your institution is responsible for developing an effective collateral valuation program. First, consider the independence of your program, which should be isolated from influence by your loan production staff. Individuals who order, review and accept appraisals or evaluations should have reporting lines independent of the production staff as well. Appraisers and individuals performing evaluations (“evaluators”) need to be independent of loan production and loan collection and obviously should have no interest in the transaction or property.

Special rules apply to smaller institutions that lack the staff needed to separate their collateral valuation programs from the production process.

For mortgages and other loans secured by a principal dwelling, review amendments to Regulation Z that impose strict independence and conflict-of-interest requirements on appraisers.

Selection Criteria for Valuators are Crucial

Next consider how you select valuators. Set criteria for selecting, evaluating and monitoring appraisers and evaluators, and for documenting their credentials. Among other things, ensure that those selected are qualified, competent and independent and that appraisers hold appropriate state certifications or licenses.

Select and engage appraisers directly, although appraisals prepared for other institutions may be used if certain requirements are met. Approved appraiser lists are permitted, provided you establish safeguards to ensure that list members continue to be qualified, competent and independent.

Minimum Appraisal Standards Must be Met

Then make sure that your appraisals conform to the Uniform Standards of Professional Appraisal Practice, although safe and sound banking practices may call for stricter standards. Written reports should provide sufficient detail — according to the transaction’s risk, size and complexity — to support the credit decision. Appraisers should analyze appropriate deductions and discounts (detailed in Appendix C of the guidelines) for proposed construction or renovation, partially leased buildings, nonmarket lease terms and tract developments with unsold units.

Other Factors Weigh In

In addition to these touchstones, your program should facilitate credit decisions by ensuring the timely receipt and review of appraisal or evaluation reports. It also should provide criteria for determining whether existing appraisals or evaluations may be used to support subsequent transactions. Moreover, your valuation program should have in place internal controls that promote compliance. And it should contain standards for monitoring collateral values and for handling transactions not otherwise covered by appraisal regulations.

If you outsource valuation functions, your institution remains responsible for all appraisals and evaluations. The interagency guidelines discuss the resources, expertise, controls and due diligence procedures your institution needs to identify, monitor and manage risks associated with these outsourcing arrangements.

If It’s Broke…

Like any effective bank endeavor, your real estate collateral valuation program should be reviewed and updated regularly. If any part of your program isn’t working properly, make adjustments promptly.