Navigating the Real Estate Valuation Process

ffective collateral valuation observations from field examinations policies and practices are and dialogue with financial institutions. Ecritical to the success of The article describes appraisal-related any real estate lending program. A regulatory expectations dealing prudent valuation process can help specifically with valuation review, an institution fully understand its reviewer independence, content real estate collateral position and standards, preparer selection, and minimize losses when the collateral monitoring. The use of evaluations becomes the primary repayment and third party arrangements are source. To clarify supervisory also discussed, as well as recent expectations for prudent real independence and fee standards estate appraisals and evaluations, resulting from the Dodd-Frank the federal financial institution Wall Street Reform and Consumer regulatory agencies1 issued the Protection Act (Dodd-Frank Act).3 Interagency Appraisal and Evaluation Guidelines (Guidelines)2 on December 2, 2010. Banks have Reviewing Appraisals/ implemented the various provisions Evaluations of the Guidelines to strengthen their overall real estate valuation program, A review of valuation information is but continue to seek feedback from an essential component of sound credit their regulators about several issues administration and is mandated by the discussed in this article. Dodd-Frank Act.4 Reviewing appraisals The purpose of this article is to and evaluations before engaging in highlight certain aspects of the a loan transaction ensures the value Guidelines and discuss sound practices conclusion is reliable and enables for banks’ real estate valuation financial institutions to make informed processes. The tenets described herein credit decisions, manage credit risk, are based on existing regulatory and meet supervisory requirements. guidance and the authors’ collective

1 The Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve System (FRB), the Federal Deposit Insurance Corporation (FDIC), the Office of Thrift Supervision (OTS), and the National Credit Union Administration (NCUA). Note that OTS functions transferred to other federal financial institution regulatory agencies on July 21, 2011, and the agency was abolished 90 days later. 2 See FIL-82-2010, Interagency Appraisal and Evaluation Guidelines, December 2, 2010, at http://www.fdic.gov/ news/news/financial/2010/fil10082a.pdf. 3 See Section 1472 of the Dodd-Frank Act, Pub. L. No. 111-203 (July 21, 2010) available at http://www.gpo.gov/ fdsys/pkg/PLAW-111publ203/pdf/PLAW-111publ203.pdf. 4 The Uniform Standards of Professional Appraisal Practice (USPAP) 2010-2011 edition defines an appraisal review as the act or process of developing and communicating an opinion about the quality of another appraiser’s work that was performed as part of an appraisal, appraisal review, or appraisal consulting assignment. In addition, Section 1473(e) of the Dodd-Frank Act amended Section 1110 of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 to require the federal financial regulatory agencies, Federal Housing Finance Agency (FHFA), and Consumer Financial Protection Bureau (CFPB) to issue appraisal review standards.

3 Supervisory Insights Winter 2011 Real Estate Valuations continued from pg. 3 The following practices can help Reviewer independence. To ensure banks employ a more effective independence in the valuation valuation review process: review process, banks should assess whether the reviewer is independent Valuation reviewer experience. of loan production staff by: Establishing reviewer qualification • Analyzing the institution’s criteria helps ensure internal and organization reporting lines. external (if outsourced) reviewers Chart 1 depicts a credit have the requisite education, organization that is not experience, and competence sufficiently independent, as the to perform the level of review valuation review staff reports appropriate for the type, risk, and directly to an individual who complexity of the transaction. It also approves real estate loans. ensures that the appraisal/evaluation Chart 2 shows how reviewer contains sufficient information and independence could be optimized analysis to support the decision at the organization. to engage in the transaction. In addition, having a qualified reviewer • Observing the reporting lines, conduct a risk-based, secondary document flows, and decision review of a sample of each points between the valuation reviewer’s work products can help reviewer and his or her supervisor. achieve consistency in the review process, monitor the effectiveness of the reviewers, and address any weaknesses in a timely manner.

Chart 1 Chart 2

Chief Loan Valuation Board or Review Loan Of cer Staff Committee

Residential Commercial Chief Loan Valuation Real Estate Real Estate Of cer Review Loan Loan Staff Of cers Of cers

Residential Commercial Real Estate Real Estate Loan Loan Of cers Of cers

4 Supervisory Insights Winter 2011 • Examining the institution’s loan weaknesses identified through the approval or voting process. review process before engaging in a credit transaction, as outlined • Discussing the issue of indepen- in the Guidelines.6 dence internally with executive management and the credit • Ensuring the review provides review staff, and possibly with meaningful results. A review’s regulators that are familiar with depth and technical nature the institution’s real estate lend- should be commensurate with the ing program. size, type, risk, and complexity of the underlying credit transac- • Ensuring the valuation reviewer is tion. Factual or checklist-type independent when the institution reviews may be sufficient for outsources the review function. low-risk transactions to verify In such situations, the selected report content, policy compli- reviewer should not be in the ance, and conformance with competitive pool of appraisers the USPAP. However, reviews of who bid for the valuation assign- complex or higher-risk properties ment under review. may need to be supplemented with an explanatory narrative Depth of review. The scope of a or other data to ensure critical review is usually a function of the assumptions and conclusions are property’s complexity and the supported. Generally, complex or institution’s perceived risk thresh- higher-risk transactions should old.5 Therefore, the review’s depth receive a more comprehensive should be sufficient to ensure that review that assesses the technical methods, assumptions, data sources, quality of the appraiser’s analysis. and conclusions are reasonable and appropriate. A risk-focused review approach can assist in: • Identifying valuations that are not adequately supported. Institutions should establish policies and procedures for resolving any appraisal or evaluation

5 The Appraisal of Real Estate, Thirteenth Edition, 2008. Chicago, IL: The Appraisal Institute, page 593. 6 Guidelines, page 18 (XV. Reviewing Appraisals and Evaluations – Resolution of Deficiencies).

5 Supervisory Insights Winter 2011 Real Estate Valuations continued from pg. 5 • Detecting potential fraud and the appropriate state appraisal following-up as appropriate. regulatory body when the institu- As Chart 3 illustrates, a recent tion suspects that a state-certified study found that approximately or state-licensed appraiser failed one-third of all mortgage fraud to comply with the USPAP, state cases in 2010 involved appraisal/ laws, or engaged in unethical or valuation fraud. According to the unprofessional conduct.8 Guidelines, institutions should file a Suspicious Activity Report (SAR) with the Financial Crimes Valuation Standards Enforcement Network when fraud is suspected or other transac- The USPAP requires appraisers to tions are identified as meeting the use appropriate valuation methods and 7 SAR filing criteria. Moreover, a techniques in the development and proactive review program should reporting of appraisals.9 Accordingly, include procedures for submit- appraisals should include information ting referrals or complaints to required by USPAP relative to the the appropriate state authorities research, methodology, and analysis when warranted. The Guide- in the valuation. Banks should ensure lines state an institution should that appraisal reports meet USPAP consider filing a complaint with requirements and include an analysis

Chart 3: Mortgage Fraud and Misrepresentations: Post-Funding Investigations (all states)

2010 56% 33% 12% 20% 16% 8% 10%

2009 63% 31% 13% 17% 12% 12% 8%

2008 69% 21% 15% 17% 12% 10% 12%

2007 67% 23% 16%21% 11% 15% 12%

2006 59% 27%20% 17% 10% 12%10%

Application Appraisal/Valuation Tax Return/Financial Statement Veri cation of Deposit Veri cation of Employment Escrow/Closing Documents Credit Report

Source: LexisNexis Mortgage Asset Research Institute, Thirteenth Periodic Mortgage Fraud Case Report, May 2011, available at: http://img.en25.com/Web/LexisNexis/MortgageFraudReport-13thEdition.pdf

7 Guidelines, page 23 (XVIII. Referrals). 8 Ibid. 9 USPAP Standards Rule 1-1.

6 Supervisory Insights Winter 2011 of the project’s market, marketability and its highest and best use.10 Lenders’ Selection and Monitoring valuation policies and engagement of Appraisers letters should instruct appraisers to conduct appropriate research and Selecting competent appraisers is analysis on market supply and demand critical to obtaining reliable collateral characteristics. Fees for such services valuation information. Best practices should provide for an appraisal’s for selecting and monitoring appraisers development commensurate with the include: risk associated with the type of real estate and the loan transaction. Verifying an appraiser’s credentials and standing through the National A property with a highest and best Registry at https://www.asc.gov/ use conclusion such as “hold for future National-Registry/NationalRegistry. development” or “hold as investment” aspx. The Appraisal Subcommit- may indicate potentially higher risk tee (ASC) of the Federal Financial for a development project, as these Institutions Examination Council are prospective investment strategies maintains the National Registry of versus a highest and best use analysis state-licensed and -certified apprais- based on actual current market condi- ers. The National Registry lists the tions as of the effective date of the state(s) in which an appraiser is appraisal. In cases of a prospective licensed, the license number and highest and best use analysis, lenders type (e.g., Certified Residential or should require appraisers to perform Certified General), whether the an appropriate depth of analysis, license status is active or inactive, including a discussion of their conclu- whether the license holder meets sions about a potential purchaser’s the qualification criteria (education, profile (e.g., investor, merchant experience, and examination) of builder, or end user) and a reasonable, the Appraiser Qualifications Board, market-supported absorption period. and whether the licensee is subject to active disciplinary actions. The ASC Web site includes a link to all state appraisal regulatory agencies, which can provide more information regarding appraiser disciplinary actions and other matters.11

10 USPAP Standards Rule 1-3. 11 https://www.asc.gov/State-Appraiser-Regulatory-Programs/StateContactInformation.aspx.

7 Supervisory Insights Winter 2011 Real Estate Valuations continued from pg. 7 Using the findings from the appraisal review process Ongoing Collateral and to evaluate an appraiser’s Other Real Estate Portfolio performance. The appraisal Monitoring review process can assist in the evaluation of individual appraisers’ A sound valuation function should performance and report accuracy. include procedures for monitoring Some banks have found that collateral on a portfolio and individual tracking deficiencies in each asset basis over the life of the asset. reviewer’s valuation reports can be a useful way to strengthen the Loans. Monitoring collateral values performance of the bank’s real for a real estate loan portfolio and estate valuation function. individual loans enables institutions to better identify changing market Conducting random quality conditions which affect credit risk reviews of appraisals obtained exposure. Establishing criteria through appraisal management for obtaining collateral valuations companies. Such reviews can help over the life of a performing credit ensure third-party valuation services supports the effective management meet regulatory requirements and of credit risk, particularly in the institution’s internal standards. declining markets. Valuation policies Banks should also establish a should establish parameters for the process for addressing deficiencies frequency and type of collateral found in third-party appraisals. valuation information to be obtained

Chart 4

The dollar volume of ORE has increased 10 times since rst quarter 2006, and has risen in step with the noncurrent rate.

Other real estate, $Billions (Bar) Noncurrent loan ratio, Percent (Line)

Source: FDIC Call Report data.

8 Supervisory Insights Winter 2011 to ensure banks have useful market of evaluations.14 Further, Appendix data to monitor changes in the B of the Guidelines discusses the use risk profile of individual loans or of analytical methods or technologi- portfolio segments. cal tools (such as automated valuation models) as a basis for evaluations.15 Other Real Estate (ORE). The recent financial crisis resulted Institutions are encouraged to in a significant increase in consider the following points as they non-performing loans and a surge enhance their real estate evaluation in the volume of distressed sales processes: and foreclosures (see Chart 4 on previous page). When valuing a Evaluation content. Develop- foreclosed property to determine ing minimum evaluation content its initial carrying value as ORE, standards helps ensure that evalu- institutions should consider ations contain sufficient informa- selecting appraisers/evaluators not tion to support the market value involved in the previous valuation(s) conclusion. Specifying criteria for of that property. Institutions also determining the level and extent of should consider establishing policies research or inspection necessary and procedures for obtaining ORE to ascertain the property’s physi- valuation information to monitor its cal condition also helps support the carrying value on an ongoing basis. value conclusion and minimize the potential for fraud. Evaluations Valuation techniques and tools. The tools and techniques used for Part 323 of the FDIC’s Rules and the evaluation should support the Regulations requires institutions to property’s market value. Broker obtain an evaluation when an appraisal 12 price opinions or automated valu- is not required. The Guidelines estab- ation models should not be solely lish supervisory expectations for real 13 relied upon to develop an evaluation estate evaluations. The Guidelines of value. also identify real estate-related transactions that allow evaluations, outline Determining when an evaluation standards for developing an evalua- is appropriate. The Guidelines tion, and detail the minimum content identify the types of real estate- related transactions for which an

12 See Part 323 at http://www.fdic.gov/regulations/laws/rules/2000-4300.html. 13 Guidelines, pages 5-6 (VI. Selection of Appraisers or Persons Who Perform Evaluations). 14 Guidelines, pages 12-14 (XII. Evaluation Development and XIII. Evaluation Content). 15 Guidelines, pages 31-35, (Appendix B – Evaluations Based on Analytical Methods or Technological Tools).

9 Supervisory Insights Winter 2011 Real Estate Valuations continued from pg. 9

evaluation is permissible.16 The provisions; however, there has been Guidelines also recommend that some confusion regarding what type institutions establish policies and of valuation is needed for new and procedures for determining when existing real estate-related trans- to obtain an appraisal even though actions. Some of the regulatory an evaluation may be permissible.17 requirements for obtaining an evalu- Most institutions understand these ation or appraisal are detailed below.

A Real Estate Evaluation is Required When: A new real estate-related transaction is $250,000 or less, A new real estate-related transaction is a business loan of $1 million or less and the sale of or rental income derived from real estate is not the primary source of repayment, or A real estate-related transaction involves an existing extension of credit at the lending institution, provided that: • There has been no obvious and material change in market conditions or the physi- cal aspects of property that threatens the adequacy of the institution’s real estate collateral protection after the transaction, even with the advancement of new monies; or • There is no advancement of new monies, other than funds necessary to cover reasonable closing costs.

A Real Estate Appraisal is Required When: A new real estate-related transaction exceeds $250,000, unless another exemption applies, A lease is the economic equivalent of a purchase or sale of leased real estate, or The banking supervisor requires an appraisal be obtained.

A Real Estate Appraisal is Not Required When: A lien on real estate is taken as an “abundance of caution,” A loan is not secured by real estate, A lien has a purpose other than the real estate’s value, A new business loan is $1 million or less and the sale of or rental income derived from real estate is not the primary source of repayment, or A renewal, refinancing, or other subsequent transaction of an existing extension of credit where an evaluation is permitted. NOTE: This list highlights selected supervisory valuation requirements, and readers should refer to Part 323 of the FDIC’s Rules and Regulations for complete details.

16 Guidelines, pages 11-12 (XI. Transactions That Require Evaluations). 17 Ibid., page 12. Depending on the extent of collateral exposure and overall credit risk involved, the institution may obtain an appraisal in lieu of an evaluation out of prudential concerns. Such appraisals must comply with USPAP.

10 Supervisory Insights Winter 2011 Conduct a review of the AMC’s Overseeing Third-Party selection process for appraisers/ Arrangements reviewers. To ensure the institution’s qualification requirements are A financial institution may engage met (e.g., education, experience, a third party, such as an appraisal type and status of state license, and management company (AMC), to technical competency for particu- perform certain collateral valuation lar property types and markets), functions on its behalf. Outsourc- it is critical the AMC be provided ing this function may be motivated the institution’s criteria for review- by concerns about appraiser inde- ing and selecting appraisers and pendence or the lack of internal appraisal report reviewers. technical expertise or resources to properly review appraisals of complex or non-local properties. Importantly, Dodd-Frank Act Appraisal the Guidelines state that the lender Independence Requirements is responsible for ensuring that third- party servicers comply with applicable The Dodd-Frank Act required the FRB laws and regulations and their work to prescribe interim final regulations products are consistent with supervi- defining specific acts or practices that sory guidance.18 To facilitate effective violate appraisal independence in the oversight of third-party arrangements, context of the Truth in Lending Act.19 financial institutions should: The FRB issued such interim final rules, effective April 1, 2011, by adding Perform appropriate due diligence Section 226.42 to Regulation Z. While when selecting and overseeing the new rules address several issues, an AMC. Performing due diligence three key appraisal-related matters for before engaging a third party, real estate credit transactions include: as well as ongoing oversight of the arrangement, increases the Appraiser independence. Section likelihood the third-party provider 226.42(c) encourages appraiser will perform the services consistent independence by prohibiting certain with the financial institution’s acts that directly or indirectly standards and regulatory cause the value assigned to a requirements. consumer’s principal dwelling to be based on any factor other than the independent judgment of the person who prepares the valuation.

18 Guidelines, pages 18-20 (XVI. Third Party Arrangements). 19 See Section 1472 of the Dodd-Frank Act, Pub. L. No. 111-203 (July 21, 2010) available at http://www.gpo.gov/ fdsys/pkg/PLAW-111publ203/pdf/PLAW-111publ203.pdf. Section 1472 also provides that the FRB, OCC, FDIC, NCUA, FHFA and CFPB may jointly issue rules, interpretive guidelines, and general statements of policy with respect to acts or practices that violate appraisal independence in the provision of mortgage lending services for a consumer credit transaction secured by the principal dwelling of the consumer and mortgage brokerage services for such a transaction.

11 Supervisory Insights Winter 2011 Real Estate Valuations continued from pg. 11 Examples of such prohibited acts those with limited staff or a include, but are not limited to, relatively low volume of residential seeking to influence the appraiser/ mortgage loan originations. evaluator to report a minimum Institutions should document or maximum value, withholding the prudent safeguards that have timely payment to the preparer been implemented to isolate the because the property is not valued valuation function from influence at or above a certain amount, by the loan production process. and conditioning the preparer’s Such safeguards could include compensation on consummation of having trained administrative staff the covered transaction. These and control the appraisal ordering other acts that would compromise process based on a list of approved the collateral valuation function also appraisers and requiring qualified are noted in the Guidelines.20 officers and directors not involved in the origination of the pending Conflicts of interest. Section real estate-related transaction to 226.42(d) seeks to limit potential review the appraisal. Institutions conflicts of interest by prohibiting may contact their local FDIC office persons preparing a valuation or to discuss possible safeguards. performing valuation management Examiners should continue to functions from having a direct or exercise judgment in determining indirect interest in the property or whether a bank’s valuation function transaction for which the valuation complies with these requirements. is being performed. Notably, a person employed by or affiliated Customary and reasonable with the creditor does not have fees. Section 226.42(f) requires a conflict of interest based solely the creditor and its agents to on that employment or affiliate compensate a fee appraiser for relationship so long as certain performing appraisal services at conditions establishing a safe a rate customary and reasonable harbor are met. for comparable appraisal services performed in the geographic market The safe harbor for financial of the property being appraised. Two institutions with more than safe harbors are provided. The first $250 million in assets as of year- is based on the creditor or its agents end for the past two calendar reviewing certain factors and not years essentially requires total engaging in anticompetitive acts. independence between the The second is based on the creditor valuation function and the loan or its agents relying on certain production process. This degree external information for determining of separation may be problematic the amount of compensation. Some for many community banks with financial institutions may have assets over $250 million, especially

20 Guidelines, pages 3-5 (V. Independence of the Appraisal and Evaluation Program).

12 Supervisory Insights Winter 2011 difficulty obtaining sufficient and Diane P. McKee appropriate data to comply with SRPA, SRA, Appraisal Review these requirements. An institution Specialist may demonstrate compliance by San Francisco Field Office documenting the information it [email protected] considered and used in determining what is a customary and reasonable Donald T. Mulherin fee for a given appraisal service. Examiner Cedar Rapids Field Office [email protected] Conclusion Richard G. Rawson A borrower’s ability to repay a real MAI, Appraisal Review estate loan according to reasonable Specialist terms remains the primary consider- Phoenix Field Office ation in the lending decision and in [email protected] examiner review of the loan portfolio. However, when collateral becomes the primary repayment source for a loan, the valuation and assessment of that The authors would like to acknowl- collateral will help determine whether edge the valuable contributions of a loss could be sustained. Institutions Timothy P. McMahon, Examiner, to the should review valuation policies and research and writing of this article. procedures to ensure the valuation function is appropriate for the size, nature, and complexity of an institution’s real estate lending program. Efforts to provide accurate valuations can enable the institution to make more prudent and informed credit decisions.

Dennis C. Ankenbrand Senior Examination Specialist San Francisco Regional Office [email protected]

Beverlea Suzy Gardner Senior Examination Specialist Washington Office [email protected]

13 Supervisory Insights Winter 2011