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

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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 $_________

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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)

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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