COMMERCIAL LOAN MODIFICATION/WORKOUTS APPRAISER

COMMERCIAL LOAN MODIFICATION/WORKOUTS APPRAISER http://www.fdic.gov/news/news/financial/2009/fil09061a1.pdf

Policy Statement on

Prudent Commercial Real Estate Loan Workouts

The financial regulators1 recognize that financial institutions face significant challengeswhen working with commercial real estate (CRE)2 borrowers that are experiencing diminished

operating cash flows, depreciated collateral values, or prolonged sales and rental absorption

periods. While CRE borrowers may experience deterioration in their financial condition, many

continue to be creditworthy customers who have the willingness and capacity to repay their

debts. In such cases, financial institutions and borrowers may find it mutually beneficial to work

constructively together.

The regulators have found that prudent CRE loan workouts are often in the best interest

of the financial institution and the borrower. Examiners are expected to take a balanced

approach in assessing the adequacy of an institution’s risk management practices for loan

workout activity. Financial institutions that implement prudent CRE loan workout arrangements

after performing a comprehensive review of a borrower’s financial condition will not be subject

to criticism for engaging in these efforts even if the restructured loans have weaknesses that

result in adverse credit classification. In addition, renewed or restructured loans to borrowers

who have the ability to repay their debts according to reasonable modified terms will not be

subject to adverse classification solely because the value of the underlying collateral has declined

to an amount that is less than the loan balance.

I. Purpose

This statement updates and replaces existing supervisory guidance to assist examiners in

evaluating institutions’ efforts to renew or restructure loans to creditworthy CRE borrowers.3 It

is intended to promote supervisory consistency, enhance the transparency of CRE workout

transactions, and ensure that supervisory policies and actions do not inadvertently curtail the

availability of credit to sound borrowers. This guidance addresses supervisory expectations for

an institution’s risk management elements for loan workout programs, loan workout

arrangements, classification of loans, and regulatory reporting and accounting considerations.

1 The financial regulators consist of the Board of Governors of the Federal Reserve System (FRB), the Federal

Deposit Insurance Corporation (FDIC), the National Credit Union Administration (NCUA), the Office of the

Comptroller of the Currency (OCC), the Office of Thrift Supervision (OTS), and the Federal Financial Institutions

Examination Council (FFIEC) State Liaison Committee (collectively, the regulators).

2 Consistent with the FRB, FDIC, and OCC joint guidance and the OTS guidance on Concentrations in CommercialReal Estate Lending, Sound Risk Management Practices (December 2006), CRE loans include loans secured by

multifamily property, and nonfarm nonresidential property where the primary source of repayment is derived from

rental income associated with the property (that is, loans for which 50 percent or more of the source of repayment

comes from third party, nonaffiliated, rental income) or the proceeds of the sale, refinancing, or permanent financing

of the property. CRE loans also include land development and construction loans (including 1- to 4-family

residential and commercial construction loans), other land loans, loans to real estate investment trusts (REITs), and

unsecured loans to developers. For credit unions, “commercial real estate loans” refers to “member business loans,”

as defined in Section 723.1 of the NCUA Rules and Regulations, secured by real estate.

3 This statement replaces the Interagency Policy Statements on the Review and Classification of Commercial Real

Estate Loans (November 1991) and Review and Classification of Commercial Real Estate Loans (June 1993).

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The statement also includes references and materials related to regulatory reporting,4 but it does

not change existing regulatory reporting guidance provided in relevant interagency statements

issued by the regulators or accounting requirements under generally accepted accounting

principles (GAAP). These general principles also could apply to commercial loans that are

secured by real property or other business assets of a commercial borrower.

 

 

C. Assessing Collateral Values

As the primary sources of loan repayment decline, the importance of the collateral’s

value as a secondary repayment source increases in analyzing credit risk and developing an

appropriate workout plan. The institution is responsible for reviewing current collateral

valuations (i.e., an appraisal or evaluation) to ensure that their assumptions and conclusions are

reasonable. Further, the institution should have policies and procedures that dictate when

collateral valuations should be updated as part of its ongoing credit review, as market conditions

change, or a borrower’s financial condition deteriorates.

For CRE loans involved in a workout situation, a new or updated appraisal or evaluation,

as appropriate, should address current project plans and market conditions that were considered

in the development of the workout plan. The consideration should include whether there has

been material deterioration in the following factors: the performance of the project; conditions

for the geographic market and property type; variances between actual conditions and original

appraisal assumptions; changes in project specifications (e.g., changing a planned condominium

project to an apartment building); loss of a significant lease or a take-out commitment; or

increases in pre-sales fallout. A new appraisal may not be necessary in instances where an

internal evaluation by the institution appropriately updates the original appraisal assumptions to

reflect current market conditions and provides an estimate of the collateral’s fair value for

impairment analysis.9

The market value in a collateral valuation and the fair value in an impairment analysis are

based on similar valuation concepts. However, the market valuation may differ from the

collateral’s fair value for regulatory reporting purposes. For example, differences may result if

the market value and the fair value estimates are determined as of different dates or the fair value

estimate reflects different assumptions than those in the market valuation. Such situations may

occur as a result of changes in market conditions and property use since the “as of” date of the

appraisal.

9 According to the FASB ASC Master Glossary, “fair value” is “the price that would be received to sell an asset or

paid to transfer a liability in an orderly transaction between market participants at the measurement date.”

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The documentation on the collateral’s market value should demonstrate a full

understanding of the property’s current “as is” condition (considering the property’s highest and

best use) and other relevant risk factors affecting value. Collateral valuations of commercial

properties typically contain more than one value conclusion and could include an “as is” market

value, a prospective “as complete” market value, and a prospective “as stabilized” market value.

The institution should use the market value conclusion (and not the fair value) that

corresponds to the workout plan and the loan commitment. For example, if the institution

intends to work with the borrower to get a project to stabilized occupancy, then the institution

can consider the “as stabilized” market value in its collateral assessment for credit risk grading

after reviewing the reasonableness of the appraisal’s assumptions and conclusions. Conversely,

if the institution intends to foreclose, then the institution should use the fair value (less costs to

sell) of the property in its current “as is” condition in its collateral assessment.

Examiners will analyze collateral values based on the institution’s original appraisal or

internal evaluation, any subsequent updates, additional information, and relevant market

conditions. An examiner should review the appropriateness of the major facts, assumptions, and

valuation approaches in the collateral valuation and in the institution’s internal credit review and

impairment analysis.

If weaknesses are noted in the institution’s supporting documentation or appraisal or

evaluation review process, examiners should direct the institution to address the weaknesses,

which may require the institution to obtain a new collateral valuation. However, if the institution

is unable or unwilling to address these deficiencies in a timely manner, examiners will have to

assess the degree of protection that the collateral affords in analyzing and classifying a credit.

This may result in examiners making adjustments, if applicable, to the collateral’s value to

reflect current market conditions and events. When reviewing the reasonableness of the facts

and assumptions associated with the value of an income-producing property, examiners should

evaluate:

• Current and projected vacancy and absorption rates

• Lease renewal trends and anticipated rents

• Effective rental rates or sale prices, considering sales and financing concessions

• Time frame for achieving stabilized occupancy or sellout

• Volume and trends in past due leases

• Net operating income of the property as compared with budget projections, reflecting

reasonable operating and maintenance costs

• Discount rates and direct capitalization rates (refer to Attachment 3 for more

information)

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Assumptions, when recently made by qualified appraisers (and, as appropriate, by the

institution) and when consistent with the discussion above, should be given a reasonable amount

of deference by examiners. Examiners also should use the appropriate market value conclusion

in their collateral assessments. For example, when the institution plans to provide the resources

to complete a project, examiners can consider the project’s prospective market value and the

committed loan amount in their analysis.

Examiners generally are not expected to challenge the underlying valuation assumptions,

including discount rates and capitalization rates, used in appraisals or evaluations when these

assumptions differ only in a limited way from norms that would generally be associated with the

collateral under review. The estimated value of the underlying collateral may be adjusted for

credit analysis purposes when the examiner can establish that any underlying facts or

assumptions are inappropriate or can support alternative assumptions.

Many CRE borrowers may have other indebtedness secured by other business assets such

as furniture, fixtures, equipment, inventory, and accounts receivable. For these commercial

loans, the institution should have appropriate policies and practices for quantifying the value of

such assets, determining the acceptability of the collateral, and perfecting its security interest.

The institution also should have appropriate procedures for ongoing monitoring of the value of

its collateral interests and security protection.

IV. Classification

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