The Use of Evaluations in a Prudent Risk Management Framework for Real Estate Lending
by Carmen Holly, Senior Supervisory Financial Analyst, Board of Governors of the Federal Reserve System
Underwriting credit to finance real estate is a significant component of risk management activity at many financial institutions. Whether considering a loan request to finance residential property, owner-occupied commercial property, or income-producing commercial property, most lenders will at some point in their careers need to consider the value of real estate when making a decision to extend or not extend credit. Some lenders may be conservative and follow prudent risk management practices when obtaining property valuations by choosing to use appraisals for all real estate–related financial transactions, even those that would require only evaluations under the federal banking agencies’ appraisal regulations.1 This article discusses the appropriate use of evaluations as part of a prudent risk management program for an institution’s real estate lending activity. It also addresses some of the reasons bankers may hesitate to use evaluations and shows how these hesitations can be overcome.2 The agencies’ appraisal regulations and the Interagency Appraisal and Evaluation Guidelines (IAEG) address circumstances in which a bank must obtain an appraisal or may use an evaluation.3
Bankers should exercise prudent risk management by gaining a full understanding of all repayment sources prior to extending credit. Cash derived from the sale of collateral provides a secondary source of repayment in the event that a borrower’s primary cash flow and liquidity are insufficient to make loan payments in accordance with the loan agreement. For a bank to understand the capacity of the real estate collateral that is to serve as a secondary source of repayment, a bank can use both appraisals and evaluations to provide an estimate of the market value of the property for which a credit extension is being secured.
Connection to the Real Estate Lending Standards Regulations
The agencies’ real estate lending standards regulations set forth the regulatory requirements for a bank’s real estate lending activity.4 These regulations and accompanying guidelines establish underwriting standards and supervisory loan-to-value (LTV) limits to address the risk of real estate lending. A bank is expected to comply with the regulations’ supervisory LTV limits and to understand the value of a real estate loan’s collateral. Bankers, therefore, need to obtain an estimate of the market value of a loan’s collateral to determine its LTV ratio and whether the loan complies with the supervisory LTV limits and the institution’s risk appetite. The agencies’ guidelines define value as “an opinion or estimate set forth in an appraisal or evaluation, whichever may be appropriate, of the market value of real property, prepared in accordance with the agency’s appraisal regulations and guidance. For loans to purchase an existing property, the term ‘value’ means the lesser of the actual acquisition cost or the estimate of value.”5
Requirements for Evaluations
The agencies’ appraisal regulations and the IAEG provide guidance for determining market values, creating an effective real estate valuation program, and establishing the usage and content of evaluations. Institutions should establish policies and procedures to determine the appropriate valuation method for a given transaction, taking into consideration the associated risks. On a portfolio level, institutions should review their policies and practices related to real estate lending and should maintain risk management practices and capital levels commensurate with the level and nature of their real estate concentration risk while remaining in compliance with regulations and supervisory guidance.
When establishing a real estate valuation program, banks should keep in mind the following:
- One primary difference between appraisals and evaluations is who can perform them. While appraisals can be performed only by a state-certified or licensed appraiser, evaluations can be performed by a person who possesses appropriate appraisal or collateral valuation education. As such, banks can use internal qualified staff to prepare evaluations and comply with federal regulations. The IAEG discusses specific criteria that institutions should consider when selecting individuals to perform
- Professional standards are another difference between appraisals and evaluations. The agencies’ appraisal regulations require that appraisals must conform to generally accepted appraisal standards as evidenced by the Uniform Standards of Professional Appraisal Practice (USPAP). While there are no professional standards listed for evaluations in the regulations or guidance, the IAEG provides supervisory expectations for the development and content of an evaluation.
- Reporting standards also differ between the valuation methods. USPAP provides various appraisal report options that appraisers may use to present an opinion of value. Reporting standards for evaluations are not specified.
- In regard to content, the agencies’ appraisal regulations and guidance require both appraisals and evaluations to contain sufficient information to support the credit decision. However, USPAP also defines specific content standards for appraisals.
There are some similarities in the supervisory expectations for appraisals and evaluations. Both methods have an expectation of independence, meaning that the agencies expect the preparer of an evaluation not be a party to the transaction. The agencies also expect that an appraisal and an evaluation provide an estimate of the market value of the collateral and, equally important, provide sufficient information to support the bank’s credit decision.
Evaluations Versus Appraisals
Bankers have voiced concerns that they are hesitant to use evaluations even when the agencies’ appraisal regulations permit the use of them. Bankers have also noted that examiners appear to favor appraisals over evaluations. The following discussion attempts to clarify the regulatory expectations for evaluations by highlighting common reasons why bankers may hesitate to use evaluations.
1. We are not sure when we can use evaluations; examiners seem to favor appraisals and may be extra critical if we use evaluations.
The agencies’ appraisal regulations permit an evaluation instead of an appraisal for three transaction types:
- Transactions with a value equal to or less than $250,000
- Real estate secured business loans with values equal to or less than $1,000,000
- Renewals, refinancings, or other subsequent transactions when there has been no obvious or material change in market conditions or physical aspects of the property that threatens the adequacy of the institution’s collateral protection (even with the advancement of new monies) or no advancement of new monies other than funds necessary to cover reasonable closing costs6
2. Our bank does not have sufficient staff or does not have staff with the expertise to perform evaluations, so we just use appraisals.
Bankers may feel that they are understaffed in the valuation function or that their employees do not have the level of expertise necessary to determine the value of the real estate. Community banks with limited staff resources may not be able to maintain a real estate valuation program that is independent from the lending function or the credit approval process. The bank personnel with the most knowledge about real estate are typically the bank’s real estate lending officers. As such, a bank without sufficient internal expertise may need to hire an appraiser or another outside party to complete an evaluation and may not see much of a cost benefit between appraisal fees and the cost of an evaluation.
Although permitted, a state-certified or licensed appraiser is not required to prepare an evaluation. However, the important task of estimating collateral value should be given only to an individual with the knowledge, experience, or expertise relevant to the property being valued. The IAEG names several examples of individuals who may have the expertise to perform evaluations, including appraisers, real estate lending professionals, agricultural extension agents, and foresters (if applicable). In addition to these professionals, some institutions hire and train their own personnel to do evaluations or engage an appraisal management company or a third party to prepare evaluations. The use of a third party can address issues of cost and independence for some lenders.
3. In the past, our bank used drive-by estimates or brokers’ price opinions, but now we are unsure whether these estimates meet the agencies’ requirements for an evaluation.
Drive-by estimates or brokers’ price opinions on their own do not meet the agencies’ requirements for the content of an evaluation. The IAEG lists minimum content requirements for an evaluation; banks may establish criteria in addition to the requirements listed in the guidance. The most important concepts in evaluation development are that evaluations should be written, contain sufficient information to support the credit decision, and be developed in accordance with safe and sound banking practices.7 There is no standard format or template for an evaluation as long as it contains the minimum content listed in the guidance. A second fundamental concept in evaluation development is that the institution understands the physical condition of the property. Institutions can develop their own criteria for achieving this level of understanding. Most often this comes in the form of a site visit and physical inspection. Banks may also use analytical methods or technological tools such as automated valuation models, brokers’ price opinions, and perhaps one day even drones to assist in gaining an understanding of a property. These tools, however, do not stand on their own or replace the IAEG’s content requirements for an evaluation.
4. Our bank’s personnel who perform evaluations often have problems finding recent comparable sales information; therefore, we just order appraisals.
Valuation professional standards allow three approaches to valuing real estate: the sales comparison approach (compare the property with similar properties to determine the value), the cost approach (determine how much it would cost to rebuild the property after subtracting accrued depreciation), and the income approach (determine or calculate the market value of a property by the income it generates). Any of these methods can be used to estimate market value as part of an evaluation. An institution should use whatever method is appropriate for the type of property being valued. For example, for new construction, the cost approach may be more appropriate than the sales comparison approach. Likewise, the income approach is more appropriate when estimating the value of income-producing properties. Individuals performing evaluations should be familiar with the approaches for valuing real estate and have experience using them. If the property being valued is so unique that suitable comparisons cannot be found, it may be more appropriate to engage an appraiser who has more comprehensive expertise or knowledge of alternative acceptable methods.
5. We are not sure how long we can rely on an evaluation or when an appraisal is really needed.
Monitoring collateral values over the life of a loan is one important element for controlling credit risk. Changes in market conditions can result in declines in the value of real estate collateral that jeopardize it as a source of loan repayment. Problems with collateral valuations can also result in an inadequate methodology for determining the allowance for loan and lease losses (ALLL) and the carrying value for other real estate owned (OREO). Examiners would question continued reliance on old appraisals or evaluations when there is inadequate support for the ALLL or the value of OREO.
Institutions should monitor changes in market conditions and test the validity of the evaluations used for subsequent transactions. The IAEG contains a list of factors to check when considering validity. Institutions should refresh values when the market conditions supporting appraisals or evaluations have changed or become volatile. A risk-focused approach to a particular transaction should determine if an appraisal is needed instead of an evaluation to address market volatility. Institutions that want to better utilize evaluations should have an overall real estate valuation program that encompasses standards and procedures for both appraisals and evaluations. Further, institutions should set clear expectations for valuations in their internal policies. A compliant real estate valuation program should address the following components of the IAEG:
- Maintain a system of adequate controls, verification, and testing to ensure that appraisals and evaluations provide credible market values
- Insulate the individuals responsible for ascertaining the compliance of the institution’s appraisal and evaluation function from any influence by loan production staff
- Ensure the institution’s practices result in the selection of appraisers and individuals who perform evaluations with the appropriate qualifications and demonstrate competency for the assignment
- Establish procedures to test the quality of the appraisal and evaluation review process
- Use, as appropriate, the results of the institution’s review process and other relevant information as a basis for considering a person for a future appraisal or evaluation assignment
- Report appraisal and evaluation deficiencies to appropriate internal parties and, if applicable, to external authorities in a timely manner8
In addition to reviewing individual valuations during a loan review, examiners should also consider whether an institution’s real estate valuation program complies with the agencies’ appraisal regulations and the IAEG. Examiners commonly cite problems with both individual valuations and deficiencies in real estate valuation programs.
An institution that wants to expand or underpin real estate lending activities with strong risk management should not move away from including evaluations. A bank should first consider the requirements of state appraisal laws that govern the use of a licensed or certified appraiser for estimating the market value of real property. A bank should also consider including experienced real estate valuation professionals on its real estate lending teams who understand lending and property values in the markets in which the bank does business. A bank may have personnel dedicated to completing evaluations or may use a third party. The process should also address the review of evaluations to promote compliance with the IAEG. If a real estate valuation program is managed properly and is compliant with the agencies’ appraisal regulations and the IAEG, evaluations can contribute to the process of making sound credit decisions. Senior managers should consider incorporating evaluations into their bank’s policies and procedures for real estate lending.Back to top
- 1 These agencies include the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, and the National Credit Union Administration.
- 2 Institutions should also consider state regulations pertaining to certification and licensing requirements for individuals valuing real estate in federally related transactions.
- 3 See 12 CFR part 208, subpart E, and 12 CFR part 225, subpart G. See also Supervision and Regulation (SR) letter 10-16, “Interagency Appraisal and Evaluation Guidelines,” available at www.federalreserve.gov/boarddocs/srletters/2010/sr1016.htm.
- 4 See 12 CFR part 208, subpart E, and Appendix C.
- 5 See 12 CFR part 208 and Appendix C.
- 6 As with any decision involving a credit extension, exemptions from the appraisal requirements should be applied appropriately based on the risk of the transaction. Policies and procedures developed by an institution should specify the conditions under which exemptions can be applied and should specify instances when it is more prudent to use an appraisal even if that may be over and above the regulatory requirements. The agencies reserve the right to require an institution to obtain an appraisal when safety and soundness concerns exist in regard to a particular transaction. Refer to 12 CFR part 225.63 (b). See also Appendix A, “Appraisal Exemptions,” in SR letter 10-16, “Interagency Appraisal and Evaluation Guidelines.”
- 7 Refer to SR letter 10-16, “Interagency Appraisal and Evaluation Guidelines.”
- 8 Refer to SR letter 10-16, “Interagency Appraisal and Evaluation Guidelines.”