Internal Evaluations and LTV Tracking Systems [RMA Journal, The]

Why Banks Should Use These Cost-Effective Tools to Manage Collateral Risk in CRE Lending

It is actually in a bank's best interest to implement collateral risk management practices that use internal evaluations and portfolio-level LTV tracking systems for commercial real estate loans.

For many CRE projects, the value of the collateral and the repayment of the loan are both dependent on the cash flows that the underlying project is expected to generate. Because of this linkage, current collateral values can be an important indicator of the project's viability and can signal adverse changes that will adversely affect the cash flow available to service or repay the loan.

-John Dugan, Comptroller of the Currency, 2005-10 Testimony before the House Committees on Financial Services and Small Business, February 26, 2010

In their guidelines and statements, regulators have expressed concern over banks' ongoing monitoring of commercial real estate (CRE) collateral values. The Interagency Appraisal and Evaluation Guidelines state that a bank "should monitor collateral risk on a portfolio and on an individual credit basis ... [and] should have policies and procedures that address the need for obtaining current collateral valuation information to understand its collateral position over the life of a credit and effectively manage the risk in its real estate credit portfolios."

Keeping track of collateral values and recording accurate loan-to-values (LTVs) is a challenge, especially considering the volatile commercial real estate market over the last five years. The principles of safety and soundness would suggest that LTV data should be current in order to accurately judge the bank's exposure on CRE credits; however, ordering third-party appraisals and evaluations when they are not required may be impractical from a profitability standpoint and may not be in the best interest of shareholders, particularly if the bank's credit underwriting personnel have a thorough understanding of the local real estate market and the credits within their portfolio.

Accordingly, in the period between the date of the initial or most recent appraisal and the date when an updated appraisal is deemed necessary, the appropriate bank associates who are independent of the loan approval process- portfolio managers, credit analysts, or other credit professionals-should estimate collateral values by using a combination of market data, information from recent appraisals of similar properties, and valuation techniques such as the income and sales comparable approaches used in the original appraisal.

The October 2009 Policy Statement on Prudent Commercial Real Estate Loan Workouts issued by the regulators1 states that "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."

Internal Evaluations: Monitoring LTVs on an Individual Credit Basis

The internal evaluation process should follow five basic steps.

Step #1: Gather market data.

Because the analyst will be estimating the current market value of several different classes of income-producing CRE properties-office (Class A, B, and C), industrial/warehouse, and retail-the information search should include research on:

* Market rental rates and trends.

* Market vacancy rates and trends.

* Capitalization rates and trends.

Monthly and quarterly information is obtainable from several sources.2

* CB Richard Ellis: Capital Market, Cap Rate Survey (free).

* Marcus and Millichap Local Market Research Reports (free).

* Cushman & Wakefield Local Market Reports (free).

* CoStar Local Market Reports: CoStar Property Professional ® (subscription).

* PwC Real Estate Investor Survey (subscription).

Broad market data sources do present a potential problem, however. There are many submarkets within every metropolitan statistical area (MSA), and they can differ greatly from the surrounding MSA in terms of cap rates, rental demand, rental rates, and vacancy rates. For this reason, recent like-appraisals of similar properties can provide valuable insight into market conditions within these submarkets.

According to the Interagency Appraisal and Evaluation Guidelines, "sources of relevant information may include external market data, internal data, or reviews of recently obtained appraisals and evaluations." Appraisers within the MSA will already have knowledge of the different submarkets and any disparate trends between them; therefore, the analyst may be able to use the market research gathered by these appraisers and incorporate it into the analysis.

Step #2: Perform the appropriate valuation approach(es).

The key to choosing the appropriate valuation approach is to conduct a thorough review of the original appraisal, using it as a guide and following a consistent methodology. The analyst will use both market data gathered from reliable sources and insight gleaned from studying the original and similar appraisals to perform one or both (depending on the type of property) of the following valuation approaches.

Income Approach: Direct Capitalization

1. Calculate the net operating income (NOI) using the market rental rate, normalized expense structure, and market vacancy rate determined through research.

The analyst can use the information on market r ental rates gathered through research and estimate a stabilized rental rate for the property type being valued (office, warehouse, retail, etc.). If an appropriate rental rate cannot be determined from market research or from reviewing recent appraisals of similar properties, then the analyst can perform a comparable rental analysis, using sources such as Loopnet.com to find rental comparables similar to the subject property.

2. Divide the NOI by the appropriate capitalization rate (Table 1).

Sales Comparison Approach

Use resources like Loopnet.com and other appraisals to find strong sales comparables. Next, make the appropriate adjustments to the comparables' sales prices/square footage to reflect changes in market conditions since the date of sale and differences in physical characteristics (Table 2).

Step #3: Conduct a property inspection when necessary.

According to the Interagency Appraisal and Evaluation Guidelines, "an institution should consider performing an inspection to ascertain the actual physical condition of the property and market factors that affect its market value. When an inspection is not performed, an institution should be able to demonstrate how these property and market factors were determined."

Step #4: Use the "common sense" test.

The analyst should ask whether the value conclusion makes sense in light of real estate market trends and other relevant information. Several sources are available to track trends in commercial real estate prices, such as Moody's/REAL Commercial Property Price Index (CPPI) or Loopnet.com, so the analyst should be able to judge the accuracy and reasonableness of the market value estimate.

If the CPPI is reporting a 30% decline in commercial real estate property values in the bank's market since 2008, and the internal evaluation is showing only 10% depreciation in the subject collateral's value since the 2008 appraisal, then the analyst may need to reexamine the market data and valuation methods. The analyst should explain any unique factors that may cause the property's value to deviate from the expected rise/decline in value, such as exclusive features and improvements or changes in zoning and land use.

Step #5: Perform an independent review.

As a final check, another bank associate, someone who is independent of the loan approval process, should review the internal evaluation to verify that the analysis is sound, accurate, and based on reliable and current market data.

Portfolio managers, credit analysts, and other credit professionals do not have the same level of training in real estate valuation that MAI-certified appraisers do; however, that doesn't mean bankers cannot perform safe and sound practices of internally estimating collateral values and monitoring LTVs for their portfolios. There are certain situations-renewals, modifications, and annual reviews-where appraisals are not always required and may not be practical from a cost standpoint, especially in banks that have credit professionals with the necessary skills to perform the analysis internally.

These banks are saving on costs and also are not making any trade-off between increased profitability and greater risk because the quality of the internal analysis is enhanced by the analysts' familiarity with the local market and current trends. In these situations, internal evaluations provide great benefits to the bank in terms of risk management and LTV tracking, and the regulators will support these practices as long as the internally calculated collateral values are backed by relevant market data and sound analysis.

Example: WC Engineering, Inc.

Even though property values across all categories of real estate have declined significantly over the past four years, collateral values and corresponding LTVs for some global loan relationships are still being based on appraisals dating back to 2007 and 2008, the period just before the most precipitous fall in commercial real estate values (Figure 1).

The following example highlights the need to update these outdated collateral values. It illustrates a real-world scenario where the decision to use internal evaluations not only improves the bank's understanding of its exposure but also leads to a change in the actions taken by the bank during the review and approval process.

Consider the case of WC Engineering, Inc., whose line of credit is currently up for renewal. Three related real estate loans were originated in 2007 and 2008. In 2009, a cross collateralization requirement was added for all related loans. The global lending relationship is summarized in Table 3.

WC Engineering has been a profitable and performing relationship for ABC Bank, with a 1.4x global debt service coverage ratio and all loans having been paid as agreed. Thus, there's been no requirement to order new appraisals on the two collateral office properties. An updated appraisal was ordered for the vacant land (loan #1003) in 2010.

To see the advantages of using internal evaluations as an effective risk management tool, look at the following two scenarios for the renewal of WC Engineering's line of credit. In Scenario 1, ABC Bank relies on outdated appraisals to arrive at a global LTV. In Scenario 2, ABC Bank uses internal evaluations to update the values for the two office properties. The results are shown in Table 4.

Scenario 1: Relying on the outdated appraisals, the loan officer doesn't have an accurate picture of the true exposure and risk of the global relationship. Because of the strong debt service coverage, guarantor support, and continued profitability of the borrower, the loan officer renews the line of credit and recommends no additional requirements or covenants.

Scenario 2: After reviewing a portfolio manager's internal evaluations on the two collateral office properties, the loan officer realizes that the bank's true exposure is much greater than previously thought, with a global LTV of 115% and around $310M in outstanding loans technically unsecured. Without the internal evaluations, the loan officer may have renewed the loan without placing greater scrutiny on the credit and without considering any of the following options to mitigate the bank's exposure:

* Requesting additional collateral.

* Structuring the interest-only loan on an aggressive amortization.

* Securing additional guarantees.

* Requiring additional principal reductions.

With knowledge of the price trends for office properties in the local market over the last four years, the analyst concludes that the internal evaluations provide an accurate estimate of current market values because the percentage decline in the value of the collateral office properties for loans #1002 and #1004, between the original appraisal date and the internal evaluation date, is consistent with the percentage decline in office prices across the market during the same period (Figure 2).

Collateral Monitoring and LTV Tracking at the Portfolio Level

Collateral value and LTV monitoring systems are an integral part of portfolio risk management, especially when used in conjunction with portfolio stress testing. Having an up-to-date database that tracks items like NOI, cap rates, and LTVs helps banks understand their exposure on commercial real estate credits, and this knowledge is incredibly valuable in the current economic environment where uncertainty and slow growth still threaten the financial health of already weakened borrowers.

Table 5 shows a simplified report that can be generated from a bank's database that tracks relevant loan information. The size, structure, and complexity of the LTV tracking system will vary from bank to bank, but the data and tracking items shown in this report should be monitored in every bank's CRE portfolio.

An LTV tracking system is extremely useful not only as a portfolio risk management tool for assessing the impact of collateral valuation trends on portfolio risk, but also as a current and easily accessible source of market data for analysts. For example, an analyst performing an internal evaluation for a Class B office property can query the database to find other recent appraisals and/or internal evaluations for similar properties in the portfolio. With this information, he or she can quickly find and review the market data used in these appraisals and evaluations. Without a collateral value and LTV tracking system, it would be more time consuming for the analyst to find relevant market data.

Conclusion

At a time when financial institutions are facing increased scrutiny from examiners, some bankers might be reluctant to adopt a collateral-monitoring system that uses internal evaluations, especially since it will likely reveal higher LTVs across CRE portfolios. But as indicated by the regulators' issued guidelines and the testimony of their senior officials, loans "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."3

Examiners may be more likely to downgrade loans if banks fail to update collateral values to correspond with material changes in market conditions. Moreover, out-of-market examiners may be tougher in their criticism if they lack current collateral valuations and familiarity with the local market.

It is vital for financial institutions to have an accurate and comprehensive understanding of current collateral values and overall exposure. Banks cannot strategically manage individual credit exposure or portfolio-level exposure without timely internal evaluations and a comprehensive collateral monitoring and LTV tracking system.

Keeping track of collateral values and recording accurate loan-to-values is a challenge, especially considering the volatile commercial real estate market over the last five years.

Notes

1. The regulators referenced here are the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation (FDIC), the National Credit Union Administration (NCUA), the (OCC), the Office of Thrift Supervision (OTS), and the Federal Financial Institutions Examination Council (FFIEC) State Liaison Committee.

2. Market data from these sources is available on the following websites:

* http://capitalmarkets.cbre.com (free).

* www.marcusmillichap.com/Services/Research (free).

* www.cushwake.com/cwglobal/jsp/kcLocalReportLanding.jsp (free).

* www.costar.com/Products/Property.aspx (subscription only).

* www.pwc.com/us/en/asset-management/real-estate/publications/index.jhtml (subscription only).

3. Excerpt from Policy Statement on Prudent Commercial Real Estate Loan Workouts, issued jointly on October 30, 2009, by the Federal Reserve, FDIC, NCUA, OCC, OTS, and the FFIEC State Liaison Committee.

Matthew Coughlin is a portfolio manager and credit analyst at First Citrus Bank, Tampa, Florida. He can be reached at [email protected].