For the past few years, bankers have lamented the perceived lack of reliability from the appraisals they have received. This refrain is expressed across the country. Bankers simply do not believe that appraisers are providing a useful product.
This issue has been around for years and years, and yet we seem no closer to a solution. So what is the problem? The most obvious is that appraisals are based on the traditional market value definition (as defined by the Financial Institutions Reform, Recovery and Enforcement Act), which has a specific criteria and set of assumptions. The most intriguing is the assumption of competent management. Here is the reality:
There are differences in how an appraiser estimates a market value cash flow and how an analyst underwrites a property cash flow for loan repayment purposes. Further, there is debate among appraisers about the validity of using other real estate owned sales as comps. From hundreds of appraisals reviewed in bank files all over the country, it is apparent that the appraiser’s estimate of market value tends to reflect the best-case value, or at least, the better-case value. To fully understand a loan’s potential for impairment, the bank needs to know the likely proceeds from the sale of the collateral. The difference in the interpretation of market value is the cause of the disconnect between appraiser and banker.
While the appraisal community lives in the predefined world of market value, the bank community, for its part, has been unwilling or unable to hold appraisers accountable for the answers they need. Appraisal policies and procedures have focused on compliance, more so than relevance. The cost of competent appraisal administration and pressure on liquidity and capital ratios have allowed banks to deflect responsibility.
A litany of appraisal issues has been observed through the years; two examples are presented here. The first is a loan on a tract of land located in the western United States, made by a bank closed well over a year ago. The property is a 1,250-acre tract in a town of less than 1,000. It was purchased in 2007 for $2,250/acre for development of a retirement community. It was appraised by an MAI member in 2008 for $10,000/acre “as developed” and $9,000/acre “as is.”
Think about that; the property was purchased in 2007 for $2,250/acre and the “as is” value a year later was $9,000/acre. There were no entitlements, development plans or zoning variances that would have added value. That is a 300 percent return in one year. The bank had the appraisal reviewed, also by an MAI member, who concluded that the appraisal was based on hypothetical conditions and extraordinary assumptions that were unreasonable. And the reviewer signed off on the value without requesting any further explanation or review by the appraiser.
When we reviewed this loan a couple of years after the appraisal, we arrived at a collateral value significantly less than the 2007 acquisition price. Even though the bank made a low-leverage loan, after review, it needed to be downgraded.
The second example is of a 30,000 sq. ft. office building in a tertiary market that was significantly impacted by the economic downturn. It had never had an occupancy level more than 74 percent. During the previous year, occupancy had declined from 74 percent to 59 percent. The appraiser, nevertheless, completed a discounted cash flow analysis with a two-year lease up and stabilized the asset at 93 percent. This appraisal was reviewed and approved internally.
When we reviewed this appraisal a few months ago, we calculated a value almost 40 percent less than the appraiser. And our collateral value estimate was supported by recent sales. Again, a larger loss was indicated than was expected by the bank.
Here is what banks can do to improve the relevance and usefulness of appraisals:
— Banks must demand accountability from the appraiser for each appraisal.
— Hire the right person or the right third-party provider; this person should have the experience and skill set to adequately assess the data in the appraisal, judge the relevance of the appraiser’s methodology and have the ability to efficiently understand the appropriateness of the information contained in the appraisal ensuring that a relevant piece of information has not been missed or misused. Unfortunately, taking someone from credit administration and sending them to a few appraisal courses is not going to make that person an experienced real estate appraiser with a deep understanding of the nuances of commercial real estate.
— Give this person the full support of senior management including, if necessary, the board of directors.
— If the bank uses an appraisal management company or outside third party for appraisal review, the same level of accountability must be required.
— When hiring an appraiser, clearly communicate the bank’s expectations. Provide guidelines in the instructions to the appraiser. For example, request that market value be based on a six-month to one-year marketing period. For OREO or potential OREO, request the liquidation value based on a three-month or six-month marketing period. In the letter of transmittal, request that a range of value be provided along with the appraiser’s final estimate of value.
— As part of the engagement letter, let the appraiser know that every appraisal and appraisal review will have an impact on the appraiser’s status on the bank’s approved appraiser list. Also, clearly state in the engagement letter that any appraisal received that is based on unreasonable assumptions and conditions or violates the Appraisal Foundation’s USPAP will result in the appraiser being reported to the Appraisal Institute and the state’s appropriate appraisal oversight agency.
— Finally, banks must be willing to amend their approved appraiser lists on a regular basis.
Banks and examiners should have a certain level of comfort with the appraised value that forms the foundation of credit and risk management. An understanding of potential impairment and provisioning requires a reasonably accurate estimate of collateral value. The points suggested above, implemented into a bank’s policies and procedures will lead to more useful appraisals and translate into better loan approval and credit/risk management decisions.
Larry S. Lewis is founder and principal of Green Bench Advisors LLC, a bank advisory firm offering third-party loan review for bank recapitalizations, mergers and acquisitions, and loan portfolio acquisition. Contact him at llewis(at)greenbenchadvisors.com.
Copyright (c) June 2013 by BankNews Media