Winter 2005

Are You in Compliance with FIRREA Appraisal Requirements?

The latest emphasis by regulators on financial institutions is in the area of federally regulated commercial real estate appraisals.

After the savings and loan crisis of the late 1980s, Congress passed the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) to address the abuses that contributed to the crisis. FIRREA defined the appraisal requirements for all federally regulated real estate transactions. But more than a decade later, some of the appraisal abuses from the late ‘80s are starting to resurface again, which has regulators paying special attention to how banks are handling appraisals.

Independence Is Key

Independence in the appraisal and review processes is the biggest issue with bank examiners. Appraisals must be ordered by the bank - which must define the purpose of the appraisal and provide guidance to the appraiser as to the bank requirements - and the bank must engage the appraiser, who cannot be related in any way to the seller or buyer.

Regulators are putting special emphasis on the ordering of the appraisal being separate from the lending decision, especially in banks with assets over $500 million. In other words, the lender shouldn't order the appraisal - an individual independent of the loan process (perhaps someone in credit administration) should.

FIRREA also requires that, once the bank has received an appraisal, a written appraisal review must be performed by a qualified individual independent of the lending decision to test compliance with policy and detect deficiencies in the appraisal. At some banks, the appraisal review process has been reduced to a cursory checklist review by a clerk, rather than a qualified professional making judgment calls on things like whether comprehensives, rent, vacancy, expenses and cap utilization rates are realistic and representative of the local market.

The regulators recognize that smaller banks with limited resources may not have access to this type of qualified individual on staff. In these cases, it is acceptable simply for a bank lender who is separate from this transaction to do the appraisal review. Or, some smaller banks are contracting with third parties to do reviews - outside appraisers, community college professors, retired lenders, etc.

Appraisal Policy

Regulators are also focusing in on whether banks have a separate commercial real estate appraisal policy that:

  • Defines appraisal standards.
  • Establishes a method to monitor the value of real estate collateral.
  • Establishes the manner in which the institution selects, evaluates and monitors the individuals who perform or review real estate appraisals.
  • Defines the steps the bank will take when ordering an appraisal.

What does all this mean? Simply put, the increased scrutiny and attention being paid by regulators to commercial real estate appraisals makes now a good time to go back and review the fundamental appraisal requirements of FIRREA to make sure that you're in compliance.

For more details on commercial real estate appraisals, please contact our office.

Appraisals: The Nuts and Bolts

Following are the primary appraisal requirements of FIRREA:

  • Residential appraisals and certain transactions involving properties valued at less than $1 million may be performed by licensed appraisers.

  • Appraisals of properties securing commercial transactions, transactions in excess of $1 million and complex properties of any type valued at less than $1 million must be performed by a certified appraiser.

  • Transactions of less than $250,000 require an evaluation by a qualified individual.

Appraisals are classified as complete or limited. A complete appraisal utilizes the cost, market and income approaches in determining an estimate of value, while a limited appraisal omits one or more of the approaches (for example, a residential appraisal may omit the income approach).

Appraisal reports can take one of three forms: A self-contained report includes all the information used in preparing the estimate of value, a summary report omits non-essential information, and a restricted report provides only an estimate of value with no supporting documentation.

What Drives Value?

There are four primary factors that drive the appraisal of commercial real estate:

  1. Gross potential rent
  2. Vacancy and collection loss
  3. Operating expenses
  4. Present value (or capitalization rate)

In an economic downturn, it's not that one factor changes, but that all change at once, which leads to an exponential adverse impact on value.

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