Internal Evaluations and LTV Tracking Systems: 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

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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 regulators (1) 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[R] (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. …