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Fe d e r a l R e s e r v e
B a n k o f N e w Yo r k
N E W YORK, N.Y. 10 0-45
AREA CODE 212 7 2 0 - 6375
C hester
B. F e l d b e r g
E x e c u t i v e V ic e P r e s i d e n t
TO THE CHIEF EXECUTIVE OFFICERS OF
ALL STATE MEMBER BANKS, BANK HOLDING COMPANIES,
AND DOMESTIC OFFICES OF FOREIGN BANKS
IN THE SECOND FEDERAL RESERVE DISTRICT
SUBJECT:
INTERAGENCY POLICY STATEMENT ON THE REVIEW AND
CLASSIFICATION OF COMMERCIAL REAL ESTATE LOANS
On November 7, 1991, the Federal Reserve and the other
federal bank and thrift regulatory agencies issued an interagency
policy statement to their examiners on the review and classifica
tion of commercial real estate loans.
This policy statement
expands upon guidance presented in the March 1, 1991 joint policy
statement on the supervisory treatment of commercial real estate
loans and is consistent with the Federal Reserve's existing
examination policies and practices.
The attached policy statement addresses a wide range of
topics relating to the supervisory evaluation of commercial real
estate loans, including classification guidelines for troubled
commercial real estate loans and the treatment of guarantees.
The
policy statement also discusses general principles for the
evaluation by examiners of the allowance for loan and lease
losses, including portions based on an analysis of the commercial
real estate loan portfolio.
Furthermore, it emphasizes that the
evaluation of real estate loans is not based solely on the value
of the collateral, but on a review of the borrower's willingness
and capacity to repay and on the income-producing capacity of the
properties over time.
Enclosed is a copy of this policy statement.
Questions
on these matters may be directed to Barbara A. Klein, Assistant
Chief Examiner, Domestic Examinations, at (212) 720-8324.
Yours sincerely,
Chester B. Feldberg
Enclosure
‘M
to
Interagency Policy Statement on the Review and
Classification of Commercial Real Estate Loans'
Introduction
This policy statement addresses the review and classification of commercial real estate
loans by examiners of the federal bank and thrill regulatory agencies.1 Guidance is
also provided on the analysis of the value of the underlying collateral. In addition,
this policy statement summarizes principles for evaluating an institution’s process for
determining the appropriate level for the allowance for loan and lease losses, including
amounts that have been based on an analysis of the commercial real estate loan
portfolio.3 These guidelines arc intended to promote the prudent, balanced, and
consistent supervisory treatment of commercial real estate loans, including those to
borrowers experiencing financial difficulties.
The attachments to this policy statement address three topics related to the review of
commercial real estate loans by examiners. The topics include the treatment of
guarantees in the classification process (Attachment 1); background information an the
valuation of income-producing commercial real estate loans in the examination process
(Attachment 2); and definitions of classification terms used by the federal bank and
thrift regulatory agencies (Attachment 3).
Examiner Review of Commercial Real Estate Loans
Loan Policy and Administration Review. As part of the analysis of an Institution's
commercial real estate loan portfolio, examiners review lending policies, loan
administration procedures, and credit risk control procedures. The maintenance of
prudent written lending policies, effective internal systems and controls, and thorough
1 Pot purpose* of this policy moment, "commercial real estate loans” rcfen tu all loans secured by seal orate, except
fur loans secured by 1 - 4 family residential properties. This does not refer to loans where the underlying collateral has
been taken solely through an abundance of caution where the terms as a consequence have not been made more favorable
than they would have been in the absence of the ben.
* The agenda iesumg this policy statement arc the Board of Governors of the Federal Reserve System, the Federal
Deposit Insurance Corporation, the Office of the Comptroller of the Currency, ami the Of]ice of Thrift Supervision.
* For analytical purposes, as part of iu overall estimate of the allowance for loan and lease losses (ALLL) management
may attribute a portion of the ALU. to the commercial real estate ta n portfolio. However, this does not imply that any
pan of the ALLL is segregated for. or allocated to, any particular asset or group of assets. The ALLL is available to absorb
all credit losses originating from the ta n and lease portfolio.
For savings institutions, the ALLL is referred to as the "general valuation ellowtnce* for purporea of the Thrift
Financial Report
1
loan documentation art essential to the institution’s management of the lending
function.
The policies governing an institution's real estate lending activities must include
prudent underwriting standards that are periodically reviewed by the board of directors
and clearly communicated to the institution's management and lending staff. The
institution must also have credit risk control procedures that include, for example,
prudent internal limits on exposure, an effective credit review and classification
process, and a methodology for ensuring that the allowance for loan and lease losses is
maintained at an adequate level. The complexity and scope of these policies and
procedures should be appropriate to the size of the institution and the nature of the
institution's activities, and should be consistent with prudent banking practices and
relevant regulatory requirements.
Indicators of Troubled Real Estate Markets and Projects, and Related
Indebtedness. In order to evaluate the collectibility of an institution's commercial real
estate portfolio, examiners should be alcn for Indicators of weakness in the real estate
markets served by the institution. They should also be alert for indicators of actual or
potential problems in the individual commercial real estate projects or transactions
financed by the institution.
Available indi<x..ors, such as permits for — and the value of — new construction,
absorption rates, employment trends, and vacancy rates, are useful in evaluating the
condition of commercial real estate markets. Weaknesses disclosed by these types of
statistics may indicate that a real estate market is experiencing difficulties that may
result in cash flow problems for individual real estate projects, declining real estate
values, and ultimately, in troubled commercial real estate loans.
Indicators of potential or actual difficulties in commercial real estate projects may
include:
« An excess of similar projects under construction.
•
Construction delays or other unplanned adverse events resulting in cost overruns
that may require renegotiation of loan terms.
• Lack of a sound feasibility study or analysis that reflects current and reasonably
anticipated market conditions.
•
Changes in concept or plan (for example, a condominium project converted to an
apartment project because of unfavorable market conditions).
« Rem concessions or sales discounts resulting in cosh flow below the level projected
in the original feasibility study or appraisal.
• Concessions on finishing tenant space, moving expenses, and lease buyouts.
2
X
• Slow leasing or lack of sustained sales activity and increasing sales cancellations
that may reduce the project's income potential, resulting in protracted repayment or
default on the loan.
• Delinquent lease payments from mttfor tenants.
« Land values that assume Aiturc iczoning.
• Tax arrearages.
As the problems associated with a commercial teal estate project become more
pronounced, problems with the related indebtedness may also arise. Such problems
include diminished cash flow to service the debt and delinquent interest and principal
payments.
While some commercial real estate loans become troubled because of a general
downturn in the market, others become troubled because they were originated on an
unsound or a liberal basis. Common examples of these types of problems include:
• Loans with no or minimal borrower equity.
• Loans on speculative undeveloped property where the borrowers* only source of
repayment is the sale of the property.
• Loans based on land values that have been driven up by rapid turnover of
ownership, but without any corresponding improvements to the property or support
able income projections to justify an increase in value.
• Additional advances to service an existing loan that lacks credible support for full
repayment from reliable sources.
•
Loans to borrower* with no development plans or noncurrent development plans.
• Renewals, extensions and refinancings that lack credible support for full repayment
from reliable sources and that do not have a reasonable repayment schedule.4
Examiner Review of Individual Loans, Including the Analysis of Collateral Value.
The focus of an examiner's review of a commercial real estate loan, including binding
commitments, is the ability of the loan to be repaid. The principal factors that bear on
this analysis arc die income-producing potential of the underlying collateral and the
borrower’s willingness and capacity to repay under the existing loan terms from die
borrower's other resources if necessary. In evaluating the overall risk associated with
4Ai diiamad more fully in the action on classification guidelines, the ra&nancinj or ronawmg of loans to vuund
burro*m would nut result in a auptmaory clarification or criticism uniat! well-defined wcatacises cxlft that jeopardize
repayment of the loans. Consistent with sound banking practices, institution* should work in in appropriate and
constructive manner with borrowers who may be experiencing temporary difficulties.
3
t commercial real estate loan, examiners consider a number of factors, including the
character, overall financial condition and resources, and payment record of the
borrower, the prospects for support from any financially responsible guarantors; and
the nature and degree of protection provided by the cash flow and value of the
nnderlying collateral.5 However, as other sources of repayment for a troubled
commercial real estate loan become inadequate over time, the importance of the
collateral's value in the analysis of the loan necessarily increases.
The appraisal regulations of the federal bank and thrift regulatory agencies require
institutions to obtain appraisals when certain criteria are met* Management is
responsible for reviewing each appraisal's assumptions and conclusions for reasonable
ness. Appraisal assumptions should not be based solely on current conditions that
ignore the stabilized income-producing capacity of the property.7 Management should
adjust any assumptions used by an appraiser in determining value that are overly
optimistic or pessimistic.
An examiner analyzes the collateral's value as determined by the institution's most
recent appraisal (or Internal evaluation, as applicable). An examiner reviews the major
facts, assumptions, and approaches used by the appraiser fmcluding any comments
made by management on the value rendered by the appraiser). Under the
circumstances described below, the examiner may make adjustments to this assessment
of value. This review and any resulting adjustments to value are solely for purposes
of an examiner's analysis and classification of a credit and do not involve actual
adjustments to an appraisal.
A discounted cash flow analysis is an appropriate method for estimating the value of
income-producing real estate collateral.1 This approach is discussed in more detail in
Attachment 2. This analysis should not be based solely on the current performance of
the collateral or similar properties; rather, it should take into account, on a discounted
basis, the ability of the real estate to generate Income over time based upon reasonable
and supportable assumptions.
* Ibe treatment at guarantees la the classification proccxi k doomed m Attachment 1.
* Department of the Treasury, Office of the Comptroller at the Currency, 12 CFR Pvt !M (Docket No. 90-16); Board
ef Governors of the Federal Reeerve Syitem, 12 CFR Putt 208 end 225 (Regulation U end Y; Docket No. R-06S5)
Federal Deposit Insurance Corporation, 12 Q K 323 (RIN 3064-AB05) Department of the TroaiuTy, Office uf Thrift
Supervision, 12 CFR Pert 564 (Docket No. 90-1495).
7
Stabilized income generally ii defined as die yearly net operating Income produced by the property at normal
occupancy «id rente! ratea, it may he adjusted upward or downward from today's actual market condition*.
* The real eitate appraisal regulations of the federal bank and thrift regulatory agencies include a requirement that m
appraisal (a) follow a reasonable valuatioo method that addrenes the direct tales comparison, income, and c u t approaches
to market value; (b) reeoocik these approaches; and (c) eiplain the elimination of each approach not used. A discounted
cash flow analysis is recognized v a valuation method for the income approach.
4
! When reviewing the reasonableness of the facts and assumptions associated with the
value of the collateral, examiners may evaluate:
j •
Current and projected vacancy and absorption rates;
| • Lease renewal trends and anticipated rents;
! • Volume and trends In past due leases;
j
• Effective rental rates or sale prices (taking into account all concessions);
| • Net operating income of the property as compared with budget projections; and
• Discount rates and direct capitalization ("cap") rates*
•
!
!
.
;
'
i
The capacity of a properly to generate cash flow to service a loan is evaluated based
upon rents (or sales), expenses, and rates of occupancy that are reasonably estimated to
be achieved over time. The determination of the level of stabilized occupancy and
rental rates should be based upon an analysis of current and reasonably expected
market conditions, taking into consideration historical levels when appropriate. The
anatysis of collateral values should not be based upon a simple projection of current
levels of net operating Income if markets are depressed or reflect speculative pressures
but can be expected over a reasonable period of time to rei-m to normal (stabilized)
conditions. Judgment is involved in determining the time that it will take for a
property to achieve stabilized occupancy and rental rates.
: Examiners do not make adjustments to appraisal assumptions for credit analysis
purposes based on worst case scenarios that are unlikely to occur. For example, an
: examiner would not necessarily assume that a building will become vacant just
■ because an existing tenant who is renting at a rate above today’s market rate may
! vacate the property when the current lease expires. On the other hand, an adjustment
' to value may be appropriate for credit analysis purposes when the valuation assumes
: renewal at the above*m&rkct rate, unless that rate is a reasonable estimate of the
: expected market rate at the time of renewal.
i
• When estimating the value of income-producing real estate, discount rales and "cap"
; rates should reflect reasonable expectations about the rate of return that inventors
require under normal, orderly and sustainable market conditions. Exaggerated,
imprudent, or unsustainably high or low discount rates, "cap" rates, and income
; projections should not be used. Direct capitalization of nonstabilized income flows
; should also not be used.
, Assumptions, when recently made by qualified appraisers (and, as appropriate, by
; institution management) and when consistent with the discussion above, should be
*A t c m n 2icue adsuso o dson rtsaddrc cptlzto rts
t a h e t nlds icsin f icut ae n iet aiaiain ae.
i
5
given a reasonable amount of deference. Examiners should not challenge the
underlying assumptions, Including discount rates and "cap* tabes used in appraisals,
that differ only in a limited way from norms that would generally be associated with
the property under review. The estimated value of the underlying collateral may be
adjusted for credit analysis purposes when the examiner can establish that any underly
ing facts or assumptions are inappropriate and can support alternative assumptions.
Classification Guidelines
As with other types of loans, commercial real estate loans that are adequately protected
by the current sound worth and debt service capacity of the borrower, guarantor, or the
underlying collateral generally are not classified. Similarly, loans to sound borrowers
that are refinanced or renewed in accordance with prudent underwriting standards,
including loans to creditworthy commercial or residential real estate developers, should
not be classified or criticized unless well-defined weaknesses exist that jeopardize
repayment. An institution will not be criticized for continuing to carry loans having
weaknesses that result in classification or criticism as long as the institution has a wellconccivcd and effective workout plan for such borrowers, and effective internal
controls to manage the level of these loans.
In evaluating commercial real estate credits for possible classification, examiners apply
standard classification definitions (Attachment 3).1 In determining the appropriate
0
classification, consideration should be given to all important information on repayment
prospects, including Information on the borrower’s creditworthiness, the value of, and
cash flow provided by, all collateral suf^orting the loan, and any support provided by
financially responsible guarantors.
The loan's record of performance to date is important and must be taken into
consideration. As a general principle, a performing commercial real estate loan should
not automatically be classified or charged-off solely because the value of the
underlying collateral has declined to an amount that is less than the loan balance.
However, It would be appropriate to classify a performing loan when well-defined
weaknesses exist that jeopardize repayment, such as the lack of credible support for
full repayment from reliable sources.1
1
These principles hold for Individual credits, even if portions or segments of the
industry to which the borrower belongs arc experiencing financial difficulties. The
evaluation of each credit should be based upon the fundamental characteristics
m T me dfntoi r peetd n t a h e t a dades
i eiiin ae rsne i Atcmn 3 n drs amu c»iiJ"usadr, "obfl"o "oi fr
Uif« sbtnad" dutu, r lt" a
aprioyproe.
oevsr ups!
0
1 Aohriset« aie i terve o acmm r i ra ett la I ttli' teteti a eeon ast
1 nte su ht rss n h eiw f o e ca el xaa on s h ons ramn s n crti se
l
o a armcrt s e frrprigproe. T efdrlbn a dtrf rgltr aece hv poie giac
r » uacul u t o eotn upii h eea ak n hit euaoy gnis ae rvdd udne
o nncra s m i teisrcin for teR p n o CniinadI c m (alRprs frbns a dt te
n oicuj u s n h ntutos h e o s f odto n n o e Cl eot) o ak, n o h
iwreir frte’rf FnnilRpr frsvnsascain,a di rltdsprioygiac o teaece.
rtutnu o h J it iaca eot o aig soitos n n eae uevsr udne f h gnis
h
affecting the collectibility of the particular credit The problems broadly associated
: with some sectors or segments of an industry, such as certain commercial real estate
markets, should not lead to overly pessimistic assessments of particular credits that are
: not affected by the problems of the troubled sectors.
.
Classification of troubled project-dependent commercial real estate loans.™ The
following guidelines for classifying a troubled commercial real estate loan apply when
the repayment of the debt will he provided solely by the underlying real estate
collateral and there are no other available and reliable sources of repayment.
‘|
]
i
|
i
I
I
As a general principle, for a troubled project-dependent commercial real estate loan,
any portion of the loan balance that exceeds the amount that is adequately secured by
the value of the collateral, and that can clearly be identified as uncollectible, should be
classified "loss."1 The portion of the loan balance that is adequately secured by the
3
value of the collateral should generally be classified no worse than "substandard." The
amount of the loan balance in excess of the value of the collateral, or portions thereof,
should be classified "doubtful” when the potential for full loss may be mitigated by the
outcomes of certain pending events, or when loss is expected but the amount of the
loss cannot be reasonably determined.
. If warranted by the underlying circumstances, an examiner may use a "doubtful"
: classification on the entire loan balance. However, this would occur infrequently.
i
i
;
;
:
.
*
■
;
|
Guidelines for classifying partially charged-off loans. Based upon consideration of
all relevant factors, an evaluation may indicate that a credit has well-defined
weaknesses that jeopardize collection in foil, but that a portion of the loan may be
reasonably assured of collection. When an institution has taken a charge-off in an
amount sufficient that the remaining recorded balance of the loan (a) is being serviced
(based upon reliable sources) and (b) is reasonably assured of collection, classification
of the remaining recorded balance may not be appropriate. Classification would be
appropriate when well-defined weaknesses continue to be present in the remaining
recorded balance. In such cases, the remaining recorded balance would generally be
classified no more severely than "substandard."
;
■
,
i
!
A more severe classification than "substandard" for the remaining recorded balance
would be appropriate if the loss exposure cannot be reasonably determined, e.g., where
significant risk exposures are perceived, such as might be the case for bankruptcy
situations or for loans collateralized by properties subject to environmental hazards,
Jn addition, classification of the remaining recorded balance would be appropriate
when sources of repayment are considered unreliable.
uT edsuso k ti rt o intitne t adesltita mui b tetdu "te ml euco n d for
h icsin hs ai n i o nedd o drs on ht t o rae ohr it w e "
b n rgltr rpnigproe o "u u u u o n d frtrfrgltr rprigp r o e G i a c o teeast
u k euaoy eetn ups* r rt
w e " o hit euaoy eotn u p s * u d n e c ha ses
j i peetdi sprioye drpriggiac o f teaeee.
t rsne n oevsr n eotn udne h gnii
<
u F a proe of t udsuso,te'au o f teeiaca" ste au w d b tee a i e frcei aayi
upss h icsin h vle h citrl i h vle e y h xm n r o rdt nlss
proe,a dsusdi apeiu scino f ti plc saeet
upss s icse n rvos eto hs oiy ttmn
7
\
Guidelines for classifying formally restructured loans. The classification treatment
previously discussed for a partially changed off loan would also generally be
appropriate for a formally restructured loan when partial charge-otts have been taken.
For a formally restructured loan, the focus of the examiner's analysis Is on the ability
of foe borrower to repay the loan in accordance with its modified terms. Classification
of a formally restructured loan would be appropriate, If, after foe restructuring, welldefined weaknesses exist that jeopardize the orderty repayment of the loan in
accordance with reasonable modified terms}1 Troubled commercial real estate loans
whose terms have been restructured should be identified in the institution's internal
credit review system, and closely monitored by management
Review of the Allowance for Loan and Lease Losses (ALLL) 15
The adequacy of a depository institution's ALLL, including amounts based on an
analysis of the commercial real estate portfolio, must be based on a careful, well
documented, and consistently applied analysis of the institution's loan and lease portfolio.,e
The determination of foe adequacy of foe ALLL should be based upon management's
consideration of all current significant conditions that might affect foe ability of
borrowers (or guarantors, if any) to fulfill their obligations to the institution. While
historical loss experience provides a reasonable starting point, historical losses or even
recent trends in losses arc not sufficient without further analysis and cannot produce a
reliable estimate of anticipated loss.
In determining the adequacy of the ALLL, management should also consider other
factors, including changes in foe nature and volume of foe portfolio; die experience,
ability, and depth of lending management and staff; changes in credit standards; collec
tion policies and historical collection experience; concentrations of credit risk; trends in
the volume and severity of past due and classified loans; and trends in the volume of
nonaccrual loans, specific problem loans and commitments. In addition, this analysis
should consider the quality of foe institution’s systems and management in identifying,
monitoring, and addressing asset quality problems. Furthermore, management should
consider external factors such as local and national economic conditions and
wA e a p eo irsrcue]c m e d lra m t t nta de not hv r u c bemdfe i m wuuWb a
n x m l f etutr* o m r A el u e u ht os ie c o ui oiid c u
e
"ahflow- m r g g w i hrqie itrsp y e t uHy w e teudryn claea gnrtscs fo btpoie
cs
o t a e h c eurs neet a m n *
h n h nelig oltrl eeae ah lw u rvd!
a sbtniebnft s telending isiuin
o usatv eei* o h
nttto.
tE c o tefdrlbn a dtrf rgltr a e d hv ise giac o tealwnefrJa adb*e
f a h f h eea ak n hit euaoy g n a ie sud udne n h loac o on n
lse. T efloigdsuso am a i r gnrlpnilifrassigteaeuc o dealwnefrla a d
oss h olwn icsin u m r / s eea ncpo o sesn h dqay f i loac o on n
laek e .
es m i
“T eetmto poesdsrbdi ti scinprisfr more acrt etmt o atdae lse ta cud
h siain rcs ecie n h< eto emt o a
cuae siae f niptd oss hn ol
b ahee b assigtela prfln*t! o a ageaabss H w v r ii ol a etmtmpoesad
e civd y sesn h on utui oey n n grgt ai. o e e , ts ny n siai rcs n
de nti p yta aypr o (eALLL i sgese fr o alctdt,a ypriua asto go po ast. T e
os o m l ht n et f h
s ergtd o. r loae o n atclr se r ru f ses h
ALU,i aalhrt asr alcei tse oiiaigf o tela adlaeprflo
s visi o bob l rdt oss rgntn r m h on n es otoi.
8
developments; competition; and legal and regulatory requirements; as well as
reasonably foreseeable events that are likely to affect the collectibility of the loan
portfolio.
Management should adequately document the factors that were considered, the
methodology and process that were used in determining the adequacy of the ALLL,
and the range of possible credit losses estimated by this process. The complexity and
scope of this analysis must be appropriate to the size and nature of the institution and
provide for sufficient flexibility to accommodate changing circumstances.
Examiners will evaluate the methodology and process that management has followed
in arriving at an overall estimate of the ALLL In order to assure that all of the relevant
factors affecting the collectibility of the portfolio have been appropriately considered.
In addition, the overall estimate of the ALLL and the range of possible credit tosses
estimated by management will be reviewed for reasonableness in view of these factors.
This examiner analysis will also consider the quality of the institution's systems and
management in identifying, monitoring, and addressing asset quality problems.
As discussed in the previous section on classification guidelines, the value of the
collateral is considered by examiners in reviewing and classifying a commercial real
estate loan. However, for a performing commercial real estate loan, the supervisory
policies of the agencies do not require automatic increases to the ALLL solely because
the value of the collateral has declined to an amount that Is less than the loan balance.
\
In assessing the ALLL during examinations, it is important to recognize that
management’s process, methodology, and underlying assumptions require a substantial
degree of judgment. Even when an institution maintains sound loan administration and
collection procedures and effective internal systems and controls, the estimation of
anticipated tosses may not be precise due to the wide range of factor* that must be
considered. Further, the ability to estimate anticipated loss on specific loans and
categories of loans improves over time as substantive information accumulates
regarding the factors affecting repayment prospects. When management has (a)
maintained effective systems and controls for identifying, monitoring and addressing
asset quality problems and (b) analyzed all significant factors affecting the
collectibility of the portfolio, considerable weight should be given to management’s
estimates in assessing the adequacy of the ALLL.
9
Attachment 1
TREATMENT OF GUARANTEES
IN THE CLASSIFICATION PROCESS
Initially, the original source of repayment and the borrower's Intent and ability to
fulfill the obligation without reliance on third party guarantors will be the primary
basis for the review and classification of assets.1 The federal bank and thrift
regulatory agencies will, however, consider the support provided by guarantees in the
determination of the appropriate classification treatment for troubled loans. The
presence of a guarantee from a "financially responsible guarantor," as described below,
may be sufficient to preclude classification or reduce the severity of classification.
For purposes of this discussion, a guarantee from a "financially responsible guarantor"
has the following attributes:
• The guarantor must have both the financial capacity and willingness to provide
support for the credit;
• The nature of the guarantee lx such that it can provide support for repayment of the
indebtedness, in whole or in part, during the remaining loan term; and3
• The guarantee should be legally enforceable.
The above characteristics generally indicate that a guarantee may improve the
prospects for repayment of the debt obligation.
Considerations relating to a guarantor's financial capacity. The lending institution
must have sufficient information on the guarantor's financial condition, income,
liquidity, cash flow, contingent liabilities, and other relevant factors (including credit
ratings, when available) to demonstrate the guarantor's financial capacity to fulfill the
obligation. Also, it is important to consider the number and amount of guarantees
currently extended by a guarantor, in order to determine that the guarantor has the
financial capacity to fulfill the contingent claims that exist
Considerations relating to a guarantor's willingness to repay. Examiner* normally
rely on their analysis of the guarantor's financial strength and assume a willingness to
perform unless there is evidence to the contrary. This assumption may be modified
1S m lasieoiiae bsdpiaiyu o tefnnilsrnt c t tegaatr w o i,i sbtne te
o e on r rgntd ae rmrl p n h iaca tegh h urno, h t n usac, h
piaysuc o rpyet I sc dcmtno,e i m ngnrlyasi tecletblt o teb nbsdu o
rmr ore f eamn. n uh ruiaci a m e eeal set h olciiiy f h e ae p n
tegaatrsaiiyt rpyteto
h urno' blt o ea h o.
* o egaate m yol poiefrspotfrcranpae o ara ett poet Iw u dmt b aporae
S m urnes a ny rvd o upr o eti hss f el sae rjc. t o l
e prpit
t rl u o teegaate S sfutatobe la atrtecmlto a t teepae.
o ey p n ha urnes o tpr ruld on fe h opein hs hss
10
based on the "track record" of the guarantor, Including payments made to date on the
asset under review or other obligations.
Examiners give due consideration to those guarantors that have demonstrated their
ability and willingness to fulfill previous obligations In their evaluation of current
guarantees on similar assets. An important consideration will be whether previously
required performance under guarantees was voluntary or the result of legal or other
actions by the lender to enforce the guarantee. However, examiners give limited
credence, if any, to guarantees from obligors who have reneged on obligations in the
past, unless there is clear evidence that the guarantor has the ability and intern to
honor the specific guarantee obligation under review.
Examiners also consider the economic incentives for performance from guarantors:
• Who have already partially performed under the guarantee or who have other
significant investments in the project;
•
Whose other sound projects arc cross-collateralized or otherwise intertwined with
the credit; or
• Where the guarantees arc collateralized by readily marketable assets that are under
the control of a third party.
O ther considerations. In general, only guarantees that are legally enforceable will be
relied upon. However, all legally enforceable guarantees may not be acceptable. In
addition to the guarantor’s financial capacity and willingness to perform, it is expected
that the guarantee will not be subject to significant delays in collection, or undue
complexities or uncertainties about the guarantee.
The nature of the guarantee is also considered by examiners. For example, some
guarantees for real estate projects only pertain to the development and construction
phases of the project. As such, these limited guarantees would not be relied upon to
support a troubled loan after the completion of those phases.
Examiners also consider the institution’s intent to enforce the guarantee and whether
there are valid reasons to preclude an institution from pursuing the guarantee. A
history of timely enforcement and successful collection of the full amount of
guarantees will be Apositive consideration in the classification process.
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Attachment 2
THE VALUATION OF INCOME-PRODUCING REAL ESTATE
Approaches to the Valuation of Real Estate
Appraisals are professional judgments of the market value of real property. Three
basic valuaiion approaches are used by professional appraisers In estimating the market
value of real propcity - the cost approach, the market data or direct sales comparison
approach, and the income approach. The principles governing the three approaches are
widely known in the appraisal field and were recently referenced in parallel regulations
Issued by each of the federal bank and thrift regulatory agencies. When evaluating the
collateral for problem credits, the three valuation approaches are not equally
appropriate.
1. Cost Approach. In the cost approach, the appraiser estimates the reproduction
cost of the building and improvements, deducts estimated depreciation, and adds
the value of the land. The cost approach is particularly helpful when reviewing
draws on construction loans. However, as the property increases in age, both
reproduction cost and depredation become more difficult to estimate. Except
for special purpose facilities, the cost approach is usually inappropriate in a
troubled real estate market because construction costs for a new facility normally
exceed the market value of existing comparable properties.
2. M arket Data or Direct Sales Comparison Approach. This approach examines
the price of similar properties that have sold recently in the local market,
estimating the value of the subject property based on the comparable properties’
selling price. It is very important that the characteristics of the observed
transactions be similar in terms of market location, financing terms, property
condition and use, timing, and transaction costs. The market approach generally
is used in valuing owner-occupied residential property because comparable sales
data are typically available. When adequate sates data are available, an analyst
generally will give the most weight to this type of estimate. Often, however, the
Available sales data for commercial properties are not sufficient to justify a
conclusion.
3. The Income Approach. The economic value of an income-producing property
is the discounted value of the future net operating income stream, including any
"reversion" value of property when sold. If competitive markets arc working
perfectly, the observed sales price should be equal to this value. For unique
properties or in markets that are thin or subject to disorderly or unusual
conditions, market value based on a comparable sales approach may be either
unavailable or distorted. In such cases, the income approach is usually the
appropriate method for valuing the property.
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The income approach converts all expected future net operating income into
present value terms. When market conditions arc stable and no unusual patterns
of future rents and occupancy rates are expected, the direct capitalization method
is often used to estimate the present value of ftiture income streams. For
troubled properties, however, examiners typically utilize the more explicit
discounted cash flow (net present value) method tor analytical purposes. In that
method, a time frame for achieving a "stabilized", or normal, occupancy and
rent level is projocted. Each year's net operating income during that period is
discounted to arrive at the present value of expected future cash flows. The
property's anticipated sales value at the end of the period until stabilization (its
terminal or reversion value) is then estimated. The reversion value represents
the capitalization of all future income streams of the property after the projected
occupancy level is achieved. The terminal or reversion value is then discounted
to its present value and added to the discounted Income stream to arrive at the
total present market value of the property.
Valuation of Troubled Income-Producing Properties
When an income property is experiencing financial difficulties due to general market
conutions or due to its own characteristics, data on comparable property sales often
are difficult to obtain. Troubled properties may be hand to market, and normal
financing arrangements may not be available. Moreover, forced and liquidation sales
can dominate market activity. When the use of comparables is not feasible (which is
often the case for commercial properties), the net present value of the most reasonable
expectation of the property’s income-producing capacity — not just in today’s market
but over time — offers the most appropriate method of valuation in the supervisory
process.
Estimates of the property's value should be based upon reasonable and supportable
projections of the determinants of future net operating income: rents (or sales),
expenses and rates of occupancy. Judgment is involved in estimating all of these
factors. The primary considerations for these projections include historical levels and
trends, the current market performance achieved by the subject and similar properties,
and economically feasible and defensible projections of future demand and supply
conditions. To the extent that cumcnt market activity is dominated by a limited
number of transactions or liquidation sales, high "capitalization" and discount rates
implied by such transactions should noi be used. Rather, analysts should use rates that
reflect market conditions that arc neither highly speculative nor depressed for the type
of property being valued and that property's location.
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I Technical Notes
| In the process of reviewing a real estate loan and in the use of the net present value
• approach of collateral valuation, several conceptual issues often arc raised. The
following discussion sets forth the meaning and use of those key concepts.
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The Discount Rate. The discount rate used in the net present value approach to
convert future net cash flows of income-producing real estate into present market value
terms is the rate of return that market participants require for this type of real estate
investment The discount rate will vary over time with changes in overall interest
rates and in the risk associated with the physical and financial characteristics of the
property. The riskiness of the property depends both on the type of teal estate in
question and on local market conditions.'
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The Direct Capitalization ("C ap” Rate) Technique. The use of "cap" rates, or direct
income capitalization, is a method used by many market participants and analysts to
relate the value of a property to the net operating income it generates. In many
applications, a "cap" rate is used as a short cut for computing the discounted value of a
property’s income streams,
; The direct income c pitalizarion method calculates the value of a property by dividing
[ an estimate of its "stabilized" annual income by a factor called a "cap" rate. Stabilized
income generally is defined as the yearly net operating income produced by the
l property at normal occupancy and rental rates; it may be adjusted upward or
r downward from today’s actual market condidons.The "cap" rate — usually defined for
i each property type in a market area — is viewed by some analysts as the required rate
; of return stated in terms of current income. That is to say, the "cap" rate can be
f considered a direct observation of the required earnings-to-price ratio in current income
terms. The "cap" rate also can be viewed as the number of cents per dollar of today’s
[ purchase price investors would require annually over the life of the property to achieve
! their required rate of return,
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. The "cap" rate method is appropriate if the net operating income to which it is applied
j is representative of all future income streams or if net operating Income and the
1 property’s selling price arc expected to increase at a fixed rate. The use of this
technique assumes that cither the stabilized income or the "cap" rate used accurately
j captures all relevant characteristics of the property relating to its risk and income
; potential. If the same risk factors, required rate of return, financing arrangements, and
I income projections are used, explicit discounting and direct capitalization will yield the
r same results.
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' This method alone is not appropriate for troubled real estate since Income generated by
. the property is not at normal or stabilized levels. In evaluating troubled real estate,
ordinary discounting typically is used for the period before the project reaches its full
income potential. A "terminal" "cap" rate is then utilized to estimate the value of the
property (its reversion or sales price) at the end of that period.
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Differences Between Discount and Cap Rates. When used for estimating real estate
market values, discount and "cap" rates should reflect the current market requirements
for rates of return on properties of a given type. The discount rate is the required rate
of return including the expected increases in future prices and is applied to income
streams reflecting inflation. In contrast, the "cap" rate is used in conjunction with a
stabilized net operating income figure. The fact that discount rates for real estate are
typically higher than "cap" rates reflects the principal difference in the treatment of
expected increases in net operating income and/or property values.
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j Other factors affecting the "cap" rate used (but not the discount rate) include the useful
i life of the property and financing arrangements. The useful life of the property being
evaluated affects the magnitude of the "cap" rale because the income generated by a
i property, in addition to providing the required return on investment, must be sufficient
| to compensate the investor for the depreciation of the property over its useful life,
j The longer the useful life, the smaller is the depreciation in any one year, hence, the
smaller is the annual income requ :ed by the investor, and the lower is the "cap" rate.
! Differences in terms and the extent of debt financing and the related coals must also be
• taken into account,
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1 Selecting Discount and Cap Rates. The choice of the appropriate values for discount
i and "cap” rates is a key aspect of income analysis. Both in markets marked by lack of
j transactions and those characterized by highly speculative or unusually pessimistic
! attitudes, analysts consider historical required returns on the type of property in
: question. Where market information is available to determine current required yields,
i analysts carefully analyze sales prices for differences in financing, special rental
{ arrangements, tenant improvements, property location, and building characteristics. In
; most local markets, the estimates of discount and "cap" rates used in income analysis
j should generally fall within a fairly narrow range for comparable properties.
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Holding Period vs. Marketing Period. When the income approach is applied to
troubled properties, a time frame is chosen over which a property is expected to
achieve stabilized occupancy and rental rates (stabilized income). Ttial time period is
sometimes referred to as the "holding period.” The longer the period before
stabilization, the smaller will be the reversion value included in the total value
estimate.
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The holding period should be distinguished from the concept of "marketing period" —
a term used in estimating the value of a property under the sales comparison approach
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* and in discussions of property value when real estate Is being sold. Tlic marketing
: period is the length of time that may be required to sell the property in an open
! market.
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! Glossary
Appraisal. A written statement independently and impartially prepared by a qualified
appraiser setting forth an opinion as to the market value of an adequately described
property as of a specific date(s). supported by the presentation and analysis of relevant
j market information.
Capitalization rate* A rate used to convert income into value. Specifically, it is the
! ratio between a property's stabilized net operating income and the property's sales
j price. Sometimes referred to as an overall rate because it can be computed as a
i weighted average of component investment claims on net operating income.
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| Discount rate. A m e of return used to convert future payments or receipts into their
j present value.
: Holding period. The time frame over which a property is expected to achieve
j stabilized occupancy and rental rates (stabilized income).
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i M arket value. The most probable cash sale price which a property should bring in a
! competitive and open market under all conditions requisite to a fair sale, die buyer and
I seller each acting prudently and knowledgeably, and assuming the price is not affected
by undue stimulus. Implicit in this definition is the consummation of a sale as of a
j specified date and the passing of title from seller to buyer under conditions whereby:
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1. buyer and seller are typically motivated (Le„ motivated by self-interest);
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2. both parties are well informed or well advised, and acting in what they consider
their own best interests;
3. a reasonable time is allowed for exposure in the open maikel;
4. payment is made in terms of cash in U.S. dollars or in terms of financial
arrangements comparable thereto; and
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5. the price represents the normal consideration for the property sold unaffected by
special or creative financing or sales concessions granted by anyone associated
with the sale.
! M arketing period. The term in which an owner of a property is actively attempting to
sell that property in a competitive and open market.
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i Net operating income (NOI). Annual income after all expenses have been deducted,
except for depreciation and debt service.i
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Attachment 3
Classification Definitions1
jThc federal bank and thrift regulatory agencies currently utilize the following
definitions for assets classified ’’substandard,” "doubtful," and "loss" tor supervisory
purposes:
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{Substandard Assets. A substandard asset is inadequately protected by die current
jsound worth and paying capacity of die obligor or of the collateral pledged, if any.
jAssets so classified must have a well-defined weakness or weaknesses that Jeopardize
the liquidation of the debt. They arc characterized by the distinct possibility that the
institution will sustain some loss if the deficiencies are not corrected.
Doubtful Assets. An asset classified doubtful has all the weaknesses inherent in one
classified substandard with the added characteristic that the weaknesses make
j collection or liquidation in full, on the basis of currently existing facts, conditions, and
values, highly questionable and improbable.
jLoss Assets. Assets classified loss are considered uncollectible and of such little value
j that their continuance as bankable assets is not warranted. This classification does not
| mean that the asset has absolutely no recovery or salvage value, but rather it is not
j practical or desirable to defer writing off this basically worthless asset even though
• partial recovery may be effected in the ftiture.
1Ofc o teCmtolro teCrec,Comptroller's Handbook for National Dank Examiners, Scin251
fie f h oprle f h urny
eto 1.,
"siiaino Ceis" B t dtf oenr u teFdrlRsreSse,Commtrciai Bank Examination Manual,
Qufcto f rdt; o r tGvro! f h eea eev ytm
Scin215. t, "asfainu C^t; Ofc o Trf Spriin Thrift Adivisits Rt^ulatory Handbotrk, Scin260,
eto
Qillio f ris" fie f hit uevso,
otu
" u i i m o o Ast; FdrlDpstIirneCroain Division of Supervision Manual o f Examination P o lie k s,
G r f e i n f ses" eea eoi nuec oprto,
Scin31 " e s
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@FedFRASER