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Uncovering the Mystery of an Appraisal
by Virginia Gibbs, Manager, Board of Governors

At a recent Federal Reserve conference for community bank examiners, a significant amount of time was devoted to the discussion of banks’ appraisal function and compliance with the Federal Reserve’s appraisal regulation, including appraisal review practices.¹ Several examiners noted that when evaluating commercial real estate loans, they occasionally do not find adequate documentation of appraisal reviews.

When examiners evaluate a credit and the accompanying loan file, they are trying to determine whether the bank has:

1. Reviewed the reasonableness of the facts and assumptions in the appraisal, and
2. Concluded that the appraisal provides a credible opinion of value to support the credit decision.

Examiners rely on a bank’s review to assist them in understanding both the credit and the appraisal. For examiners, the appraisal review provides valuable information about a bank’s assessment of its collateral risk in the event that bank management has to consider the property as a secondary source of repayment. This article seeks to clarify the discussion of appraisal reviews in the Interagency Appraisal and Evaluation Guidelines and to assist bankers in understanding supervisory expectations for appraisal reviews.²

The Mystery of Appraisals

When reading a riveting mystery, it can be tempting to jump right to the last chapter of the book to learn the ending. Of course, if you just skip right to the end, not only do you miss out on the twists and turns of the plot, but you also miss how and why the mystery was solved. Some bankers may be tempted to take a similar approach to reviewing an appraisal report. For example, some bankers may prefer to just consider the appraisal transmittal letter, in which the appraiser sets forth his or her opinion of the property’s market value with an overview of the appraisal assignment. However, bankers should avoid this temptation and instead read beyond the transmittal letter to confirm that the appraiser solved the valuation "mystery" (i.e., answered the valuation question about the property) and that the information and analysis support the property’s market value as presented in the appraisal report.

In discussing appraisal reviews at the recent examiners’ conference, an examiner recounted his experience evaluating a land loan and the accompanying appraisal. When he read the appraisal, the examiner discovered that the appraiser relied on completed lot sales (i.e., a buildable lot with site improvements), even though the subject property had no on-site improvements. While the appraisal did not provide an "as developed" market value of the subject property, the disparity between the conditions of comparable properties and the subject property implied that the subject property was "developed" land. Moreover, the appraisal included a description of the subject property as "wooded land," indicating to the examiner that the land was unimproved. The bank would have identified such disparities if it had performed a more detailed appraisal review.

Examiners have also observed that even when bankers perform appraisal reviews, such reviews sometimes lack the necessary support to indicate whether the reviewer’s comments and questions were resolved prior to the credit decision or whether they were considered in the credit analysis. In one case, examiners found that a bank’s reviewer had accepted an appraisal, but the bank’s credit management function heavily discounted the appraiser’s opinion of value in its impairment analysis of an existing credit. Credit management discounted the appraised value because the new appraisal was much higher than an appraisal from two years prior, and the bank had current information indicating that the project was stalled. In this situation, while the credit management team was correct in its collateral risk assessment, it should also have raised its questions with the appraisal reviewer, who, in turn, should have discussed the matter with the appraiser.

In both situations, the bank’s approach to appraisal review indicated a weakness in risk management and a disregard for the importance of the appraisal review in the assessment of a credit’s collateral risk.

Appraisal Review Policy and Process

Banks are expected to have an appropriate appraisal review policy, considering property type and transaction risk, that confirms compliance with the appraisal regulation. Moreover, the appraisal review should assess whether the appraisal contains sufficient information and analysis to support the appraiser’s opinion of the property’s market value. As discussed in the Interagency Appraisal and Evaluation Guidelines, a bank’s appraisal review policy should achieve the following four objectives:

1. Address the independence, educational and training qualifications, and role of the reviewer;
2. Reflect a risk-focused approach for determining the depth of the review;
3. Establish a process for resolving any deficiencies in appraisals or evaluations; and
4. Set forth documentation standards for the review and resolution of noted deficiencies.

If a bank employee reviews appraisals, the individual should possess the requisite education, expertise, and competence to perform the review, commensurate with the complexity of the transaction, type of real property, and market. Further, the individual should be capable of assessing whether the appraisal contains sufficient information and analysis to support the bank’s credit decision. If a bank has limited in-house expertise to perform appraisal reviews, it may decide to engage a third party to perform the appraisal review function or engage a second appraiser to perform an appraisal review.³ While outsourcing the appraisal review function is an option, bank management remains responsible for determining the quality and assessing the adequacy of the appraisal review and, more important, whether to accept the appraisal.

Independence in the appraisal review process is just as important as independence in engaging the appraiser and ordering the appraisal. Bank employees who review appraisals should be independent of the transaction; have no direct or indirect interest, financial or otherwise, in the property or transaction; and be independent of and insulated from any influence by loan production staff. For community banks with limited in-house expertise, there may be challenges in achieving absolute lines of independence between the appraisal review function and the credit decision. As noted in the guidelines, the appraisal review may be a part of the originating loan officer’s credit analysis, as long as that officer abstains from directly or indirectly approving the loan.

The depth of the review should be sufficient to ensure that the valuation methods, assumptions, data sources, and conclusions are reasonable, well-supported, and appropriate for the transaction, property, and market. Therefore, a bank’s policy for appraisal reviews should address the expectations for an appraisal review based on the size, type, and complexity of the credit transaction and property. For example, when a rural property is appraised, the identification of the property’s market should be an important element of the appraiser’s identification and selection of comparable sales. In a rural market, there may be few or infrequent market transactions within a short distance of the subject property. Therefore, the review of a rural property appraisal should not just evaluate the selection of a comparable sale in relation to the distance between the subject property and the comparable sale but should also consider if the comparable sales are an indicator of the market in which the subject property competes.

A key element of the appraisal review policy is the documentation requirements for a review, which will vary depending on the type, risk, and complexity of the transaction. Therefore, the policy should require sufficient documentation of appraisal reviews to be included in loan files.

The reviewer may ask the appraiser to consider new information or to perform additional analytical work. The bank should have adequate internal controls to ensure that the communications between the reviewer and the appraiser do not result in any coercion or undue influence on the appraiser. The reviewer is likely to have questions for the appraiser, and such dialogue should occur to promote an understanding of the appraisal. Therefore, the documentation in the loan file should provide an audit trail of the review process and the appraiser’s responses, including any changes that the appraiser may make to the property’s market value. Further, if there are deficiencies in the appraisal that cannot be resolved with the appraiser and a second appraisal becomes necessary, the documentation should address the reasons for obtaining and relying on the second appraisal.

Reviewing a CRE Property Appraisal

The review of a commercial real estate (CRE) property appraisal should cover much more than the appraiser’s opinion of the property’s market value. It should also involve an assessment of the appropriateness of the appraiser’s market information, data sources, analysis, and assumptions. The review should consider whether:

• The appraisal reflects the terms and conditions of the appraisal assignment that the appraiser agreed to meet in accepting the appraisal assignment from the bank. An engagement letter between the bank and the appraiser can facilitate communications between the two. A typical engagement letter will address the appraiser’s scope of work; the property and property rights being appraised; and the bank’s requirements for report format, property inspection, and definition of market value.
• The discussion of current market conditions and probable future market trends addresses both rising and declining value trends. This discussion should address the market for the type of property being appraised and not just general market conditions.
• The quantity and quality of the data support the analysis.
• The opinion of the property’s market value reflects expected future market conditions, including any limiting conditions due to lack of data.
• The appraiser appropriately considered the three valuation approaches (i.e., cost, sales comparison, and income), explaining the reasons that an approach was relied upon or omitted. The appraisal should include an assessment of the inherent advantages and disadvantages of the three approaches and the relevance to the subject property.⁴
• The appraisal addresses the intended users and use of the appraisal.
• The appraisal provides the effective date of the opinion value.
• The appraiser discloses the extent to which the subject property and comparable properties were inspected and who performed the inspection.
• The value of furniture, fixtures, and equipment is disclosed separately from the value of the real property.
• In cases when an appraisal includes other value opinions, such as going concern or value in use or special value to a specific property user, the appraisal report clearly identifies and discloses these value opinions separately from the opinion of the real property’s market value.
• The appraisal includes the sales history of the subject property over the past three years.

In discussing with bank management the performance and collateral support for a particular CRE loan, bank examiners will often address the adequacy of the bank’s appraisal function, including the bank’s appraisal review practices. Some of the most common weaknesses that examiners have identified in appraisals are items that bankers may detect in the course of their own reviews. Some of these weaknesses include the following:

• The appraisal does not value the correct property rights (i.e., fee simple, leased fee, and leasehold interest).
• The appraisal includes the value of personal property, fixtures, or the business in the overall opinion of the market value of the real property.
• The appraisal does not address any negative property features or market conditions.
• The appraisal describes deteriorating or weakening market conditions but does not relate these conditions to the opinion of market value.
• The appraisal does not explain the reasons for excluding a valuation method (i.e., sales comparison, cost, and income approaches).
• The appraisal does not reflect an analysis of sales contract, including terms, conditions, and concessions.
• The appraisal does not reflect an analysis of any prior sales of the property being appraised that have occurred within the past three years.
• The information and data presented in the appraisal do not support the key assumptions.
• The appraisal does not include any reasonableness test of key assumptions. For instance, is the marketing period used in the income approach realistic in relation to current market conditions?
• The appraisal relies predominantly on data at the high end of the range of the market information.
• The sell-out rate (e.g., for a residential development) or vacancy rate (e.g., for an office building) appears to be overly optimistic.
• The descriptions of the property and improvements do not match the photographs in the appraisal. For an appraisal of a residential land development, for example, has the appraiser assumed that the lots are ready for home construction, even though the infrastructure (e.g., utilities, streets, sidewalks) has not been completed?
• Comparable properties are dissimilar to the property being appraised, in terms of market, location, or property features. For example, land zoned for residential development should not be compared with sales of land zoned for commercial use.
• The capitalization rate (or "cap rate") does not reflect the requirements of investors for a similar type of property.
• The appraisal reflects gross rents instead of net rents.
• The appraisal reflects contract rents and not market rents.
• For a residential tract development, the appraisal does not consider appropriate deductions and discounts for marketing and holding costs and entrepreneurial profit for the entire project over the sales absorption period.
  
  

Confirming the Ending to the Mystery

Just like a good mystery with an ending that is supported by the clues throughout the story, an acceptable appraisal report will present sufficient information and analysis to support the appraiser’s conclusion about the property’s market value, as well as comply with USPAP and the Federal Reserve’s appraisal regulation. An appraisal should do much more than provide a number — it should tell the story behind that number. The appraisal review should confirm that this is indeed the case, and bank management should view the appraisal review as confirmation that the appraisal supports the valuation conclusion.

Understanding the "mystery" of individual appraisals can provide valuable information to support a bank’s overall appraisal function. A robust appraisal review process confirms the adequacy of a bank’s appraisal function, supports the bank’s practices for engaging competent and qualified appraisers, and ensures that appraisals provide sufficient support and information for the bank to understand its collateral risk. By understanding its collateral risk, a bank can make a more informed credit decision, appropriately mitigate identified risk, and better serve its borrower as well as bank shareholders.