Regulator's Joint Statement on Reviewing Realty Loans

SUMMARY

The recent decline in credit extended by depository institutions has been attributed to many factors. These factors include the general slowdown in the economy; the overbuilding of commercial real estate properties in some markets; the desire of some household and business borrowers, as well as some depository institutions, to strengthen their balance sheets; changes by lenders in underwriting standards; and concerns about the potential impact of certain supervisory policies or actions.

To ensure that regulatory policies and actions do not inadvertently curtail the availability of credit to sound borrowers, the four federal regulators of banks and thrifts have taken a number of steps to clarify and communicate their policies. The attached policy statement is a further step in this effort.

On March 1, 1991, the four agencies - the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corp., the Federal Reserve Board, and the Office of Thrift Supervision - issued general guidelines that addressed a wide range of supervisory policies. Included in the March issuance were brief discussions of the workout of problem loans, lending by undercapitalized institutions, and a general statement on the valuation of real estate loans.

The attached policy statement expands upon the March 1 and subsequent guidance as it relates to the review and classification of commercial real estate loans.

The intent of the statement by the agencies is to provide clear and comprehensive guidance to ensure that supervisory personnel are reviewing loans in a consistent, prudent, and balanced fashion and to ensure that all interested parties are aware of the guidance.

The policy statement 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.

The policy statement also provides guidance on how supervisory personnel analyze the value of collateral. In general, examiners consider the institution's appraisals of collateral (or internal evaluations, when applicable) to determine value and they review the major facts, assumptions, and approaches used in determining the value of the collateral.

Examiners seek to avoid challenges to underlying assumptions that differ in only a limited way from norms that would generally be associated with the property under review. Nonetheless, when reviewing the value of the collateral and any related management adjustments, examiners ascertain that the value is based on assumptions that are both prudent and realistic, and not on overly optimistic or overly pessimistic assumptions.

The policy statement covers a wide range of specific topics, including:

* The general principles that examiners follow in reviewing commercial real estate loan portfolios.

* The indicators of troubled real estate markets, projects, and related indebtedness.

* The factors examiners consider in their review of individual loans, including the use of appraisals and the determination of collateral value.

* A discussion of approaches of valuing real estate, especially in troubled markets.

* The classification guidelines followed by the agencies, including the treatment of guarantees.

* The factors considered in the evaluation of an institution's allowance for loan and lease losses.

This statement is intended to ensure that all supervisory personnel, lending institutions, and other interested parties have a clear understanding of the agencies' policies.

POLICY STATEMENT

Introduction

This policy statement addresses the review and classification of commercial real estate loans by examiners of the federal bank and thrift regulatory agencies. 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. These guidelines are intended to promote the prudent, balance, 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, background information on the valuation of income-producing commercial real estate loans in the examination process, and definition of classification terms used by federal bank and thrift regulatory agencies.

Examiner Review

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 loan documentation is 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 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 alert for indicators of weakness in the real estate markets served by the institution. They should also be alert of indicators of actual or potential problems in the individual commercial real estate projects or transactions financed by the institution.

Available indicators, 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 includee:

* 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).

* Rent concessions or sales discounts resulting in cash flow below the level projecctd in the original feasibility study or appraisal.

* Concessions on finishing tenant space, moving expenses, and lease buyouts.

* 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 major tenants.

* Land values that assumes future rezoning.

* Tax arrearages.

As the problems associated with a commercial real estate project become more pronounced, problems with the related indebtedness may also arise. Such problems include diminished cash flow to service the debt and delinqunet interest and principal payments.

While some commerical real estate loans become troubled because of a general downturn in the market, others beccome 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 speculatiive undeveloped property where the borrower's 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 proerty or supportable 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 borrowers 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 shedule.

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 are the income-producing potential of the underlying collateral and the borrower's willingness and capacity to repay under the existing loan terms from the borrower's other resources if necessary.

In evaluating the overall risk associated with a 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 underlying collateral.

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 reasonableness.

Appraisal assumptions should not be based solely on current conditions that ignore the stabilized income-producing capacity of the property. 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 (including 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. 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.

When reviewing the reasonableness of the facts and assumptions associated with the value of the collateral, examiners may evaluate:

* Current and projected vacancy and absorption rates.

* Lease renewal trends and anticipated rents.

* Volume and trends in pastdue leases.

* Effective rental rates or sale prices (taking into account all concessions).

* Net operating icome of the property as compared with budget projectios.

* Discount rates and direct capitalization, or "cap," rates.

The capacity of a property to generate cash flow to service a loan is evaluated based upon rents (or sales), expenses, ad 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 analysis 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 return to normal (stabilized) conditions. Judgment is involved in determining the time it will take for a property to achieve stabilized occupancy and rental rates.

Examiners do not make adjustments to appraisal assumptionns 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 reting at a rate above today's market rate may vacate the property when the current rate expires.

On the other hand, an adjustment to value may be appropriate for credit analysis purposes whe the valuation assumes renewal at the above-market rate, unless that rate is a reasonable estimate of the expected market rate at the time of renewal.

When estimating the value of income-producing real estate, discount rates and "cap" rates should reflect reasonable expectations about the rate of return that investors 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 given a reasonable amount of deference. Examiners should not challenge the underlying assumptions, including discount rates and "cap" rates used in appraisals, that differ only in a limited way from norms that wowuld 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 underlying facts of 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 refinaced 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 well-conceived 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. In determining the appropriate 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 supporting the loan; and any support provided by financially resposible 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.

These principles hold for individual credits, even if portions or segments of the industry to which the borrower belongs are experiencing financial difficulties. The evaluation of each credit should be based upon the fundamental characteristics 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 be provided solely by the underlying real estate collateral and there are no other available and reliable sources of repayment.

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." The portion of the loan balance that is adequately secured by the value of the collateral should generally 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 dertermined.

If warranted by the underlying circumstances, an examiner may use a "doubtful" classification on the entire loan balance. However, this would occur infrequently.

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 full but that a portion of the loan may be reasonably assured of collection.

Whe an institution has taken a chargeoff 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."

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. In addition, classification of the remaining recorded balance would be appropriate when sources of repayment are considered unreliable.

Guideline for classifying formally restructured loans. The classification treatment previously discussed for a partially charged-off loan would also generally be appropriate for a formally restructured loan when partial chargeoffs have been taken.

For a formally restructured loan, the focus of the examiner's analysis is on the ability of the borrower to repay the loan in accordance with its modified terms. Classification of a formally restructured loan would be appropriate if, after the restructuring, well-defined weaknesses exist that jeopardize the orderly repayment of the loan in accordance with reasonable modified terms.

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.

Allowance Review

The adequacy of a depository institution's allowance for loan and lease losses, or 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.

The dertermination of the adequacy of the ALLL should be based upon management's consideration of all current significcant conditions that might affect the 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 are anot 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 the nature and volume of the portfolio; the experience, ability, and depth of lending management staff; changes in credit standards; collection 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 problems loans, and commitments.

In addition, this analysis should consider the quality of the institution's systems and management in identifying, monitoring, and addressing asset-quality problems. Furthermore, management should consider external factors such as local and national economicc conditions and developments, competition, and legal and regulatory requirements, as well as reasonably foreseeable events that are likely to affect the collectibility of the loan portofolio.

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 scopr 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.

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