TO BE ‘AS STABILIZED’ OR NOT TO BE ‘AS STABILIZED’
Bankers have long known to use the appraised valuation that best represents the phase or status being financed for a commercial real estate (CRE) acquisition, development and construction (ADC) loan. The valuation should provide an opinion of the highest and best use of the property, considering the legal and physically possible use of the property in its “as is” condition as of the appraisal’s effective date. The appraisal should also provide an opinion of the property’s “prospective” market values at the time development/construction is expected to be completed and at the time stabilized occupancy is anticipated.
The prospective “as complete” and “as stabilized” values are a component of real-estate appraisal expectations that historically have not received a significant level of attention. This subtopic relates to investment real estate when the appraisal report includes “as complete” and “as stabilized” valuations.
What is not as clear is when it is appropriate to use the “as complete” or “as stabilized” valuation when financing an investment property that is not owner occupied. The current guidance does not provide strict requirements in this area, but rather leaves this valuation selection to prudent banking practices.
Section VII of the Interagency Appraisal and Evaluation Guidelines from December 2010 (Guidance) says, “An institution should understand the real property’s ‘as is’ market value and should consider the prospective market value that corresponds to the credit decision and the phase of the project being funded, if applicable.” This clearly lays out an expectation for the banker to evaluate the stage of the project being funded but does not provide insight into when it is appropriate to use an “as stabilized” market value to support a credit transaction.
For the purpose of this article, we will focus on new credit requests and existing credit relationships that are pass grade or performing credit relationships to provide information for the best selection for the use of a prospective market value in the underwriting and analysis process.
Prospective Market Values
The Guidance defines Prospective Market Value “as completed” and “as stabilized” as: “A prospective market value may be appropriate for the valuation of a property interest related to a credit decision for a proposed development or renovation project. According to USPAP, an appraisal with a prospective market value reflects an effective date that is subsequent to the date of the appraisal report. Prospective value opinions are intended to reflect the current expectations and perceptions of market participants, based upon available data. Two prospective value opinions may be required to reflect the time frame during which development, construction, and occupancy will occur. The prospective market value “as completed” reflects the property’s market value as of the time that development is expected to be completed. The prospective market value “as stabilized” reflects the property’s market value as of the time the property is projected to achieve stabilized occupancy. For an income-producing property, stabilized occupancy is the occupancy level that a property is expected to achieve after the property is exposed to the market for lease over a reasonable period of time and at comparable terms and conditions to other similar properties.”
Generally speaking, a prospective “as stabilized” valuation will provide a higher estimate of value of the subject property as it assumes near-peak expectations for the financial performance of the property compared with a prospective “as complete” valuation. The “as stabilized” valuation can increase the amount available to lend under regulatory advance ratios, providing the potential ability to fund a greater amount of the transaction. Lenders may be tempted to prematurely use the “as stabilized” valuation in an effort to create differentiation on a competitive loan opportunity.
It is important the banker use the prospective value conclusion that best represents the current market value and is based upon current and reasonably expected market conditions. An “as stabilized” value may reflect the highest valuation and may allow for the financial institution to maximize the funding in a project. However, if the property is not actually at the level of estimated stabilization or there is not a current and reasonable expectation for market conditions to provide for stabilization as estimated in the appraisal report, the “as complete” market value should be used.
In general, the appraised “as stabilized” value should only be used in financial institution’s analysis if the property has achieved true stabilization. Examples include:
- Permanent Financing for CRE loans with either unfunded commitments for tenant improvements (TI) and/or vacancy above the appraisal estimated stabilized level – This can include loans with a funding mechanism for TI as additional leases are signed or projects where current occupancy does not meet anticipated levels stated in the appraisal report. It is generally inappropriate to use the “as stabilized” value from the appraisal report since the project has not met the stabilized levels.
- Renewal and Extensions of CRE permanent financing – This can include loans in which the subject property is beyond the estimated lease-up/stabilization period and has not met anticipated occupancy levels. An “as stabilized” value would be inappropriate in this scenario. In addition, the financial institution should consider requesting a new or updated appraisal report since estimates from the initial appraisal report have not been met and changes might have occurred in the real estate market, in the highest and best use of the property, or with other items that could result in a lower “as stabilized” value.
The appraised “as completed” market value is used predominantly in two scenarios upon completion of a project. The first is to calculate the appropriate loan to value (LTV) for purposes of determining whether a project is identified as a High Volatility CRE exposure under the BASEL III capital rules (Part 324 of the FDIC Rules and Regulations). The second scenario is when the construction project has been completed and a final inspection determines that workmanship is of expected quality; matching building plans and appraiser expectations when the “as completed” value was initially cast. A recertification of value from the initial appraiser should be provided to validate the original assumptions and estimates in the appraisal report.
Please note the regulators have provided definitive guidance for the appropriate use of a prospective “as complete” or “as stabilized” in both the FDIC’s Tabletop Exercises: Allowance for Loan and Lease Losses and Troubled Debt Restructurings under example 2 along with several examples included in the 2009 Policy Statement on Prudent Commercial Real Estate Loan Workouts.
Admittedly, this topic has not faced a high level of scrutiny as examiners dealt with larger real-estate valuation issues over the past few years. This does not mean bankers should be unaware of the expectations between choosing the prospective “as complete” or “as stabilized” value as a part of the underwriting process.
Should the financial institution elect a more aggressive valuation approach and optimistic expectations not play out, the not-so-subtle distinction between “as complete” and “as stabilized” values can leave a financial institution in a less-than-desired collateral position and potentially forced to have difficulty discussions with the borrower.
In addition, bankers need to be aware of many additional factors regarding CRE valuations including, local market conditions for lease rates and occupancy levels for the various property types along with the additional factors that can impact the reasonableness of the estimates in the appraisal report. Finally, lenders need to have an awareness of where we are in the current credit cycle, which can also lead to incremental risk. We are now approximately 8 years into the current cycle, which has historically been the approximate duration of credit cycles.
We have no expectation for a “lending bubble” regarding this topic. However, we do believe initial prudent valuation selection can minimize some likely collateral challenges and also potentially minimize the level of credit losses at some point down the road. The selection of an appropriate prospective value will also be a reflection on the financial institution’s management capabilities, credit administration and management’s ability to foster prudent lending decisions as a component of safety and soundness.