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Pitfalls in underwriting commercial real estate.

The United States is currently in the midst of the biggest financial institution crisis since the Great Depression, which has precipitated a massive effort to blame various parties involved. Out of this debacle has come such legislation as Title XI of the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA), which mandated the Resolution Trust Corporation (RTC) bailout of savings and loan institutions as well as the state certification and licensing of appraisers. Faulty and misleading appraisals, in addition to a number of other factors, were major contributors to the current savings and loan crisis--a fiasco that could ultimately cost American taxpayers an estimated $500 billion. The appraisal process did play a significant role; however, the savings and loan crisis was largely caused by inadequate loan underwriting.



Appraisal report review

If the underwriting tool of appraisal report review was used at all in the 1980s, it often was at best a perfunctory part of the underwriting process--sometimes following the loan closing. In addition, borrower-ordered appraisals were a common problem because borrowers often "shopped" for an appraiser who would provide the highest value.

If an appraisal review function did exist within a particular institution, the underwriting process was even more problematic. In most cases, appraisal departments reported to lending departments. This reporting relationship created obvious conflicts of interest and generally resulted in "made as instructed" appraisal reviews or review left incomplete as a result of imposed time constraints. A 1987 survey of financial institutions in one metropolitan area revealed that appraisal reports of major commercial real estate properties were reviewed in as few as two hours. Clearly, the credibility of this important quality-control function was seriously impaired by such hasty procedures. Recent regulatory pressures, however, have made the appraisal review function more important. A 1991 survey within the financial institutions of the same metropolitan area previously surveyed revealed that comprehensive appraisal review of similar properties are now typically completed at the more reasonable rate of two reviews per week. (1) A decision on a loan request is not made now until the appraisal review is properly completed. Finally, Standard Rule 3 of the Uniform Standards of Professional Appraisal Practice (USPAP) (2) is being taken more seriously by both institutional staff appraisers and senior management, thus making the appraisal review process more meaningful. Standard Rule 3 states in general that a reviewer must identify the report under review as well as the extent of the review process. In addition, a reviewer must form opinions concerning the following items: 1) the adequacy and relevance of the data, 2) the appropriateness of the appraisal methods, and 3) whether the conclusions of the report are reasonable. The review should be signed and included a signed certification that the review conforms with USPAP.

Sum of the retail syndrome

In the past, when a developer presented a request for a subdivision loan, the requested loan amount was generally based on the sum of the retail or gross retail value of the lots involved. Gross retail value may be defined as follows.

[Gross retail value is]the aggregate sum of the probable sale prices of all of the individual parts, with no allowance for carrying costs such as taxes, insurance, interest charges, or other costs of production, marketing costs, sales commissions, financing, or profit. The gross retail value is not discounted to reflect the time value of money. (3)

Market value, derived by discounting the gross retail value to a present value, is typically lower than the gross retail value as a result of both the consideration of appropriate charges to revenue and the sell-off of product over time. In one case that involved a large, master-planned community, the appraiser's report clearly showed that the sum of the retail value was not in fact market value. Nevertheless, the loan was closed based on retail values and not market value. In reality, the lender was under-collateralized the moment the loan was closed, and a loan-loss reserve should have been established. However, this issue was glossed over entirely in this case. Loans based on "sum of the retail" values were thus a common cause of problem loan portfolios in the 1980s, and often resulted in the complete insolvency of the institution involved.

Debt coverage ratio (DCR)


For lending decisions, DCR analysis should be one of the primary considerations; however, this valuable underwriting tool was also neglected in the past. Because well-supported estimates of net operating income (NOI) strengthens its validity, particular emphasis should be given to actual rents when estimating the NOI. In addition, a lender should establish DCR thresholds that reflect the quality of the collateral. Too often a "rule of thumb" DCR has been applied to all commercial properties regardless of age, condition, or location. For example, DCRs extracted from regional mall loans are not applicable to unanchored strip shopping centers, which may require coverage ratios at least 10% to 15% higher than the trophy properties.

DCR thresholds corresponding to such characteristics as property type, age, location, and condition should be established and included as integral factors in the determination of lending policy. These thresholds are most beneficial when based on the past loan performance of comparable properties--preferably from a lender's portfolio.

Non-recourse debt

This pervasive pitfall of real estate lending generally evolved as a result of the "herd instinct"--as development and loan demand reached heightened levels, many lenders began offering non-recourse loans in an effort to attract borrowers and retain existing clientele. Non-recourse debt essentially eliminated a lender's ability to pursue a deficiency judgment in the event of default. The pairing of a non-recourse land loan based on the sum of the retail values with an interest reserve loan created a loan with no capital investment or risk for the borrower. The threats posed to institutional capital by this form of debt have been realized in most cases--clearly reflecting the inherent problems of such underwriting methods.

Lending outside of traditional


Many financial institutions embarked on a mission of expansion into geographical areas of the country far from their traditional markets. To complete effectively against firmly established lenders in these areas, out-of-state lenders were essentially required to take more risks. These risks took the form of pricing down loans or offering fatter loans to attract business. In addition to changing markets geographically, some lenders also moved from traditional residential lending (i.e., one- to four- family) to complex commercial and industrial real estate lending. While such lenders were frequently profitable in residential lending, this change in philosophy often caused large losses even when lenders remained within their own geographic trade areas. The quest to book more loans, however, encouraged changes in lending philosophies and markets.

Interest reserve loans

Many land loan submissions were accompanied by requests for interest reserve loans. These loans often included hundreds of thousands, even millions of additional dollars with which developers were supposed to pay interest on loans. To maintain a competitive edge in the mortgage market, these loan requests became common. Land loans based on the sum of the retail values coupled with large interest reserve loans, while popular, resulted in staggering loan-to-value ratios with serious collateral valuation deficiencies. In fact, it often became impossible for a lender to recapture the original investment. As might be expected in such cases, the interest reserve loan proceeds were frequently diverted to other uses; for example, to acquire other real estate or to service the debt on other loans. The need to obtain an appraisal to estimate market value was not considered in the decision-making process for this type of loan. More often, "points" and "fees" were the major focus of loan committees.


While mandatory amounts of pre-leasing should be required by lenders, this basic element of sound underwriting fell by the wayside in the 1980s in favor of speculative construction in office, retail, and industrial development. In the current market, however, it is not uncommon for lenders to require 25% to 50% pre-leasing for a proposed project. While verification of the leases should also be included in the pre-leasing stipulation, the existence of undisclosed lease addendums and rental concessions were often unknown to lenders in the past. In some instances, particularly when an appraisal was not available, unsigned leases were accepted and became the basis for a loan. A properly prepared appraisal would have disclosed these items. It is clearly vital to the formulation of an accurate estimate of value that a professional appraiser verify such factors as lease terms with all parties to the lease.

"Drive-by" appraisals

Contributing further to inadequately underwritren real estate loans were "drive-by" appraisals. This type of appraisal literally involves a cursory view of the property from the window of a vehicle. It is prepared on an abbreviated form that indicates a value range replete with limiting conditions and other disclaimers. Corporate lending personnel who wanted to complete a deal as presented often requested this type of report. While such a corporate borrower was usually described as financially strong, the amount of the requested loan necessitated additional collateral. This sort of borrower reportedly did not have time to wait for an appraisal report. The subject property in such a case was often a large industrial warehouse subject to a long-term lease not available for review and analysis. The shortcomings of providing a drive-by appraisal for this type of property are obvious. Yet, the urgency to do business frequently prevented the parties involved from obtaining fully documented appraisal reports. Reliance on such inadequate reports for lending purposes was common and often involved loans in excess of $1,000,000. Future lender claims against such collateral usually proved woefully inadequate.

Concentration of credit

Historically, financial institutions became insolvent as a result of concentrations of credit beyond prescribed levels of safety and soundness, usually reaching 10% of net worth. Many lenders failed to consider this vital element of sound underwriting. Invariably, the severity of loan problems increased as related borrowings entities succumbed to market problems. The effects of these web-like lending relationships made loan workouts impossible, and foreclosure became the standard outcome, sometimes creating a domino effect. Policies to prevent such problems either did not exist or were not enforced. Cleary, concentration of credit limits should also apply to any one property, and the maximum loan amount on any one property should not exceed 10% of the lender's capital.

Concept of "perceived value"

"Perceived value" is a term that was bandied about among many real estate lenders particularly in growth markets, often serving as the basis for a real estate loan. As an illustration of this concept, such a lender believed that if an office building were appraised for $5,000,000 in a market where office buildings were appreciating in value at 10% per year, in 10 years the property would be worth about $13,000,000 (perceived value). A loan would accordingly be made based on the $13,000,000 perceived value. To compound the problem, loan-to-value ratios were in the range of 75% to 90% of perceived value. In this particular example, even a 75% loan of $9,750,000, based on perceived value, would in reality constitute a loan-to-value ration of 195% in light of the estimated market value of $5,000,000. Such loans are prime candidates for a classified loan portfolio, and ultimately, for foreclosure.

Historical performance of

existing properties

The "borrower pro forma" frequently served as the weathervane of many loan submissions. For example, a subject property might be an existing shopping center in a secondary location suffering from a legacy of tenant turnover, lackluster retail sales, or structural problems. In the context of the 1980s, this list of problems would be quickly negated by an optimistic real estate entrepreneur sure that the problems were caused by poor property management. In support of this position, a potential borrower would create a pro forma spreadsheet showing improved occupancy rates, rental increases, streamlined operating expenses, all resulting in a steadily increasing NOI over the holding period. Lenders would accept these unrealistic pro formas without any real investigation into their validity. Undaunted by the factors of past performance and the presence of incurable obsolescence, the lenders would close the loans firmly convinced that improved property management was the panacea. Typically, borrowers would then be unable to correct the fundamental problems and foreclosure would ensue. Adding to this complication was often an inflated loan amount based on pro forma numbers.

American Land and Title

(ALTA) survey

Most real estate lending policies failed to require this fundamental item, primarily because of the cost. In retrospect, such costs were insignificant when compared with the resulting loan losses and insolvencies. Professionally prepared surveys help ensure that a mortgage lien is, in fact, secured by the correct property. A survey often reveals encroachments, title problems, and easement locations. In one case, a financial institution made a first mortgage loan on a 10,000-acre land parcel based on a developer's survey. Ultimately, the proposed development failed, and upon foreclosure, the lender became painfully aware for the first time that the security included only 7,500 acres. In this instance, the absence of a properly prepared survey essentially guaranteed a loan problem the day the loan was booked.

Further, the reliability of the ALTA survey should be based on a current title report. Such a report was lacking in many cases in the past. After obtaining the information produced by such a survey, a lender should provide it to the appraiser, who will then be able to properly evaluate the subject property and in turn provide a more reliable appraisal report.


These underwriting pitfalls are not unique to the savings and loan industry--similar problems exist within commercial banks, insurance companies, and pension funds. The strong demand for commercial real estate loans combined with imprudent lending practices on the part of these and other players in the mortgage market have resulted in real estate loan portfolio problems that have contributed to large loan losses. Further, such practices often have led to the complete erosion of capital in many financial institutions. The full implications of these problems have not yet been realized. Other financial markets are already being affected by pressures resulting from the federal deficit, which has been growing in large part as a result of financial institution failures.

Perhaps other pitfalls could be identified in the underwriting process. In addition, the negative impact on values caused by the 1986 federal income tax laws, the extreme changes in interest rates between 1979 and 1986, and changes in savings and loan regulations should not be ignored. The short-comings outlined in this article represent flaws observed to be the most frequent causes of major loan losses. In many cases, insolvency of an institution resulted simply from a preponderance of one or more of these pitfalls.

Regulatory integrity and a return to fundamental fiduciary thinking is necessary to ensure the stability of financial institutions as well as the future economy of the United States. In fact, the freedoms and opportunities of our future could be greatly hampered if sound and safe lending practices are not followed.

(1) The 1987 and 1991 surveys were conducted by the author and are unpublished.

(2) The Appraisal Foundation, Uniform Standards of Professional Appraisal Practice (Washington, DC: The Appraisal Foundation, 1990), B-18--B-19.

(3) American Inst. of Real Estate Appraisers, The Dictionary of Real Estate Appraisal, 2d ed. (Chicago: American Inst. of Real Estate Appraisers, 1989), 143.

Philip Marc Barlow, MAI, is currently senior vice president and chief appraiser at Southwest Savings and Loan Association in Phoenix, Arizona. His background also includes classified loan management, REO management, and mortgage loan underwriting. He is a past contributor to The Appraisal Journal.
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Copyright 1992 Gale, Cengage Learning. All rights reserved.

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Author:Barlow, Philip Marc
Publication:Appraisal Journal
Date:Jan 1, 1992
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