Does your loan applicant qualify for an extension of credit based on a strong cash flow or collateral that is not real estate-related? If the answer is yes, the abundance of caution exemption could apply.
There is often an air of uncertainty surrounding appraisal exemptions in general, and financial institutions would be wise to err on the side of caution. Banks or credits unions invoking the abundance of caution exemption are required to keep strict documentation of the final credit report and to verify that the exemption has been appropriately applied to their own established appraisal processes.
However, these cautionary warnings shouldn’t deter financial institutions from utilizing this exemption appropriately. With guidance from the OCC and the Federal Reserve, we’ve outlined when to use the abundance of caution exemption and why.
The Meaning of Abundance of Caution
Typically, an appraisal is required for all real estate-related financial transactions, unless an exemption applies.
Under title XI of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA), appraisal agencies have the authority to identify categories of real estate-related financial transactions that do not require the services of an appraiser to protect federal financial and public policy interests or to satisfy principles of safe and sound lending. Within these categories, the agencies identified certain real estate-related financial transactions that do not require the services of an appraiser and that are exempt from the appraisal requirement.
One of those exemptions is the abundance of caution exemption, which, in summary, states that an appraisal is not needed in transactions where a borrower qualifies for an extension of credit based on the strength of the associated cash flow or non-real estate collateral.
According to the OCC, a borrower can qualify for an abundance of caution in very rare cases, including when the market value of the collateral is not necessary when making a final credit decision. If a bank or credit union has the full support of detailed repayment sources, such as sound global cash flow, sufficient debt coverage, or even the value of owned equipment superseding the outstanding balance, a final commitment can be made to the borrower without additional reporting measures.
So, when is it appropriate for financial institutions to use the abundance of caution exemption?
The OCC states that the abundance of caution exemption may only be used in those transactions where a borrower qualifies for an extension of credit based on the strength of the associated cash flow or non-real estate collateral, and knowledge of the market value of the real estate collateral taken as security for the transaction is unnecessary in making the credit decision.
The financial institution’s credit analysis should document and verify that the credit decision was well supported by repayment sources other than real estate collateral. For transactions that meet the abundance of caution exemption, neither an appraisal nor an evaluation is required. The OCC cites the following examples.
Example 1: Commercial and Industrial Cash Flow Loan
A financial institution extends a commercial business line of credit to a heating and cooling repair business. The financial institution holds the owner’s personal guaranty and has taken a security interest in an investment property owned by the guarantor. The financial institution’s credit analysis determines that cash flow from business operations has generated sufficient debt service coverage. The guarantor’s global cash flow also reflects sufficient debt service coverage, and the guarantor maintains a strong liquid asset position. All of the borrower’s other credit attributes are satisfactory. The financial institution’s credit analysis has verified and documented that the financial institution would have made the loan without any knowledge of the market value of the real estate. Based on the borrower’s overall creditworthiness and the sufficiency of cash flow generated by the business to cover the debt service on the loan, the security interest in the real estate can be considered an abundance of caution.
Example 2: Loan Secured by Other Collateral
A financial institution extends a term loan to a construction company to purchase equipment used in the construction business and secures the loan with a lien on the equipment and the borrower’s headquarters building. The real estate lien can be considered an abundance of caution if, for example, the value of the equipment adequately secures the outstanding balance of the loan, and the borrower’s global cash flow provides for repayment of the loan. In such a case, the cash flow from the operation of the business is the primary source of repayment for the loan and the equipment is the secondary source of repayment. All of the borrower’s other credit attributes are satisfactory. The financial institution’s credit analysis verified and documented that the financial institution would have made the loan without any knowledge of the market value of the real estate.
To summarize, the OCC states that before making a final commitment to the borrower, the financial institution should document and retain in the credit file the analysis performed to verify that the abundance of caution exemption has been appropriately applied. If the operating performance or financial condition of the borrower subsequently deteriorates and the financial institution determines that the real estate will be relied upon as a repayment source, an appraisal should then be obtained, unless another exemption applies.
What the Federal Reserve Has to Say
In section A.4140.1 of the Real Estate Appraisals and Evaluations Appendixes, the Federal Reserve states that an institution may take a lien on real estate and be exempt from obtaining an appraisal if the lien on real estate is taken by the lender in an abundance of caution. This exemption is intended to have limited application, especially for real estate loans secured by residential properties in which the real estate is the only form of collateral.
For a business loan to qualify for the abundance of caution exemption, the agencies expect the extension of credit to be well supported by the borrower’s cash flow or collateral other than real property. The institution’s credit analysis should verify and document the adequacy and reliability of these repayment sources and conclude that knowledge of the market value of the real estate on which the lien will be taken as an abundance of caution is unnecessary in making the credit decision.
When NOT to Use the Abundance of Caution Exemption
The Federal Reserve also states that an institution should not invoke the abundance of caution exemption if its credit analysis reveals that the transaction would not be adequately secured by sources of repayment other than the real estate, even if the contributory value of the real estate collateral is low relative to the entire collateral pool and other repayment sources.
Similarly, the exemption should not be applied to a loan or loan program unless the institution verifies and documents the primary and secondary repayment sources. In the absence of verification of the repayment sources, this exemption should not be used merely to reduce the cost associated with obtaining an appraisal, minimize transaction processing time, or offer slightly better terms to a borrower that would be otherwise provided.
The Importance of Documentation
To reiterate, proper documentation is an essential component of invoking this exemption. The institution should document and retain in the credit file the analysis performed to verify that the abundance of caution exemption has been appropriately applied. If the operating performance or financial condition of the company subsequently deteriorates and the lender determines that the real estate will be relied upon as a repayment source, an appraisal should then be obtained, unless another exemption applies.
If an institution has a question as to whether a particular transaction qualifies for the abundance of caution exemption (or any exemption, for that matter), the institution should seek guidance from its primary federal regulator.
Ultimately, the abundance of caution exemption was designed to be used sparingly and in the appropriate situations. However, when utilized correctly, the exemption can help protect federal financial and public policy interests and satisfy principles of safe lending. In summary, it’s important to remember:
- What is the abundance of caution exemption? The abundance of caution exemption is an appraisal exemption that states an appraisal is not needed in transactions where a borrower qualifies for an extension of credit based on the strength of the associated cash flow or non-real estate collateral.
- When should a financial institution use the abundance of caution exemption? A borrower can qualify for an abundance of caution in very rare cases, including when the market value of the collateral is not necessary when making a final credit decision.
- When not to use the exemption. An institution should not invoke the abundance of caution exemption if its credit analysis reveals that the transaction would not be adequately secured by sources of repayment — even if the value of the real estate collateral is low relative to other repayment sources.
- The importance of thorough documentation. The institution should document and retain in the credit file the analysis performed to verify that the abundance of caution exemption has been appropriately applied.
Have additional questions about the abundance of caution exemption and how it applies to the loan process or the commercial real estate appraisal process at your financial institution? Get in touch with one of our appraisal experts to learn more about appraisal exemptions and how they apply to your bank or credit union.