Recommendation F on Basic Criteria Used by the Financial Supervision Commission in Approving Mortgage Banks' Regulations for Determining Bank-Mortgage Property Value

Financial Supervision Commission
Recommendation F concerning the basic criteria used by the Financial Supervision Commission when approving regulations determining the bank-mortgage value of real estate issued by mortgage banks Warsaw, July 2014

INTRODUCTION
The following recommendation replaces "Recommendation F of 2003 concerning the basic criteria used by the Banking Supervision Commission when approving regulations determining the bank-mortgage value of real estate issued by mortgage banks".
On January 1, 1998, the Act on Mortgage Bonds and Mortgage Banks entered into force. The rules governing the operation of specialized mortgage banks in Poland were contained in a legal act separate from banking law. The legislator wished to present the principles of their operation in a clear and transparent manner, thereby emphasizing their specialized character.
This Act, in addition to defining the rules and requirements whose fulfillment is necessary for the operation of mortgage banks, also introduced a concept unknown to previous Polish law: "bank-mortgage value of real estate" as the value accepted by a specialized mortgage bank for the purpose of securing a granted loan.
Specialized mortgage banks, due to the specificity of their activity and its concentration on an area related essentially to a homogeneous type of risk (the real estate market), must assess the risk associated with real estate as collateral for granted loans with particular caution. The level of real estate value, reflecting the level of risk, is the starting value for determining the size of loans granted by mortgage banks, the amount of which in turn constitutes the basis for the issuance of mortgage bonds, which are the main instrument for refinancing their activity. Taking the above into account, as well as the sectoral risk to which mortgage banks are exposed, the bank-mortgage value of real estate should be regarded as a sort of prudential norm for their activity. Mortgage banks are also obliged to comply with the provisions of Recommendation S concerning good practices in the management of mortgage-secured credit exposures. Guided by concern for the quality of security for mortgage banks' claims, the legislator imposed on the Financial Supervision Commission the obligation to approve their internal regulations concerning the rules for determining the bank-mortgage value of real estate. Imposing this obligation on the KNF means limiting the total discretion of banks in constructing these regulations, and thus a high degree of standardization in their approach to assessing risk associated with real estate as collateral for loans. The aforementioned regulations must meet the condition of transparency and reproducibility of the procedures used by banks for preparing bank-mortgage value appraisals, in order to enable their proper control by the bank, the trustee, and the supervisory authority. The level of the bank-mortgage value of real estate is determined mainly based on factors obtained from the market. For this reason, especially under Polish conditions, particular caution is recommended in their selection and assessment. It is therefore necessary for mortgage banks to conduct a broad market analysis (not only of the real estate market). Banks engaging in real estate market financing, especially mortgage banks, must possess broad knowledge about the real estate market and all risk factors affecting it. Without fulfilling these conditions, it is not possible to properly prepare bank-mortgage value appraisals and estimate long-term risk. In Recommendation J of September 2012 concerning the rules for the collection and processing by banks of data on real estate, the KNF indicated areas of this market that should be of particular interest to banks operating in it. In order to facilitate mortgage banks in constructing their internal regulations, the Financial Supervision Commission considered it appropriate to issue a recommendation concerning the basic criteria used in approving regulations for determining the bank-mortgage value of real estate issued by mortgage banks. The Financial Supervision Commission expects that Recommendation F
concerning the basic criteria used by the Financial Supervision Commission when approving regulations for determining the bank-mortgage value of real estate issued by mortgage banks, constituting an annex to Resolution No. .../2014 of the Financial Supervision Commission of ... July 2014 (Journal of Laws of KNF pos........), will be implemented by January 1, 2015.

I.

1. Tasks of the bank-mortgage value of real estate appraisal - general issues
   1.1. Bank-mortgage value of real estate is the value determined based on an appraisal in accordance with the provisions of the Act on Mortgage Bonds and Mortgage Banks, which in the opinion of the mortgage bank reflects the level of risk associated with the real estate as collateral for loans granted by the mortgage bank.
   1.2. Determining the bank-mortgage value of real estate based on an appraisal serves the mortgage bank as a basis for issuing an opinion on the amount to which a mortgage loan may be granted, secured by a mortgage established on the real estate in question, and in the case of the mortgage bank acquiring a claim secured by the real estate in question - for the decision on whether the claim may be acquired.
   1.3. The bank-mortgage value of real estate appraisal takes into account as many types of risk as possible, which, based on past experience and analyses and forecasts1, may have a negative impact on the bank-mortgage value of real estate. These analyses and forecasts should primarily take into account parameters specific to the given real estate (detailed in the further part of this recommendation), which affect the assessment of collateral risk, as well as general factors, including:
   a) economic cycles, b) tax regulations, c) population development (demography), d) unemployment rate, e) changes in the purchasing power of money, f) regional and urban development (e.g., study of conditions and directions of spatial development or local spatial development plan).
   The mortgage bank periodically prepares and makes available to persons preparing appraisals and determining the bank-mortgage value of real estate analyses and assumptions regarding items a)-f). The preparations are made by persons with appropriate qualifications and professional experience.
   Based on the factors mentioned in items a-f), a reduction corresponding to anticipated decreases in real estate prices is made, and this reduction should be not less than 5%.
   1.4. The appraisal serving as the basis for determining the bank-mortgage value of real estate should be carried out with due care and caution, in particular by taking into account only those characteristics of the real estate and associated revenues which, assuming its rational exploitation, have a permanent character and which can be obtained by any owner of the real estate.
   1.5. The bank-mortgage value of real estate appraisal is performed in accordance with the bank's regulations by:
   a) persons or organizational units of the bank designated by the bank's management board, or b) other entities, at the request of the mortgage bank, after agreement with the borrower, in particular entities referred to in Article 174 paragraphs 2 and 6 of the Act of August 21, 1997 on Real Estate Management.
   1.6. The bank-mortgage value of real estate appraisal should be prepared by persons with documented appropriate qualifications and professional experience, in particular possessing the ability to estimate banking risk in the context of securing mortgage loans and continuously improving their skills in this area.
   1.7. The bank-mortgage value of real estate appraisal in the bank is prepared within the organizational area responsible for risk management, independently of the bank's organizational units dealing with credit acquisition or preparing credit applications. An exception to this rule is permissible, as referred to in point III.6.4.
   1.8. The amount of remuneration for persons preparing the bank-mortgage value of real estate appraisal must not be dependent in any way on the amount of the bank-mortgage value of real estate.
   1.9. All analysis results must be presented in a transparent manner with appropriate justification, to enable proper control of the degree of risk taken by the bank by the supervisory authority and the trustee.
   1.10. When reviewing applications for approval of detailed regulations for determining the bank-mortgage value of real estate submitted by banks, the Financial Supervision Commission will check whether they include at least the aspects contained in this recommendation regarding the methodology for conducting a prudent assessment of risk associated with real estate as collateral for loans granted by the mortgage bank.

II.

1. General rules for preparing and assessing the bank-mortgage value of real estate appraisal
   1.1. Bank-mortgage value of real estate is determined for all real estate constituting the subject of collateral for loans granted or acquired by the bank.
   1.1.1. In the case of real estate for which determining the bank-mortgage value using the methods referred to in point III.1.1 is impossible in a reliable manner or the result of such an appraisal would not have credible grounds, the mortgage bank should not grant nor acquire loans secured by such real estate.
   1.2. Before performing the bank-mortgage value of real estate appraisal, except for the cases listed in point 1.2.1, and III.6.2 and III.6.3, external and internal inspections of the real estate are necessary.
   In the case of performing an appraisal for real estate in the preparation phase of investment or its implementation, in addition to the aforementioned external inspections, a detailed analysis of appropriate documentation related to the investment is carried out.
   After the completion of the investment, a control is performed of the bank-mortgage value of the analyzed real estate established at the beginning, regarding compliance with documentation and changes in parameters significantly affecting the need to reduce the bank-mortgage value of real estate.
   1.2.1 In the case of the acquisition by a mortgage bank of a claim secured on residential real estate from another financial institution, the appraisal process may dispense with conducting an inspection of the interior of the given real estate and preparing photographic documentation of the interior of this real estate, provided that the established bank-mortgage value of real estate is reduced by an additional correction, the amount of which is established and appropriately justified by the bank's management board. If, in the case of a loan related to the real estate, delays were noted or the external condition of the real estate significantly deteriorated, this correction should be not less than 10% relative to the result of the bank-mortgage value of real estate.
   1.3. The appraisal, in addition to the specific proposal for the bank-mortgage value of real estate and a transparent procedure for its determination, contains in particular:
   a) the date of preparation of the appraisal, b) information about the data sources used by the appraiser, which may concern the given real estate (in particular, appropriate real estate plans, local spatial development plan of the given area, and in the absence thereof, the study of conditions and directions of spatial development, possibly - if issued - the decision on development conditions), c) the type of the given real estate and its description (including photographic documentation), d) description of the location, e) characterization of quality features (utility values, finishing standard and equipment), f) information about the legal status of the given real estate (e.g.: ownership, co-ownership, perpetual usufruct, encumbrances), g) description of additional internal and external technical equipment constituting a component part of the given real estate, h) assessment of the long-term possibility of selling the given real estate (taking into account alternative usage options), including potential demand, timeframes, and sales costs (commission, court costs, etc.), i) first and last name and signature of the person preparing the appraisal.
   1.4. The bank-mortgage value of real estate appraisal contains adequate justification for all parameters included in it.
   1.5. Parameters taken into account in the bank-mortgage value of real estate appraisal are selected taking into account their long-term character. Any parameters that do not have a long-term permanent character or may be considered speculative are excluded from the analysis.
   1.6. Assessments of parameters relating to the given real estate are made in relation to local market conditions. From the perspective of risk, local market conditions are assessed with due caution based on past experience and after making estimates regarding possible predictable negative changes in the future. If there is a lack of sufficient experience regarding the local market, experience from other comparable real estate markets is included in the analysis (only after preparing a detailed justification).
   1.7. The bank-mortgage value of real estate appraisal is prepared on a form developed by the bank (recommended shape is presented in the annexes to the recommendation), in a manner enabling authorized bank employees, the supervisory authority, and the trustee to reproduce and check the entire analysis process referred to in point III.1, and to control the level of risk taken by the bank associated with real estate as collateral for a loan. These forms take into account at least the aspects of bank-mortgage value of real estate contained in this recommendation.

III.

1. Procedure for preparing the bank-mortgage value of real estate appraisal
   1.1. In the bank-mortgage value of real estate appraisal, three basic directions of analysis of risk associated with real estate as collateral for loans financed by the mortgage bank may be used, independently of each other:
   a) analysis of appropriate, long-term permanent total costs of construction of the given real estate (including appropriate, long-term permanent costs of acquiring the land), concluded with the determination of their total sum, b) analysis of the long-term profitability of the given real estate, concluded with the determination of the amount of capitalized net revenues possibly achievable in the long term from the given real estate, c) analysis related to the market value of the given real estate, concluded with the determination based on long-term permanent characteristics of the real estate of the price of the given real estate possibly achievable in the long term. The results of these analyses constitute the basic auxiliary element for determining the bank-mortgage value of real estate.
   1.2. For real estate intended for residential purposes and treated as such by the market, at least one of the analyses referred to in point III.1.1 must be performed, with the reservation of preparing a simplified appraisal procedure, as referred to in point III.6. The condition for performing only one analysis is a justified expectation that for real estate of such a type (e.g., condominiums, single-family homes, row houses, but excluding rental houses) in the long-term perspective, there will be sufficient local demand at a price corresponding to the bank-mortgage value of real estate determined based on the selected analysis referred to in point III.1.1.
   1.3 For real estate intended for commercial purposes, the analysis referred to in point III.1.1.b) must be performed.
   Additionally, another analysis must be performed: if the real estate has not been put into use, the analysis referred to in point III.1.1.a) must be performed; if the real estate has been put into use, the analysis referred to in point III.1.1.c) must be performed. If the analysis in point III.1.1.a) or in point III.1.1.c) is deemed unjustified or impossible to perform, it may be dispensed with. The reason for dispensing with it must be described and justified in detail; the description constituting the justification should be attached to the bank-mortgage value of real estate documentation.
   1.4. The amount obtained in the process of determining the bank-mortgage value of real estate may not exceed the actual size documented on the market, i.e.:
   a) in the case of real estate intended for commercial purposes - these are the gross capitalized revenues for the last year for comparable real estate, b) in the case of real estate intended for residential purposes, as referred to in point III.1.2 - this is the determined level of transaction prices for the last year for comparable real estate, c) for real estate associated with a higher than average level of risk (e.g., due to their type and size), the upper limit of the bank-mortgage value of real estate is its current market value determined by a real estate appraiser.
   1.5. The analysis referred to in point III.1.1.c) should be based on at least one of three value sources, with the reservation of upper limits referred to in point III.1.4. If more than one source is used, the lowest value provided by these sources must be used:
   a) determined level of transaction prices for comparable real estate based on current transactions, b) market value determined by a real estate appraiser for the given real estate, c) acquisition price determined in the notarial deed, with the reservation of point III.4.1.c).
   If the analysis referred to in point III.1.1.c) is based exclusively on the currently determined level of transaction prices for comparable real estate, as referred to in item a), a correction of not less than 10% established by the bank's management board must be applied to the obtained starting value; if it is based exclusively on the market value determined by a real estate appraiser, as referred to in item b), then in the case where the source is an appraisal prepared by an appraiser at the request of an entity other than the mortgage bank, an additional reducing correction of not less than 10% established by the bank's management board must be applied. The acquisition price from the notarial deed, as referred to in item c), may not constitute the exclusive source of value.
   1.6. For real estate used in a mixed manner, analyses of risk associated with the given real estate as collateral for loans financed by the mortgage bank are carried out separately for the part intended for residential purposes and separately for the part intended for commercial purposes (taking into account point III.1.6.1), with the reservation of exclusion within the simplified bank-mortgage value of real estate appraisal procedure for residential purposes, as referred to in point III.6.5.
   1.6.1. If the share of the area of the real estate for one of the aforementioned types of use does not exceed 10% of the total usable area or the gross revenues obtained from it do not exceed 10% of the total gross revenues from the entire real estate, the requirement specified in point III.1.6 may be dispensed with.

2. Analysis of appropriate, long-term permanent total costs of construction of the given real estate
   2.1. In the analysis of appropriate, long-term permanent, total costs of construction of the given real estate, the sum of the results of:
   a) analysis of appropriate, long-term permanent costs of acquiring the land, and b) analysis of appropriate, long-term permanent costs of construction of the given real estate is taken into account.
   2.2. Analysis of local, long-term permanent costs of acquiring the land is carried out based on a comparison with purchase-sale transactions carried out in the given location separately from the analysis of appropriate, long-term permanent costs of construction of the given real estate. The specific location of the land, appropriate size, shape, type, legal status, local spatial development plan, and infrastructure are taken into account. Other factors that may influence the result of this analysis are also taken into account.
   2.3. The starting point for the analysis of appropriate, long-term permanent costs of construction of the given real estate is appropriate, local costs of construction of the given type of real estate. In the further part of the analysis, appropriate allowances for the degree of technical wear and tear (age), functional, and environmental obsolescence of the given real estate are taken into account.
   2.4. Costs for design and architectural services, official and administrative costs, appropriate financing costs during the construction phase, and costs for producing external devices (e.g., access roads, connections, fences, gardens) may be included in the analysis of appropriate, long-term permanent costs of construction of the given real estate only up to a maximum level established by the bank's management board, expressed as a percentage of construction costs.
   2.5. For prudential reasons, the results of the analysis of appropriate, long-term permanent costs of construction of the given real estate are reduced by an additional factor. The bank's management board, based on a detailed analysis, establishes the minimum level of this factor, which will be included in the calculations.
   2.5.1. The Financial Supervision Commission, in accordance with the principle of prudence (based on Article 34 paragraph 4 of the Act on Mortgage Bonds and Mortgage Banks), may determine the required maximum level of costs referred to in point III.2.4 and the minimum level of the factor referred to in point III.2.5.

3. Analysis of long-term profitability of real estate
   3.1. The assessment regarding the amount of long-term permanent, annual gross revenues possibly achievable from the given real estate should - besides existing experience - be based on significant local conditions for the development of the market. The starting point for the analysis is the typical annual gross revenues2 for the given type of real estate in the given location. In particular, the following are taken into account:
   a) type of real estate use (including its attractiveness, architectural concept, total area, usable area, built-up area, ratio of circulation area to usable area), b) location, c) technical equipment (both internal and external), d) current and alternative possibilities of using the real estate, e) remaining period of use, 2 Their size depends on typical local rental conditions (or other regulations). f) communication and economic conditions of the given location, g) current and expected future market situation.
   3.2. The measure for the analysis is the probable, long-term amount of annual gross revenues. If current annual gross revenues are assessed as too high due to reasons arising from the past, or if there is a justified probability of their reduction due to reasons...