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BOARD OF GOVERNORS

OF THE

FEDERAL RESERVE SYSTEM

WASHINGTON, D.C. 20551 

DIVISION OF SUPERVISION

AND REGULATION

SR 23-5 

June 30, 2023 

TO THE OFFICER IN CHARGE OF SUPERVISION

 AT EACH FEDERAL RESERVE BANK 

SUBJECT: Prudent Commercial Real Estate Loan Accommodations and Workouts 

Applicability: This guidance applies to all institutions supervised by the Federal Reserve, 

including those with $10 billion or less in consolidated assets.

The Federal Reserve, along with the other financial regulators,1 has adopted the attached 

policy statement on Prudent Commercial Real Estate Loan Accommodations and Workouts. The 

Federal Reserve and the other financial regulators issued this policy statement to update previous 

guidance, reinforce the message that financial institutions should work prudently and 

constructively with creditworthy commercial borrowers experiencing financial difficulties, and 

clarify that such message applies in all stages of the economic cycle. This policy statement is 

intended to promote supervisory consistency among examiners and ensure that supervisory 

policies and actions do not inadvertently curtail the availability of credit to sound borrowers. 

This policy statement provides a broad set of principles relevant to all commercial loan 

accommodations and workouts. The policy statement also includes guidance applicable to the 

specific risks and structures of commercial real estate (CRE) loans. Consistent with the safety 

and soundness standards, this policy statement updates and supersedes existing supervisory 

guidance to assist financial institutions’ efforts to modify CRE and other commercial loans to 

borrowers who are, or may be, unable to meet a loan’s current contractual payment obligations.2

 

The policy statement also includes: a section on short-term loan accommodations; a discussion 

of recent accounting changes on estimating loan losses; and updated examples that clarify how to 

classify and account for loans modified or affected by loan accommodations or loan workout 

activity. 

1 The other financial regulators are the Federal Deposit Insurance Corporation, National Credit Union

Administration, and Office of the Comptroller of the Currency.

2

 This policy statement replaces the interagency Policy Statement on Prudent Commercial Real Estate Loan 

Workouts (October 2009).
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Reserve Banks are asked to distribute this letter to the supervised institutions in their 

districts and to appropriate supervisory staff. Questions may be sent via the Board’s public 

website.3

Michael S. Gibson

Director

Division of Supervision and Regulation

Attachments: 

• Policy Statement on Prudent Commercial Real Estate Loan Accommodations and Workouts

• Federal Register Notice

Supersedes:

• SR letter 09-7, “Prudent Commercial Real Estate Loan Workouts”

3 See http://www.federalreserve.gov/apps/contactus/feedback.aspx.
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_________________________________________________________________________________ 

Board of Governors of the Federal Reserve System 

Federal Deposit Insurance Corporation 

National Credit Union Administration 

Office of the Comptroller of the Currency 

_________________________________________________________________________________ 

June 30, 2023 

Policy Statement on Prudent Commercial Real Estate Loan Accommodations and Workouts 

The agencies1 recognize that financial institutions2 face significant challenges when 

working with commercial real estate (CRE)3 borrowers who are experiencing diminished operating 

cash flows, depreciated collateral values, prolonged sales and rental absorption periods, or other 

issues that may hinder repayment. While such borrowers may experience deterioration in their 

financial condition, many borrowers will continue to be creditworthy and have the willingness and 

ability to repay their debts. In such cases, financial institutions may find it beneficial to work 

constructively with borrowers. Such constructive efforts may involve loan accommodations4 or 

more extensive loan workout arrangements.5 

This statement provides a broad set of risk management principles relevant to CRE loan 

accommodations and workouts in all business cycles, particularly in challenging economic 

environments. A wide variety of factors can negatively affect CRE portfolios, including economic 

downturns, natural disasters, and local, national, and international events. This statement also 

describes the approach examiners will use to review CRE loan accommodation and workout 

arrangements and provides examples of CRE loan workout arrangements as well as useful references 

in the appendices.

The agencies have found that prudent CRE loan accommodations and workouts are often in 

the best interest of the financial institution and the borrower. The agencies expect their examiners to 

1 The Board of Governors of the Federal Reserve System (Board), the Federal Deposit Insurance Corporation (FDIC), 

the National Credit Union Administration (NCUA), and the Office of the Comptroller of the Currency (OCC)

(collectively, the agencies). This Policy Statement was developed in consultation with state bank and credit union 

regulators. 

2 For the purposes of this statement, financial institutions are those supervised by the Board, FDIC, NCUA, or OCC. 3 Consistent with the Board, FDIC, and OCC joint guidance on Concentrations in Commercial Real Estate Lending, 

Sound Risk Management Practices (December 2006), CRE loans include loans secured by multifamily property, and 

nonfarm nonresidential property where the primary source of repayment is derived from rental income associated with 

the property (that is, loans for which 50 percent or more of the source of repayment comes from third party, 

nonaffiliated, rental income) or the proceeds of the sale, refinancing, or permanent financing of the property. CRE loans 

also include land development and construction loans (including 1-4 family residential and commercial construction 

loans), other land loans, loans to real estate investment trusts (REITs), and unsecured loans to developers. For credit 

unions, “commercial real estate loans” refers to “commercial loans,” as defined in Section 723.2 of the NCUA Rules and 

Regulations, secured by real estate.

4 For the purposes of this statement, an accommodation includes any agreement to defer one or more payments, make a 

partial payment, forbear any delinquent amounts, modify a loan or contract, or provide other assistance or relief to a 

borrower who is experiencing a financial challenge. 5 Workouts can take many forms, including a renewal or extension of loan terms, extension of additional credit, or a 

restructuring with or without concessions.
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take a balanced approach in assessing the adequacy of a financial institution’s risk management 

practices for loan accommodation and workout activities. Consistent with the Interagency 

Guidelines Establishing Standards for Safety and Soundness,

6 financial institutions that implement 

prudent CRE loan accommodation and workout arrangements after performing a comprehensive 

review of a borrower’s financial condition will not be subject to criticism for engaging in these 

efforts, even if these arrangements result in modified loans that have weaknesses that result in 

adverse classification. In addition, modified loans to borrowers who have the ability to repay their 

debts according to reasonable terms will not be subject to adverse classification solely because the 

value of the underlying collateral has declined to an amount that is less than the outstanding loan 

balance.

I. Purpose

Consistent with the safety and soundness standards, this statement updates and supersedes 

previous supervisory guidance to assist financial institutions’ efforts to modify CRE loans to 

borrowers who are, or may be, unable to meet a loan’s current contractual payment obligations or 

fully repay the debt.7 This statement is intended to promote supervisory consistency among 

examiners, enhance the transparency of CRE loan accommodation and workout arrangements, and 

support supervisory policies and actions that do not inadvertently curtail the availability of credit to 

sound borrowers. 

This statement addresses prudent risk management practices regarding short-term loan 

accommodations, risk management for loan workout programs, long-term loan workout 

arrangements, classification of loans, and regulatory reporting and accounting requirements and 

considerations. The statement also includes selected references and materials related to regulatory 

reporting.8

 The statement does not, however, affect existing regulatory reporting requirements or 

supervisory guidance provided in relevant interagency statements issued by the agencies or 

accounting requirements under U.S. generally accepted accounting principles (GAAP). Certain 

principles in this statement are also generally applicable to commercial loans that are secured by 

either real property or other business assets of a commercial borrower.

Five appendices are incorporated into this statement:

• Appendix 1 contains examples of CRE loan workout arrangements illustrating the 

application of this statement to classification of loans and determination of nonaccrual 

treatment.

• Appendix 2 lists selected relevant rules as well as supervisory and accounting guidance for 

6 12 CFR part 30, appendix A (OCC); 12 CFR part 208 Appendix D-1 (Board); and 12 CFR part 364 appendix A 

(FDIC). For the NCUA, refer to 12 CFR part 741.3(b)(2), 12 CFR part 741 appendix B, 12 CFR part 723, and letter to 

credit unions 10-CU-02 “Current Risks in Business Lending and Sound Risk Management Practices” issued January 

2010. Credit unions should also refer to the Commercial and Member Business Loans section of the NCUA Examiner’s 

Guide. 7 This statement replaces the interagency Policy Statement on Prudent Commercial Real Estate Loan Workouts (October 

2009). See FFIEC Press Release, October 30, 2009, available at: https://www.ffiec.gov/press/pr103009.htm. 8 For banks, the FFIEC Consolidated Reports of Condition and Income (FFIEC Call Report), and for credit unions, the 

NCUA 5300 Call Report (NCUA Call Report). 
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real estate lending, appraisals, allowance methodologies,9 restructured loans, fair value 

measurement, and regulatory reporting matters such as nonaccrual status. The agencies 

intend this statement to be used in conjunction with materials identified in Appendix 2 to 

reach appropriate conclusions regarding loan classification and regulatory reporting. 

• Appendix 3 discusses valuation concepts for income-producing real property.10

• Appendix 4 provides the special mention and adverse classification definitions used by the 

Board, FDIC, and OCC.11

• Appendix 5 addresses the relevant accounting and supervisory guidance on estimating loan 

losses for financial institutions that use the current expected credit losses (CECL) 

methodology. 

II. Short-Term Loan Accommodations 

The agencies encourage financial institutions to work proactively and prudently with 

borrowers who are, or may be, unable to meet their contractual payment obligations during periods 

of financial stress. Such actions may entail loan accommodations that are generally short-term or 

temporary in nature and occur before a loan reaches a workout scenario. These actions can mitigate 

long-term adverse effects on borrowers by allowing them to address the issues affecting repayment 

ability and are often in the best interest of financial institutions and their borrowers.

When entering into an accommodation with a borrower, it is prudent for a financial 

institution to provide clear, accurate, and timely information about the arrangement to the borrower 

and any guarantor. Any such accommodation must be consistent with applicable laws and 

regulations. Further, a financial institution should employ prudent risk management practices and 

appropriate internal controls over such accommodations. Weak or imprudent risk management 

practices and internal controls can adversely affect borrowers and expose a financial institution to 

increases in credit, compliance, operational, or other risks. Imprudent practices that are widespread 

at a financial institution may also pose a risk to its capital adequacy. 

Prudent risk management practices and internal controls will enable financial institutions to 

identify, measure, monitor, and manage the credit risk of accommodated loans. Prudent risk 

management practices include developing and maintaining appropriate policies and procedures, 

updating and assessing financial and collateral information, maintaining an appropriate risk rating 

(or grading) framework, and ensuring proper tracking and accounting for loan accommodations. 

Prudent internal controls related to loan accommodations include comprehensive policies12 and 

practices, proper management approvals, an ongoing credit risk review function, and timely and 

9 The allowance methodology refers to the allowance for credit losses (ACL) under Financial Accounting Standards 

Board (FASB) Accounting Standards Codification (ASC) Topic 326, Financial Instruments – Credit Losses. 10 Valuation concepts applied to regulatory reporting processes also should be consistent with ASC Topic 820, Fair 

Value Measurement.

11 Credit unions must apply a relative credit risk score (i.e., credit risk rating) to each commercial loan as required by 12 

CFR part 723 Member Business Loans; Commercial Lending (see Section 723.4(g)(3)) or the equivalent state regulation 

as applicable. 

12 See 12 CFR 34.62(a) and 160.101(a) (OCC); 12 CFR 208.51(a) (Board); and 12 CFR 365.2(a) (FDIC) regarding real 

estate lending policies at financial institutions. For NCUA, refer to 12 CFR part 723 for commercial real estate lending 

and 12 CFR part 741, appendix B, which addresses loan workouts, nonaccrual policy, and regulatory reporting of 

workout loans.
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accurate reporting and communication. 

III. Loan Workout Programs 

When short-term accommodation measures are not sufficient or have not been successful in 

addressing credit problems, financial institutions could proceed into longer-term or more complex 

loan arrangements with borrowers under a formal workout program. Loan workout arrangements 

can take many forms, including, but not limited to: 

• Renewing or extending loan terms; 

• Granting additional credit to improve prospects for overall repayment; or 

• Restructuring13 the loan with or without concessions.

A financial institution’s risk management practices for implementing workout arrangements 

should be appropriate for the scope, complexity, and nature of the financial institution’s lending 

activity. Further, these practices should be consistent with safe and sound lending policies and 

supervisory guidance, real estate lending standards and requirements,14 and relevant regulatory 

reporting requirements. Examiners will evaluate the effectiveness of a financial institution’s 

practices, which typically include: 

• A prudent loan workout policy that establishes appropriate loan terms and amortization 

schedules and that permits the financial institution to reasonably adjust the loan workout plan 

if sustained repayment performance is not demonstrated or if collateral values do not 

stabilize;15

• Management infrastructure to identify, measure, and monitor the volume and complexity of 

the loan workout activity; 

• Documentation standards to verify a borrower’s creditworthiness, including financial 

condition, repayment ability, and collateral values; 

• Management information systems and internal controls to identify and track loan 

performance and risk, including impact on concentration risk and the allowance; 

• Processes designed to ensure that the financial institution’s regulatory reports are consistent 

with regulatory reporting requirements;

• Loan collection procedures; 

• Adherence to statutory, regulatory, and internal lending limits;

• Collateral administration to ensure proper lien perfection of the financial institution’s 

collateral interests for both real and personal property; and

13 A restructuring involves a formal, legally enforceable modification in the loan’s terms. 14 12 CFR part 34, subpart D, and Appendix to 160.101 (OCC); 12 CFR section 208.51 (Board); and 12 CFR part 365 

(FDIC). For NCUA requirements, refer to 12 CFR part 723 for member business loan and commercial loan regulations, 

which addresses CRE lending, and 12 CFR part 741, Appendix B, which addresses loan workouts, nonaccrual policy, 

and regulatory reporting of workout loans. 15 Federal credit unions are reminded that in making decisions related to loan workout arrangements, they must take into 

consideration any applicable maturity limits (12 CFR 701.21(c)(4)).
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• An ongoing credit risk review function.16

 

IV. Long-Term Loan Workout Arrangements

An effective loan workout arrangement should improve the lender’s prospects for repayment 

of principal and interest, be consistent with sound banking and accounting practices, and comply 

with applicable laws and regulations. Typically, financial institutions consider loan workout 

arrangements after analyzing a borrower’s repayment ability, evaluating the support provided by 

guarantors, and assessing the value of any collateral pledged. Proactive engagement by the financial 

institution with the borrower often plays a key role in the success of the workout. 

Consistent with safety and soundness standards, examiners will not criticize a financial 

institution for engaging in loan workout arrangements, even though such loans may be adversely 

classified, so long as management has: 

• For each loan, developed a well-conceived and prudent workout plan that supports the 

ultimate collection of principal and interest and that is based on key elements such as:

 Updated and comprehensive financial information on the borrower, real estate project, 

and all guarantors and sponsors; 

 Current valuations of the collateral supporting the loan and the workout plan; 

 Appropriate loan structure (e.g., term and amortization schedule), covenants, and 

requirements for curtailment or re-margining; and

 Appropriate legal analyses and agreements, including those for changes to original or 

subsequent loan terms;

• Analyzed the borrower’s global debt17 service coverage, including realistic projections of the 

borrower’s cash flow, as well as the availability, continuity, and accessibility of repayment 

sources; 

• Analyzed the available cash flow of guarantors; 

• Demonstrated the willingness and ability to monitor the ongoing performance of the 

borrower and guarantor under the terms of the workout arrangement; 

• Maintained an internal risk rating or loan grading system that accurately and consistently 

reflects the risk in the workout arrangement; and

• Maintained an allowance methodology that calculates (or measures) an allowance, in 

accordance with GAAP, for loans that have undergone a workout arrangement and 

recognizes loan losses in a timely manner through provision expense and recording

appropriate charge-offs.18

A. Supervisory Assessment of Repayment Ability of Commercial Borrowers

16 See Interagency Guidance on Credit Risk Review Systems. OCC Bulletin 2020-50 (May 8, 2020); FDIC Financial 

Institution Letter FIL-55-2020 (May 8, 2020); Federal Reserve Supervision and Regulation (SR) letter 20-13 (May 8, 

2020); and NCUA press release (May 8, 2020).

17 Global debt service coverage is inclusive of the cash flows generated by both the borrower(s) and guarantor(s), as well 

as the combined financial obligations (including contingent obligations) of the borrower(s) and guarantor(s). 18 Additionally, if applicable, financial institutions should recognize in a separate liability account an allowance for 

expected credit losses on off-balance sheet credit exposures related to restructured loans (e.g., loan commitments) and 

should reverse interest accruals on loans that are deemed uncollectible. 
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The primary focus of an examiner’s review of a CRE loan, including binding commitments, is an 

assessment of the borrower’s ability to repay the loan. The major factors that influence this analysis 

are the borrower’s willingness and ability to repay the loan under reasonable terms and the cash flow 

potential of the underlying collateral or business. When analyzing a commercial borrower’s 

repayment ability, examiners should consider the following factors:

• The borrower’s character, overall financial condition, resources, and payment history;

• The nature and degree of protection provided by the cash flow from business operations or 

the underlying collateral on a global basis that considers the borrower’s and guarantor’s total 

debt obligations; 

• Relevant market conditions,19 particularly those on a state and local level, that may influence 

repayment prospects and the cash flow potential of the business operations or the underlying 

collateral; and 

• The prospects for repayment support from guarantors. 

 

B. Supervisory Assessment of Guarantees and Sponsorships 

Examiners should review the financial attributes of guarantees and sponsorships in 

considering the loan classification. The presence of a legally enforceable guarantee from a 

financially responsible guarantor may improve the prospects for repayment of the debt obligation 

and may be sufficient to preclude adverse loan classification or reduce the severity of the loan 

classification. A financially responsible guarantor possesses the financial ability, the demonstrated 

willingness, and the incentive to provide support for the loan through ongoing payments, 

curtailments, or re-margining. 

Examiners also review the financial attributes and economic incentives of sponsors that 

support a loan. Even if not legally obligated, financially responsible sponsors are similar to 

guarantors in that they may also possess the financial ability, the demonstrated willingness, and may 

have an incentive to provide support for the loan through ongoing payments, curtailments, or remargining. 

Financial institutions that have sufficient information on the guarantor’s global financial 

condition, income, liquidity, cash flow, contingent liabilities, and other relevant factors (including 

credit ratings, when available) are better able to determine the guarantor’s financial ability to fulfill 

its obligation. An effective assessment includes consideration of whether the guarantor has the 

financial ability to fulfill the total number and amount of guarantees currently extended by the 

guarantor. A similar analysis should be made for any material sponsors that support the loan. 

Examiners should consider whether a guarantor has demonstrated the willingness to fulfill all 

current and previous obligations, has sufficient economic incentive, and has a significant investment 

19 See 12 CFR 34.62(c) and 160.101(c)(OCC); 12 CFR 208.51(a) (Board); and 12 CFR 365.2(c) (FDIC) regarding the 

need for financial institutions to monitor conditions in the real estate market in its lending area to ensure that its real 

estate lending policies continue to be appropriate for current market conditions. For the NCUA, refer to 12 CFR 

723.4(f)(6) requiring that a federally insured credit union’s commercial loan policy have underwriting standards that 

include an analysis of the impact of current market conditions on the borrower and associated borrowers.
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in the project. An important consideration is whether any previous performance under its 

guarantee(s) was voluntary or the result of legal or other actions by the lender to enforce the 

guarantee(s).

C. Supervisory Assessment of Collateral Values

As the primary sources of loan repayment decline, information on the underlying collateral’s

estimated value becomes more important in analyzing the source of repayment, assessing credit risk, 

and developing an appropriate loan workout plan. Examiners will analyze real estate collateral 

values based on the financial institution’s original appraisal or evaluation, any subsequent updates, 

additional pertinent information (e.g., recent inspection results), and relevant market conditions. 

Examiners will assess the major facts, assumptions, and valuation approaches in the collateral 

valuation and their influence in the financial institution’s credit and allowance analyses.

The agencies’ appraisal regulations require financial institutions to review appraisals for 

compliance with the Uniform Standards of Professional Appraisal Practice.20 As part of that 

process, and when reviewing collateral valuations, financial institutions should ensure that 

assumptions and conclusions used are reasonable. Further, financial institutions typically have 

policies21 and procedures that dictate when collateral valuations should be updated as part of 

financial institutions’ ongoing credit risk reviews and monitoring processes, as relevant market 

conditions change, or as a borrower’s financial condition deteriorates.22

For a CRE loan in a workout arrangement, a financial institution should consider the current 

project plans and market conditions in a new or updated appraisal or evaluation, as appropriate. In 

determining whether to obtain a new appraisal or evaluation, a prudent financial institution considers 

whether there has been material deterioration in the following factors: 

• The performance of the project; 

• Conditions for the geographic market and property type; 

• Variances between actual conditions and original appraisal assumptions; 

• Changes in project specifications (e.g., changing a planned condominium project to an 

apartment building); 

• Loss of a significant lease or a take-out commitment; or 

• Increases in pre-sale fallout. 

A new appraisal may not be necessary when an evaluation prepared by the financial institution 

appropriately updates the original appraisal assumptions to reflect current market conditions and 

provides a reasonable estimate of the underlying collateral’s fair value.

23 If new money is being 

advanced, financial institutions should refer to the agencies’ appraisal regulations to determine 

20 See 12 CFR part 34, subpart C (OCC); 12 CFR part 208, subpart E, and 12 CFR part 225, subpart G (Board); 12 CFR 

part 323 (FDIC); and 12 CFR part 722 (NCUA). 21 See Footnote 12. 22 For further reference, see Interagency Appraisal and Evaluation Guidelines, 75 FR 77450 (December 10, 2010). 23 According to the FASB ASC Master Glossary, “fair value” is “the price that would be received to sell an asset or paid 

to transfer a liability in an orderly transaction between market participants at the measurement date.” 
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whether a new appraisal is required.24 

The market value provided by an appraisal and the fair value for accounting purposes are based 

on similar valuation concepts.25 The analysis of the underlying collateral’s market value reflects the 

financial institution’s understanding of the property’s current “as is” condition (considering the 

property’s highest and best use) and other relevant risk factors affecting the property’s value. 

Valuations of commercial properties may contain more than one value conclusion and could include 

an “as is” market value, a prospective “as complete” market value, and a prospective “as stabilized” 

market value.

Financial institutions typically use the market value conclusion (and not the fair value) that 

corresponds to the workout plan objective and the loan commitment. For example, if the financial 

institution intends to work with the borrower so that a project will achieve stabilized occupancy, then 

the financial institution can consider the “as stabilized” market value in its collateral assessment for 

credit risk grading after confirming that the appraisal’s assumptions and conclusions are reasonable. 

Conversely, if the financial institution intends to foreclose, then it is required for financial reporting 

purposes that the financial institution use the fair value (less costs to sell)26 of the property in its 

current “as is” condition in its collateral assessment.

If weaknesses exist in the financial institution’s supporting loan documentation or appraisal or 

evaluation review process, examiners should direct the financial institution to address the 

weaknesses, which may require the financial institution to obtain additional information or a new 

collateral valuation.27 However, in the rare instance when a financial institution is unable or 

unwilling to address weaknesses in a timely manner, examiners will assess the property’s operating 

cash flow and the degree of protection provided by a sale of the underlying collateral as part of

determining the loan’s classification. In performing their credit analysis, examiners will consider 

expected cash flow from the property, current or implied value, relevant market conditions, and the 

relevance of the facts and the reasonableness of assumptions used by the financial institution. For an 

income-producing property, examiners evaluate: 

• Net operating income of the property as compared with budget projections, reflecting 

reasonable operating and maintenance costs; 

24 See footnote 20. 25 The term “market value” as used in an appraisal is based on similar valuation concepts as “fair value” for accounting 

purposes under GAAP. For both terms, these valuation concepts about the real property and the real estate transaction 

contemplate that the property has been exposed to the market before the valuation date, the buyer and seller are well 

informed and acting in their own best interest (that is, the transaction is not a forced liquidation or distressed sale), and

marketing activities are usual and customary (that is, the value of the property is unaffected by special financing or sales 

concessions). The market value in an appraisal may differ from the collateral’s fair value if the values are determined as 

of different dates or the fair value estimate reflects different assumptions from those in the appraisal. This may occur as 

a result of changes in market conditions and property use since the “as of” date of the appraisal. 26 Costs to sell may be used in determining any allowance for collateral-dependent loans. Under ASC Topic 326, a loan 

is collateral dependent when the repayment is expected to be provided substantially through the operation or sale of the 

collateral when the borrower is experiencing financial difficulty based on the entity’s assessment as of the reporting date. 

Costs to sell are used when the loan is dependent on the sale of the collateral. Costs to sell are not used when the 

collateral-dependent loan is dependent on the operation of the collateral. 27 See 12 CFR 34.43(c) (OCC); 12 CFR 225.63(c) (Board); 12 CFR 323.3(c) (FDIC); and 12 CFR 722.3(e) (NCUA).
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• Current and projected vacancy and absorption rates; 

• Lease renewal trends and anticipated rents;

• Effective rental rates or sale prices, considering sales and financing concessions;

• Time frame for achieving stabilized occupancy or sellout;

• Volume and trends in past due leases; and 

• Discount rates and direct capitalization rates (refer to Appendix 3 for more information).

Assumptions, when recently made by qualified appraisers (and, as appropriate, by qualified, 

independent parties within the financial institution) and when consistent with the discussion above, 

should be given reasonable deference by examiners. Examiners should also use the appropriate 

market value conclusion in their collateral assessments. For example, when the financial institution 

plans to provide the resources to complete a project, examiners can consider the project’s 

prospective market value and the committed loan amount in their analyses.

Examiners generally are not expected to challenge the underlying assumptions, including 

discount rates and capitalization rates, used in appraisals or evaluations when these assumptions 

differ only marginally from norms generally associated with the collateral under review. The 

examiner may adjust the estimated value of the collateral for credit analysis and classification 

purposes when the examiner can establish that underlying facts or assumptions presented by the 

financial institution are irrelevant or inappropriate or can support alternative assumptions based on 

available information. 

CRE borrowers may have commercial loans secured by owner occupied real estate or other 

business assets, such as inventory and accounts receivable, or may have CRE loans also secured by 

furniture, fixtures, and equipment. For these loans, examiners should assess the adequacy of the 

financial institution’s policies and practices for quantifying the value of such collateral, determining 

the acceptability of the assets as collateral, and perfecting its security interests. Examiners should 

also determine whether the financial institution has appropriate procedures for ongoing monitoring 

of this type of collateral. 

V. Classification of Loans 

Loans that are adequately protected by the current sound worth and debt service ability of the 

borrower, guarantor, or the underlying collateral generally are not adversely classified. Similarly, 

loans to sound borrowers that are modified in accordance with prudent underwriting standards 

should not be adversely classified by examiners unless well-defined weaknesses exist that jeopardize 

repayment. However, such loans could be flagged for management’s attention or for inclusion in

designated “watch lists” of loans that management is more closely monitoring.

Further, examiners should not adversely classify loans solely because the borrower is 

associated with a particular industry that is experiencing financial difficulties. When a financial 

institution’s loan modifications are not supported by adequate analysis and documentation, 

examiners are expected to exercise reasonable judgment in reviewing and determining loan 

classifications until such time as the financial institution is able to provide information to support 

management’s conclusions and internal loan grades. Refer to Appendix 4 for the classification 
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definitions.28 

A. Loan Performance Assessment for Classification Purposes

The loan’s record of performance to date should be one of several considerations when 

determining whether a loan should be adversely classified. As a general principle, examiners should 

not adversely classify or require the recognition of a partial charge-off on a performing commercial 

loan solely because the value of the underlying collateral has declined to an amount that is less than 

the loan balance. However, it is appropriate to classify a performing loan when well-defined 

weaknesses exist that jeopardize repayment.

One perspective on loan performance is based upon an assessment as to whether the 

borrower is contractually current on principal or interest payments. For many loans, the assessment 

of payment status is sufficient to arrive at a loan’s classification. In other cases, being contractually 

current on payments can be misleading as to the credit risk embedded in the loan. This may occur 

when the loan’s underwriting structure or the liberal use of extensions and renewals masks credit 

weaknesses and obscures a borrower’s inability to meet reasonable repayment terms. 

For example, for many acquisition, development, and construction projects, the loan is 

structured with an “interest reserve” for the construction phase of the project. At the time the loan is 

originated, the lender establishes the interest reserve as a portion of the initial loan commitment. 

During the construction phase, the lender recognizes interest income from the interest reserve and 

capitalizes the interest into the loan balance. After completion of the construction, the lender 

recognizes the proceeds from the sale of lots, homes, or buildings for the repayment of principal, 

including any of the capitalized interest. For a commercial construction loan where the property has 

achieved stabilized occupancy, the lender uses the proceeds from permanent financing for repayment 

of the construction loan or converts the construction loan to an amortizing loan. 

However, if the development project stalls and management fails to evaluate the 

collectability of the loan, interest income could continue to be recognized from the interest reserve 

and capitalized into the loan balance, even though the project is not generating sufficient cash flows 

to repay the loan. In this case, the loan will be contractually current due to the interest payments

being funded from the reserve, but the repayment of principal may be in jeopardy. This repayment 

uncertainty is especially true when leases or sales have not occurred as projected and property values 

have dropped below the market value reported in the original collateral valuation. In this situation, 

adverse classification of the loan may be appropriate.

A second perspective for assessing a loan’s classification is to consider the borrower’s expected 

performance and ability to meet its obligations in accordance with the modified terms over the 

remaining life of the loan. Therefore, the loan classification is meant to measure risk over the term 

28 The NCUA does not require credit unions to adopt a uniform regulatory classification schematic of loss, doubtful, or 

substandard. A credit union must apply a relative credit risk score (i.e., credit risk rating) to each commercial loan as 

required by 12 CFR part 723, Member Business Loans; Commercial Lending, or the equivalent state regulation as 

applicable (see Section 723.4(g)(3)). Adversely classified refers to loans more severely graded under the credit union’s 

credit risk rating system. Adversely classified loans generally require enhanced monitoring and present a higher risk of 

loss. Refer to the NCUA’s Examiner’s Guide for further information on credit risk rating systems.
Page 11 of 39

of the loan rather than just reflecting the loan’s payment history. As a borrower’s expected 

performance is dependent upon future events, examiners’ credit analyses should focus on: 

• The borrower’s financial strength as reflected by its historical and projected balance sheet 

and income statement outcomes; and 

• The prospects for the CRE property considering events and market conditions that reasonably 

may occur during the term of the loan.

 

B. Classification of Renewals or Restructurings of Maturing Loans

Loans to commercial borrowers can have short maturities, including short-term working 

capital loans to businesses, financing for CRE construction projects, or bridge loans to finance 

recently completed CRE projects for a period to achieve stabilized occupancy before obtaining 

permanent financing or selling the property. When there has been deterioration in collateral values, 

a borrower with a maturing loan amid an economic downturn may have difficulty obtaining shortterm financing or adequate sources of long-term credit, despite the borrower’s demonstrated and 

continued ability to service the debt. In such cases, financial institutions may determine that the 

most appropriate course is to restructure or renew the loan. Such actions, when done prudently, are 

often in the best interest of both the financial institution and the borrower. 

A restructured loan typically reflects an elevated level of credit risk, as the borrower may not 

be, or has not been, able to perform according to the original contractual terms. The assessment of 

each loan should be based upon the fundamental characteristics affecting the collectability of that 

loan. In general, renewals or restructurings of maturing loans to commercial borrowers who have 

the ability to repay on reasonable terms will not automatically be subject to adverse classification by 

examiners. However, consistent with safety and soundness standards, such loans should be 

identified in the financial institution’s internal credit grading system and may warrant close 

monitoring. Adverse classification of a renewed or restructured loan would be appropriate if, despite 

the renewal or restructuring, well-defined weaknesses exist that jeopardize the orderly repayment of 

the loan pursuant to reasonable modified terms.

C. Classification of Problem CRE Loans Dependent on the Sale of Collateral for Repayment 

As a general classification principle for a problem CRE loan that is dependent on the sale of 

the collateral for repayment, any portion of the loan balance that exceeds the amount that is 

adequately secured by the fair value of the real estate collateral less the costs to sell should be 

classified “loss.” This principle applies to loans that are collateral dependent based on the sale of the 

collateral in accordance with GAAP and for which there are no other available reliable sources of 

repayment such as a financially capable guarantor.29

The portion of the loan balance that is adequately secured by the fair value of the real estate 

collateral less the costs to sell generally should be adversely classified no worse than “substandard.” 

The amount of the loan balance in excess of the fair value of the real estate collateral, or portions 

thereof, should be adversely 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 determined. If warranted by the underlying circumstances, an examiner may 

29 See footnote 26. 
Page 12 of 39

use a “doubtful” classification on the entire loan balance. However, examiners should use a 

“doubtful” classification infrequently, as such a designation is temporary and subject to a financial 

institution’s timely reassessment of the loan once the outcomes of pending events have occurred or 

the amount of loss can be reasonably determined. 

D. Classification and Accrual Treatment of Restructured Loans with a Partial Charge-off

Based on consideration of all relevant factors, an assessment may indicate that a loan has 

well-defined weaknesses that jeopardize collection in full of all amounts contractually due and may 

result in a partial charge-off as part of a restructuring. When well-defined weaknesses exist and a 

partial charge-off has been taken, the remaining recorded balance for the restructured loan generally 

should 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. Such situations may occur when significant remaining risk exposures are 

identified but are not quantified, such as bankruptcy or a loan collateralized by a property with 

potential environmental concerns.

A restructuring may involve a multiple note structure in which, for example, a loan is 

restructured into two notes (referred to as Note A and Note B). Lenders may separate a portion of 

the current outstanding debt into a new, legally enforceable note (Note A) that is reasonably assured 

of repayment and performance according to prudently modified terms. When restructuring a 

collateral-dependent loan using a multiple note structure, the amount of Note A should be 

determined using the fair value of the collateral. This note may be placed back in accrual status in 

certain situations. In returning the loan to accrual status, sustained historical payment performance 

for a reasonable time prior to the restructuring may be taken into account. Additionally, a properly 

structured and performing Note A generally would not be adversely classified by examiners. The 

portion of the debt that is unlikely to be repaid or collected and therefore is deemed uncollectible

(Note B) would be adversely classified “loss” and must be charged off.

In contrast, the loan should remain on, or be placed in, nonaccrual status if the financial

institution does not split the loan into separate notes, but internally recognizes a partial charge-off. 

A partial charge-off would indicate that the financial institution does not expect full repayment of 

the amounts contractually due. If facts change after the charge-off is taken such that the full 

amounts contractually due, including the amount charged off, are expected to be collected and the 

loan has been brought contractually current, the remaining balance of the loan may be returned to 

accrual status without having to first receive payment of the charged-off amount.30 In these cases, 

examiners should assess whether the financial institution has well-documented support for its credit 

assessment of the borrower’s financial condition and the prospects for full repayment. 

VI. Regulatory Reporting and Accounting Considerations 

30 The charged-off amount should not be reversed or re-booked, under any condition, to increase the recorded investment 

in the loan or its amortized cost, as applicable, when the loan is returned to accrual status. However, expected 

recoveries, prior to collection, are a component of management’s estimate of the net amount expected to be collected for 

a loan under ASC Topic 326. Refer to relevant regulatory reporting instructions for supervisory guidance on returning a 

loan to accrual status.
Page 13 of 39

Financial institution management is responsible for preparing regulatory reports in 

accordance with GAAP and regulatory reporting requirements. Management also is responsible for 

establishing and maintaining an appropriate governance and internal control structure over the 

preparation of regulatory reports. The agencies have observed this governance and control structure 

commonly includes policies and procedures that provide clear guidance on accounting matters. 

Accurate regulatory reports are critical to the transparency of a financial institution’s financial 

position and risk profile and are imperative for effective supervision. Decisions related to loan 

workout arrangements may affect regulatory reporting, particularly interest accruals and loan loss 

estimates. Therefore, it is important that loan workout staff appropriately communicate with the 

accounting and regulatory reporting staff concerning the financial institution’s loan restructurings 

and that the consequences of restructurings are presented accurately in regulatory reports. 

In addition to evaluating credit risk management processes and validating the accuracy of 

internal loan grades, examiners are responsible for reviewing management’s processes related to 

accounting and regulatory reporting. While similar data are used for loan risk monitoring, 

accounting, and reporting systems, this information does not necessarily produce identical outcomes. 

For example, loss classifications may not be equivalent to the associated allowance measurements. 

A. Allowance for Credit Losses

Examiners need to have a clear understanding of the differences between credit risk 

management and accounting and regulatory reporting concepts (such as accrual status and the 

allowance) when assessing the adequacy of the financial institution’s reporting practices for on- and 

off-balance sheet credit exposures. Refer to Appendix 5 for a summary of the allowance standard 

under ASC Topic 326, Financial Instruments – Credit Losses. Examiners should also refer to 

regulatory reporting instructions in the FFIEC Call Report and the NCUA 5300 Call Report 

guidance as well as applicable accounting standards for further information.

B. Implications for Interest Accrual

A financial institution needs to consider whether a loan that was accruing interest prior to the 

loan restructuring should be placed in nonaccrual status at the time of modification to ensure that 

income is not materially overstated. Consistent with FFIEC and NCUA Call Report instructions, a 

loan that has been restructured so as to be reasonably assured of repayment and performance 

according to prudent modified terms need not be placed in nonaccrual status. Therefore, for a loan 

to remain in accrual status, the restructuring and any charge-off taken on the loan must be supported 

by a current, well-documented credit assessment of the borrower’s financial condition and prospects 

for repayment under the revised terms. Otherwise, the restructured loan must be placed in 

nonaccrual status. 

A restructured loan placed in nonaccrual status should not be returned to accrual status until 

the borrower demonstrates sustained repayment performance for a reasonable period prior to the date 

on which the loan is returned to accrual status. A sustained period of repayment performance 

generally would be a minimum of six months and would involve payments of cash or cash 

equivalents. It may also include historical periods prior to the date of the loan restructuring. While 

an appropriately designed restructuring should improve the collectability of the loan in accordance 
Page 14 of 39

with a reasonable repayment schedule, it does not relieve the financial institution from the 

responsibility to promptly charge off all identified losses. For more detailed instructions about 

placing a loan in nonaccrual status and returning a nonaccrual loan to accrual status, refer to the 

instructions for the FFIEC Call Report and the NCUA 5300 Call Report. 
Page 15 of 39

Appendix 1

Examples of CRE Loan Workout Arrangements 

The examples in this appendix are provided for illustrative purposes only and are designed to 

demonstrate an examiner’s analytical thought process to derive an appropriate classification and 

evaluate implications for interest accrual.

31 Although not discussed in the examples below, 

examiners consider the adequacy of a financial institution’s supporting documentation, internal 

analysis, and business decision to enter into a loan workout arrangement. The examples also do not 

address the effect of the loan workout arrangement on the allowance and subsequent reporting 

requirements. Financial institutions should refer to the appropriate regulatory reporting instructions 

for supervisory guidance on the recognition, measurement, and regulatory reporting of loan 

modifications. 

Examiners should use caution when applying these examples to “real-life” situations, 

consider all facts and circumstances of the loan being evaluated, and exercise judgment before 

reaching conclusions related to loan classification and nonaccrual treatment.32 

A. Income Producing Property – Office Building

BASE CASE: A lender originated a $15 million loan for the purchase of an office building with 

monthly payments based on an amortization of 20 years and a balloon payment of $13.6 million at 

the end of year five. At origination, the loan had a 75 percent loan-to-value (LTV) based on an 

appraisal reflecting a $20 million market value on an “as stabilized” basis, a debt service coverage 

(DSC) ratio of 1.30x, and a market interest rate. The lender expected to renew the loan when the 

balloon payment became due at the end of year five. Due to technological advancements and a 

workplace culture change since the inception of the loan, many businesses switched to hybrid workfrom-home arrangements to reduce longer-term costs and improve employee retention. As a result, 

the property’s cash flow declined as the borrower has had to grant rental concessions to either retain 

its existing tenants or attract new tenants, since the demand for office space has decreased.

SCENARIO 1: At maturity, the lender renewed the $13.6 million loan for one year at a market 

interest rate that provides for the incremental risk and payments based on amortizing the principal 

over the remaining 15 years. The borrower had not been delinquent on prior payments and has 

sufficient cash flow to service the loan at the market interest rate terms with a DSC ratio of 1.12x, 

based on updated financial information. 

A review of the leases reflects that most tenants are stable occupants, with long-term leases and 

sufficient cash flow to pay their rent. The major tenants have not adopted hybrid work-from-home 

arrangements for their employees given the nature of the businesses. A recent appraisal reported an 

“as stabilized” market value of $13.3 million for the property for an LTV of 102 percent. This 

reflects current market conditions and the resulting decline in cash flow. 

Classification: The lender internally graded the loan pass and is monitoring the credit. The 

31 The agencies view that the accrual treatments in these examples as falling within the range of acceptable practices 

under regulatory reporting instructions. 32 In addition, estimates of the fair value of collateral use assumptions based on judgment and should be consistent with 

measurement of fair value in ASC Topic 820, Fair Value Measurement; see Appendix 2. 
Page 16 of 39

examiner agreed, because the borrower has the ability to continue making loan payments based 

on reasonable terms, despite a decline in cash flow and in the market value of the collateral.

Nonaccrual Treatment: The lender maintained the loan in accrual status. The borrower has 

demonstrated the ability to make the regularly scheduled payments and, even with the decline in 

the borrower’s creditworthiness, cash flow appears sufficient to make these payments, and full 

repayment of principal and interest is expected. The examiner concurred with the lender’s 

accrual treatment.

SCENARIO 2: At maturity, the lender renewed the $13.6 million loan at a market interest rate that 

provides for the incremental risk and payments based on amortizing the principal over the remaining 

15 years. The borrower had not been delinquent on prior payments. Current projections indicate the 

DSC ratio will not drop below 1.12x based on leases in place and letters of intent for vacant space. 

However, some leases are coming up for renewal, and additional rental concessions may be 

necessary to either retain those existing tenants or attract new tenants. The lender estimates the 

property’s current “as stabilized” market value is $14.5 million, which results in a 94 percent LTV, 

but a current valuation has not been ordered. In addition, the lender has not asked the borrower or 

guarantors to provide current financial statements to assess their ability to support any cash flow 

shortfall. 

Classification: The lender internally graded the loan pass and is monitoring the credit. The 

examiner disagreed with the internal grade and listed the credit as special mention. While the 

borrower has the ability to continue to make payments based on leases currently in place and 

letters of intent for vacant space, there has been a declining trend in the property’s revenue 

stream, and there is most likely a reduced collateral margin. In addition, there is potential for 

further deterioration in the cash flow as more leases will expire in the upcoming months, while 

absorption for office space in this market has slowed. Lastly, the examiner noted that the lender 

failed to request current financial information and to obtain an updated collateral valuation,33

representing administrative weaknesses. 

Nonaccrual Treatment: The lender maintained the loan in accrual status. The borrower has 

demonstrated the ability to make regularly scheduled payments and, even with the decline in the 

borrower’s creditworthiness, cash flow is sufficient at this time to make payments, and full 

repayment of principal and interest is expected. The examiner concurred with the lender’s 

accrual treatment.

SCENARIO 3: At maturity, the lender restructured the $13.6 million loan on a 12-month interestonly basis at a below market interest rate. The borrower has been sporadically delinquent on prior 

principal and interest payments. The borrower projects a DSC ratio of 1.10x based on the 

restructured interest-only terms. A review of the rent roll, which was available to the lender at the 

time of the restructuring, reflects the majority of tenants have short-term leases, with three leases 

expected to expire within the next three months. According to the lender, leasing has not improved 

since the restructuring as market conditions remain soft. Further, the borrower does not have an 

33 In relation to comments on valuations within these examples, refer to the appraisal regulations applicable to the 

financial institution to determine whether there is a regulatory requirement for either an evaluation or appraisal. See

footnote 20. 
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update as to whether the three expiring leases will renew at maturity; two of the tenants have moved 

to hybrid work-from-home arrangements. A recent appraisal provided a $14.5 million “as 

stabilized” market value for the property, resulting in a 94 percent LTV.

Classification: The lender internally graded the loan pass and is monitoring the credit. The 

examiner disagreed with the internal grade and classified the loan substandard due to the 

borrower’s limited ability to service a below market interest rate loan on an interest-only basis, 

sporadic delinquencies, and an increase in the LTV based on an updated appraisal. In addition, 

there is lease rollover risk because three of the leases are expiring soon, which could further limit 

cash flow.

Nonaccrual Treatment: The lender maintained the loan in accrual status due to the positive 

cash flow and collateral margin. The examiner did not concur with this treatment as the loan was 

not restructured with reasonable repayment terms, and the borrower has not demonstrated the 

ability to amortize the loan and has limited ability to service a below market interest rate on an 

interest-only basis. After a discussion with the examiner on regulatory reporting requirements, 

the lender placed the loan on nonaccrual. 

B. Income Producing Property – Retail Properties

BASE CASE: A lender originated a 36-month, $10 million loan for the construction of a shopping 

mall. The construction period was 24 months with a 12-month lease-up period to allow the borrower 

time to achieve stabilized occupancy before obtaining permanent financing. The loan had an interest 

reserve to cover interest payments over the three-year term. At the end of the third year, there is $10 

million outstanding on the loan, as the shopping mall has been built and the interest reserve, which 

has been covering interest payments, has been fully drawn. 

At the time of origination, the appraisal reported an “as stabilized” market value of $13.5 million for 

the property. In addition, the borrower had a take-out commitment that would provide permanent 

financing at maturity. A condition of the take-out lender was that the shopping mall had to achieve a 

75 percent occupancy level. 

Due to weak economic conditions and a shift in consumer behavior to a greater reliance on ecommerce, the property only reached a 55 percent occupancy level at the end of the 12-month lease 

up period. As a result, the original takeout commitment became void. In addition, there has been a 

considerable tightening of credit for these types of loans, and the borrower has been unable to obtain 

permanent financing elsewhere since the loan matured. To date, the few interested lenders are 

demanding significant equity contributions and much higher pricing. 

SCENARIO 1: The lender renewed the loan for an additional 12 months to provide the borrower 

time for higher lease-up and to obtain permanent financing. The extension was made at a market 

interest rate that provides for the incremental risk and is on an interest-only basis. While the 

property’s historical cash flow was insufficient at a 0.92x debt service ratio, recent improvements in 

the occupancy level now provide adequate coverage based on the interest-only payments. Recent 

events include the signing of several new leases with additional leases under negotiation; however, 

takeout financing continues to be tight in the market. 

In addition, current financial statements reflect that the builder, who personally guarantees the debt, 

has cash on deposit at the lender plus other unencumbered liquid assets. These assets provide 
Page 18 of 39

sufficient cash flow to service the borrower’s global debt service requirements on a principal and 

interest basis, if necessary, for the next 12 months. The guarantor covered the initial cash flow 

shortfalls from the project and provided a good faith principal curtailment of $200,000 at renewal, 

reducing the loan balance to $9.8 million. A recent appraisal on the shopping mall reports an “as is” 

market value of $10 million and an “as stabilized” market value of $11 million, resulting in LTVs of 

98 percent and 89 percent, respectively.

Classification: The lender internally graded the loan as a pass and is monitoring the credit. The 

examiner disagreed with the lender’s internal loan grade and listed it as special mention. While 

the project continues to lease up, cash flows cover only the interest payments. The guarantor has 

the ability, and has demonstrated the willingness, to cover cash flow shortfalls; however, there 

remains considerable uncertainty surrounding the takeout financing for this loan. 

Nonaccrual Treatment: The lender maintained the loan in accrual status as the guarantor has 

sufficient funds to cover the borrower’s global debt service requirements over the one-year 

period of the renewed loan. Full repayment of principal and interest is reasonably assured from 

the project’s and guarantor’s cash resources, despite a decline in the collateral margin. The 

examiner concurred with the lender’s accrual treatment. 

SCENARIO 2: The lender restructured the loan on an interest-only basis at a below market interest 

rate for one year to provide additional time to increase the occupancy level and, thereby, enable the 

borrower to arrange permanent financing. The level of lease-up remains relatively unchanged at 55 

percent, and the shopping mall projects a DSC ratio of 1.02x based on the preferential loan terms. 

At the time of the restructuring, the lender used outdated financial information, which resulted in a 

positive cash flow projection. However, other file documentation available at the time of the 

restructuring reflected that the borrower anticipates the shopping mall’s revenue stream will further 

decline due to rent concessions, the loss of a tenant, and limited prospects for finding new tenants. 

Current financial statements indicate the builder, who personally guarantees the debt, cannot cover 

any cash flow shortfall. The builder is highly leveraged, has limited cash or unencumbered liquid 

assets, and has other projects with delinquent payments. A recent appraisal on the shopping mall 

reports an “as is” market value of $9 million, which results in an LTV ratio of 111 percent. 

Classification: The lender internally classified the loan as substandard. The examiner disagreed 

with the internal grade and classified the amount not protected by the collateral value, $1 million, 

as loss and required the lender to charge-off this amount. The examiner did not factor costs to 

sell into the loss classification analysis, as the current source of repayment is not reliant on the 

sale of the collateral. The examiner classified the remaining loan balance, based on the 

property’s “as is” market value of $9 million, as substandard given the borrower’s uncertain 

repayment ability and weak financial support. 

Nonaccrual Treatment: The lender determined the loan did not warrant being placed in 

nonaccrual status. The examiner did not concur with this treatment because the partial chargeoff is indicative that full collection of principal is not anticipated, and the lender has continued 

exposure to additional loss due to the project’s insufficient cash flow and reduced collateral 

margin and the guarantor’s inability to provide further support. After a discussion with the 

examiner on regulatory reporting requirements, the lender placed the loan on nonaccrual. 
Page 19 of 39

SCENARIO 3: The loan has become delinquent. Recent financial statements indicate the borrower 

and the guarantor have minimal other resources available to support this loan. The lender chose not 

to restructure the $10 million loan into a new single amortizing note of $10 million at a market

interest rate because the project’s projected cash flow would only provide a 0.88x DSC ratio as the 

borrower has been unable to lease space. A recent appraisal which reasonably estimates the fair 

value on the shopping mall reported an “as is” market value of $7 million, resulting in an LTV of 

143 percent. At the original loan’s maturity, the lender restructured the $10 million debt, which is a 

collateral-dependent loan, into two notes. The lender placed the first note of $7 million (Note A) on 

monthly payments that amortize the debt over 20 years at a market interest rate that provides for the 

incremental risk. The project’s DSC ratio equals 1.20x for the $7 million loan based on the 

shopping mall’s projected net operating income. For the second note (Note B), the lender placed the 

remaining $3 million, which represents the excess of the $10 million debt over the $7 million market 

value of the shopping mall, into a 2 percent interest-only loan that resets in five years into an 

amortizing payment. The lender then charged-off the $3 million note due to the project’s lack of 

repayment ability and to provide reasonable collateral protection for the remaining on-book loan of 

$7 million. The lender also reversed accrued but unpaid interest. Since the restructuring, the 

borrower has made payments on both loans for more than six consecutive months and an updated 

financial analysis shows continued ability to repay under the new terms. 

Classification: The lender internally graded the on-book loan of $7 million as a pass loan due to 

the borrower’s demonstrated ability to perform under the modified terms. The examiner agreed 

with the lender’s grade as the lender restructured the original obligation into Notes A and B, the 

lender charged off Note B, and the borrower has demonstrated the ability to repay Note A. 

Using this multiple note structure with charge-off of the Note B enables the lender to recognize 

interest income. 

Nonaccrual Treatment: The lender placed the on-book loan (Note A) of $7 million loan in 

nonaccrual status at the time of the restructure. The lender later restored the $7 million to 

accrual status as the borrower has the ability to repay the loan, has a record of performing at the 

revised terms for more than six months, and full repayment of principal and interest is expected. 

The examiner concurred with the lender’s accrual treatment. Interest payments received on the 

off-book loan have been recorded as recoveries because full recovery of principal and interest on 

this loan (Note B) was not reasonably assured. 

SCENARIO 4: Current financial statements indicate the borrower and the guarantor have minimal 

other resources available to support this loan. The lender restructured the $10 million loan into a 

new single note of $10 million at a market interest rate that provides for the incremental risk and is 

on an amortizing basis. The project’s projected cash flow reflects a 0.88x DSC ratio as the borrower 

has been unable to lease space. A recent appraisal on the shopping mall reports an “as is” market 

value of $9 million, which results in an LTV of 111 percent. Based on the property’s current market 

value of $9 million, the lender charged-off $1 million immediately after the renewal.

Classification: The lender internally graded the remaining $9 million on-book portion of the 

loan as a pass loan because the lender’s analysis of the project’s cash flow indicated a 1.05x DSC 

ratio when just considering the on-book balance. The examiner disagreed with the internal grade 
Page 20 of 39

and classified the $9 million on-book balance as substandard due to the borrower’s marginal 

financial condition, lack of guarantor support, and uncertainty over the source of repayment. 

The DSC ratio remains at 0.88x due to the single note restructure, and other resources are scant. 

Nonaccrual Treatment: The lender maintained the remaining $9 million on-book portion of the 

loan on accrual, as the borrower has the ability to repay the principal and interest on this balance. 

The examiner did not concur with this treatment. Because the lender restructured the debt into a 

single note and had charged-off a portion of the restructured loan, the repayment of the principal 

and interest contractually due on the entire debt is not reasonably assured given the DSC ratio of 

0.88x and nominal other resources. After a discussion with the examiner on regulatory reporting 

requirements, the lender placed the loan on nonaccrual. The loan can be returned to accrual 

status34 if the lender can document that subsequent improvement in the borrower’s financial 

condition has enabled the loan to be brought fully current with respect to principal and interest 

and the lender expects the contractual balance of the loan (including the partial charge-off) will 

be fully collected. In addition, interest income may be recognized on a cash basis for the 

partially charged-off portion of the loan when the remaining recorded balance is considered fully 

collectible. However, the partial charge-off would not be reversed.

C. Income Producing Property – Hotel

BASE CASE: A lender originated a $7.9 million loan to provide permanent financing for the 

acquisition of a stabilized 3-star hotel property. The borrower is a limited liability company with 

underlying ownership by two families who guarantee the loan. The loan term is five years, with 

payments based on a 25-year amortization and with a market interest rate. The LTV was 79 percent 

based on the hotel’s appraised value of $10 million. 

At the end of the five-year term, the borrower’s annualized DSC ratio was 0.95x. Due to 

competition from a well-known 4-star hotel that recently opened within one mile of the property, 

occupancy rates have declined. The borrower progressively reduced room rates to maintain 

occupancy rates, but continued to lose daily bookings. Both occupancy and Revenue per Available 

Room (RevPAR)35 declined significantly over the past year. The borrower then began working on 

an initiative to make improvements to the property (i.e., automated key cards, carpeting, bedding, 

and lobby renovations) to increase competitiveness, and a marketing campaign is planned to 

announce the improvements and new price structure. 

The borrower had paid principal and interest as agreed throughout the first five years, and the 

principal balance had reduced to $7 million at the end of the five-year term.

SCENARIO 1: At maturity, the lender renewed the loan for 12 months on an interest-only basis at 

a market interest rate that provides for the incremental risk. The extension was granted to enable the 

borrower to complete the planned renovations, launch the marketing campaign, and achieve the 

borrower’s updated projections for sufficient cash flow to service the debt once the improvements 

are completed. (If the initiative is successful, the loan officer expects the loan to either be renewed 

on an amortizing basis or refinanced through another lending entity.) The borrower has a verified, 

pledged reserve account to cover the improvement expenses. Additionally, the guarantors’ updated 

34 Refer to the supervisory guidance on “nonaccrual status” in the FFIEC Call Report and NCUA 5300 Call Report 

instructions. 35 Total guest room revenue divided by room count and number of days in the period.
Page 21 of 39

financial statements indicate that they have sufficient unencumbered liquid assets. Further, the 

guarantors expressed the willingness to cover any estimated cash flow shortfall through maturity. 

Based on this information, the lender’s analysis indicates that, after deductions for personal 

obligations and realistic living expenses and verification that there are no contingent liabilities, the 

guarantors should be able to make interest payments. To date, interest payments have been timely. 

The lender estimates the property’s current “as stabilized” market value at $9 million, which results 

in a 78 percent LTV. 

Classification: The lender internally graded the loan as a pass and is monitoring the credit. The 

examiner agreed with the lender’s internal loan grade. The examiner concluded that the 

borrower and guarantors have sufficient resources to support the interest payments; additionally, 

the borrower’s reserve account is sufficient to complete the renovations as planned. 

Nonaccrual Treatment: The lender maintained the loan in accrual status as full repayment of 

principal and interest is reasonably assured from the hotel’s and guarantors’ cash flows, despite a 

decline in the borrower’s cash flow due to competition. The examiner concurred with the 

lender’s accrual treatment.

SCENARIO 2: At maturity of the original loan, the lender restructured the loan on an interest-only 

basis at a below market interest rate for 12 months to provide the borrower time to complete its 

renovation and marketing efforts and increase occupancy levels. At the end of the 12-month period, 

the hotel’s renovation and marketing efforts were completed but unsuccessful. The hotel continued 

to experience a decline in occupancy levels, resulting in a DSC ratio of 0.60x. The borrower does 

not have ability to offer additional incentives to lure customers from the competition. RevPAR has 

also declined. Current financial information indicates the borrower has limited ability to continue to 

make interest payments, and updated projections indicate that the borrower will be below break-even 

performance for the next 12 months. The borrower has been sporadically delinquent on prior 

interest payments. The guarantors are unable to support the loan as they have limited unencumbered 

liquid assets and are highly leveraged. The lender is in the process of renewing the loan again.

The most recent hotel appraisal, dated as of the time of the first restructuring, reports an “as 

stabilized” appraised value of $7.2 million ($6.7 million for the real estate and $500,000 for the 

tangible personal property of furniture, fixtures, and equipment), resulting in an LTV of 97 percent. 

The appraisal does not account for the diminished occupancy, and its assumptions significantly 

differ from current projections. A new valuation is needed to ascertain the current value of the 

property. 

Classification: The lender internally classified the loan as substandard and is monitoring the 

credit. The examiner agreed with the lender’s treatment due to the borrower’s diminished 

ongoing ability to make payments, the guarantors’ limited ability to support the loan, and the 

reduced collateral position. The lender is obtaining a new valuation and will adjust the internal 

classification, if necessary, based on the updated value.

Nonaccrual Treatment: The lender maintained the loan on an accrual basis because the 

borrower demonstrated an ability to make interest payments. The examiner did not concur with 

this treatment as the loan was not restructured on reasonable repayment terms, the borrower has 

insufficient cash resources to service the below market interest rate on an interest-only basis, and 
Page 22 of 39

the collateral margin has narrowed and may be narrowed further with a new valuation, which 

collectively indicates that full repayment of principal and interest is in doubt. After a discussion 

with the examiner on regulatory reporting requirements, the lender placed the loan on 

nonaccrual. 

SCENARIO 3: At maturity of the original loan, the lender restructured the debt for one year on an 

interest-only basis at a below market interest rate to give the borrower additional time to complete 

renovations and increase marketing efforts. While the combined borrower/guarantors’ liquidity 

indicated they could cover any cash flow shortfall until maturity of the restructured note, the 

borrower only had 50 percent of the funds to complete its renovations in reserve. Subsequently, the 

borrower attracted a sponsor to obtain the remaining funds necessary to complete the renovation plan 

and marketing campaign. Eight months later, the hotel experienced an increase in its occupancy and 

achieved a DSC ratio of 1.20x on an amortizing basis. Updated projections indicated the borrower 

would be at or above the 1.20x DSC ratio for the next 12 months, based on market terms and rate. 

The borrower and the lender then agreed to restructure the loan again with monthly payments that 

amortize the debt over 20 years, consistent with the current market terms and rates. Since the date of 

the second restructuring, the borrower has made all principal and interest payments as agreed for six 

consecutive months.

Classification: The lender internally classified the most recent restructured loan substandard. 

The examiner agreed with the lender’s initial substandard grade at the time of the subject 

restructuring, but now considers the loan as a pass as the borrower was no longer having 

financial difficulty and has demonstrated the ability to make payments according to the modified 

principal and interest terms for more than six consecutive months. 

Nonaccrual Treatment: The original restructured loan was placed in nonaccrual status. The 

lender initially maintained the most recent restructured loan in nonaccrual status as well, but 

returned it to an accruing status after the borrower made six consecutive monthly principal and 

interest payments. The lender expects full repayment of principal and interest. The examiner 

concurred with the lender’s accrual treatment. 

SCENARIO 4: The lender extended the original amortizing loan for 12 months at a market interest 

rate. The borrower is now experiencing a six-month delay in completing the renovations due to a 

conflict with the contractor hired to complete the renovation work, and the current DSC ratio is 

0.85x. A current valuation has not been ordered. The lender estimates the property’s current “as 

stabilized” market value is $7.8 million, which results in an estimated 90 percent LTV. The lender 

did receive updated projections, but the borrower is now unlikely to achieve break-even cash flow 

within the 12-month extension timeframe due to the renovation delays. At the time of the extension, 

the borrower and guarantors had sufficient liquidity to cover the debt service during the twelvemonth period. The guarantors also demonstrated a willingness to support the loan by making 

payments when necessary, and the loan has not gone delinquent. With the guarantors’ support, there 

is sufficient liquidity to make payments to maturity, though such resources are declining rapidly. 

Classification: The lender internally graded the loan as pass and is monitoring the credit. The 

examiner disagreed with the lender’s grading and listed the loan as special mention. While the 

borrower and guarantor can cover the debt service shortfall in the near-term, the duration of their 
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support may not extend long enough to replace lost cash flow from operations due to delays in 

the renovation work. The primary source of repayment does not fully cover the loan as 

evidenced by a DSC ratio of 0.85x. It appears that competition from the new hotel will continue 

to adversely affect the borrower's cash flow until the renovations are complete, and if cash flow 

deteriorates further, the borrower and guarantors may be required to use more liquidity to 

support loan payments and ongoing business operations. The examiner also recommended the 

lender obtain a new valuation. 

Nonaccrual Treatment: The lender maintained the loan in accrual status. The borrower and 

guarantors have demonstrated the ability and willingness to make the regularly scheduled 

payments and, even with the decline in the borrower’s creditworthiness, global cash resources 

appear sufficient to make these payments, and the ultimate full repayment of principal and 

interest is expected. The examiner concurred with the lender’s accrual treatment. 

D. Acquisition, Development and Construction – Residential 

BASE CASE: The lender originated a $4.8 million acquisition and development (A&D) loan and a 

$2.4 million construction revolving line of credit (revolver) for the development and construction of 

a 48-lot single-family project. The maturity for both loans is three years, and both are priced at a 

market interest rate; both loans also have an interest reserve. The LTV on the A&D loan is 75 

percent based on an “as complete” value of $6.4 million. Up to 12 units at a time will be funded 

under the construction revolver at the lesser of 80 percent LTV or 100 percent of costs. The builder 

is allowed two speculative (“spec”) units (including one model). The remaining units must be presold with an acceptable deposit and a pre-qualified mortgage. As units are settled, the construction 

revolver will be repaid at 100 percent (or par); the A&D loan will be repaid at 120 percent, or 

$120,000 ($4.8 million/48 units x 120 percent). The average sales price is projected to be $500,000, 

and total construction cost to build each unit is estimated to be $200,000. Assuming total cost is 

lower than value, the average release price will be $320,000 ($120,000 A&D release price plus 

$200,000 construction costs). Estimated time for development is 12 months; the appraiser estimated 

absorption of two lots per month for total sell-out to occur within three years (thus, the loan would 

be repaid upon settlement of the 40th unit, or the 32nd month of the loan term). The borrower is 

required to curtail the A&D loan by six lots, or $720,000, at the 24th month, and another six lots, or 

$720,000, by the 30th month. 

SCENARIO 1: Due to issues with the permitting and approval process by the county, the 

borrower’s development was delayed by 18 months. Further delays occurred because the borrower 

was unable to pave the necessary roadways due to excessive snow and freezing temperatures. The 

lender waived both $720,000 curtailment requirements due to the delays. Demand for the housing 

remains unchanged. At maturity, the lender renewed the $4.8 million outstanding A&D loan 

balance and the $2.4 million construction revolver for 24 months at a market interest rate that 

provides for the incremental risk. The interest reserve for the A&D loan has been depleted as the 

lender had continued to advance funds to pay the interest charges despite the delays in development. 

Since depletion of the interest reserve, the borrower has made the last several payments out-ofpocket. Development is now complete, and construction has commenced on eight units (two “spec” 

units and six pre-sold units). Combined borrower and guarantor liquidity show they can cover any 

debt service shortfall until the units begin to settle and the project is cash flowing. The lender 
Page 24 of 39

estimates that the property’s current “as complete” value is $6 million, resulting in an 80 percent 

LTV. The curtailment schedule was re-set to eight lots, or $960,000, by month 12, and another eight 

lots, or $960,000, by month 18. A new appraisal has not been ordered; however, the lender noted in 

the file that, if the borrower does not meet the absorption projections of six lots/quarter within six 

months of booking the renewed loan, the lender will obtain a new appraisal. 

Classification: The lender internally graded the restructured loans as pass and is monitoring the 

credits. The examiner agreed, as the borrower and guarantor can continue making payments on 

reasonable terms and the project is moving forward supported by housing demand and is 

consistent with the builder’s development plans. However, the examiner noted weaknesses in 

the lender’s loan administrative practices as the financial institution did not (1) suspend the 

interest reserve during the development delay and (2) obtain an updated collateral valuation. 

Nonaccrual Treatment: The lender maintained the loans in accrual status. The project is 

moving forward, the borrower has demonstrated the ability to make the regularly scheduled 

payments after depletion of the interest reserve, global cash resources from the borrower and 

guarantor appears sufficient to make these payments, and full repayment of principal and interest 

is expected. The examiner concurred with the lender’s accrual treatment. 

SCENARIO 2: Due to weather and contractor issues, development was not completed until month 

24, a year behind the original schedule. The borrower began pre-marketing, but sales have been 

slow due to deteriorating market conditions in the region. The borrower has achieved only eight presales during the past six months. The borrower recently commenced construction on the pre-sold 

units. 

At maturity, the lender renewed the $4.8 million A&D loan balance and $2.4 million construction 

revolver on a 12-month interest-only basis at a market interest rate, with another 12-month option 

predicated upon $1 million in curtailments having occurred during the first renewal term (the lender 

had waived the initial term curtailment requirements). The lender also renewed the construction 

revolver for a one-year term and reduced the number of “spec” units to just one, which also will 

serve as the model. A recent appraisal estimates that absorption has dropped to four lots per quarter 

for the first two years and assigns an “as complete” value of $5.3 million, for an LTV of 91 percent. 

The interest reserve is depleted, and the borrower has been paying interest out-of-pocket for the past 

few months. Updated borrower and guarantor financial statements indicate the continued ability to 

cover interest-only payments for the next 12 to 18 months. 

Classification: The lender internally classified the loan as substandard and is monitoring the 

credit. The examiner agreed with the lender’s treatment due to the deterioration and uncertainty 

surrounding the market (as evidenced by slower than anticipated sales on the project), the lack of 

principal reduction, and the reduced collateral margin. 

Nonaccrual Treatment: The lender maintained the loan on an accrual basis because the 

development is complete, the borrower has pre-sales and construction has commenced, and the 

borrower and guarantor have sufficient means to make interest payments at a market interest rate 

until the earlier of maturity or the project begins to cash flow. The examiner concurred with the 

lender’s accrual treatment.
Page 25 of 39

SCENARIO 3: Lot development was completed on schedule, and the borrower quickly sold and 

settled the first 10 units. At maturity, the lender renewed the $3.6 million A&D loan balance ($4.8 

million reduced by the sale and settlement of the 10 units ($120,000 release price x 10) to arrive at 

$3.6 million) and $2.4 million construction revolver on a 12-month interest-only basis at a below 

market interest rate.

The borrower then sold an additional 10 units to an investor; the loan officer (new to the financial 

institution) mistakenly marked these units as pre-sold and allowed construction to commence on all 

10 units. Market conditions then deteriorated quickly, and the investor defaulted under the terms of 

the bulk contract. The units were completed, but the builder has been unable to re-sell any of the 

units, recently dropping the sales price by 10 percent and engaging a new marketing firm, which is 

working with several potential buyers. 

A recent appraisal estimates that absorption has dropped to three lots per quarter and assigns an “as 

complete” value of $2.3 million for the remaining 28 lots, resulting in an LTV of 156 percent. A 

bulk appraisal of the 10 units assigns an “as-is” value of the units of $4.0 million ($400,000/unit). 

The loans are cross-defaulted and cross-collateralized; the LTV on a combined basis is 95 percent 

($6 million outstanding debt (A&D plus revolver) divided by $6.3 million in combined collateral 

value). Updated borrower and guarantor financial statements indicate a continued ability to cover 

interest-only payments for the next 12 months at the reduced rate; however, this may be limited in 

the future given other troubled projects in the borrower’s portfolio that have been affected by market 

conditions. 

The lender modified the release price for each unit to net proceeds; any additional proceeds as units 

are sold will go towards repayment of the A&D loan. Assuming the units sell at a 10 percent 

reduction, the lender calculates the average sales price would be $450,000. The financial 

institution’s prior release price was $320,000 ($120,000 for the A&D loan and $200,000 for the 

construction revolver). As such (by requiring net proceeds), the financial institution will be 

receiving an additional $130,000 per lot, or $1.3 million for the completed units, to repay the A&D 

loan ($450,000 average sales price less $320,000 bank’s release price equals $130,000). Assuming 

the borrower will have to pay $30,000 in related sales/settlement costs leaves approximately 

$100,000 remaining per unit to apply towards the A&D loan, or $1 million total for the remaining 10 

units ($100,000 times 10). 

Classification: The lender internally classified the loan as substandard and is monitoring the 

credit. The examiner agreed with the lender’s treatment due to the borrower and guarantor’s 

diminished ability to make interest payments (even at the reduced rate), the stalled status of the 

project, and the reduced collateral protection. 

Nonaccrual Treatment: The lender maintained the loan on an accrual basis because the 

borrower had previously demonstrated an ability to make interest payments. The examiner 

disagreed as the loan was not restructured on reasonable repayment terms. While the borrower 

and guarantor may be able to service the debt at a below market interest rate in the near term 

using other unencumbered liquid assets, other projects in their portfolio are also affected by poor 

market conditions and may require significant liquidity contributions, which could affect their 

ability to support the loan. After a discussion with the examiner on regulatory reporting 

requirements, the lender placed the loan on nonaccrual. 

E. Construction Loan – Single Family Residence 
Page 26 of 39

BASE CASE: The lender originated a $1.2 million construction loan on a single-family “spec” 

residence with a 15-month maturity to allow for completion and sale of the property. The loan 

required monthly interest-only payments at a market interest rate and was based on an “as 

completed” LTV of 70 percent at origination. During the original loan construction phase, the 

borrower was able to make all interest payments from personal funds. At maturity, the home had 

been completed, but not sold, and the borrower was unable to find another lender willing to finance 

this property under similar terms. 

SCENARIO 1: At maturity, the lender restructured the loan for one year on an interest-only basis at 

a below market interest rate to give the borrower more time to sell the “spec” home. Current 

financial information indicates the borrower has limited ability to continue to make interest-only 

payments from personal funds. If the residence does not sell by the revised maturity date, the 

borrower plans to rent the home. In this event, the lender will consider modifying the debt into an 

amortizing loan with a 20-year maturity, which would be consistent with this type of incomeproducing investment property. Any shortfall between the net rental income and loan payments 

would be paid by the borrower. Due to declining home values, the LTV at the renewal date was 90 

percent. 

Classification: The lender internally classified the loan substandard and is monitoring the credit. 

The examiner agreed with the lender’s treatment due to the borrower’s diminished ongoing 

ability to make payments and the reduced collateral position. 

Nonaccrual Treatment: The lender maintained the loan on an accrual basis because the 

borrower demonstrated an ability to make interest payments during the construction phase. The 

examiner did not concur with this treatment because the loan was not restructured on reasonable 

repayment terms. The borrower had limited ability to continue to service the debt, even on an 

interest-only basis at a below market interest rate, and the deteriorating collateral margin 

indicated that full repayment of principal and interest was not reasonably assured. The examiner 

instructed the lender to place the loan in nonaccrual status.

SCENARIO 2: At maturity of the original loan, the lender restructured the debt for one year on an 

interest-only basis at a below market interest rate to give the borrower more time to sell the “spec” 

home. Eight months later, the borrower rented the property. At that time, the borrower and the 

lender agreed to restructure the loan again with monthly payments that amortize the debt over 20 

years at a market interest rate for a residential investment property. Since the date of the second 

restructuring, the borrower had made all payments for over six consecutive months. 

Classification: The lender internally classified the restructured loan substandard. The examiner 

agreed with the lender’s initial substandard grade at the time of the restructuring, but now 

considered the loan as a pass due to the borrower’s demonstrated ability to make payments 

according to the reasonably modified terms for more than six consecutive months. 

Nonaccrual Treatment: The lender initially placed the restructured loan in nonaccrual status but 

returned it to accrual after the borrower made six consecutive monthly payments. The lender 

expects full repayment of principal and interest from the rental income. The examiner concurred 
Page 27 of 39

with the lender’s accrual treatment. 

SCENARIO 3: The lender restructured the loan for one year on an interest-only basis at a below 

market interest rate to give the borrower more time to sell the “spec” home. The restructured loan 

has become more than 90 days past due, and the borrower has not been able to rent the property. 

Based on current financial information, the borrower does not have the ability to service the debt. 

The lender considers repayment to be contingent upon the sale of the property. Current market data 

reflects few sales, and similar new homes in this property’s neighborhood are selling within a range 

of $750,000 to $900,000 with selling costs equaling 10 percent, resulting in anticipated net sales 

proceeds between $675,000 and $810,000. 

Classification: The lender graded $390,000 loss ($1.2 million loan balance less the maximum 

estimated net sales proceeds of $810,000), $135,000 doubtful based on the range in the 

anticipated net sales proceeds, and the remaining balance of $675,000 substandard. The 

examiner agreed, as this classification treatment results in the recognition of the credit risk in the 

collateral-dependent loan based on the property’s value less costs to sell. The examiner 

instructed management to obtain information on the current valuation on the property. 

Nonaccrual Treatment: The lender placed the loan in nonaccrual status when it became 60 days 

past due (reversing all accrued but unpaid interest) because the lender determined that full 

repayment of principal and interest was not reasonably assured. The examiner concurred with 

the lender’s nonaccrual treatment. 

SCENARIO 4: The lender committed an additional $48,000 for an interest reserve and extended 

the $1.2 million loan for 12 months at a below market interest rate with monthly interest-only 

payments. At the time of the examination, $18,000 of the interest reserve had been added to the loan 

balance. Current financial information obtained during the examination reflects the borrower has no 

other repayment sources and has not been able to sell or rent the property. An updated appraisal 

supports an “as is” value of $952,950. Selling costs are estimated at 15 percent, resulting in 

anticipated net sales proceeds of $810,000. 

Classification: The lender internally graded the loan as pass and is monitoring the credit. The 

examiner disagreed with the internal grade. The examiner concluded that the loan was not 

restructured on reasonable repayment terms because the borrower has limited ability to service 

the debt, and the reduced collateral margin indicated that full repayment of principal and interest 

was not assured. After discussing regulatory reporting requirements with the examiner, the 

lender reversed the $18,000 interest capitalized out of the loan balance and interest income. 

Further, the examiner classified $390,000 loss based on the adjusted $1.2 million loan balance 

less estimated net sales proceeds of $810,000, which was classified substandard. This 

classification treatment recognizes the credit risk in the collateral-dependent loan based on the 

property’s market value less costs to sell. The examiner also provided supervisory feedback to 

management for the inappropriate use of interest reserves and lack of current financial 

information in making that decision. The remaining interest reserve of $30,000 is not subject to 

adverse classification because the loan should be placed in nonaccrual status. 

Nonaccrual Treatment: The lender maintained the loan in accrual status. The examiner did not 
Page 28 of 39

concur with this treatment. The loan was not restructured on reasonable repayment terms, the 

borrower has limited ability to service a below market interest rate on an interest-only basis, and 

the reduced collateral margin indicates that full repayment of principal and interest is not 

assured. The lender’s decision to provide a $48,000 interest reserve was not supported, given the 

borrower’s inability to repay it. After a discussion with the examiner on regulatory reporting 

requirements, the lender placed the loan on nonaccrual, and reversed the capitalized interest to be 

consistent with regulatory reporting instructions. The lender also agreed to not recognize any 

further interest income from the interest reserve.

F. Construction Loan – Land Acquisition, Condominium Construction and Conversion

BASE CASE: The lender originally extended a $50 million loan for the purchase of vacant land 

and the construction of a luxury condominium project. The loan was interest-only and included an 

interest reserve to cover the monthly payments until construction was complete. The developer 

bought the land and began construction after obtaining purchase commitments for 1/3 of the 120 

planned units, or 40 units. Many of these pending sales were speculative with buyers committing to 

buy multiple units with minimal down payments. The demand for luxury condominiums in general 

has declined since the borrower launched the project, and sales have slowed significantly over the 

past year. The lack of demand is attributed to a slowdown in the economy. As a result, most of the 

speculative buyers failed to perform on their purchase contracts and only a limited number of the 

other planned units have been pre-sold. 

The developer experienced cost overruns on the project and subsequently determined it was in the 

best interest to halt construction with the property 80 percent completed. The outstanding loan 

balance is $44 million with funds used to pay construction costs, including cost overruns and 

interest. The borrower estimates an additional $10 million is needed to complete construction. 

Current financial information reflects that the developer does not have sufficient cash flow to pay 

interest (the interest reserve has been depleted); and, while the developer does have equity in other 

assets, there is doubt about the borrower’s ability to complete the project.

SCENARIO 1: The borrower agreed to grant the lender a second lien on an apartment project in its 

portfolio, which provides $5 million in additional collateral support. In return, the lender advanced 

the borrower $10 million to finish construction. The condominium project was completed shortly 

thereafter. The lender also agreed to extend the $54 million loan ($44 million outstanding balance 

plus $10 million in new money) for 12 months at a market interest rate that provides for the 

incremental risk, to give the borrower additional time to market the property. The borrower agreed 

to pay interest whenever a unit was sold, with any outstanding balance due at maturity. 

The lender obtained a recent appraisal on the condominium building that reported a prospective “as 

complete” market value of $65 million, reflecting a 24-month sell-out period and projected selling 

costs of 15 percent of the sales price. Comparing the $54 million loan amount against the $65 

million “as complete” market value plus the $5 million pledged in additional collateral (totaling $70 

million) results in an LTV of 77 percent. The lender used the prospective “as complete” market 

value in its analysis and decision to fund the completion and sale of the units and to maximize its 

recovery on the loan. 

Classification: The lender internally classified the $54 million loan as substandard due to the 

units not selling as planned and the project’s limited ability to service the debt despite the 1.3x 
Page 29 of 39

gross collateral margin. The examiner agreed with the lender’s internal grade.

Nonaccrual Treatment: The lender maintained the loan in accrual status due to the protection 

afforded by the collateral margin. The examiner did not concur with this treatment due to the 

uncertainty about the borrower’s ability to sell the units and service the debt, raising doubts as to 

the full repayment of principal and interest. After a discussion with the examiner on regulatory 

reporting requirements, the lender placed the loan on nonaccrual. 

SCENARIO 2: A recent appraisal of the property reflects that the highest and best use would be 

conversion to an apartment building. The appraisal reports a prospective “as complete” market 

value of $60 million upon conversion to an apartment building and a $67 million prospective “as 

stabilized” market value upon the property reaching stabilized occupancy. The borrower agreed to 

grant the lender a second lien on an apartment building in its portfolio, which provides $5 million in 

additional collateral support. In return, the lender advanced the borrower $10 million, which is 

needed to finish construction and convert the project to an apartment complex. The lender also 

agreed to extend the $54 million loan for 12 months at a market interest rate that provides for the 

incremental risk, to give the borrower time to lease the apartments. Interest payments are deferred. 

The $60 million “as complete” market value plus the $5 million in other collateral results in an LTV 

of 83 percent. The prospective “as complete” market value is primarily relied on as the loan is 

funding the conversion of the condominium to apartment building. 

Classification: The lender internally classified the $54 million loan as substandard due to the 

units not selling as planned and the project’s limited ability to service the debt. The collateral 

coverage provides adequate support to the loan with a 1.2x gross collateral margin. The 

examiner agreed with the lender’s internal grade.

Nonaccrual Treatment: The lender determined the loan should be placed in nonaccrual status 

due to an oversupply of units in the project’s submarket, and the borrower’s untested ability to 

lease the units and service the debt, raising concerns as to the full repayment of principal and 

interest. The examiner concurred with the lender’s nonaccrual treatment.

G. Commercial Operating Line of Credit in Connection with Owner Occupied Real Estate

BASE CASE: Two years ago, the lender originated a CRE loan at a market interest rate to a 

borrower whose business occupies the property. The loan was based on a 20-year amortization 

period with a balloon payment due in three years. The LTV equaled 70 percent at origination. A 

year ago, the lender financed a $5 million operating line of credit for seasonal business operations at 

market terms. The operating line of credit had a one-year maturity with monthly interest payments 

and was secured with a blanket lien on all business assets. Borrowings under the operating line of 

credit are based on accounts receivable that are reported monthly in borrowing base reports, with a 

75 percent advance rate against eligible accounts receivable that are aged less than 90 days old. 

Collections of accounts receivable are used to pay down the operating line of credit. At maturity of 

the operating line of credit, the borrower’s accounts receivable aging report reflected a growing 

trend of delinquency, causing the borrower temporary cash flow difficulties. The borrower has 

recently initiated more aggressive collection efforts. 
Page 30 of 39

SCENARIO 1: The lender renewed the $5 million operating line of credit for another year, 

requiring monthly interest payments at a market interest rate, and principal to be paid down by 

accounts receivable collections. The borrower’s liquidity position has tightened but remains 

satisfactory, cash flow available to service all debt is 1.20x, and both loans have been paid according 

to the contractual terms. The primary repayment source for the operating line of credit is conversion 

of accounts receivable to cash. Although payments have slowed for some customers, most 

customers are paying within 90 days of invoice. The primary repayment source for the real estate 

loan is from business operations, which remain satisfactory, and an updated appraisal is not 

considered necessary. 

Classification: The lender internally graded both loans as pass and is monitoring the credits. 

The examiner agreed with the lender’s analysis and the internal grades. The lender is monitoring 

the trend in the accounts receivable aging report and the borrower’s ongoing collection efforts. 

Nonaccrual Treatment: The lender determined that both the real estate loan and the renewed 

operating line of credit may remain in accrual status as the borrower has demonstrated an 

ongoing ability to perform, has the financial ability to pay a market interest rate, and full 

repayment of principal and interest is reasonably assured. The examiner concurred with the 

lender’s accrual treatment.

SCENARIO 2: The lender restructured the operating line of credit by reducing the line amount to 

$4 million, at a below market interest rate. This action is expected to alleviate the borrower’s cash 

flow problem. The borrower is still considered to be a viable business even though its financial 

performance has continued to deteriorate, with sales and profitability declining. The trend in 

accounts receivable delinquencies is worsening, resulting in reduced liquidity for the borrower. 

Cash flow problems have resulted in sporadic over advances on the $4 million operating line of 

credit, where the loan balance exceeds eligible collateral in the borrowing base. The borrower’s net 

operating income has declined but reflects the ability to generate a 1.08x DSC ratio for both loans, 

based on the reduced rate of interest for the operating line of credit. The terms on the real estate loan 

remained unchanged. The lender estimated the LTV on the real estate loan to be 90 percent. The 

operating line of credit currently has sufficient eligible collateral to cover the outstanding line 

balance, but customer delinquencies have been increasing. 

Classification: The lender internally classified both loans substandard due to deterioration in the 

borrower’s business operations and insufficient cash flow to repay the debt at market terms. The 

examiner agreed with the lender’s analysis and the internal grades. The lender will monitor the 

trend in the business operations, accounts receivable, profitability, and cash flow. The lender 

may need to order a new appraisal if the DSC ratio continues to fall and the overall collateral 

margin further declines. 

Nonaccrual Treatment: The lender reported both the restructured operating line of credit and 

the real estate loan on a nonaccrual basis. The operating line of credit was not renewed on 

market interest rate repayment terms, the borrower has an increasingly limited ability to service 

the below market interest rate debt, and there is insufficient support to demonstrate an ability to 

meet the new payment requirements. The borrower’s ability to continue to perform on the 

operating line of credit and real estate loan is not assured due to deteriorating business 
Page 31 of 39

performance caused by lower sales and profitability and higher customer delinquencies. In 

addition, the collateral margin indicates that full repayment of all of the borrower’s indebtedness 

is questionable, particularly if the borrower fails to continue as a going concern. The examiner 

concurred with the lender’s nonaccrual treatment.

H. Land Loan 

BASE CASE: Three years ago, the lender originated a $3.25 million loan to a borrower for the 

purchase of raw land that the borrower was seeking to have zoned for residential use. The loan 

terms were three years interest-only at a market interest rate; the borrower had sufficient funds to 

pay interest from cash flow. The appraisal at origination assigned an “as is” market value of $5 

million, which resulted in a 65 percent LTV. The zoning process took longer than anticipated, and 

the borrower did not obtain full approvals until close to the maturity date. Now that the borrower 

successfully obtained the residential zoning, the borrower has been seeking construction financing to 

repay the land loan. At maturity, the borrower requested a 12-month extension to provide additional 

time to secure construction financing which would include repayment of the subject loan. 

SCENARIO 1: The borrower provided the lender with current financial information, demonstrating 

the continued ability to make monthly interest payments and principal curtailments of $150,000 per 

quarter. Further, the borrower made a principal payment of $250,000 in exchange for a 12-month 

extension of the loan. The borrower also owned an office building with an “as stabilized” market 

value of $1 million and pledged the property as additional unencumbered collateral, granting the 

lender a first lien. The borrower’s personal financial information also demonstrates that cash flow 

from personal assets and the rental income generated by the newly pledged office building are 

sufficient to fully amortize the land loan over a reasonable period. A decline in market value since

origination was due to a change in density; the project was originally intended as 60 lots but was 

subsequently zoned as 25 single-family lots because of a change in the county’s approval process. A 

recent appraisal of the raw land reflects an “as is” market value of $3 million, which results in a 75 

percent LTV when combined with the additional collateral and after the principal reduction. The 

lender restructured the loan into a $3 million loan with quarterly curtailments for another year at a 

market interest rate that provides for the incremental risk.

Classification: The lender internally graded the loan as pass due to adequate cash flow from the 

borrower’s personal assets and rental income generated by the office building to make principal 

and interest payments. Also, the borrower provided a principal curtailment and additional 

collateral to maintain a reasonable LTV. The examiner agreed with the lender’s internal grade.

Nonaccrual Treatment: The lender maintained the loan in accrual status, as the borrower has 

sufficient funds to cover the debt service requirements for the next year. Full repayment of 

principal and interest is reasonably assured from the collateral and the borrower’s financial 

resources. The examiner concurred with the lender’s accrual treatment. 

SCENARIO 2: The borrower provided the lender with current financial information that indicated 

the borrower is unable to continue to make interest-only payments. The borrower has been 

sporadically delinquent up to 60 days on payments. The borrower is still seeking a loan to finance 

construction of the project and has not been able to obtain a takeout commitment; it is unlikely the 
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borrower will be able to obtain financing, since the borrower does not have the equity contribution 

most lenders require as a condition of closing a construction loan. A decline in value since 

origination was due to a change in local zoning density; the project was originally intended as 60 lots 

but was subsequently zoned as 25 single-family lots. A recent appraisal of the property reflects an 

“as is” market value of $3 million, which results in a 108 percent LTV. The lender extended the 

$3.25 million loan at a market interest rate for one year with principal and interest due at maturity.

Classification: The lender internally graded the loan as pass because the loan is currently not 

past due and is at a market interest rate. Also, the borrower is trying to obtain takeout 

construction financing. The examiner disagreed with the internal grade and adversely classified 

the loan. The examiner concluded that the loan was not restructured on reasonable repayment 

terms because the borrower does not have the ability to service the debt and full repayment of 

principal and interest is not assured. The examiner classified $550,000 loss ($3.25 million loan 

balance less $2.7 million, based on the current appraisal of $3 million less estimated cost to sell 

of 10 percent or $300,000). The examiner classified the remaining $2.7 million balance 

substandard. This classification treatment recognizes the credit risk in this collateral-dependent 

loan based on the property’s market value less costs to sell. 

Nonaccrual Treatment: The lender maintained the loan in accrual status. The examiner did not 

concur with this treatment and instructed the lender to place the loan in nonaccrual status 

because the borrower does not have the ability to service the debt, value of the collateral is 

permanently impaired, and full repayment of principal and interest is not assured. 

I. Multi-Family Property 

BASE CASE: The lender originated a $6.4 million loan for the purchase of a 25-unit apartment 

building. The loan maturity is five years, and principal and interest payments are based on a 30-year 

amortization at a market interest rate. The LTV was 75 percent (based on an $8.5 million value), 

and the DSC ratio was 1.50x at origination (based on a 30-year principal and interest amortization).

Leases are typically 12-month terms with an additional 12-month renewal option. The property is 88 

percent leased (22 of 25 units rented). Due to poor economic conditions, delinquencies have risen 

from two units to eight units, as tenants have struggled to make ends meet. Six of the eight units are 

90 days past due, and these tenants are facing eviction. 

SCENARIO 1: At maturity, the lender renewed the $5.9 million loan balance on principal and 

interest payments for 12 months at a market interest rate that provides for the incremental risk. The 

borrower had not been delinquent on prior payments. Current financial information indicates that 

the DSC ratio dropped to 0.80x because of the rent payment delinquencies. Combining borrower 

and guarantor liquidity shows they can cover cash flow shortfall until maturity (including reasonable 

capital expenditures since the building was recently renovated). Borrower projections show a return 

to break-even within six months since the borrower plans to decrease rents to be more competitive 

and attract new tenants. The lender estimates that the property’s current “as stabilized” market value 

is $7 million, resulting in an 84 percent LTV. A new appraisal has not been ordered; however, the 

lender noted in the file that, if the borrower does not meet current projections within six months of 

booking the renewed loan, the lender will obtain a new appraisal. 
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Classification: The lender internally graded the renewed loan as pass and is monitoring the 

credit. The examiner disagreed with the lender’s analysis and classified the loan as substandard. 

While the borrower and guarantor can cover the debt service shortfall in the near-term using 

additional guarantor liquidity, the duration of the support may be less than the lender anticipates 

if the leasing fails to materialize as projected. Economic conditions are poor, and the rent 

reduction may not be enough to improve the property’s performance. Lastly, the lender failed to 

obtain an updated collateral valuation, which represents an administrative weakness.

Nonaccrual Treatment: The lender maintained the loan in accrual status. The borrower has 

demonstrated the ability to make the regularly scheduled payments and, even with the decline in 

the borrower’s creditworthiness, the borrower and guarantor appear to have sufficient cash 

resources to make these payments if projections are met, and full repayment of principal and 

interest is expected. The examiner concurred with the lender’s accrual treatment. 

SCENARIO 2: At maturity, the lender renewed the $5.9 million loan balance on a 12-month 

interest-only basis at a below market interest rate. In response to an event that caused severe 

economic conditions, the federal and state governments enacted moratoriums on all evictions. The 

borrower has been paying as agreed; however, cash flow has been severely impacted by the rent 

moratoriums. While the moratoriums do not forgive the rent (or unpaid fees), they do prevent 

evictions for unpaid rent and have been in effect for the past six months. As a result, the borrower’s 

cash flow is severely stressed, and the borrower has asked for temporary relief of the interest 

payments. In addition, a review of the current rent roll indicates that five of the 25 units are now 

vacant. A recent appraisal values the property at $6 million (98 percent LTV). Updated borrower 

and guarantor financial statements indicate the continued ability to cover interest-only payments for 

the next 12 to 18 months at the reduced rate of interest. Updated projections that indicate below 

break-even performance over the next 12 months remain uncertain given that the end of the 

moratorium (previously extended) is a “soft” date and that tenant behaviors may not follow historical 

norms. 

Classification: The lender internally classified the loan as substandard and is monitoring the 

credit. The examiner agreed with the lender’s treatment due to the borrower’s diminished ability 

to make interest payments (even at the reduced rate) and lack of principal reduction, the 

uncertainty surrounding the rent moratoriums, and the reduced and tight collateral position. 

Nonaccrual Treatment: The lender maintained the loan on an accrual basis because the 

borrower demonstrated an ability to make principal and interest payments and has some ability to 

make payments on the interest-only terms at a below market interest rate. The examiner did not 

concur with this treatment as the loan was not restructured on reasonable repayment terms, the 

borrower has insufficient cash flow to amortize the debt, and the slim collateral margin indicates 

that full repayment of principal and interest may be in doubt. After a discussion with the 

examiner on regulatory reporting requirements, the lender placed the loan on nonaccrual. 

SCENARIO 3: At maturity, the lender renewed the $5.9 million loan balance on a 12-month 

interest-only basis at a below market interest rate. The borrower has been sporadically delinquent on 

prior principal and interest payments. A review of the current rent roll indicates that 10 of the 25 

units are vacant after tenant evictions. The vacated units were previously in an advanced state of 
Page 34 of 39

disrepair, and the borrower and guarantors have exhausted their liquidity after repairing the units. 

The repaired units are expected to be rented at a lower rental rate. A post-renovation appraisal 

values the property at $5.5 million (107 percent LTV). Updated projections indicate the borrower 

will be below break-even performance for the next 12 months. 

Classification: The lender internally classified the loan as substandard and is monitoring the 

credit. The examiner agreed with the lender’s concerns due to the borrower’s diminished ability 

to make principal or interest payments, the guarantor’s limited ability to support the loan, and 

insufficient collateral protection. However, the examiner classified $900,000 loss ($5.9 million 

loan balance less $5 million (based on the current appraisal of $5.5 million less estimated cost to 

sell of 10 percent, or $500,000)). The examiner classified the remaining $5 million balance 

substandard. This classification treatment recognizes the collateral dependency.

Nonaccrual Treatment: The lender maintained the loan on accrual basis because the borrower 

demonstrated a previous ability to make principal and interest payments. The examiner did not 

concur with the lender’s treatment as the loan was not restructured on reasonable repayment 

terms, the borrower has insufficient cash flow to service the debt at a below market interest rate 

on an interest-only basis, and the impairment of value indicates that full repayment of principal 

and interest is in doubt. After a discussion with the examiner on regulatory reporting 

requirements, the lender placed the loan on nonaccrual. 
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Appendix 2

Selected Rules, Supervisory Guidance, and Authoritative Accounting Guidance

Rules

• Federal regulations on real estate lending standards and the Interagency Guidelines for Real 

Estate Lending Policies: 12 CFR part 34, subpart D, and appendix A to subpart D (OCC), 

160.100, 160.101, and Appendix to 160.101 (OCC); 12 CFR part 208, subpart E and appendix 

C (Board); and 12 CFR part 365 and appendix A (FDIC). For NCUA, refer to 12 CFR part 

723 for member business loan and commercial loan regulation which addresses commercial 

real estate lending and 12 CFR part 741, appendix B, which addresses loan workouts, 

nonaccrual policy, and regulatory reporting of workout loans. 

• Federal regulations on the Interagency Guidelines Establishing Standards for Safety and 

Soundness: 12 CFR part 30, appendix A (OCC); 12 CFR part 208 Appendix D-1 (Board); and 

12 CFR part 364 appendix A (FDIC). For NCUA safety and soundness regulations and 

supervisory guidance, see 12 CFR 741.3(b)(2); 12 CFR part 741, appendix B; 12 CFR part 

723; and NCUA letters to credit unions 10-CU-02 “Current Risks in Business Lending and 

Sound Risk Management Practices” issued January 2010 (NCUA). Credit unions should also 

refer to the Commercial and Member Business Loans section of the NCUA Examiner’s Guide.

• Federal appraisal regulations: 12 CFR part 34, subpart C (OCC); 12 CFR part 208, subpart E 

and 12 CFR part 225, subpart G (Board); 12 CFR part 323 (FDIC); and 12 CFR part 722 

(NCUA). 

Supervisory Guidance

• FFIEC Instructions for Preparation of Consolidated Reports of Condition and Income (FFIEC 

031, FFIEC 041, and FFIEC 051 Instructions) and NCUA 5300 Call Report Instructions. 

• Interagency Policy Statement on Allowances for Credit Losses (Revised April 2023), issued 

April 2023.

• Interagency Guidance on Credit Risk Review Systems, issued May 2020. 

• Interagency Supervisory Examiner Guidance for Institutions Affected by a Major Disaster,

issued December 2017.

• Board, FDIC, and OCC joint guidance entitled Statement on Prudent Risk Management for 

Commercial Real Estate Lending, issued December 2015.

• Interagency Appraisal and Evaluation Guidelines, issued October 2010. 

• Board, FDIC, and OCC joint guidance on Concentrations in Commercial Real Estate Lending, 

Sound Risk Management Practices, issued December 2006. 

• Interagency FAQs on Residential Tract Development Lending, issued September 2005. 

Authoritative Accounting Standards 

• ASC Topic 310, Receivables 

• ASC Topic 326, Financial Instruments – Credit losses 

• ASC Topic 820, Fair Value Measurement 

• ASC Subtopic 825-10, Financial Instruments – Overall
Page 36 of 39

Appendix 3

Valuation Concepts for Income Producing Real Estate

Several conceptual issues arise during the process of reviewing a real estate loan and in using 

the present value calculation to determine the value of collateral. The following discussion sets forth 

the meaning and use of those key concepts. 

The Discount Rate and the Present Value: The discount rate used to calculate the present value is 

the rate of return that market participants require for the specific type of real estate investment. The 

discount rate will vary over time with changes in overall interest rates and in the risk associated with 

the physical and financial characteristics of the property. The riskiness of the property depends both 

on the type of real estate in question and on local market conditions. The present value is the value

of a future payment or series of payments discounted to the date of the valuation. If the income 

producing real estate is a property that requires cash outlays, a net present value calculation may be 

used in the valuation of collateral. Net present value considers the present value of capital outlays 

and subtracts that from the present value of payments received for the income producing property. 

Direct Capitalization (“Cap” Rate) Technique: Many market participants and analysts use the 

“cap” rate technique to relate the value of a property to the net operating income it generates. In 

many applications, a “cap” rate is used as a short cut for computing the discounted value of a 

property’s income streams. 

The direct income capitalization method calculates the value of a property by dividing an 

estimate of its “stabilized” annual income by a factor called a “cap” rate. Stabilized annual income 

generally is defined as the yearly net operating income produced by the property at normal 

occupancy and rental rates; it may be adjusted upward or downward from today’s actual market 

conditions. The “cap” rate, usually defined for each property type in a market area, is viewed by 

some analysts as the required rate of return stated in terms of current income. The “cap” rate can be 

considered a direct observation of the required earnings-to-price ratio in current income terms. The 

“cap” rate also can be viewed as the number of cents per dollar of today’s purchase price investors 

would require annually over the life of the property to achieve their required rate of return. 

The “cap” rate method is an appropriate valuation technique if the net operating income to 

which it is applied is representative of all future income streams or if net operating income and the 

property’s selling price are expected to increase at a fixed rate. The use of this technique assumes 

that either the stabilized annual income or the “cap” rate used accurately captures all relevant 

characteristics of the property relating to its risk and income potential. If the same risk factors, 

required rate of return, financing arrangements, and income projections are used, the net present 

value approach and the direct capitalization technique will yield the same results. 

The direct capitalization technique is not an appropriate valuation technique for troubled real 

estate since income generated by the property is not at normal or stabilized levels. In evaluating 

troubled real estate, ordinary discounting typically is used for the period before the project reaches 

its full income potential. A “terminal cap rate” is then utilized to estimate the value of the property 

(its reversion or sales price) at the end of that period. 
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Differences between Discount and Cap Rates: When used for estimating real estate market 

values, discount and “cap” rates should reflect the current market requirements for rates of return 

on properties of a given type. The discount rate is the required rate of return accomplished through 

periodic income, the reversion, or a combination of both. In contrast, the “cap” rate is used in 

conjunction with a stabilized net operating income figure. The fact that discount rates for real 

estate are typically higher than “cap” rates reflects the principal difference in the treatment of

periodic income streams over a number of years in the future (discount rate) compared to a static 

one-year analysis (“cap” rate).

Other factors affecting the “cap” rate (but not the discount rate) include the useful life of the 

property and financing arrangements. The useful life of the property being evaluated affects the 

magnitude of the “cap” rate because the income generated by a property, in addition to providing the 

required return on investment, has to be sufficient to compensate the investor for the depreciation of 

the property over its useful life. The longer the useful life, the smaller the depreciation in any one 

year, hence, the smaller the annual income required by the investor, and the lower the “cap” rate. 

Differences in terms and the extent of debt financing and the related costs are also taken into 

account. 

Selecting Discount and Cap Rates: The choice of the appropriate values for discount and “cap” 

rates is a key aspect of income analysis. In markets marked by both a lack of transactions and highly 

speculative or unusually pessimistic attitudes, analysts consider historical required returns on the 

type of property in question. Where market information is available to determine current required 

yields, analysts carefully analyze sales prices for differences in financing, special rental 

arrangements, tenant improvements, property location, and building characteristics. In most local 

markets, the estimates of discount and “cap” rates used in an income analysis generally should fall 

within a fairly narrow range for comparable properties. 

Holding Period versus Marketing Period: When the net present value approach is applied to 

troubled properties, the chosen time frame should reflect the period over which a property is 

expected to achieve stabilized occupancy and rental rates (stabilized income). That period is 

sometimes referred to as the “holding period.” The longer the period is before stabilization, the 

smaller the reversion value will be within the total value estimate. The marketing period is the time 

that may be required to sell the property in an open market. 
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Appendix 4

Special Mention and Adverse Classification Definitions36

The Board, FDIC, and OCC use the following definitions for assets adversely classified for 

supervisory purposes as well as those assets listed as special mention:

Special Mention

Special Mention Assets: A Special Mention asset has potential weaknesses that deserve 

management’s close attention. If left uncorrected, these potential weaknesses may result in 

deterioration of the repayment prospects for the asset or in the institution’s credit position at some 

future date. Special Mention assets are not adversely classified and do not expose an institution to 

sufficient risk to warrant adverse classification.

Adverse Classifications

Substandard Assets: A substandard asset is inadequately protected by the current sound 

worth and paying capacity of the obligor or of the collateral pledged, if any. Assets so classified 

must have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. They 

are characterized by the distinct possibility that the institution will sustain some loss if the 

deficiencies are not corrected.

Doubtful Assets: An asset classified doubtful has all the weaknesses inherent in one 

classified substandard with the added characteristic that the weaknesses make collection or 

liquidation in full, on the basis of currently existing facts, conditions, and values, highly questionable 

and improbable. 

Loss Assets: Assets classified loss are considered uncollectible and of such little value that 

their continuance as bankable assets is not warranted. This classification does not mean that the 

asset has absolutely no recovery or salvage value, but rather it is not practical or desirable to defer 

writing off this basically worthless asset even though partial recovery may be effected in the future. 

36 Federal banking agencies loan classification definitions of Substandard, Doubtful, and Loss may be found in the 

Uniform Agreement on the Classification and Appraisal of Securities Held by Depository Institutions Attachment 1—

Classification Definitions (OCC: OCC Bulletin 2013-28; Board: SR Letter 13-18; and FDIC: FIL-51-2013). The Federal 

banking agencies definition of Special Mention may be found in the Interagency Statement on the Supervisory Definition 

of Special Mention Assets (June 10, 1993). The NCUA does not require credit unions to adopt the definition of special 

mention or a uniform regulatory classification schematic of loss, doubtful, substandard. A credit union must apply a 

relative credit risk score (i.e., credit risk rating) to each commercial loan as required by 12 CFR part 723 Member 

Business Loans; Commercial Lending (see Section 723.4(g)(3)) or the equivalent state regulation as applicable. 

Adversely classified refers to loans more severely graded under the credit union’s credit risk rating system. Adversely 

classified loans generally require enhanced monitoring and present a higher risk of loss.
Page 39 of 39

Appendix 5

Accounting – Current Expected Credit Losses Methodology (CECL)

This appendix addresses the relevant accounting and supervisory guidance for financial 

institutions in accordance with Accounting Standards Update (ASU) 2016-13, Financial Instruments 

– Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments and its 

subsequent amendments (collectively, ASC Topic 326) in determining the allowance for credit 

losses (ACL). Additional supervisory guidance for the financial institution’s estimate of the ACL 

and for examiners’ responsibilities to evaluate these estimates is presented in the Interagency Policy 

Statement on Allowances for Credit Losses (Revised April 2023). Additional information related to 

identifying and disclosing modifications for regulatory reporting under ASC Topic 326 is located in 

the FFIEC Call Report and NCUA 5300 Call Report instructions. 

In accordance with ASC Topic 326, expected credit losses on restructured or modified loans 

are estimated under the same CECL methodology as all other loans in the portfolio. Loans, 

including loans modified in a restructuring, should be evaluated on a collective basis unless they do 

not share similar risk characteristics with other loans. Changes in credit risk, borrower 

circumstances, recognition of charge-offs, or cash collections that have been fully applied to 

principal, often require reevaluation to determine if the modified loan should be included in a 

different pool of assets with similar risks for measuring expected credit losses. 

Although ASC Topic 326 allows a financial institution to use any appropriate loss estimation 

method to estimate the ACL, there are some circumstances when specific measurement methods are 

required. If a financial asset is collateral dependent,37 the ACL is estimated using the fair value of 

the collateral. For a collateral-dependent loan, regulatory reporting requires that if the amortized 

cost of the loan exceeds the fair value38 of the collateral (less costs to sell if the costs are expected to 

reduce the cash flows available to repay or otherwise satisfy the loan, as applicable), this excess is 

included in the amount of expected credit losses when estimating the ACL. However, some or all of 

this difference may represent a loss for classification purposes that should be charged off against the 

ACL in a timely manner.

Financial institutions also should consider the need to recognize an allowance for expected 

credit losses on off-balance sheet credit exposures, such as loan commitments, in other liabilities 

consistent with ASC Topic 326.

37 The repayment of a collateral-dependent loan is expected to be provided substantially through the operation or sale of 

the collateral when the borrower is experiencing financial difficulty based on the entity’s assessment as of the reporting 

date. Refer to the glossary entry in the FFIEC Call Report instructions for “Allowance for Credit Losses – CollateralDependent Financial Assets.” 38 The fair value of collateral should be measured in accordance with FASB ASC Topic 820, Fair Value Measurement. 

For allowance measurement purposes, the fair value of collateral should reflect the current condition of the property, not 

the potential value of the collateral at some future date.