Agents, investors, property owners and anyone riding on the results of an appraisal want the value to come out the way they expect, and the way they think it should, but is that how high-risk financing decisions should be made? Who is most qualified to evaluate a subject property and select the best comps based on the broadest scope of possible variables, while narrowing in on the comps that match most specifically for the factors that have the great impact on value considering the market?
Why does the real estate industry and financial regulatory infrastructure place such a great emphasis maintaining transparency and impartiality in real estate appraisals? This post will reflect on these issues and offer historical as well as practical insight.
Regulations requiring appraisals for real estate loans go back 30 years. As a result of the savings and loan crisis of the late 1980s, the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) was created by U.S. Congress. One of FIRREA’s many directives was the establishment of broad oversight of real estate appraisers. States were required to license or certify professional appraisers; those appraisers were required to practice in accordance with a new set of standards, the Uniform Standards of Professional Appraisal Practice (USPAP). USPAP had been developed by a collective of appraisal industry groups; those same groups cooperated in the formation of the Appraisal Foundation, which was charged through FIRREA to maintain and promulgate standards for appraiser certification and appraisal practice.
Appraiser oversight continued to evolve after 1989. In 2009, in response to the Great Recession, the Federal Housing Finance Agency adopted the “Home Valuation Code of Conduct (HVCC)”. This code was intended to stop influence of lenders on appraisers and improve the reliability of home appraisals. HVCC required that lenders retain appraisers only through appraisal management companies. This provision caused upheaval in the appraisal and lending industries, but had negligible effect on appraisal reliability.
The “Dodd–Frank Wall Street Reform and Consumer Protection Act” of 2010 was a more comprehensive response to the Great Recession. Title XIV, Subsection F, of Dodd-Frank requires appraisal independence for any appraisal performed as part of a credit transaction. The section, often called “Appraiser Independence Regulations”, or AIR, effectively replaces the HVCC.
Debt and Equity Lender Perspectives
Both primary and secondary lenders have financial stakes in loan transactions. A primary lender only makes money, through fees and interest, by making loans. The secondary lender wants to acquire as many loans as possible to build a diverse and attractive investment portfolio.
All the participants in a mortgage loan are exposed to risk. The borrower risks losing whatever money he has put down for the property, plus possession of the property itself. The lending institution, which could be a bank, credit union or mortgage company, risks losing the loan amount, plus the costs of foreclosing on and liquidation of a reclaimed property. The secondary lender, such as the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), risks asset loss and diminished credit rating.
Primary lenders rely on secondary lenders for cash resources. Secondary lenders are generally both government-backed and publicly traded. Together, their risk is minimized by the credit-worthiness of a borrower and the value of the collateral, or subject property, in a transaction. That collateral is most reliably represented by an accurate, unbiased appraisal.
In addition to asset loss, both primary and secondary lenders are subject to significant penalties if their activities are weakened by unreliable appraisals. The Securities and Exchange Commission (SEC) can fine both primary and secondary lenders for fraud and operational irregularities. Consumers can claim compensation for fraudulent lender activity from the Consumer Financial Protection Bureau.
To strive towards compliance with Dodd-Frank, both primary and secondary lenders have established additional appraisal guidelines. Secondary lenders have detailed requirements for the banks whose loans they acquire or insure. For example, Part B4 of Fannie Mae’s Selling Guide lays out detailed appraisal guidelines for their portfolio properties. Lending institutions also add their own inhouse appraisal guidelines.
Perspectives of Agents and Principals
Real estate agents, buyers and sellers, by definition, have financial interests in real estate transactions. The buyer wants to accomplish the transaction, but at the lowest price. The seller also wants to close the transaction, but at the highest price. The agent usually has at least two stakes in a transaction: he will only be paid for his work if the transaction occurs and that payment is often a percentage of the sale price.
The seller likely has the most knowledge about the subject property. The buyer has a somewhat broader view, having looked at other properties before offering to purchase subject property. The agent likely has an even wider perspective, having helped clients buy and sell a variety of properties.
An appraiser may not have knowledge identical to that of a buyer, seller or agent. However, she alone has impartiality, which is mandated by Dodd-Frank, secondary lending guidelines and individual banking institutions. USPAP requires a lack of bias. That requirement continues through all parties’ appraisal guidelines. USPAP also requires competency: “An appraiser must: (1) be competent to perform the assignment; (2) acquire the necessary competency to perform the assignment; or (3) decline or withdraw from the assignment. In all cases, the appraiser must perform competently when completing the assignment.” So, while the appraiser may not have the same experience of the subject property as that of buyer, seller and agent, she must have enough information, or obtain that information, to develop a reliable value estimate.
Real estate agents routinely prepare comparative market analyses to help clients set property selling prices. Comparable data in these analyses can contain not only verified sales, but also real estate listings, pending listings, contracts, properties that were withdrawn, canceled, or are off-market, and expired listings. But agents don’t have to comply with national professional standards when preparing comparative market analyses, nor do they risk losing their licenses if their analyses are incomplete or misleading.
By comparison, completed sales transactions are the preferred data an appraiser uses to estimate value; some agency and institutional guidelines even prohibit appraisers relying on anything else. Appraisers are very careful to exclude sales held under unusual situations, e.g., aren’t arms-length, and those that occurred when market conditions were different. And appraisers do stand lose their places on approved appraiser lists, and even their licenses, if they produce flawed appraisals. Agents can rely on speculative comparable data that an appraiser can’t use, and appraisers have greater risk exposure than agents if speculative data proves to be misleading.
The Nitty Gritty – High Level Appraisal Techniques
Paired sales analysis is the primary tool appraisers use to estimate value of residential properties. An appraiser will research actual sale transactions that have occurred in subject property’s neighborhood and will further analyze those most similar to subject property. The appraiser will compare each sale property to subject in terms of sales concessions, time of sale, location, site size, view, construction quality, actual improvements’ age, and design features. For each factor where the comparable sale property differs from subject, the appraiser will adjust the comparable’s sale price to more closely match subject. The appraiser’s adjustments must be based on actual market data, analyzed for each comparison factor. The sales requiring the least adjustment are often the most indicative of subject value.
Multiple regression analysis is a database tool sometimes used to isolate the effect on price of individual comparison factors. This tool is the basis of automated valuation models used by assessors and online home price estimators. Multiple regression is most useful where there are many similar properties that have sold under similar market conditions. The validity of multiple regression is dependent on the quality of the database’s sales data and the skill of the database analyst.
Because neither the individual comparable sales nor the analyst’s skills are readily apparent, regression analysis alone is not accepted by regulators and institutions to describe the value of a specific property. Though it is a useful analytical tool, regression analysis lacks the transparency necessary for individual loan decisions.
Satisfying Every Stakeholder
An appraiser must develop an independent opinion of value, but the buyer, seller and agent can be helpful. A seller can point out added features of the property; actual proof of the costs of new or special features is even better. Though the appraiser can’t rely on sale listings or contracts, knowing about them is useful in describing market conditions. The agent also may provide details of sale transactions that aren’t readily available to others.
The appraiser’s task is especially difficult when market conditions are abnormal or rapidly changing. In an accelerating market, sale prices occurring only months ago may not reflect what buyers will pay now. An agent can be particularly helpful by providing data such as days listed, number of offers made, and concessions made by buyer or seller for sale transactions. The appraiser can then describe these sale factors and account for them in his analysis.
Finally, Dodd-Frank specifically allows agents, lenders and consumers to ask an appraiser to consider additional information, to provide further detail or explanation of her value conclusion and to correct any errors in the appraisal report. Though those requests might extend the time for closing a loan, they may also result in a different value conclusion.