The ABCs of Appraisal

The property appraisal business has been coming under the spotlight lately. I expect the lights to get a lot hotter. This has implications for the real estate market overall, NYC in particular and it has implications for how you the buyer may want to approach your real estate transaction.

First a few disclaimers. I am not an appraiser (so all of you who are please cut me some slack on the particulars). Second I have nothing against appraisers, in fact I think they are among the most highly trained professionals in the art of valuing real estate. Thirdly, my apologies for being late on this story. In my piece on asset cycles a couple of months back I did mention that appraisers and bond rating agencies were apt to come in for some severe criticism during this real estate down cycle. But honestly, I should have written about this subject earlier in keeping with Noah's practice of being ahead of the crowd in spotting trends that will be important to you the real estate buyer and investor. That said here goes.

The cover of last Thursday's Wall Street Journal read "Probe Widens on Inflated Home Appraisals"; online version has free preview only.

The bottom line is that N.Y. State Attorney General Andrew Cuomo wants Fannie Mae and Freddie Mac to look into how well they helped protect mortgage investors from losses due to faulty appraisals on loans that should not have been made. This follows on the heels of The Governator of California signing a law in October trying to prevent lenders from pressuring appraisers into making the numbers work on deals. The issue of mortgage fraud - and faulty appraisals being behind 80% of these scams - was raised as far back as early 2005 in the articles below. Now remember fraud follows assets that are in bull markets because as Willie Sutton said "That's where the money is". It's not a characteristic of all the professionals who work as stock or rating agency analysts or appraisers to commit fraud, but these people's opinions are very important to how money is raised and invested and there is great potential for them to abuse their positions or aide and abet others who do.

Certain loans secured by real property fall under the purview of the Federal Institutions Reform, Recovery and Enforcement Act of 1989 (FIREA) and require a written appraisal of the value of the real property asset. Read the law here.

As can be noted from the name of the law this is one of those great pieces of after the fact legislation written in the wake of the last real estate debacle - the S&L crisis. As in all bear markets bad underwriting (assessment of risk) was at fault and FIRREA tried to address this after it was too late.

So Jeff? Why do I care?

1) Expect more properties not to appraise at levels buyers and sellers hoped for - As I opined in my asset cycles piece:

Virtuous cycles where real estate or other asset prices rise for several years tend to condition the professional evaluators like stock analysts to bias their assumptions and adjustments up. On the other side when the asset cycles turn vicious assumptions and adjustments start to be biased down.

Often times the government moves this process along by beating up on the evaluators. For example, after a decade long bull market, stock analysts had buy ratings on everything in sight, some ended up being quasi investment bankers. Their positive ratings helped companies' stocks rise helping them pay themselves and raise money. When the boom ended regulators asked why no one had sell recommendations on stocks that appeared to a reasonable person to be overvalued. Wall Street complied and in the teeth of the bear market with stocks getting cheaper daily, analysts came out with tons of sell recommendations. In fact research departments, though they hadn't been given a quota by the SEC, voluntarily decided it was only reasonable to have 20 or 30% of their recommendations be sells. This is a good article on the conflicts of interest in stock ratings and one on the new rules the SEC adopted soon after to prevent future problems.

My prediction is now that the heat is being placed on appraisers they to will adopt some kind of unspoken quota system on how many properties "don't hit the number". This will just put more pressure on the downward move in home prices. According to Jim Gannon of Guild Partners (a trained appraiser):

"Some lenders may appreciate this trend and hide behind more conservative appraisals when telling good customers they can't make a loan that they would rather avoid extending anyway."

2) In New York City two of the three appraisal methodologies are typically not used for valuing coops and condos. Coops are leased fee, not fee simple interests. You own shares in a corporation and a right to use an apartment, you don't own the asset, therefore replacement cost can't be used to value these assets. Condos are fee simple interests (you actually own the apartment), but you don't own the building and replacing a single condo is un-realistic. (Note that in the suburbs replacement cost is looked at for home valuations which may put a floor on appraisals if sky rocketing building costs offset the inevitable decline in land values). Secondly, you can't sub-let coops easily, therefore you can't equate them to rentals and value them on an "if rented" income capitalization basis. In general, although Manhattan is dominated by rentals and you should do your own rent vs. buy analysis, appraisers don't try to look at what the cash flows on a condo would be if it were sub let and equate that with value of the condo. So in general appraisers have to rely on one valuation technique, which is comparable sales. With comparable sales prices likely to start to soften, it will be harder to get an appraiser to sign off on your paying up for an apartment. It may even be hard to get them to sign off on a purchase in line with comps from a few months ago if prices have been generally falling.

3) If your dream apartment doesn't appraise don't panic ...RENEGOTIATE. It ain't gonna appraise for anyone else who is trying to buy it. So if the seller wants to sell, its a perfect reason for you to get them to knock down the price.

I love happy endings!

Just a few more details for you macro mavens.

The tools of real estate appraisal. There are three accepted methods to valuing a piece of real estate of any kind - below are some vast simplifications of what they are and why they are very subjective.

1) The income or yield capitalization method - What are the potential cash flows the property can produce and what are they worth in today's dollars. This includes the cash generated by the sale of the property five or ten years out. These future values must be quantified and brought back to today based on a discount rate for the cash flows and a reversion rate for the future sale price. What discount and reversion rates to use are a subjective judgement by the appraiser and the only way to actually get an idea of what rates are being used in the market are by surveys or using historical transaction data (which tends to be a bit stale). FYI nothing says that investors will still apply these same rates to a property in the future...or even next week.

2) The replacement cost method - If you had to build this home or building today, what would it cost, then add on the value of the land (which can be determined from comparable land sales, which can be somewhat stale depending on the market) and subtract any depreciation due to the age of the building being valued versus a new one. For this analysis the appraiser needs to have a good sense of what current construction costs are for different types of buildings, despite the rapid rates of increase and swings in commodity prices in recent years.

3) Comparable sales method - What are comparable properties selling for in the market today, adjusted for any differences in location, size, utility (does it have a pool etc.) and ownership structure (condo vs. coop etc.) and when the sale took place. In a rising market appraisers adjust upward the value of comps that were sold a while ago to account for market appreciation. In a falling market they will have to adjust them down This is often a very good indicator of the current market value of a property, particularly for real estate that trades a lot (its harder to use for valuing things like golf courses that have a serious land value but don't turn over that much). Comp information for residential real estate is reasonably available, and tends to be fresh in large markets, but must be adjusted as no group of four or five properties are that alike.

In many cases more than one technique can and should be used for the appraisal process and an average or median of the values is used to determine a value judgment. Sometimes its weighted towards one or other method, which looks like it should be more accurate in particular case. This along with all assumptions and adjustments mentioned above is where the art of appraisal comes in. Just like valuing a stock, its not a science. There is no absolute correct answer. Only future trading will tell you how far off an appraisal was from the eventual sale value of a property as an appraisal values a property only on a particular date, because market conditions are ever changing.

Billions of dollars of consumer wealth and borrowing power - on paper at least- depend on appraisals. As appraisers start to get less sanguine about valuing properties, there will be less wealth in the nation....how much less is an open question. Due to the additional appraisal methods available to evaluate commercial real estate the impact of changing sentiment among appraisers may be less of an issue.

Other related posts from the blogosphere:

Fannie & Freddie Get Appraised (Matrix)

Appraisers: Pushers & Pressures (Matrix)

What's Wrong with Approved Appraiser Lists (Calculated Risk)

Price is NOT Right: Appraisals Sink Home Sales (Boston Herald)

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