There is a new legislative proposal to radically alter the appraisal industry. Should the use of comparables be arbitrary when establishing appraised value? Do appraisers need to better “appreciate” a neighborhood (what does this even mean?) Should an appraiser use comparables in a different neighborhood to justify values? How will these changes impact real estate values, lending, and the secondary markets?
What is spurring the proposed changed to Real estate appraisals
Research has shown that homes located in neighborhoods primarily populated by black households tend to be valued lower than similar homes in majority-white communities. A 2018 study from the Brookings Institution, a Washington, D.C.-based nonprofit found that homes of similar quality and with similar amenities were appraised for 23% less in majority-black neighborhoods than in neighborhoods with few black residents.
This study is perplexing as it is comparing apples to potatoes. Essentially the study concludes that race is the leading driver of property values. This couldn’t be further from the truth. Location, Location, Location drives values. You see this in any major city where people flock to certain areas and neighborhoods.
Current appraisal standards
Under the current standards government sponsored loans are required to use an appraisal service to ensure no undue influence on the appraisal. Furthermore, appraisers select comparables in the same neighborhood/location that closely resemble the subject property. There is no factor for race, gender, etc… the appraiser is merely selecting comparable properties to establish value. Furthermore, the appraiser has no clue on the ethnicity of comparable homeowners so it would be impossible to hold implicit bias.
What is the new proposal?
To address the racial inequality there is a proposal to radically “update” the appraisal standards in order to remove any implicit bias. They would establish a national standard for housing appraisals that ensures appraisers have adequate training and a full appreciation for neighborhoods and do not hold implicit biases because of a lack of community understanding.
I’m confused on how an appraiser has an “appreciation of a neighborhood” or how this is even relevant to value. Essentially, the changes would encourage appraisers to value properties in certain neighborhoods higher in order to ensure “fairness” and show an “appreciation for the neighborhood”. For example, in a challenging neighborhood, an appraiser could use a comparable in a nicer adjacent neighborhood in order to “help” the struggling neighborhood values.
New Appraisal standards are a disaster in the making
Unfortunately, these new standards are a disaster. The appraisal is now subjective as opposed to fact based. With the new proposed standards, how does anyone have confidence in the value of a property, just putting a higher appraised value on the property does not mean the value is real.
2007 is a prime example of what happens when things go wrong due to appraisals. Before the last meltdown, banks, mortgage brokers, etc.. could select the appraisers and there were many instances where appraisers were “encouraged” to get a particular value in order to ensure future work. We found out quickly that many of the values were inflated and homeowners, lenders, purchasers of securities, taxpayers, etc.. lost billions of dollars.
The new standards will force appraisers to value a property based on race to ensure “parity” amongst neighborhoods. Unfortunately, real estate doesn’t work this way, the value is what someone is willing to pay for a property, just because an appraiser says a property is x doesn’t mean the property will sell for x. The new standards will create huge risks in the mortgage market as loans would be made for more than a properties true market value.
The market will not buy the new standards
Unfortunately, as is typically the case, the wonderful officials who devise many regulations have zero clue how the mortgage market actually works. When a loan is made a bank or mortgage broker typically sells the loan to Fannie Mae, Freddie Mac, FHA, VA, HUD, etc… The Government sponsored entity then pools the loans and resells them to the secondary market. The secondary market will then run the properties through automated valuations to determine the actual value of the property. This is where the new regulations will fail. The AVMs will determine the value of the property that is likely substantially less than the supposed appraised value. The purchaser will then demand a discount on the note to bridge the gap between the two values. Essentially the GSE would have to sell the notes at a loss because nobody is going to buy overvalued securities.
With loans now being sold at a loss, who absorbs the loss. The GSE’s are backed by the government so taxpayers will be on the hook for any losses. Furthermore to compensate for losses the GSE’s will have to raise revenue from other performing loans through higher fees essentially creating a transfer tax on other borrowers. Finally, what happens in a recession when a large majority of properties have mortgages that are worth less than the house (negative equity), there will be a wave of defaults and prices will plummet further eroding the same neighborhoods the regulations are trying to assist.
Summary
The new regulations create a new appraisal question. What would a house be worth if it were in a different location? Essentially the appraiser is now be asked to speculate on value regardless of location. Unfortunately, the real world doesn’t work this way. There are not allot of houses being moved from challenging areas to better areas. A house is worth what it is worth based on its location.
For example, if you were looking at a house in Aspen, CO a house on the slopes it is worth a radically different amount than one looking at the airport. Unfortunately, the new regulations have no semblance of determining the true market value of the property as they factor location out of the equation.
Politicians from both parties have confused cause with effect. The cause of lower prices is not appraised value it is fundamentally market driven. Regulating opinions of value is the quickest way to create problems within the housing markets. The secondary markets will quickly see through this scheme as losses cascade creating larger issues for the same areas the regulations were trying to assist. Regardless of the regulations the old adage location, location, location will remain the driver of value.
Additional Reading/Resources
- https://www.bloomberg.com/news/articles/2020-09-21/race-gap-in-home-appraisals-has-doubled-since-1980?srnd=premium
- https://www.marketwatch.com/story/joe-biden-wants-tougher-standards-for-real-estate-appraisers-to-help-black-and-latinx-homeowners-2020-02-25
- https://www.appraisalinstitute.org/ano/ai-opposes-bidens-call-for-more-appraisal-standards/
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Written by Glen Weinberg, COO/ VP Fairview Commercial Lending. Glen has been published as an expert in hard money lending, real estate valuation, financing, and various other real estate topics in Bloomberg, Businessweek ,the Colorado Real Estate Journal, National Association of Realtors Magazine, The Real Deal real estate news, the CO Biz Magazine, The Denver Post, The Scotsman mortgage broker guide, Mortgage Professional America and various other national publications.
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