The United States is the world’s largest economy. It can be and has been brought to its knees on many occasions throughout history by real estate loans. As the US rode thru these cycles of real estate boom and bust, it was gradually seen as good business practice to have an impartial third party estimate real estate value before a loan was approved. This 3rd party analysis, although adding expenses to the loan, was considered a prudent check for the bank, and assisted them with loan underwriting. Thus the real estate appraiser was born.
Days of the Wild, Wild West for Appraisers
For many decades, anyone could say they were a real estate appraiser, simply by saying that they were. Real estate appraisal was not a licensed profession, yet many lending decisions by financial institutions relied on an estimate of value from a real estate appraiser to help them determine if they should risk a loan to a borrower. From the perspective of the lender, (a bank, credit union, mortgage company, or savings and loan), they had to rely on an appraisal to provide a value estimate before they could justify a loan to a borrower.
But if appraiser’s were not licenced, how could a lender determine if a particular appraiser knew what they were doing? How could a lender determine if an appraiser was qualified to offer an opinion of value on real estate?
For many decades, professional appraisal organizations filled this void by training appraisers and offering certifications and designations to appraiser’s that joined their group and went thru their training programs. A lender may not know about the qualifications of a specific appraiser, but they did know about the American Institute of Real Estate Appraisers, (AIREA), or the Society of Real Estate Appraisers, or other similar organizations, (the AIREA and the Society merged into the Appraisal Institute in 1991).
A lender could trust that if an appraiser had completed the educational and experience requirements to obtain an SRA or MAI designation from these groups, they were likely qualified. So if a mechanism for training and qualifying specific appraisers to the satisfaction of the lending community existed, what happened to change this?
Lender’s Started Using poorly Qualified Appraisers
During the years preceding the Savings and Loan crises, some lender’s started using poorly qualified or ethically challenged appraisers. Good lender’s understand that leadership guides the business culture. A good bank has to look thru a lot of bad loan applications to find quality loans secured by well appraised collateral. These lenders will have modest loan losses during an economic downturn. (Sort of like a princess having to kiss a lot of frogs to find their knight in shining armor. And yes, I know it’s a little misogynistic, but keep reading anyway).
A good lender with a good culture will set up an expectation for quality loans that is understood by everyone including loan officers, processors, and closer’s. A good lender would track loan losses and track the percentage of non-preforming loans. Loan officers would not want their name associated with bad loans, and a good lender would consider the bad loans brought into the organization before promotions or advancements were offered to staff.
On the other hand, a bank or financial organization with a goal of 20% annual loan growth over the next five years, and doing whatever it takes, (including finding and using ethically challenged appraisers), will likely not survive an economic downturn. Such a lender would put more emphasis on loan volume by month, by loan officer, and by annual loan growth. Anyone who protested the unsafe loan growth would be at odds with the company culture; a culture where the appraisal process, the underwriting, and the rapid closing of loans are more important than the safety and soundness of the assets being booked.
Lenders Want to Lend
I get it. Lender’s are in business to lend. There is pressure from everywhere to place money into loans, to generate a return to the stock holders (for banks and other private companies), or to generate cheaper financial services to members, (if a credit union). They want to lend, and they have the money to do so.
But they have to underwrite the loan, to make sure that the borrower is going to pay them back. Quick question, – How many times does a banker lend to somebody that he knows is not going to pay him back? Answer – Never. The banker has to believe that the money he is lending will be paid back in full with interest, and on time. That said there is that never-ending pressure to lend.
So a borrower comes in to a commercial lender and wants a loan. Both the lender and the borrower have a vested interest in making a deal. The lender wants to make a loan and generate interest monies for the bank, and the borrower wants the money because it increases his return on investment, and decreases his risk. Because real estate loans can be risky, (many banks, S&L’s and credit unions have failed over the decades because of bad real estate loans), federal law requires that federally insured banks and other financial institutions obtain an independent opinion on the collateral value for most real estate loans before committing the money. The regulatory agencies that insure the deposits of financial institutions didn’t start insisting on third party appraisals because they could, they did it because of all the people that lost deposit money when their bank failed because of bad loans, and then they raised hell afterward, demanding that congress insure it never happens again.
Congress responded to the will of the people, and passed laws and created regulations that are intended to insure that banks and other financial institutions protect their depositors by administering the bank in a conservative fashion. But the problem with bank policies that are conservative is that they make money very slowly, often with slow growth of the financial institution. And some lender’s want to grow muc
Quicken Loans is the largest mortgage lender in the United States as of 2018. They provide a popular residential loan product called Rocket Mortgage. Quicken is not a bank. A traditional bank or credit union takes deposits from savers and lends them out to borrowers in the form of mortgages, car loans, and personal credit. These traditional banks are heavily regulated by federal and state governments. Quicken, and other similar mortgage companies, rely on investors to make loans. Unlike banks or credit unions, investor monies are not guaranteed. The risk these investors are taking is fine, so long as they understand that they could lose their investment. None of it is guaranteed, unlike a bank.
When real estate prices are falling, (like they did in 2007 – 2011), lender’s must sell their loans at depressed prices to be able to return money to investors, and this creates a downward spiral, making the downturn worse as the value of declining loans are sold at lower and lower prices to pay investors. It should be noted that the last recession was caused in part by non-bank financial institutions, (like Lehman Brothers, Bear Stearns and AIG).
Quicken loan reached a $32.5 million dollar settlement with the US Department of Justice for knowingly approving loans insured by the FHA to unqualified borrowers, which cost the government millions.
Liar Loans are Back
A liar loan is a mortgage the relies on little to no documentation to verify income or assets of the borrower. It is also know as a “Stated Income Loan“, a loan in where the borrower justs fills in an amount on the loan application about what they make – and the lender does not bother to verify the borrower’s income claim. It relies on the “Honor System”.
During the financial crises that started in 2007, liar loans were at the center of the crisis, with residential mortgage backed securities failing in mass because the underlying loans went bad. This was caused by fraudulent origination practices that bundled bad loans into securities that were then sold to unsuspecting investors. It has been estimated that liar loans contributed to 70% of total losses.
Commercial real estate (vs) residential real estate
Commercial real estate lending is vastly different than residential real estate lending. Residential lending often focuses primarily on the quality of the borrower, and their ability to repay the loan, Although commercial lenders also evaluate the borrower’s ability to pay back the loan, they also want to know about the properties ability to generate revenue. A commercial lender will want to know if the property itself can produce enough revenue to repay the loan.
How commercial lending is different then residential lending
- Residential lending is typically made to an individual, while commercial lending can also be made to corporations, partnerships, trusts, and other legal entities.
- Commercial properties are often multi-tenant, where the revenue from the building is used for loan debt service. Income from tenant leases must be analyzed in detail to provide a clear picture of the properties ability to repay the debt service.
- The borrower will need to submit cash flow statements, leases, tenant improvement obligations, income and expense data for several years, including rent rolls and operating statements.
- Commercial lender’s need to understand how to take all of the above and calculate a net operating income, how to select an appropriate capitalization rate, how to calculate a debt coverage ratio and understand and analyze a discounted cash flow (DCF).
- A good commercial real estate appraiser can help with all of that.
Commercial real estate (vs) residential real estate
According to CrediFi, US lenders provided $925 billion in commercial real estate in 2018. Lenders have a great deal of risk in the current economy, particularly if the economy slows. The Federal Reserve reports there is $4.1 trillion in commercial real estate debt, with banks holding 55% of that debt. Risk to banks revolve around construction loans, because of 10% per year increases in construction costs. Banks typically fund 75 – 80% of new construction costs. If a project takes two years to finish, with construction costs increasing at 10%, banks could end up with a 90% loan or higher – increasing risk. And banks typically have the lending expertise to analyze these scenerios.
Credit Unions Should be Cautious
In 2019 the National Credit Union Administration (NCUA) raised its commercial lending threshold before an appraisal is required to $1,000,000. Raising the de minimis to $1,000,000 for credit unions makes no sense, given that most credit unions do not have the expertise to lend on commercial property. The Savings and Loan crisis of the 1980’s was due, in part, to deregulation that included allowing S&L’s to lend on commercial real estate. Unfortunately most S&L’s had no experience with commercial property, and they ended up losing millions. Credit Unions would be wise to learn from recent history, and be very cautious of lending on property types they do not thoroughly understand. A good commercial appraiser can help with that, but credit unions need to understand that the higher percentage of loans that they have in commercial property, the more likely they are to fail, as was evidenced by the failed banks and S&L’s of the 1980’s.
Low Commercial Appraisal (vs) Low Residential Appraisal
When a residential appraisal come in under the purchase price, or under the value that the lender wants, many bad things happen. The homeowner is not happy because they don’t get to sell and or buy the house at the contract price. Perhaps they don’t get the full amount of the loan they wanted from the lender. Perhaps, as a buyer, they have to make up the difference between the contract price and the appraisal or lose the property to another buyer.
The AMC is upset at the low appraisal, because they get calls from the lender threatening to find another AMC that will give them the values they want. To save the deal, the AMC will often ask the appraiser if he looked at all comparables, (typically higher priced). The AMC will engage a different appraiser, and will likely not every again engage the original appraiser.
The lender is upset because most don’t hold the mortgages they underwrite. They sell them back to Freddie Mac or Fannie Mae. If there is a problem with the appraisal, they can’t sell the loan and reload with new money to start the lending cycle again.
Comparatively, the bank doesn’t get to sell their loan to Freddie or Fannie – there is no such buyer in the commercial market. As a result, an competently written appraisal with good analysis that comes in low is often considered good for the bank – meaning that they won’t have an underperforming loan on the books.
The theory of using a real estate appraiser is that the appraiser is the only independent or a neutral party involved in the transaction, as opposed to borrowers and lenders, who all have a vested interest in the outcome. An experienced appraiser can bring specialized knowledge of local real estate markets to the transaction, and can act as a check on the amount of money the bank or lending institution commits to the project. In essence, an appraiser can kill a deal, and that is why many in the residential lending community often do their best to circumvent a low appraisal, or an appraiser in general.
How do home lenders circumvent the appraiser?
Raise the appraisal threshold. Current regulations state that if the loan is federally related, (where the lending institutions deposits are guaranteed by the federal government), that appraisals are only necessary if they are lending on a property valued at more then $500,000 for commercial, and $400,000 for residential, (these values were recently increased in 2019 from $250,000 for both residential and commercial values). The National Credit Union Administration has raised its commercial lending value to $1,000,000, which will likely encourage other players, like the FDIC, to raise their commercial appraisal threshold.
Blacklist Appraisers. Lenders are not supposed to go appraisal shopping, but sometimes they still do, (Dodd-Frank laws). A real estate agent might know that a particular appraiser has been assigned by a lender to his deal, and says, “this appraiser killed by last two deals. You need to reassign this appraisal to a different appraiser”.
Lender’s can often use an AVM, (Automated Valuation Model), which uses a mathematical model to estimate property value, (think Zillow). AVM’s are usually cheaper than a full appraisal, and are much faster. But they can be wildly inaccurate, depending on the availability of public records in a particular geographical area. They often don’t include neighborhood changes or property improvements that they have no data on. They don’t provide information on property condition, and typically don’t provide a detailed market analysis.
Instead of using a local appraiser who knows the local market, hire an appraiser from out of the area who will work for less. Or use a “Hybrid Appraisal”, where an appraiser who never visits the property will look at interior pictures provided by a third party and provide an estimate of value, typically for $50 – $100 per assignment, significantly less than the typical fee of $350 – $500 per assignment. Often these “third parties” measure the property and take photos, and are allowed on the property without a criminal background check, as is required of almost all licensed appraisers.
It should be noted that Fannie Mae allows exterior only property inspections using Desktop Form 2075, but it requires that the appraiser look at the property from the street. “Hybrid” or “Bifurcated” appraisals have property inspections and measurements often taken by non-appraisers, with little or no training on how and what to inspect. In addition, these “hybrid” or “bifurcated” appraisals are typically on a form or report provided by the AMC or lender, and not the appraiser. But they are faster and cheaper, and therefore are often favored by the lending community for portfolio management, foreclosure, or pre-foreclosure, regardless of the increased risk they bring to the loan by not having a trained and licensed professional physically inspect the property.
Yes, the world still needs appraisers, and if you are in the profession, you can see it plainly. But the rest of the world won’t figure it out until the next financial crises causes by real estate loans. But even then, likely rule changes won’t benefit the appraiser, rather they will benefit they groups that can hire lobbyists – Appraisal Management Companies and companies providing Automated Valuation Models.