Why All Appraisals are Always Wrong
Appraisal Bias & Appraiser Pressure: Why All Appraisals are Always Wrong
Real estate markets cooled down in the fourth quarter of 2014, and despite historically low interest rates, refinance volumes dropped as well. The increasing pressure on lenders and real estate agents to maintain loan and sales volumes has brought about renewed interest in appraisal accuracy and increasing concern that residential real estate appraisals are inflated.
A recent Wall Street Journal article asserts that
“home appraisers are inflating the values of some properties they assess (appraise), often at the behest of loan officers and real estate agents, in what industry executives say is a return to practices seen before the financial crisis.”
This is a legitimate concern. It is widely believed that faulty appraisals played a role in both the duration and magnitude of the financial crisis of the 2000’s. However, faulty appraisals were more enablers of the crisis than creators of it.
The majority of residential appraisers do a great job, but there are some appraisers who lack education, ethics or both, and who are often the target of unscrupulous lenders and agents.
One key reason some appraisers give in to pressure is that they believe that if they do not give in, before long they will have very little work and pressure from real estate agents for the appraiser to simply endorse the contract price is ever-present.
The Appraisal Process
There are three traditional approaches to establishing real estate value: the Sales Comparison Approach, the Cost Approach and the Income Approach; the Sales Comparison Approach is the most commonly used and most widely known. In this approach the appraiser compares the property being appraised to similar, nearby properties that have recently sold using the selling prices of those “comparable” homes as a basis for the value of the home being appraised.
In the Cost Approach to value the appraiser calculates the replacement cost of the structure(s), less any depreciation, then adds the value of the underlying land to develop an estimate of the replacement cost.
The Income Approach estimates the value of the property based on the amount of rent the property might produce. This approach is more commonly used in non-residential properties, and although it has application in residential valuation, historically, there has not been much readily available rental data; therefore most residential appraisals do not include this approach.
Typically, when an appraisal does not support either the contract price in a purchase transaction or the threshold value required to complete a refinance, the blame goes to the appraiser. The predominant complaint is that the appraiser did not use the best comparable sales (known as “comps” in the industry) to support the value.
Responding to Appraiser Pressure
Appraisers are poorly armed to fight back in part, because the appraisal process itself is fundamentally flawed. Since the Sales Comparison Approach is the only approach developed, whoever can more persuasively demonstrate that their comps are the better comps often wins the battle. Some appraisers become battle worn and concede to use the supplied comps in order to conclude the assignment without rendering themselves ineligible for future work by being “uncooperative”.
Part of the problem is that nearly a decade ago the GSEs announced that, with rare exception, residential appraisals no longer required completion of the Cost Approach to value. Since the Income Approach had long ago gone out of use in residential lending appraisals, this left only a single approach – the Sales Comparison Approach. It isn’t so much that the Cost Approach itself was critical, rather, with the Income Approach already gone, what was lost was the only information against which to cross-check the outcome of the Sales Comparison Approach to value.
A primary reason for developing more than one approach to value is to test the reasonableness of any one approach against the outcome of another approach. When multiple approaches produce tight agreement, there is greater confidence that the outcome is sound. When there is a lack of agreement, one or another of the approaches is most probably flawed.
A single approach to value is risky enough by itself, but when the only approach is Sales Comparison, the conclusion rendered is not a value opinion; it is simply a price opinion. When collateral risk policy is built around GSE form appraisals, every loan is a potentially risky loan simply because the basis for assessing value risk is a price-focused process. Since the entire residential mortgage lending system is built around these forms, the entire system is at risk. Instead of mitigating risk, the current appraisal process actually increases risk.
An appraiser is really a researcher. Fundamental tenets of research require that all aspects of the problem are addressed, and that the researcher’s conclusions are based on sound evidence and logic. Final research results should anticipate and refute counter-arguments before they are raised by others. Results from various methods of research are correlated to a conclusion. In a single approach appraisal research is confined to a very narrow subset of the relevant data; only one answer is returned and there is nothing to correlate.
The price isn’t always right
The concern about appraisal error is currently focused on inflated values. In reality, errors in valuation whether overstated or understated create problems that impact the entire financial system. The problem with identifying appraisal error is that the measure of error is almost always made against home sale prices, which presupposes that the sale price is always an accurate representation of true value. In the Wall Street Journal article cited above, Michael Fratantoni, chief economist at the Mortgage Bankers Association “cited the agreed-upon purchase price among the best measures of a home’s value.” Since other efforts to quantify appraisal error use automated value models (AVMs), I would agree with Mr. Fratantoni that an agreed upon purchase price may be a better measure than an AVM, but only marginally so, and only when markets are very stable.
But what if there is error in purchase prices themselves? My research (The Adverse Effects of Single Approach Appraisals and Single Point Valuations) demonstrates volatility in market prices for residential real estate, even in very stable markets with nearly identical homes. Where homogeneity is lacking, volatility and lack of precision is greater. What if the agreed upon purchase price is a result of multiple offers where the highest bidder’s offer is the agreed upon purchase price? That price is the highest probable price, not the most probable price and does not represent market value as defined in banking regulations. Yet, upon closing, that price is now a benchmark for measuring appraisal error.
Ultimately, there is a clear lack of precision in house prices themselves which makes it impossible to claim that an appraisal is fundamentally wrong simply because it disagrees with a selling price. To the same extent that there is a lack of precision in selling prices, we must accept that there is no such thing as absolute precision in appraised values as well.
How do we solve the problem?
The essential starting point is recognizing and accepting that the marketplace itself is imprecise. Once we accept that premise, we are eligible to address the appraisal process. As long as we impose the idea of a single, accurate value on each property we will be confronted with an unsolvable problem of so-called inaccurate appraisals.
There are several steps that need to be taken to restore confidence in the residential valuation process. The good news is that we now have the data and the technology to take these steps quickly and effectively.
First, the single approach appraisal must be eliminated. The Sales Comparison Approach remains vital, but it simply cannot stand alone. The depth and breadth of building cost data today is remarkable. Coupled with robust analytics available right at the appraiser’s desktop, developing a credible Cost Approach to value is a practical and essential step in the valuation process.
Further, recent interest in single family homes as rental investments, evidenced in part by the creation of the first Real Estate Investment Trusts (REITs) made up of single family homes means that there is a growing pool of data from which reliable income data can be drawn for development of the Income Approach to value for residential homes. A credible Income Approach to value can and should be developed for most owner-occupied homes in the country today.
By expanding the scope of research and analysis beyond just recent sales, the conclusions developed become real values instead of merely a reflection of recent prices. Speculative price inflections can be identified for what they are and value related decisions can be made more responsibly.
…pressure to bring the number up to one that supports the deal…Second, the requirement for pinpoint valuations is itself a big contributor to inflated values. Appraisers know that a pinpoint number just a single dollar below the contract price or refinance threshold means that there will be a lot of questions and either direct or implied pressure to bring the number up to one that supports the deal. Non-complicit appraisers are labeled as “deal-killers” regardless of how much evidence they may have to support their opinion.
Allowing appraised values to be communicated as a range (e.g. the value is between $195,000 and $205,000) would remove a lot of the pressure from appraisers and shift final responsibility for the lending decision back to the lender where it has always belonged. The lender can decide where within the value range the loan amount should be pegged based on the additional information only the lender has about the income, assets, credit and character of the applicant. Using a range would clearly illustrate the degree of agreement among the various approaches to value. Simply put, the tighter the agreement, the greater the confidence.
Requiring appraisers to be responsible for a degree of precision in value conclusions that is not achievable in the very marketplace they are measuring puts appraisers in an impossible position. The market silently acknowledges the lack of precision and accepts it now – as long as the error is upward and not truly random, that is, as long as it is not equally spread above and below the agreed upon contract price or refinance threshold amount.
The standard for determining an appraiser’s performance is the Uniform Standards of Professional Appraisal Practice (USPAP). This set of performance standards does not require accuracy or precision of the value opinion; it requires credibility of the value opinion. A range of values based on multiple approaches with support through relevant evidence and logic seems far more credible than a single number that implies all other numbers – no matter how close – are not correct.
For decades now we have known that there is a problem with appraisals. The discussion has always focused on the appraiser, the loan officer, the real estate agent or the appraisal management company. The elephant in the living room is the appraisal process itself.
This article was originally published in AppraisalBuzz.
Appraisal Bias and Appraiser Pressure
- AMC Hires a Convicted Felon as Property Data Collector - May 5, 2023
- Borrowers With Good Credit Scores to Foot the Bill for Higher Risk Borrowers - April 21, 2023
- FNMA Property Data Collectors Program Violates WV Law - April 19, 2023
NOW FOR THE CONUNDRUM
Technically speaking however, an appraisal can never be wrong IF it an appraisal is an “opinion of value”.
In the end the value most similar to value sought by, the Realtor, the bank, or FNMA is seeking is the “right value”.
This is just a bunch of BS. Tell me how the cost approach is relevant to anything that has depreciation. Afterall, we give an effective age to each property we appraise, which should theoretically assist with estimating depreciation for the cost approach, but is that number going to be the same for every appraiser, no. Is every appraiser going to come up with the same site value, no. The Cost Approach is too subjective in nature to be a reliable indicator of value. Just like c3 vs c4… We have 4 appraisers in our office who have varying opinions on what a c3 looks like vs a c4. We decided to just make all homes between 1 and 5 years old c2, all between 6 and 20 c3, all over 30 c4. Unless completely remodeled – exterior, interior and mechanicals, then use the condition rating proceeding its age group, and use c5 for homes with issues that need repair, and never use c6 because that’s basically a tear down. To hell with Fannie Mae and her stupid nonsense rating system. The more variables that have to be considered the less reliable the opinion of value/confidence level. There is no exact science to what we do because the market is imperfect. If you are looking for a value range, just look at the adjusted or unadjusted range of sale prices for the comps used in each report. If you have truly comparable properties in your report they should provide a range of value that should represent a reasonable selling price range-assuming buyer and seller are equally motivated, and market conditions are stable, and so on. Any number within that range should be acceptable. This whole idea that we have to be precise with adjustments or else the value could be flawed is wrong. The value range is an exact science, the number within that range is an OPINION. The opinion of value isn’t and should not be an exact number because as was stated the market is imperfect. It’s full of uninformed buyers who think it’s ok to pay more for stupid things that shouldn’t add value, like staging, paint colors, landscaping, door knobs and handles, light fixtures….minor cost items which don’t have a significant impact on value, but may help marketability. Just compare home sales to electronics.. You have three phones. Each has everything the other has, but one is blue one is black and the third is sparkly. The black one is on sale for 100 dollars and is the one that most consumers are buying. The blue one is 110 and the sparkly one is 120. But this is a decision you have to live with and you really want a blue phone, so even though the smart thing to do is buy the black one, you end up overpaying for the blue one because it has something you want more…the color is blue, and the sparkly one is more expensive. So one appraiser will say the phone is worth 100 dollars because that is what the market shows with the most buyers, and one appraiser will say it’s worth 110 because that is what the buyer is willing to pay for it, and one will say its worth 120 because that is also a reasonable price, after all the only difference is the color preference. So now we have three different opinions. It doesn’t matter what opinion you have as long as it is in that range. ????
Mr. King’s article is excellent and remarkably applicable in all areas except the conclusion. With respects to our associate “Clint”, who disagrees, the description and applicability of each appraisal technique is spot on. We may quibble on the uniform applicability of the income approach on sfr’s, but the rest is very accurate. (Clint-there is no need to wonder what a C2 or C3 ‘looks’ like. FNMA has pretty well spelled out what THEY thin it entails. I don’t like their UAD system at all, but I have zero difficulty in understanding or applying them).
It is the article’s conclusion I disagree with (strenuously). It is not the appraisal or the appraisal process that is the fault. The ‘fault’ is in the ambiguity of enforcement language at all levels of the process.
“Reasonable & customary” is the most abused. Fees are ridiculously low and only “customary” as a result of price fixing and artificial price suppression by AMCs that ‘take their cut’ for doing banks administrative appraisal management out of the appraisers side of the total fees paid.
Faster and cheaper has been the mantra of all mortgage banking and traditional lending sources. FNMA & other GSEs are complicit in that they keep removing entire sections of meaningful appraisal (cost approach) techniques instead of requiring US to demonstrate their inapplicability when applicable.
Put the price of a non complex FNMA conforming loan appraisal up in the $650 to $950 fee range where it belongs and require all three approaches, and appraisal quality WILL improve across the board.
Prohibit ALL lenders from owning ANY share in AMCs (Such as Wells Fargo in Rels). Prohibited pressure is unavoidable; as I will be writing to WF’s Executive Board about, next week for an extremely well documented case of alleged pressure to hit a number; suspension for failing to do so, and then making a loan based on an over valuation of $100,000. Of course they are welcome to call me about it first. Mike Ford (714) 366 9404, American Guild of Appraisers Peer Review Committee.
There is no difficulty in determining c1, c2, c5 or c6. It’s the difference between c3 and c4 that’s difficult to decide when the home is around 20 to 30 years old that’s the problem. Fannie should simplify the whole thing so that there are categories…new, like new, major updates, some updates, no updates, fixer upper. That makes the most sense. Plus it’s easy enough to figure out by looking at Realtors comments and photos on the MLS. The majority of homes will fit in the “some updates” category, and make our lives easier. I just want to know what most appraisers use for a home with no kitchen or bathroom updates, but in good condition; having been well maintained, when the home is 20 to 30 years old. Is it c3 or c4? Or a home with an updated bathroom, but no kitchen updates, or a home with updated exterior..siding, windows and doors, but no cosmetic updates. Furthermore, what if you have a home with only a new roof on the exterior and in the interior it is completely remodeled? Call me an old timer, but the old way made sense to me, now I have to think and waste more time hoping that I choose the condition rating that my peers will. It takes hours longer to complete an appraisal nowadays because lenders require more comments due to all the extra stuff Lenders keep throwing at the appraiser, mostly which has nothing to do with value.
On another note, does anyone use alamode’s comp database? I have a major complaint about that. When I sign a report I have the option to choose to import the comps into the comps database, but when it finds that a comp has been used in a previous report, it doesn’t tell me the q or c rating used on it, so I have no idea whether I picked the same q or c rating for it as I have in a previous report. Since Fannie is checking you’d think alamode would want to make certain that we don’t mistake these fields. Why can’t the software check to see if we have used the comp while it is being entered. There’s an idea. After the address is entered a quick check in the database would ensure the information pertaining to the comp is consistent.
So I’ve ranted enough. Sorry to be such a grump, but I really hate how this industry is constantly being blamed and not trusted.
Clint, a la mode is actually releasing a new free tool called SmartAddress. It automatically looks for prior uses of the subject and comps and flags for inconsistencies. For more info click on this link.
That sounds exactly like what I need. Thanks for providing the link. Only problem is they make it for Total, but not Aurora. I guess I’ll have to upgrade.
Good article, but disagree with the premise. It’s the aggressive parties who play the market that set the stage for the rest. Silent partner LLC, foreign investors, flippers and floppers and everything in between, including lending rate manipulation, which is a sellers game. They pump or dump the price, and that’s the wave the rest of the market follows. Then you’ve got external pressures which alter the effective market valuation rates and purchasing power, through income analysis. A subsidised person can quite often pay more than an unsibisided one. As the HUD rental price scales are tied to area median incomes, as incomes go up, so does rent, so does subsidies, so does purchasing power, so does area rental costs from little individual section 8 voucher homes to major corporate entities who run multiple section 8 or subsidised projects. Subsidy happens on multiple levels, and hence we get purchase value misalignment, market to market, quite often based on the populace demographic and the ratios of subsidies. Home price hardly has anything to do with actual cost anymore, especially considering the restrictions to market entry for a guy who just wants to build his own home. Enter the PUD’s, a control mechanism which promotes larger building projects. Then cost comes into play because the entire new home construction market rides those mv and income waves as well. They calculate affordability, and make sure they’re at least the same or more expensive than the rental markets. Cost figures rise yearly. And it all revolves around inflation, rate control, and the effective value of the dollar. External influence drives the appraisal valuation points. I’m just the analyst who reviews current market data to make sure the purchase agreement is aligned with existing market trends. But somehow the appraiser is blamed for rising markets when they utilize existing data points as proof. How does it go again? Oh yes; in a normal open market scenario with buyers and sellers acting prudently? What is prudent? Who defines that? Not the appraiser, that’s for sure. We have such a limited participation in the bigger picture of lending, that focus on the appraisal as the culprit of rising market trends is completely illogical. We apply the process of checks and balances to individual market deals, not the larger market. The larger market is controlled by the Fed, whom controls the value of the dollar, the rate, the purchasing power of buyers, and hence, the price. If you show me data misrepresentation, quality misrepresentation, extremely out of range contract offerings, etc, I’ll catch that for you and make sure you’re protected. Put me into an appraisal scenario with constant market over valuation trends, and there is not a dang thing I can do about it except to report that such trends are ongoing. Lenders make the lending decisions. I just look at the data.
There is always something wrong with the appraisal, if the lenders risk factors don’t add up they way they would like. But as I don’t create risk, I cannot control risk. The thing about over regulation is that an appraiser can’t win. Sometimes I say; I wish I was good enough to do the job correctly. Well of course I am, but that is sarcasm which illustrates the illogical emphasis on the appraisal as the ultimate safegaurd for lending viability. If lenders were not backed by taxpayers funds, and the FED which controls the rate not a private institution ran by those very same lenders, well, you know how the story goes.
Has anyone seen this before?
New UW conditions: I was asked to clarify why my information from county records and MLS did NOT agree. County records and Realtors have been putting in there records that a home has more bedrooms & bathrooms then they actually have! County does it to increase TAXES & the REALTOR does it to increase sales price.
Example recently completed a 4 bedroom 4 bathroom home with a basement of say 2000 sf, main level of 2000 sf & 2nd level of 2000 sf. Realtor shows as 6000 sf with 6 bedrooms & 6 bathrooms (at $300 sf), county shows as 4,000sf with 6 bedrooms & 6 bathrooms and I’m left to explain why. It did not end there even with a sketch & measurements I was asked to clarify whom was correct. 29 years over 12000 appraisals and now I have to prove my existence. Is this a deliberate or just a coincidence? Except it has happened more then once and now that reviewers are getting UW information on a property that is tainted from the county and the REALTOR where does that leave the appraiser. rhetorical. The assessors job is not to follow fnma/fha/va guidelines of reporting above ground sf! The REALTOR only want more money no matter if the living space is above or below ground and the assessor only wants more TAX money and the appraiser’s are left where