Dumping Workfiles

Visitors to my basement at one time were treated to the sight of dozens of file storage boxes stacked there. The majority of those appraisal workfiles dated from my tenure as a staff appraiser from 2003 - 2004. USPAP requires that a copy of the appraisal and the workfile be retained for 5 years from the effective date of the valuation. After that the files can be discarded, but the rules governing client confidentiality have to be followed. As a result, when the files reach their fifth birthday, I use them to heat the house.

While going through the boxes (yes, I do glance at the reports to make sure I do not inadvertently destroy something which should be retained) I found the following peer review done by a third appraiser regarding my appraisal of a home and the value opinion provided by another appraiser retained by a litigious borrower:

"November 4, 2004

I have been asked to review two appraisal reports that were completed on this property. The first report was completed by James Hrubik based on an interior viewing of the home on February 12, 2004 and the indicated opinion of value was stated as $33,000. A second report was completed for a different client by Appraiser X based on an interior viewing of the home on August 18, 2004 and the indicated opinion of value is stated as $70,000. For this review I viewed the exterior of the subject property and all comparable sales used and have attached photos of these properties and a location map to this review. Please note that approximately six months have transpired between the effective dates of these reports and I am therefore unable to confirm if the condition of the home had changed in this period of time.

For this review, I surveyed the Akron Area MLS and public record information. The MLS describes this neighborhood as Southwest Akron and is Area SUM34. Per the MLS there had been a total of 93 sales of single family homes of all property ages and styles in the twelve months preceding the effective date of Mr. Hrubik’s report. The price range was $3,000 to $134,900 with nearly 2/3 of all sales ranging between $3,000 to $30,000, and many were described as being ‘Bank Owned’. The median price was $21,500 and virtually every sale between $71,900 to $134,900 was described as being a ‘New’ home.

The report completed by Mr. Hrubik provides a neighborhood description that states this is an urban neighborhood with property price ranges between $10,000 and $125,000 with a predominant price of $40,000. The age range is described as being from New to 100+ years with a predominant age of 80 years, which is reasonable and consistent with MLS data. Mr. Hrubik selected three sales for his analysis that were offered in the MLS and I was able to verify the sale price and property features as reported based on the MLS descriptions and public record information as follows:

Comparable #1: 643 W. Thornton sold in 9-2003 at $30,000 after being listed at $32,000 for 54 days. The property descriptions are consistent though Mr. Hrubik fails to report that this home was reported to have a finished basement rec room with wet bar and a negative adjustment could have been included. There was no prior sale or listing of this home in the previous 36 months.

Comparable #2: 987 Laurel Avenue sold in 10-2003 at $29,500 after being listed at $32,900 for 119 days. The property descriptions are consistent with the data sources noted. Though there was no prior sale of this home in the 36 months prior to the date of value, the home had been offered for sale in the MLS on two previous occasions, once at $49,900 for 184 days until the listing expired on 2-14-2002 and again at $39,900 for 92 days until the listing expired on 7-31-2002.

Comparable #3: 994 Celina Avenue sold in 10-2003 at $33,530 after being listed at $34,900 for 122 days. The property descriptions are consistent with the data sources noted. There was no prior sale or listing of this home in the 36 months prior to the date of value.

All three sales are in close proximity, similar in age and living area, and were within six months of the effective date of value and are therefore considered relevant and reasonable. Each was listed for sale with a professional Realtor and had adequate market exposure in the MLS.

As noted, I was also provided an appraisal report completed by Appraiser X for a different client and have found a number of significant deficiencies with the report. The neighborhood is described as being ‘Suburban’ rather than ‘Urban’. The neighborhood price range is stated as $50,000 to $90,000+ with a predominant price of $60-75,000 which clearly contradicts MLS data for this neighborhood. In addition the age range is 60 to 100 years which does not include a significant number of homes in this market that are much less than 60 years old. Appraiser X fails to provide the FEMA flood zone information which leads me to question if she had adequate data sources for this community. The land value estimate of $15,000 is not reasonable for a site of 32’ x 132’ in this urban setting as this is more than 50% of the total sale price of nearly 2/3 of the reported sales in the MLS as noted above. Finally, Appraiser X provided three sales in the market analysis that were non-MLS transactions. The data source stated (Auditor’s Office/Exterior Inspection) does not provide information regarding any terms of sale, property condition, or if the transaction was at market and arm’s length. Other concerns regarding these sales are as follows:

Comparable #1: 817 Raymond is reported to have sold in 4-2004 at $72,000 per public record information. Appraiser X states that there was no prior sale of this home in the preceding 36 months. However, this home was offered in the MLS at $20,000 in 1-2004 and transferred to SMB & A LLC in 1-2004 at $14,000. The home then was sold in 4-2004 at $72,000 with terms and conditions of the transaction not known nor is there verification that the home had been restored for this purchase. Appraiser X’s failure to disclose the previous recent sale is a violation of USPAP and leads me to question if this was actually a ‘flip’ transaction.

Comparable #2: 1006 Nathan is reported to have sold in 11-2003 at $67,000 per public record and seller. Appraiser X fails to disclose that the [n.b. - I deleted this buyer-seller relationship disclosure for retention of confidentiality] and is likely biased toward the transaction. Failure to disclose this relevant information regarding the seller is considered misleading as a typical reader would assume this was a verified and unbiased transaction. There was no prior sale or listing of this home in the 36 months prior to the effective date of value.

Comparable #3: 640 W. Thornton is reported to have sold in 2-2004 at $75,000 per public record, The data source can not be used to verify the terms and conditions of this transaction nor the condition of the home at the time of its sale. However, upon my exterior viewing on November 3, 2004 this home appears to have been vacated and at least one window is broken which again leads me to question the reliability of this sale. No other sale or listing in the preceding 36 months was found in data sources for this property.

It is highly unusual for a qualified appraiser to not utilize the MLS as a primary data source for this established urban neighborhood in the city of Akron, which leads me to question if Appraiser X had adequate experience or resources to have accepted this appraisal request.

For the purposes of this review, I also surveyed the MLS for active listings in the subject’s neighborhood to help establish a reasonable upper limit of value for homes of similar vintage.

Currently, a property at 388 Raasch Avenue is offered for sale at $45,000. This home is described in the MLS as being completely renovated including newer drywall, carpet, furnace, A/C, windows, roof, kitchen with oak cabinets, newer bathroom. The home is reported to have been built in 1925 and offers 1128 sq ft living area, which would be competitive with the subject. As noted, this home has yet to sell and has been on the market for over 200 days. It is my opinion that this active listing provides some helpful insight into this neighborhood for homes that are renovated to this degree.

For these reasons I am of the opinion that the value as reported by Appraiser X is without merit or support. The neighborhood description does not accurately reflect the reality of the predominant sales activity in this market area. The use of questionable or unreliable sales data without utilizing the MLS in this market, or seeking assistance from someone with access to the MLS, leads the reader of the report to unreasonable conclusions and for this reason the report is misleading."

I remember that incident well, as I was required to sit beside my client's attorney as we faced the borrower and his counsel. That is how I managed to get a copy of the review. Also, because the report was involved in litigation, it and all pertinent files need to be retained an additional five years beyond the settlement of the dispute.

The rest of the story? The borrower (who wanted to borrow about $60,000) claimed my client would have made the loan had the borrower been a member of a protected group. Appraiser X, whose office was 60 miles away, was brought in to make the case that I had significantly undervalued the home and that my client had utilized it in an attempt to prevent the loan. It is of interest that I was not named in the suit; there was nothing in my report which could have been interpreted as bias. I just had not come up with the correct number, and my client trusted my judgment.

No mention was made anywhere in the proceedings that the tax appraised value of the home was only $30,750. My client settled out of court by agreeing to hire a fourth appraiser who managed to appraise the subject property for about $45,000, thereby allowing the client to loan the borrower the tax appraisal amount and still stay within Federal guidelines.

To my knowledge the second appraisal was never submitted to the Ohio Division of Real Estate for review; protection of Appraiser X was possibly a part of the settlement. Now you may have a bit more insight into why the banking industry was in need of a stimulus in 2008.

Finding the First Corner

Fable of the Day

An old man watched a young boy tease a bear that was tied to a tree with a rope. Each time the bear would rise, the boy would back off. Each time the bear would sink back down, the boy would poke it with a long stick. The old man asked, "Sonny, what do you think you are doing? If that bear gets loose, it will tear you and everybody else in the neighborhood to shreds."

"No worry, old man." says the boy. "I'm just playing the stock market."

.........................................

We proceed with my underlying claim that an investment whose value is based solely on the ability to "flip" an asset is on shaky ground.

The Fannie Mae Form 216 (Aug '88), Operating Income Statement, is a frequently neglected tool that should be included with any appraisal of a 1-4 family income residence and critically scrutinized. The biggest problems (at least from my perspective) center around the facts that:

• most appraisers have no real-world experience or training in the maintenance and operation of a residential rental
• most appraisers lack the experience to adequately address the need for periodic repairs to real property, and,
• as a result, appraisers using the 216 generally accept borrower estimates or simply PFA to fill in the blanks.

When this is followed by a reviewer or an underwriter who may not have been adequately trained to spot inconsistencies between the appraisal report and the 216, the Monthly Operating Income developed on the 216 will provide an unrealistic or even fraudulent indication of the property's net income generation potential. Fannie Mae requires this form to be properly filled out and submitted with every Fannie Mae 1025, Small Residential Income Property Appraisal.

The 216 should also be completed for every single-family appraisal (Fannie Mae Form 1004) where the home is to be used as a rental. It usually is not, however, because loan officers do not want to pay the additional fee most appraisers charge to do extra work, and in any event, it is easy to get around by simply claiming that the home is to be owner occupied. Unfortunately, there is no space on the forms to indicate whether the borrower already owns a dozen single-family homes within the county. (Such information is embarrassingly easy to find and is sometimes very difficult to hide, but has nothing to do with the valuation of the subject property. The amount of fraud seen by the average appraiser is incredible, but reporting it can be hazardous to his business. Maybe I should post a few war stories?)

If the subject property is a single-family residence that will be used as a rental, the Fannie Mae 1007 (8/88), Single Family Comparable Rent Schedule should also be filled out. This will provide an estimate of the subject's gross income potential, as of the appraisal date. In general, the rent comparables used in the Fannie Mae 1025 will be used for the same purpose if the property is a 2-4 family rental.

The front of the 216 is used to project the anticipated income and expenses for the next 12 months. It is sometimes necessary to survey income property owners to get a feel for what is typical in a given neighborhood; quite often the subject property's owner will underestimate his actual expenses. The form carries this statement :

"If the appraiser is retained to complete the form instead of the applicant, the lender must provide to the appraiser the aforementioned operating statements (n.b ' actual year-end operating statements for the past two years'), mortgage insurance premium, HOA dues, leasehold payments, subordinate financing, and/or any other relevant information as to the income and expenses of the subject property received from the applicant to substantiate the projections."

In over 20 years of residential appraisal practice, I have never had a lender provide that information. I always had to acquire it from the applicant, the property owner (if it was a sale), or market surveys. Many borrowers treat a request for such information with an attitude of offense, and market surveys are time-consuming because the competition in the rental market makes landlords treat such information as proprietary. It is, nevertheless, critical data, and on more than one occasion I have had to conclude that the projected Net Operating Income shows that the landlord's business is not viable. Once that happens, you have a very unhappy investor, who will never again willingly give you data about his investment plan. You also will have a very unhappy loan officer, who will try to guarantee that you never again get an appraisal order from his company.

So, what is so difficult about this Form 216? For one thing, is asks for items like projected vacancy and the "customary expenses that a professional management company would charge to manage the property". Those two items alone can sink the NOI. The second page, though, is the real killer. On page 2 is the Replacement Reserve Schedule. Many investors will ask, "What is THAT?". THAT is what causes many of the investors in my market to lose their investment.

Even assuming that the rental is unfurnished, and the tenant must supply stove and refrigerator, items like dishwashers, furnaces, central air units, and water heaters need periodic replacement. It is not unusual to see an appraiser indicate on a form that a home has a Remaining Economic Life of 40-50 years (hey - would you make a 30 year loan if the REL was 30 years or less?). Let us suppose you are talking about a duplex, with two of each. Assuming the equipment is brand spanking new the day of the appraisal, in a 50 year period the investor will need to buy and install two furnaces, four central air units, eight water heaters, and eight dishwashers. That is based on average life expectancies for those items. He will also need to re-roof the building at least once, and, based on my experience and the experiences related to me by local investors, will need to totally replace the flooring -- carpet and vinyl -- about nine times. Assuming he sells it at the end of the fifty year period, on that schedule, all of the replacement items would be needing to be replaced at that point, and he would be selling a building in need of updating.

The Replacement Reserve Schedule provides an amount that should be set aside each month to have money in reserve to complete the repairs that will be required over time. A wise lender would require an escrow account for those items, but using that criterion, I have never done business with a wise lender. Those figures are totaled and transferred to page 1 and added to all the other expenses to give the Total Operating Expenses. The numbers are then reconciled: the Total Operating Expenses are subtracted from the Effective Gross Income and divided by 12 to give a Monthly Operating Income. The Monthly Operating Income is then reduced by the Monthly Housing Expense (P & I on the mortgage, hazard insurance, property taxes, MIP, etc) to give a Net Cash Flow. If this form were completed honestly and properly, the percentage of loans made on residential rental real estate would plummet. In most cases, the only way to generate a positive cash flow is to reduce the amount that is to be borrowed, since that is usually the largest single monthly expense. This calls for a bigger down payment, and would spell the end of cash-out refinancing of most rental properties.

Next time we will look into the case of the honest investor who wants to actually get an income from real estate rental property, and expects to hold the property for a lengthy period of time.

Cornering a Market

As a review appraiser, one of the biggest problems with appraisals of residential investment properties -- rental homes -- has been the lack of careful attention by the appraiser to the actual return on investment anticipated by the investor. If the investor were putting money into a stock, he would surely be interested in whether that stock was likely to earn money and pay dividends. The investor would look at the money in hand, examine the alternate choices (i.e., bank interest, other stocks, bonds, state lottery, etc) and see what rate of return could be expected. That caution has been lacking in recent decades, as investors look at stocks from the standpoint of their possible resale value (buy low, sell high) rather than their income generation potential (long term gain through dividends).

When it is realized that the entire rationale for the existence of the stock market is the generation of capital for start-up and expansion of a business enterprise, the prostitution of the market by those who use the change in stock price as their sole reason for participation should give shareholders and directors reason to very seriously consider the potential negative consequences of going public with the stock, for, at that point, the financial stability of the company becomes hostage to the perceived profit-taking ability by the market at large.

The real estate industry has been taken over by this same mind-set. It was the anticipation of a quick profit by the property "flippers" that drove the real estate bubble, much the same way that stock "flippers" have driven other "bubbles" in financial markets. The "flippers" made their money by buying low and selling high. Just as the stock market attracted non-traditional investors, the real estate market attracted "flippers" across the spectrum. It was not unusual during the bubble years for Average Joe to buy a house, live in it for a year or so, then sell and buy another, making a small (sometimes large) profit and moving up in the world. Indeed, there is nothing wrong with that kind of approach to real estate. The problem arises when Other Peoples' Money (OPM) enters the equation.

If you have a few spare shekels of your own, what you do with them is your own business. You can engage in risky economic behavior because it is YOUR money. If you went to the local bank and said, "I would like a personal loan so I can buy some lottery tickets, and I will offer the tickets as collateral", any rational banker would either throw you out or die from laughter. (That is not to say that if you looked hard enough, you could find an irrational banker.)

The basic underpinning of the study of economics is an understanding of the relationship between supply and demand. That relationship is never perfect; it is always in flux. Today I demand eggs for breakfast, tomorrow I demand cereal. What I pay for breakfast today is determined by how many eggs there are to be had, and how many other people want eggs. If eggs are scarce, and many people want them today, I may have to pay the California Gold Rush price of $100 per egg today, and if everybody wants cereal tomorrow, the guy who wants to sell a dozen eggs tomorrow may not get $1 for the whole dozen. Supply and demand; the market works in cycles and despite the claims of experts, is unpredictable because it involves the perceived wants and needs of people, and every day brings a new itch to be scratched.

Therefore, if I go to the bank to borrow money for an investment, the banker wants to know what the value of that investment will be over the life of the loan. He wants to know if it will be a winner or a loser. If I want to invest in Pet Rocks, he wants to know if they produce dividend income, or if they have good resale potential. For that reason, few sane bankers will loan money for an investment in a day at the horse races, or even an investment in the stock market. Such gambles are heavily regulated.

When the public fell for the canard that residential real estate was a good investment, most people failed to recognize that what they were falling for was a property flipping scheme, and not a dividend stream investment. The mantra was that real estate never goes down in value, therefore it was "safe". It was thus felt that using OPM was legitimate for property "flipping", whether done by investors who had that as their sole objective, or by Average Joe, who just wanted to make a profit when he sold his house.

Enter government social engineering. Very few economists are elected to Congress. This is also a result of the Law of Supply and Demand, but I will leave the reader to figure out what I mean by that. Official government policy for several decades has tried to maximize home ownership, without regard to whether the new homeowners understood their responsibilities. This has resulted in lowering the equity barrier for entry into the real estate market, and the lowered requirements have been extended even to non-owner-occupied dwellings.

In previous years, it was believed that a loan to value ratio of 80% was a reasonable risk, and borrowers with less than 20% down were required to purchase mortgage insurance, either through a GSE (FHA insurance) or through private mortgage insurance (PMI) companies. The insurance was then used to guarantee the repayment to the lender in the event of default.

Because of the common belief that values were increasing (based partly on government indexes that measure the buying power of the dollar) the property "flipping" could continue as long as a higher resale price could be obtained by the investor. Little real attention was paid to the actual return earned on the investment. This was where the Operating Income Statement -- the Form 216 -- should have been of greater concern. It is also where the use of Gross Rent Multipliers (GRMs) lead to false impressions of value.

Enough for now, I have other things that must be done at the moment. The investment idea that I am toying with will be developed over the next few posts.

Sad Stories Abound

I read today a story about a woman in Southern California who, in February, lost her $70,000 per year job, and less than two months later, is obtaining food for herself and her two children from a food bank because she did not qualify for Food Stamps. She was uncertain of her future, with a $2500/month interest only loan on her home. Comments to the news story were mostly sympathetic, but there were a number of people who could not see how someone making $70,000 a year could go broke so quickly. It seems that a huge number of Americans never make anywhere near that kind of money and have learned to live on less than half that amount.

So here's my sad story. Yesterday I went out on an appraisal assignment for a refinance. The house was an older dwelling, straddling two parcels. The front parcel was zoned commercial, and the rear parcel residential. The property does not conform to zoning. The home had a new roof, and the windows had been replaced a while ago with insulated glass units, and the basement had just been waterproofed. It still had a septic sewage system, even though the city sewer line was stubbed out to the property at the street.

The gentleman wanted to talk, and I let him. He showed me the front property pin, which was under his driveway; part of the drive was on the neighbor's property. He showed me the septic tank lids, which were right on the property line. Worse yet, the septic tank had a spruce tree growing on top of it, and there was no way of telling which way the effluent drained, if it drained at all. He showed me the basement, with its new, professionally done waterproofing, and also the missing basement steps (we had to climb down a step ladder) that the contractor had removed and not replaced, and the partially removed partition wall that he said the contractor had not completely removed because he was afraid the floor above would sag. He showed me the crumbling and collapsing plaster on an upstairs ceiling, where water had been leaking in for some time before he had the roof reshingled.

Not quite a slam-dunk as a valuation problem.

He told me his story. He once had a good paying job, years ago, but the company closed up shop in the northern part of the state. It seems that the union was based in Cleveland, and insisted on Cuyahoga County wages for workers in Summit County, where things just were not as expensive as they were further north. For years he had worked at odd jobs, and was now drawing his Social Security. His wife was bringing in most of the current income, working as a waitress, and she seemed very displeased with life. She shut herself in the bathroom, and it was with great difficulty that he was able to persuade her to come out and allow me to examine that room. With poverty there is often familial distress.

It seems that easy money was part of the problem. He had refinanced the house in 2004, and if it was an 80% refinance, then the appraisal at that time was probably close to the actual market value. But, in 2005, he needed to fix the roof, and he took out a home equity loan. That brought him close to 100% financing. He was also paying a very high interest rate for his car, and last August, refinanced his home equity loan to roll the balance that he owed on the car into the second mortgage. Bad move. The HELOC is adjustable, and he is upside-down on his mortgage. He was trying to refinance to roll it all into one lower interest fixed rate loan, but based on the fact that prices in his neighborhood have been falling at about 1%/month since 2006, and the needed repairs, I think he is stuck right where he is.

He told me where he needed to have the value come in (and I doubt that he realized he was engaging in a criminal act by doing so); it would have been far better from the standpoint of making the loan if the appraiser who had appraised it last August had been there yesterday instead of me. Had that appraiser accurately reported in August the problems with the site alone, I doubt the loan would have been made. Then again, it was a different bank, and we are in a different economic world than we were in just a few months ago. I have a feeling that my opinion of value is going to contribute to greater marital discord.

I wish I could help, but I think the solution is to be found only by squeezing through the tunnel. How did we, as a nation, get in such a fix? It may be simple human insecurity. We are herd animals, afraid of judgment and always seeking peer approval. People live beyond their means because they need to put up a public front. Just like the people who will speed up on the highway because somebody is tailgating them, rather than sticking to their convictions about obeying the law, we somehow rationalize that it is OK to engage in risky economic activity because "everyone else is doing it". We think that safety lies in numbers, and delude ourselves about the virtues of democracy. It is not a virtue to collectively go broke.

Let's Hope She Still Has Her Voice

I am glad I am not Ben Bernanke. Or George W. Bush. Or the head of the OTC, Fannie, Freddie, or Ginnie, or the Secretary of the Treasury. Or a CEO of any of the major lenders.

One reason is that I do not at all understand the machinations occurring in the financial markets right now. I do understand a few basic themes :

• when supply is low and demand is high, prices go up


• when supply is high and demand is low, prices go down


• when people cannot afford to pay their debts, they default


• when risk is high, investors look for high yields


• when a man is broke and his credit is bad, he goes without

I also see the following things in the marketplace :

• incomes have not kept pace with expenses for the majority of Americans


• residential real estate lending provided much of the means for consumption in the past decade


• there are far more houses in the market than there are buyers who can afford them


• the loans that were made in 2005-2006 are at their peak for their first reset

For a decade I have been warning that the use of Home Equity Lines of Credit are not only dangerous, but have the effect of robbing the Average Joe's piggy bank. Most Joes have no idea that when they borrow against their home, they sell an interest to the lender. They do not stop to consider that when Sharkey loans them the money, he expects to make a profit. Therefore, the interest he takes in the home is ALWAYS greater than the amount of money lent. In good times, this fact is difficult to visualize. Joe rarely thinks about his home as a savings account; he is often told that it is an investment. Nothing could be farther from the truth.

An investment is a vehicle for providing a return on capital. An investment that does not keep pace with inflation is a bad deal. A home is a place to live. No matter where Joe wants to live, he must pay rent. If the price of houses goes up, the landlord will raise the rent. If Joe buys the house, and sells an interest to Sharkey at a fixed rate, he has purchased a form of rent control. Then, if the price of houses goes up, Joe's monthly rent stays the same, and the equity he builds in the house becomes a hedge against future rent inflation. The hedge is usually not very high, because while land does not suffer from obsolescence, the improvements (der hut?) will depreciate (translation : deteriorate) and will need repairs from time to time. Joe will normally pay for those repairs out of his pocket.

Over time -- the life of the improvement or the life of the owner, whichever comes to an end first -- it is almost certain that the cost of maintaining and repairing the improvement will, with any inflation, equal the total equity Joe has in his home. New roofing, siding, windows, furnaces, water heaters, paint, carpeting, cabinets, etc. will have to be purchased and installed at least once (and maybe more -- figure three times for a water heater) during the typical 30 year amortization period. Joe will also need to address the cost of taxes and insurance. If Joe does not need to touch his equity in that time period, he will indeed have a lump-sum amount available if he would sell his home. But --

What if Joe borrows against that equity? For one thing, it is almost certain that the interest rate charged for a second mortgage or a line of credit will be higher than the rate on the first mortgage. If it is not, then Joe has been sleeping at the wheel and should have already refinanced his principal balance at a lower fixed rate. By borrowing against his equity, Joe has just raised his own rent. If he uses the money to repair his home, he might have made a wise move, especially if the cost could not be paid out of pocket and the repair was essential for maintaining the structure or systems and preventing further deterioration. Use of the equity for any other purpose is foolish unless Joe is fully willing to surrender to Sharkey (who is really his landlord, you see) control over the monthly rent.

What if Joe does not borrow against the equity, but sells the house he now owns free and clear and buys another? If he pays the same amount for his new home that he got for his old home, he will have actually gotten a raw deal unless his intent was only to move to a new location. If he moved up in the world and bought a more expensive home, he will borrow again; the cost of fancy digs is higher rent. A home is not an investment; at best it is a forced savings account and rent control device.

Alas, Joe has been suckered by Sharkey into a cash-out refinancing or a HELOC. Worse yet, Sharkey has convinced Joe that since house prices are rising, the value of Joe's house must be increasing, and therefore Joe can borrow MORE than the difference between what he originally paid and what he still owes. And, even worse, Sharkey has talked Joe into an adjustable rate loan -- a loan which Joe is qualified to take on at its lowest increment, but which he has no hope of keeping up the payments on after it resets a time or two.

By now we see that Average Joe has no idea what he is doing. (But if you ask him, he will tell you how good a deal he got from Sharkey. At least until the first reset of his loan.) Joe sells Sharkey the rest of his interest in his house, and spends the money on a new pickup and a bassboat and a cute car for the wife; they also go to Disney World and watch the Pirates of the Caribbean without catching the joke underneath. And, guess what? His neighbors, Harry and Sam and Bebop (have to be multi-cultural in this neighborhood, you know) do exactly the same thing. Twenty-four months later they each get a letter from Sharkey. Sharkey is raising their rent by 2% of the total amount they each owe.

Joe and Harry and Sam and Bebop each get together with their wives to discuss this new development. Harry's wife, Zelda Sue, tells him he was stupid, walks out, gets a divorce, and the house has to be sold for the settlement. Joe's wife and Bebop's wife agree with them that they had better sell their houses; the signs go up the next day. Sam has a heart attack over the whole matter and his widow is forced to sell to settle the estate. Suddenly, there are four houses for sale on Joe's block.

Think : when supply is high and demand is low, prices go down. Three months later, all four houses are still on the market, and the four neighbors (OK, so they do miss old Sam) are now busy trying to undercut each other with the prices. Sam's widow gets desperate, and sells the house for the loan balance just to get out from under it.

Think : when people cannot afford to pay their debts, they default. Harry gets fed up with the situation and disappears; he does send Joe a postcard from Ecuador where he has a new job with a pharmaceutical company.

Think : when risk is high, investors look for high yields. Bebop finally gets a buyer, but has to do a short sale. His credit is no good, but he does manage to get another house in a poorer section of town, buying it on Land Contract at 15% interest (but look at the bright side -- it's a fixed rate!).

Think : when a man is broke and his credit is bad, he goes without. Joe? Joe is evicted by the foreclosure order. He and his wife are living in the pickup, and they aren't planning any vacations for a while.

Wait a minute, you say. You forgot the first one : when supply is low and demand is high, prices go up. No, I didn't forget the first one. Sharkey convinced Joe that prices were going up. Sharkey had an appraiser who would hit his numbers. Sharkey quoted government figures that painted a rosy economic picture. Sharkey lied; he didn't tell Joe that the neighborhood was overbuilt and that there were lots of empty houses to go around.

So here is a snapshot of the economy. For a decade it was buoyed by consumer spending while American industrial production fell and imports rose. For a decade the Sharkeys convinced people that they could borrow their way to prosperity. For a decade the economy was based on mortgage fraud and government economic deceit. For a decade, the money supply was artificially inflated by low interest rates, and foreign investors were suckered into buying overvalued mortgage backed securities.

All good things (and all bad things) come to an end. When the money supply could no longer be stretched because the foreign balance of payments was causing imported goods to rise in cost, interest rates were raised. At the same time, the adjustable rate mortgages began to reset, and the borrowers could no longer afford their rent. As they began to default in large numbers, sales prices on existing homes began to drop in a competitive spiral. As the money supply tightened, new constructions became harder to sell, their prices also declined, and defaults among the buyers of more recent new homes rose, again dragging prices downward.

When it became apparent that the margin of profit on the adjustable rate mortgages was declining, the investors began to look for more profitable venues, and as they sold their securities, first the sub-prime lenders, and then the mainstream lenders began to suffer from a lack of cash to continue lending, even to good credit risks.

We are now in the second full year of this debacle. The peak number of first-time resets is now occurring. That means that the peak number of foreclosures from default will begin in about six months. Through this entire time period, some real estate sales have been occurring. As I examine the lending data, it is appalling to see the high percentage of 100% finances; a huge number of homes in the past two years, in the face of the subprime melt-down, have been financed with 80% conventional fixed first mortgages and 20% adjustable second mortgages to make the down payment. I can easily see strong foreclosure activity occurring as far along as three years from now, short of draconian measures on the order of nationalization of the lending industry and restructuring of the loans.

America has been cash poor for some time now. Foreign investors, lured by the seeming stability of the mortgage backed securities, provided a significant portion of the cash that fueled residential real estate finance and consumer spending, all the while piling up an imbalance in foreign debt. The recent forced buyout of Bear Stearns at the command of the Federal Reserve did little but lower foreign confidence in the securities. There are other brokerages just as upside down in their portfolios; an investor needs to ask whether the risk of losing equity in a fire sale such as the Bear sale is worth taking on.

Remember that it was the oversupply of money created by the Fed's low interest rate policy that drove the consumer spending and foreign payment imbalance. The willingness of the Fed to lend money to the troubled lenders by allowing them to borrow against shaky securities cannot make our foreign trading partners see the dollar as a currency worth holding. The lowering of the discount rate will make taking on additional debt backed by US assets even less palatable. It could even be that lowing the discount rate could make mortgage lending more difficult since there would be fewer foreign investors willing to risk such a low-paying venture. And what will Big Ben do if lowering the discount rate does not cure the problem? Lower it to 0%? Offer to PAY investors to take Fed money?

We are living in interesting times. As I said above I do not understand what is happening in the financial markets. I only know one little saying that might fit the situation.

"it ain't over until the Fat Lady sings."

Project Wrapup

Just out of curiosity (bad character trait, that) I decided to take a look at the median prices for brokered sales in the Kenmore (North) and Summit Lake markets, then compare those figures with the data drawn from the foreclosure/REO sales studied and the public records data available in the MLS from Realist.com.

Several things need to be kept in mind. The public record data in Realist.com has some quirks. Not all sales are to be found there, since the search was done by using the 510 Land Use Code on the Auditor's Card, and that information is not entirely accurate. It is not unusual to find single family homes mis-filed under LUCs 520 and 530, and to also find 2- and 3-family homes showing up under LUC 510. This is one of those little caveats to keep in the back of the noodle when thinking about Automated Valuation Models (AVMs) that have become favorite tools of the banks and which are used by the mass appraisal folks (gummint fellers, fer the most part). I will say it once more : I think a lot of the statistics blown our way by the government are economically incorrect even though they may be politically correct.

Also, the public records data in Realist.com, as reported for the end of a calendar year, will only show the final transfer of a parcel. If it was foreclosed and sold at Sheriff Sale, then sold by the bank as an REO, and then "flipped" by the REO buyer, all in the same year, only the last sale will show. This has a tendency to skew the statistics in Realist.com upward. Theoretically, it should all even out in the end, but it never seems to work that way.

Finally, the MLS sales include only brokered transactions by MLS members -- Realtors. Sales brokered by members of the Realtist organization do not show up there unless the Realtist broker is also a Realtor (most are).

OK. Here comes the data table.

	Appraisal: Auditor	Appraisal: Sheriff	Realist.com SP	REO SP	MLS Non-REO SP
Kenmore (N) Mean	$65,031.78	$67,931.51	$64,581.00	$29,929.19	$71,789.00
Kenmore (N) Median	$61,860.00	$69,000.00	$66,454.00	$30,000.00	$71,000.00
Summit Lake Mean	$39,802.00	$44,700.00	$46,074.00	$11,218.03	$21,125.00
Summit Lake Median	$38,720.00	$48,000.00	$43,553.00	$7,587.50	$22,750.00

Cute, isn't it? I see some very interesting correlations that could lead to some questions. However, I'm not going to beat this horse any more. The entire spreadsheet is available for download from my website, www.hrubikappraisal.com/, as
February 2008 Blog Project Data
Excel Spreadsheet, 60kB.

WARNING!! Correlation Does Not Prove Causation!!

Just thought I'd throw that out, since there could be some misconceptions about the data I am presenting and the correlations that appear.

This warning is brought to you courtesy of the on-going Global Warming controversy. Like most controversies involving science, that controversy exists because people forget that correlation does not prove cause. It has now occasioned a lawsuit by an Eskimo village in Alaska, which is suing Exxon for causing the sea level to rise and wash away part of the village.

The danger here is similar to that posed by the Dow Corning silicone implant lawsuit. Lawyers realize that in civil suits, all they need to do is convince the jury that the defendant needs to be punished. The typical jurist has no idea that correlation and causation are two completely different things. American jurisprudence thrives on circumstantial evidence, which is another way of saying that it is based in superstition.

Correlation is created by relationships in statistical data giving a probability that something could or could not occur, and is useless without a statement setting out the level at which the correlation would be considered significant. That statement is based on a purely subjective decision.

Causation is shown when witnesses can prove that a particular action resulted in a particular effect. It is a statement of fact, and has no subjective component.

Unfortunately, the American legal system is intoxicated with the concept of correlation implying causation. From a purely scientific standpoint, circumstantial evidence NEVER proves innocence or guilt beyond the level of confidence predetermined by the trier. Defense in civil suits is primarily a matter of proving one's innocence, with the same kind of intelligence and reasoning as pervaded the Salem Witchcraft Trials.

The Dow case resulted in a judgment against Dow Corning that was so large the company filed for bankruptcy. The lawyers got their fees, the class action members got their piddly awards, and lots of people lost their jobs, because the legal system allows pseudoscience in the courtroom. The fact that it was later shown that the Dow product was not the cause of the problems was simply too bad for common sense and justice.

My data does not imply causation of any kind.

Project Results

The hypothesis : there is a correlation between either the Auditor's appraised value (which is not market value) and the foreclosure appraisal value (which is supposed to be at market value), or between the outstanding loan balance and the foreclosure appraisal value.

The procedure : both the Kenmore (North) and Summit Lake neighborhoods were searched via a polygon map search for REO sales which took place in 2007. The sales were cross-checked with the Summit County Common Pleas Court Records and the Summit Count Sheriff's Sales data. The data was entered in an Excel spreadsheet, and included the names of the appraisers used by the Sheriff, and also included pre- and post REO sales data where it was deemed pertinent. The ratios of appraisal:auditor's appraisal for the prior tax year, the appraisal:judgment amount, and the appraisal:REO sales price were calculated, along with the range of ratios, the mean, median, and mode values for the ratios, and one standard deviation from the mean of the ratios.

Unfortunately, before the project began, no confidence level was chosen for rejecting the null hypotheses, namely, that no correlation would be found. The following items must be considered :

• standard practice allows for a variation of +/- 5% between the value opinions provided by two or more individual appraisers before serious questions about the methodolgy or data are raised


• no standard ratio exists for determining the amount of a loan to be made relative to the appraised value (underwriting guidelines which allow 100% financing have made such determinations impossible)


• the REO sales price does not meet the definition of market value as set forth in 12 CFR Part 34, but because all of the REO sales had open market exposure in the MLS, there is some reason to treat those sales as though they approximate the market value for REO sales as a class

With these things in mind, the percentage data was tabulated as follows :

	Appraisal: Auditor	Appraisal: Judgment	Appraisal: REO SP
Minimum Ratio	56.26	31.36	114.62
Maximum Ratio	165.12	247.81	1500.00
Mean Ratio	107.56	101.96	366.34
Median Ratio	104.12	98.63	276.00
Standard Deviation	15.92	28.29	238.74

Conclusion : The range of the ratios was quite wide, and only the median ratio of the appraisal:judgment amount was below 100%. There does, however, seem to be a very close correlation in the median ratio of the appraisal to the judgment amount (within 2% either direction). It would thus be interesting to know if the appraisers had knowledge of the judgment amount prior to providing their analysis.

The fact that the mean and median ratios for the appraisal to the eventual REO sales price are 366% and 276% respectively is an area of concern. It can be accepted that the appraised value prior to the foreclosure would be higher than the REO sales price, since there would be both effects present regarding the condition of the foreclosed home, and the fact that the REO sale would take place under conditions of duress.

Because it was possible to separate REO sales from non-REO sales in the analysis, there was some other very interesting stuff that came out of this exercise. More Later.

Progress Report -- of sorts

My little project is not so little. I have finally gone through all the sales and located the case numbers and court dockets for them. This allowed me to identify the Sheriff's appraisers for each property, the appraised value used to set the minimum bid (2/3) at the Sheriff Sale, and the sale date (which is different from the date the sale was recorded).

The Appraisal Subcommittee National Registry was used to check whether the appraisers used by the Sheriff were licensed. The appraisers used were Jon Poda (Licensed Residential), William Wilcox, Robert Campbell, James Yocum, David Waddell (Certified Residential), John Cunningham, Tom Robinson, Al Wilkinson, David Troutman, James Buie, Ed Abdulla, and Phil Leonard.

The "Rules of Practice and Procedure of the Court of Common Pleas, General Division of Summit County, Ohio" were consulted; Section 11, "Foreclosures", deals with appraisers' fees. There is no specification in the Common Pleas Court Rules as to form of the appraisal report. ORC 2329.17 and 2329.18 specify that the appraisal must be done by three disinterested freeholders of the county, and that their report must be deposited with the Clerk of Courts; it does not specify any form for the appraisal to follow.

Here is where it gets interesting. Two of the appraisers are licensed by the state. Because they are licensed, the USPAP holds them to a higher standard than the other, unlicensed appraisers. ORC 4763.17 (A) states that "A certificate holder, registrant, and licensee also shall comply with the uniform standards of professional appraisal practice, as adopted by the appraisal standards board of the appraisal foundation and such other standards adopted by the real estate appraiser board, to the extent that those standards do not conflict with applicable federal standards in connection with a particular federally related transaction." Standards Rule 2-3 requires a signed certification for each written property appraisal report. The reports deposited with the Clerk of Courts do not contain the required certification.

While the Jurisdictional Exception Rule can and must be cited in the certification to maintain compliance with the Ethics Rule, there is no court rule, i.e., jurisdictional exception, for violating the requirement for a certification to be attached to every report submitted by one of the licensed appraisers.

I have no idea what an attorney might do with that kind of information, if his client felt he had gotten a raw deal in a foreclosure action. I wonder what would happen if such an attorney would simply subpoena their workfiles?

'nuther thing. After all the weeding, I have 103 sales; 73 in Kenmore (North) and 30 in Summit Lake. Twelve of the Kenmore REO sales have already been "flipped". Ten of the Summit Lake sales have been "flipped", at least one of them for more than ten times the REO sale price. A number of "flip" sales have been identified where the real estate agents handling the listing have ended up owning the property; a "strawman" was used to buy the REO and then "flip" it to the agent. I'm not going to name names here. I think what I will do is make the whole spreadsheet available for download somewhere after I get done with it. The spreadsheet contains the dates and prices of the "flips", as well as the sellers' names. It is all public records stuff; nobody has bothered to compile and analyze the data until now.

and 'nuther thing more. I got curious about one of the Federal foreclosures I appraised last summer. The house was refinanced in 2005 with a $50,000 mortgage. I appraised the home for $19,000. The bank bought it at the foreclosure sale for $32,000. MLS shows it was then put on the market for $13,900 and came under contract in 6 days. Does that make sense?

The idea of packing up and going to Korea as a teacher of English as a second language is looking more attractive every day.

Oooof!

Just a quicky update. Grabbed all the MLS REO sales I could locate for the Kenmore (North) and Summit Lake neighborhoods in Akron, for the 2007 calendar year. This is some interesting stuff.

75 of the 125 sales in Kenmore (North) were REOs (60%); 37 of the 43 sales (86%) in the Summit Lake neighborhood were REOs. Thus I have a sample size of 118 sales.

For some I will not be able to get the foreclosure sale price, or the foreclosure appraisal amount (unless I can find a way to access the data for the Federal Court sales). Still, it is the county sheriff sale information I am interested in, and I now have the names of all the defendants in the foreclosure cases for these properties.

I also have the seller names and sales prices for some really spectacular post-REO flip sales!! (And here we thought the lenders were becoming cautious because of the sub-prime meltdown. They seem as stupid as ever. And there appear to be some really clueless appraisers out there yet as well -- maybe they are coming to appraise in Akron from Cleveland and Columbus and Upstate New York.)

This project will take some time, but I have already laid out the Excel spreadsheet for the project. Stay tuned!

US-less PAP?

A recent article in the Cincinnati Enquirer, Sheriff's appraisers cash in, serves generally to irritate, and is illustrative of a problem that exists in the appraisal world. That problem is the total misunderstanding of the appraisal profession by the legal profession and the public at-large. It is partly a result of the "double-dipping" that attorneys are allowed; when an appraisal is needed for a legal reason, the attorney handling the case is legally permitted to do the valuation himself. He can then pocket the fee for both the appraisal and the legal work.

Further, the courts are able to alter the rules under which appraisals are performed; the Jurisdictional Exception Rule of the USPAP was specifically designed to step around any possible conflict between legal and appraisal ethics. (Normally, what is not ethical for an appraiser -- charging for an appraisal based on the amount of value opined -- is completely ethical for the legal profession, and those "ethics" are extended by court rules even to licensed and certified appraisers working for the courts.)

The passage of SB 185 by the Ohio Legislature in 2006 was supposed to tighten up protections for consumers and reduce the pressure by lenders on appraisers to perform unethically. It is simply too bad that the rules are still as full of holes as a block of Swiss cheese. The holes begin at the Federal level and worm their way down to the local courts.

Prior to the passage of FIRREA there was no requirement for appraisers to be licensed or regulated to do business with regard to Federally Related Transactions (FRTs). Those transactions are defined in the Code of Federal Regulations (CFR) as:

12 CFR § 34.42 (OCC), § 225.62 (Federal Reserve), § 323.2 (FDIC), and § 564.2 (OTS),

(f) Federally related transaction means any real estate-related financial transaction entered into on or after August 9, 1990, that:

(1) The Board or any regulated institution engages in or contracts for; and
(2) Requires the services of an appraiser.

(Also for NCUA, CFR § 722.2 (e))

FIRREA required that appraisers for FRTs be licensed. The licensing requirements were to be drawn up by the states, but had to meet the minimum requirements set by the Appraiser Qualifications Board of the Appraisal Foundation, which was under the oversight of the Appraisal Subcommittee.

Title XI of FIRREA (1989) - aka the Savings and Loan Bailout -- in Section 1113 (1) stated, "a State certified appraiser shall be required for all federally related transactions having a value of $100,000 or more ..." It was quickly realized by the banking industry that certified appraisers were in short supply and not only were appraisals somewhat costly, but that when done correctly, created a time lag in the closing process. In 1994, the regulations were modified to require appraisals only for FRTs that exceeded the de minimus amount of $250,000.

Thus, a Federally Related Transaction does not necessarily require an appraisal. (It has always been good business practice when lending money, however, to have some idea what sort of collateral might be backing the loan, and provides a type of legal defense for the bank -- blame it on the appraiser! -- if the loan goes bad.)

But then we come to the "holes in the cheese". First, of course, at the Federal level, is the de minimus. The vast majority of mortgage loans are under $250,000. That meant that the vast majority of appraisals for those loans could be done by unlicensed -- potentially incompetent -- individuals. This is not to imply that all unlicensed appraisers are incompetent. Nor does it establish that all licensed and certified appraisers exercise competence as defined by the USPAP. It simply points out that any valuation for a FRT under the de minimus amount does not necessarily have to be done under the USPAP. It can be an estimate based on an AVM, it can be performed by a real estate agent doing a simple CMA, or it can be a PFA number supplied by anybody. FIRREA leaves up to the states, individually, to determine who can do business as an appraiser.

Ohio is not a mandatory licensure state. That means that if someone decides one day to be an appraiser, he is one. It is that easy. I am not an advocate for mandatory licensure. That is how I got my start; I simply started doing appraisal work as a real estate agent. That does not mean that prior to obtaining my certification, I did not try to comply with the USPAP. I did try. I even performed appraisals for FRTs, and conscientiously attempted to provide credible value opinions for my clients. Fortunately, I was not faced with any complex appraisal problems during that time.

Under SB 185, the Ohio Revised Code was changed to read,

"Sec. 4763.13. (F) Except as otherwise provided in section 4763.19 of the Revised Code, nothing in this chapter shall preclude a person who is not licensed or certified under this chapter from appraising real estate for compensation.

Sec. 4763.19. (A) Subject to division (B) of this section, no person shall perform a real estate appraisal for a mortgage loan if the person is not licensed or certified under this chapter to do the appraisal. [my bolds]

(B) Division (A) of this section does not apply to a lender using a market analysis or price opinion, an internal valuation analysis, or an automated valuation model or report based on an automated valuation model, and any person providing that report to the lender, in performing a valuation for purposes of a loan application, as long as the lender does both of the following:

(1) Gives the consumer loan applicant a copy of any written market analysis or price opinion or valuation report based on an automated valuation model;

(2) Includes a disclaimer on the consumer's copy specifying that the valuation used for purposes of the application was obtained from a market analysis or price opinion or automated valuation model report and not from a person licensed or certified under this chapter."

Despite all the hullabaloo about consumer protection in SB 185, it simply gave the Attorney General a tool with which to beat on licensed and certified appraisers, and loan officers who were stupid enough to use such people, if they stepped out of line.

This brings us to the problem illustrated by the Cinci Enquirer article. There is no state requirement anywhere that appraisals done for foreclosure sales be done by competent people. The statute simply says that the appraisers must be "freeholders" and residents of the county. (At least the Federal District Court has required that the appraisers for its foreclosure suits be state certified appraisers and residents of that county.)

The article does state, however, that three of the six appraisers are licensed. Those three, under the USPAP, are not permitted to waive the requirements under Standards 1 and 2, since the Hamilton County Court of Common Pleas does not appear to have made any rulings that permit them to do so! At the very least, the certifications required by Standard 2 must be attached to their appraisal reports, and must be submitted even if the reports themselves are not in writing!

Some questions :

(1) Why have none of the licensed or certified appraisers in Hamilton County filed any complaints with the Division of Real Estate against the sheriff's licensed appraisers regarding violations of the USPAP? The appraisals are public records and part of the court documents (at least they are here in Summit County).

(2) Why have no attorneys for the people being foreclosed on grasped the opportunity to take any action?

My curiosity is piqued. I am going to do some research into some of the Summit County foreclosure sales, the appraisals done prior to foreclosure, and the actual prices obtained for the properties on the REO market. I have a hypothesis : there is a correlation between either the Auditor's appraised value (which is not market value) and the foreclosure appraisal value (which is supposed to be at market value), or between the outstanding loan balance and the foreclosure appraisal value. This may take some time, but stay tuned!!

Geographic Competence as a Function of Location

The oldest saw in real estate is that "location, location, and location" are the three most important factors in the value of real property. That is, of course, a bit of an exaggeration, but it is true enough that the URAR grid has, among the top factors on the grid, "location", "site", and "view". Those items are located toward the top of the grid because they have been shown to be significant reasons why a buyer might pick a particular home. In the middle of the grid are "condition", "room count", and "GLA", which have been deemed, by those who study buyer psychology, to be lesser factors. What strikes the reviewer who is cognizant of these things is that the majority of appraisal reports will have the bulk of adjustments in the mid-section of the grid, with few at the top.

"Ah-ha!" says the reader as he leaps to a hasty conclusion that I am about to say that the adjustments are up-side down. Not really. The best arguments for a preponderance of adjustments in the mid-section are that (1) they are quantitatively easy to develop, and, (2) if the appraiser has followed common sense and the guidelines set down by FNMA for choosing comparable sales, all of the sales used will be nearby and locationally similar. There should be no need for substantial adjustments for location if all the sales are within a half mile of each other and in the same Census Tract. There should be no reason to make an adjustment for lot size when all of the lots have the same frontage and about the same area. If the subject and comparables are all on quiet residential streets, why should a view adjustment be needed?

When the market is active and there are plenty of sales to choose from, there is generally little difficulty in providing a credible opinion of value for a home in a given neighborhood. In that situation, difficulties typically arise when the lender says, "I need $xxx to make this deal go." (According to Ohio Attorney General Mark Dann, such a statement is prima facie evidence of appraiser coercion -- a misdemeanor under the Ohio Revised Code -- and he has urged appraisers who receive faxes or emails with such statements to forward those items to him for prosecution of the senders!!) An appraiser who would prostitute his or her services under such a condition might well choose sales in locations beyond the recommended distance guidelines, ignore differences in appeal (and thus value) due to location, and "hit the number." This is, too often, a problem where a local appraiser is involved, but is almost always a problem where an appraiser who is based some distance away commutes a long way to the subject neighborhood.

This is not to say that such a commuter cannot learn the nuances of the subject's neighborhood and proceed to do a credible job of valuation. The difficulty lies in the time and effort needed to become competent, and the very little amount of money that most lenders are willing to pay for an appraisal (although it has been my experience that the more times a lender has been told a particular number is not feasible, the higher the price they are willing to offer for the appraisal, and conversely, if the appraiser does not "hit the number", the greater the likelihood that the lender will ignore the appraiser's invoice).

In a "down" market, the use of an appraiser who is not very familiar with the subject's neighborhood is a prequel to appraisal fraud. In a declining market, good sales comparables become hard to come by. As data in the immediate neighborhood of the subject becomes scarce, it is necessary to reach out to other, "competitive", neighborhoods in order to bracket the subject for all features. It is highly unlikely, however, that even "competitive" neighborhoods will have exactly equivalent features and appeal. Especially in suburban or rural neighborhoods, use of a sale from an adjacent town or township may become necessary, and if a location adjustment is NOT made in such cases, the appraiser has some explaining to do.

A geographically competent appraiser will be able to make appropriate adjustments, and explain why they were made. The problem, again, is that the appraiser is faced with a changing market, it takes time and effort to dig out and analyze the sales statistics, and the fee for the appraisal is usually not worth the work involved, unless the appraiser needs simply update his files with the most recent data. Many appraisers, however, are still using neighborhood descriptions that were cooked up (or copied from somebody else) by their supervisory appraiser when they were trainees. Relatively few appraisers have actually taken the time to compile their own neighborhood statistics.

Even those appraisers who use data from the MLS may be fooled into using statistics generated by Realtor associations, without thinking that those figures may be biased in favor of convincing buyers and sellers to enter the market. There are other appraisers who buy their statistics from national services without bothering to consider the underlying assumptions that need to be made to properly interpret that data. The dangers are manifold.

So what triggered this rant? I had two recent phone calls, one from a lender, and one from a salesman hoping to sell me a listing at an appraisal directory. The loan officer asked if I could tell him whether a particular value for a home on Roslyn Avenue in Akron would be feasible. I told him that in order to make such a determination, I would have to do an appraisal. He then asked what the market was like in Akron; I told him that we had an increasing number of foreclosures, and that there were quite a few more listings in the MLS than there were sales. He thanked me and hung up. If I were to buy a lottery ticket, my odds of winning something would be smaller than the odds that he promptly called another appraiser, hoping he could find someone who would be willing to violate USPAP for him. If it were legal to record phone conversations, and Mark Dann paid a bounty for violations submitted, I could make more money doing that than appraising.

As to the second call, the salesman directed me to the web page for his directory. In order to be listed there, his company charges a fee. All you need to do, if you are looking for an appraiser, is click on the county and a list of appraisers with their contact information comes up. There are directories such as that which also offer free listings, and I am on about a half-dozen of those. The biggest problem with all of these directories is the deception inherent in all of them. The potential client is usually looking for an appraiser who is local to the subject's neighborhood. This salesman said that he was looking for an appraiser in Kansas City, and my web page came up. While I may travel up to 20 miles west to the rural Wayne and Medina County portions of my service area, I have no desire whatsoever to go outside the areas in which I feel competent. However, if you bother to click on his directory's map of Summit County, you will find that of the 14 firms that are listed, four are in Summit County, four are in Cuyahoga County, one is in Lorain County, two are near Columbus and Dayton, and the remainder are out-of-state management companies. Another directory lists appraisers by ZIP code; there are out-of-county appraisers who have several listings, each of which has a fraudulent ZIP so that they are shown as being "local" to the ZIP code a client may be searching. So much for truth in advertising.

So why is there a credibility problem with the appraisal profession? I submit that it has to do with the marketing of appraisal services, and the choosing of appraisers for the assignment by the very people who are paid a bigger commission if the loan amount is higher. If lenders were forced to be liable for the quality of the loans they made, they might be more careful about who they hired to evaluate the collateral. That is a problem that was created by Congress. If that is too hot a potato for the pols, they should consider setting up a Federal agency that would dole out the appraisal work on a rotational basis, just as the VA Fee Panel does, without any say by the lender as to who the appraiser might be. Part of the criteria might be a requirement that the appraiser's office be located within a certain distance of the subject property. A variation on such a scheme is used right now by the U. S. District Court, Northern Ohio Division, for foreclosure appraisals; the Master Commissioners are required to use a state certified appraiser whose address in the Federal registry is in the same county as the property being foreclosed.

Over twenty years of licensing has not solved the problem of appraisal fraud. The politicians created the environment for the current mortgage lending crisis. It is time the denizens of the Capitol tried a different approach to clean up the mess they made.

Incompetence Corrupts...

and just a little incompetence can corrupt absolutely.

Lord Acton may not have considered the above twist, but my new analysis of market areas in the City of Akron is raising some significant questions in my mind about the whole process of determining a "market value" for residential property in some markets. Conventional practice relies upon the Sales Comparison Approach to provide a means of forming an opinion of value. The data I am finding, however, seems to imply that sales comparison may be entirely inappropriate in some markets, and the insistence by lenders on the use of the technique may be an important contributor to the current difficulties in the mortgage lending arena.

Most appraisers are familiar with the "big three" approaches to deriving a value opinion : cost, income, and sales comparison. In residential mortgage lending, underwriting doctrine insists that sales comparison is most appropriate. Lenders (as well as most appraisers) have believed that by comparing a subject property to the market experience of other nearby homes of the same age, size, type, and condition, it is possible to predict the reaction of "typical" buyers to an attempt to market the subject. What has been ignored are the basic assumptions that must be present in developing an opinion regarding "what if we tried to sell it?".

The market area I was researching was the Summit Lake Neighborhood in the City of Akron. The city's official neighborhood data sheet for that neighborhood gives a year 2000 owner-occupancy statistic for "South Akron" as 57.3%, but also has a note that "Slightly over one-third of housing units are owner-occupied, significantly less than 55% in the City." My research from the Census 2000 data shows an average tenant-occupancy rate in the Summit Lake Neighborhood of about 70%. Consequently, the most probable buyer for a single-family home in that neighborhood, at any given time, would be an investor.

In examining the statistics from brokered MLS sales and the public records data for all sales in that area, a serious discrepancy was evident. The mean sales price for brokered sales declined from $27,167 in 2001 to $13,741 in 2007, with the median declining from $24,000 to $10,000. In complete contrast, the mean for all sales increased from $44,347 in 2001 to $63, 509 in 2006, and the median for all sales increased from $42,700 to $70,000.

What is not evident from the raw stats is the fact that the MLS sales are mostly REO sales -- the banks have been hiring agents to dispose of their foreclosed properties -- whereas the public records stats only include the final transaction price for a given home at the end of the calendar year. The private sales by the investors, who are dealing both among themselves and also with owner-occupant buyers, involve numerous "flip" sales where the REO homes have been purchased, "rehabbed", and resold. There is no ready information with regard to marketing times or seller concessions and incentives. Further, if one looks closely at the major players in the high-end sales, one finds that at the end of 2007, a number of them were either under indictment or already in jail for mortgage fraud.

Even if all the transactions taking place were honest deals, there is still a problem with trying to determine what the typical buyer and seller would be willing to agree on in this market. An owner-occupant is usually looking for a house that is ready to move in to. An investor who wishes to be a landlord will be looking for a home that will be able to generate an income stream with minimal repairs and maintenance. The investor who is rehabbing to resell will be picking up the sales at the bottom of the pile. The "market value" of the home should not differ much between each category of buyer, since open market competition for the property should drive the final sales price. However, the appropriate method of arriving at the "market value" may be something other than simple sales comparison as anticipated by the standard appraisal forms.

Out-of-town appraisers, who may be relying on public records sales data without understanding the owner/tenant composition of the neighborhood, may be providing value opinions that do not really meet the needs of the intended users or their intended use. Users of AVMs in such a neighborhood run the risk of developing value estimates completely out of line with the reality of the marketplace. This situation warrants further exploration.

New Year, Old Concerns

Well, I started off the new year with an update to my web page, to make it look more professional. It seems that with all the loss of confidence in the financials markets, it would be a better idea to have a "serious" web page rather than one which indicated a greater sense of humor. Nothing much humorous about loans going south in large flocks. We shall see if springtime sees the migration turn around. With all the financial climate change, though, a meltdown could be in the cards.

Which leads to the old business. It seems that borrowers are not the only entities going into default. Lenders who have ordered appraisals also appear to be defaulting on payment for the reports. If the the borrower has tapped out all his equity and the appraised value is so low that the lender can't make the loan at an appropriate loan-to-value ratio, the lenders are simply ignoring the appraisal invoices.

I've sent off a request for the Ohio Attorney General's office to look into this phenomenon. The O.R.C. provides for criminal penalties for appraiser coercion, and the AG's office issued a clarification (109:4-3-24) which states in part,

"Division (B)(10) of section 1345.031 of the Revised Code states that in connection with a consumer transaction, a supplier is prohibited from knowingly compensating, instructing, inducing, coercing, or intimidating, or attempting to compensate, instruct, induce, coerce, or intimidate, a person licensed or certified under Chapter 4763. of the Revised Code for the purpose of corrupting or improperly influencing the independent judgment of the person with respect to the value of the dwelling offered as security for repayment of a mortgage loan."

My question to the AG's office is whether they consider withholding payment for the report because the loan couldn't be closed an attempt to influence the judgment of the appraiser. I think it is.

Business is so slow right now that to start requiring payment in advance might cause any clients to look for suckers elsewhere. That may, however, be the only way to survive in this market.