Appraisal Bias and 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.
Not only can we develop the three traditional approaches to value – sales comparison, cost and income – we can also develop new, additional valuation measures because of advancements in technology and the development of new ways to analyze data. Additional, statistically based approaches to value have been developed and can be quickly and responsibly deployed to add considerable credibility to the process. Development of multiple approaches to value allows for testing the reasonableness of each individual approach and reconciling a conclusion that is truly based on evidence and logic.
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.
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.
 Cash-out refinances spiked in December 2014 due to unusually low interest rates along with rebounding home prices in many parts of the country.
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