There’s an interesting sign of homebuyer champing at the bit to lever up again with all the “housing has bottomed” talk in a New York Times article last week, “Scrutiny for Home Appraisers as the Market Struggles.” The headline signals the new complaint about appraisers: they aren’t rubber stamping deals entered into by willing buyers and sellers! They are therefore holding back the housing market!
While this frustration among housing enthusiasts is a squeaky wheel in the housing market that probably does warrant comment by the Grey Lady, there are more serious market failures in appraisal land that also deserve attention.
In fairness, the Times tries to play this story straight, patiently pointing out that appraisers work for banks,and their job is not to act as a dealmaker but to protect lenders. What is shocking is perspective of homeowners and brokers, that a mortgage is a right and the appraiser is an obstacle. When I was a kid, I bought apartments twice in the 1980s, and it was clear that whether the appraiser would give a valuation high enough for me to get the sort of mortgage I wanted was an open question (duh, that’s why anyone who is not making an all cash purchase has, or should have, a financing out in the down payment). But appraisers are now getting so much heat that you see at the end of the article that appraisers are defending their role in saying that they protect buyers. That’s true only as an accidental by-product.
But there is a legitimate question about how appraisers do their work, as in how they look at comparables. The problem is that any form of collateralized lending has a strong propensity to generate boom-bust cycles. If the price of a widely held asset rises, everyone looks richer and banks are willing to lend more against it. And as more people look richer and banks are willing to hand out more dough in the form of secured loans, they can bid up all sorts of asset prices. An appraisal can be a brake by being backwards looking, but in general, if a market is rising or falling, it will in general apply only a slight deceleration on the trend. And as we’ve seen, in frothy markets, the conservative, careful operators will tend to lose out to the more cooperative ones.
And the problem of appropriate selection of comparables is particularly acute, ironically, in allowing for the value of an important shift in homebuilding and renovations, that of greater energy efficiency. Now some appraisers do incorporate this type of construction in their valuation process, but from what I can tell, it’s a small minority. I got this report from a regular reader:
I recently was at an ‘energy summit’ in Appalachia, the sole purpose of which was to figure out ways for appraisers (and state housing finance agencies) to more explicitly give appraisal value to energy efficiency steps built into a house…. a very eloquent leader from one state’s appraiser association emphasized that appraisers do have flexibility to do this but most of the time most of them just focus on ‘comparables’. The point is that we’ve now figured out tons of ways to have much more energy efficient housing — and that has real cost advantages — yet our ‘system of housing’ is ‘behind the times’ because thousands of appraisers have no clue, no motivation, no impetus for doing the work to recognize this value in a way that is accurate.
The picture presented there was that the vast majority of appraisers the vast majority of the time base their work on comparable sales with, at best/most, small adjustments for ‘other things’. But, even then, the picture painted was comparables, comparables, comparables — only comparables.
This aspect bedevils nonprofit housing groups in places like Appalachia. These groups, by the way, really focus on delivering quality housing (e.g. better roofs etc). Of course, they do this within certain budget constraints — but, again, the whole point of making housing affordable is understood by the best nonprofits to mean ‘affordable over the life of the house': hence, good construction, efficient energy steps, etc.
However, what happens when appraisers fail to take quality construction and especially energy efficiency into the valuations – and only look at ‘comparables’ — is the fostering of what the nonprofits call ‘an appraisal gap’. A home that costs, say, $110,000 to build is appraised at, say, $80,000 .. meaning less financing available … meaning that unless the nonprofits can come up with creative subsidies, the family doesn’t/can’t get into the home.
Several of the speakers — including the impressive head of one of the state appraisal boards — illustrated the fallacy of all this when it comes to energy efficiency. His example (and others had almost identical examples) was a newly constructed energy efficient house that cost $108,000 versus $100,000 for a “normal” house — and, as a result, over the first seven years of homeownership saved the family $13,000 in direct savings off utility bills. (And, of course, over the useful life of the house, much more…and that might not allow for other, smaller but nevertheless meaningful ongoing maintenance savings due to better construction).
But, the way most appraisers work, he said, would be to give zero value to this… and if comparables were, say, $95,000 .. the gap exists…..
To me, this was the perfect picture of a market failure. As I pointed out to the conference, ignore that this is about housing.. just look at it in terms of cash flows. Essentially, the ‘market’ is failing to finance — entirely failing .. at any price – a seven year $13,000 cash flow with that has up front $8,000 ….. (and, as said, it’s really even more return cash if one looks out over 10, 15 or 20 years).
I pulled out my trusty HP 12C. I get an IRR of 13.8%, assuming the $13,000 savings are equally divided over the first 7 years. So the reader is right, the investment in energy efficiency is clearly attractive, yet appraisers for the most part either can’t be bothered to do the extra work or are unwilling to go outside their comfort zones.
And for my money, this sort of market failure among appraisers is more significant than buyers who need to borrow to finance their purchases being upset that appraisers aren’t as enthusiastic about the housing market as they are.