Research shows why bank-owned property inventories continue to grow costing lenders a greater amount of money to preserve these assets over time: overvaluing properties during the appraisal process.
In their “Overvaluing Residential Properties and the Growing Glut of REO” report, Thomas Fitzpatrick and Stephan Whitaker, two economists at the Federal Reserve Bank of Cleveland, determined that lenders could avoid taking on REO assets if they could more accurately estimate the value of the homes they foreclose on, especially in weak housing markets where supply of these homes exceeds the demand.
The report looked at sales data from Cuyahoga County, Ohio, from January 2006 to June 2011 and found signs that appraisers, lenders and investors could be routinely overestimating the property values of foreclosed homes there. Since lenders are valuing the price of a foreclosed home too high, the minimum bid at the sheriff’s sale is therefore set for a larger value than necessary, lowering the chance that someone will buy the home at the auction.
In the report, the authors compared the auction price paid by the lender and the subsequent sale price of the home. If the sale price was less than the minimum auction reserve listing, the lender was classified as taking a loss.
By Ohio state law, the minimum bid—or auction reserve—at the first foreclosure auction is set at two-thirds of the appraised price. If there are no bids at the first auction, the lender can set the minimum bid for subsequent auctions at any price up to the amount of the unpaid loan. In theory, the lender should be setting the minimum bid based upon what it could obtain by selling the property, less carrying and transaction costs.
The report found that purchasers of property at Cuyahoga County foreclosure auctions tend to resell the property for less than they paid. Investors tend to do the best, selling properties for an average of 27% less than they paid at auction. Federal agencies such as Fannie Mae, Freddie Mac and the Federal Housing Administration do worse on average, compared to investors, but better than lenders, as they sell properties out of REO for about 30% less than their auction reserves. Lenders tend to sell property out of REO for 42% less than the auction price.
“If lenders priced preforeclosed properties properly before they were put on the market during a foreclosure auction, buyers may not be so reluctant to purchase these assets, therefore clearing up the inventory of bank-owned homes and stabilizing the housing industry,” the authors said in the report.
During the time period of this report, lenders refined their methods of estimating the values of homes in only the lowest-poverty areas of weak markets. Data revealed that the mean percentage loss for low poverty properties was about 32% in 2010, compared to 43% and 40% in medium-poverty and high-poverty areas, respectively.
Even though Fitzpatrick and Whitaker only looked at information in one county, they said this trend is probably happening in other markets, too.
However, Ken Chitester, spokesperson for the Appraisal Institute, said appraisers are not to blame for these properties turning into REOs.
“If preforeclose homes are becoming REOs, don’t blame the appraisal,” Chitester told Mortgage Servicing News. “Real estate appraisers are undertaking the same thorough research and thoughtful analysis that they always have. To help ensure a reliable, credible opinion of value, lenders should seek out highly qualified and competent appraisers, such as designated members of the Appraisal Institute.”
The Cleveland Federal Reserve report did note that inaccuracies may be happening because appraisers or brokers might not have enough comparable arm’s-length property sales in extremely distressed markets where most sales in the last five years have involved recent foreclosures. Looking to older properties for a drive-by appraisal or broker price opinion may also overestimate the sale price in these markets, according to the report.
“Lenders might be overvaluing property in weak housing markets because they are using a uniform process that works well in most areas,” the report said. “For example, a drive by appraisal of new housing stock is more likely to produce an accurate market price than it would for older, distressed housing stock. With few exceptions, newer homes will be in good condition inside and out.”
However, the age distribution of REO homes in weak markets is much older than most of the housing stock nationwide. In the Cuyahoga data, 86% of the homes in REO are at least 50 years old. Over the decades, some older homes were well maintained and others were neglected, leading to a very wide range of conditions and values.
The Dodd-Frank Wall Street Reform and Consumer Protection Act contains interagency guidelines requiring banks to review their appraisals for USPAP compliance, which are the standards an appraiser has to follow. Carl Streck, CEO of MountainSeed Appraisal Management, said this does not necessarily include checking for value, but reviewing for value.
“Under USPAP, we are more or less saying that the appraiser told a lender that the property is worth $100,000, but how did they get there? If the appraiser built an accurate roadmap to get to that value, then they are compliant with USPAP guidelines,” Streck told this publication. “We are making sure the appraiser took the appropriate steps to be clear in the report.”
Streck said he believes that an appraiser, not an underwriter who works at a bank with real estate knowledge, needs to conduct the USPAP review in order for the report to be the most accurate. He added that appraisers can “find all the stuff that can give you the most accurate depiction of market value.”
