Are Appraisers Killing the Banking Industry?

(TMA International Headquarters)

As if the economy and tight credit markets were not enough to contend with, real estate developers are faced with a new challenge. Banks are informing real estate developers at loan maturity that their cash-flowing, debt-servicing property is now considered substandard based on the bank’s latest appraisal. The opportunity for such a developer to renew its loan is predicated on new pricing and a substantial equity contribution to pay down the existing loan balance to a "conforming" loan-to-value ratio.

For many developers this is a double whammy. Their initial shock often soon gives way to anger. The developer may have a stabilized project that meets debt service coverage ratios under the "old" deal. Now, to keep the asset, not only is the developer’s cash flow negatively impacted by increased pricing, but it must also fund additional capital to meet the required pay-down to a conforming loan to value. In many cases, the developer’s capital is already stressed and is insufficient to make loan pay-downs over its entire portfolio.

In my opinion, banks are trying to increase their spreads too quickly to restore profitability and increase their Tier 1 capital base. The problems in the financial markets didn’t happen overnight, and solving them will take time, too.

Developers who are hurt most are those who use regional banks that have poor capital bases and need to show increased yields (pricing) to justify more capital. These poorly capitalized banks have seen their cost of funds rise, and they are caught with the higher costs they must pay for liquidity to make loans. Some that cannot attract adequate capital use "new" appraisals to force pay-downs on outstanding loans, thereby recovering capital.

However, in terms of liquidity, more onerous than the increased pricing is the required pay-down to make a loan "performing." This is where the appraiser is integral to whether the borrower and lending officer are at war or peace with each other.

Defining ’Market Value’

The premise of every appraisal is "market value." Valuation experts use "fair market value" as the standard, but there really is no difference between the terms. As promulgated by the Financial Institution Reform Recovery Enforcement Act, the Federal Reserve defines the following presumptions for market value:

1. Most probable price
2. Competitive and open market under all conditions
3. Buyer and seller acting prudently and knowledgably
4. Price not affected by undue stimulus

I would suggest that almost every appraisal violates at least items two and four of this list. There is almost no market for real estate today. There are far more trades on the debt underlying real estate than on the real estate itself. Most apprisals only consider conditions today, which by any standard reflect the most depressing times in our nation’s history, considering unemployment and foreclosures. Does anybody believe that current prices derived by appraisers from the market are not impacted by undue stimulus? Bank failures, government bailouts of corporations, and a federal stimulus package for housing and autos are not business as usual.

Market transactions are difficult to find. Few of those that have occurred recently are reflective of both ingredients of a fair market sale -- a willing buyer and a willing seller. Most of these deals are depressed and reflect undue influence of a stressed sale. Typically, the seller is faced with eminent foreclosure, personal bankruptcy, or a guarantor lawsuit. Anyone who doesn’t believe such matters constitute "undue stimuli" must also accept the premise that a blindfolded prisoner forced at the tip of a sword to walk the plank jumps into shark infested waters because he seeks a leisurely swim for exercise.

The conclusion of value provided by most appraisers today prevents banks from entering into reasonable renewal or restructures, causes undue pressure on the real estate industry, and threatens the viability of financial institutions by negatively impacting their capital.

As a firm, we currently manage homebuilding activity in 20 residential subdivisions. On a number of occasions we have sold a house to a customer who has plunked down a 20 percent deposit, only to see the house appraise at only 65 percent to 80 percent of the sale price. Thirty days into the escrow process, the buyer learns that he does not qualify for a mortgage because the house appraised for substantially less than he was willing to pay for it.

Consequently no sale is consumated and the house remains empty while property taxes, utility charges, and management fees continue to accrue to the bank. For the bank this process results in a continuing liability for expenses rather than an income-producing mortgage and cash event.

While this already sounds ludicrous, it gets better. We have a willing buyer -- one who can choose from a sea of foreclosed homes, builder closeouts, or houses for sale by owners, all of whom are desperate for a transaction. This willing buyer shops around, makes the best deal he can, and is willing to plunk down his hard earned money for 20 percent of the negotiated price of his dream house. The willing seller agrees to the sale price. Yet, it is the appraiser, who is not a party to the transaction, who determines the fates of both the buyer and seller.

For the bank this is catastrophic for at least two reasons. The obvious reason is that there is no sale. The bank cannot convert its negative-cash-flow asset to an income-producing asset. Second, and maybe not so obvious, is that the bank misses a great opportunity to establish the market price in the subdivision. Usually the bank has other properties to sell in the same subdivision, and this would be a great chance to evidence a "true" market transaction instead of being compared to foreclosures and other forced sale transactions.

To me, the choice for the bank should be obvious--make the sale, establish the market, and inventory the mortgage. If the banks allow the appraisers to dictate arbitrary "market" value, then perhaps they deserve the resulting impairments to their capital.

Patience Is Required 

So what is the solution? The U.S. government could suspend mark-to-market rules, which would put less pressure on developers in a down economy and would discontinue the practice of forcing financial institutions to take paper losses that erode their capital bases. When money is flowing and times are good, nobody worries about the short-term nature of debt maturities on long-term assets. The current state of regulation is forcing transactions on the market with no liquidity. This is a perfect storm for depressed pricing and capital erosion.

There is precedent for addressing this dilemma. In the past, the federal government suspended write-downs of loans originated by banks to underdeveloped countries that couldn’t repay the money. Rather than forcing banks to write down those loans immediately, thereby eroding the originating bank’s capital, the government allowed the institutions to amortize the potential loan losses over a period of time. This show of patience allowed banks to earn profits to restore their capital bases and absorb the losses.

Similar accounting is used in valuing pension plans to determine if they are properly funded. Nobody forces a major corporation to fund an exorbitant contribution to its employee pension plan when the stock market crashes or doesn’t hit the actuarial rate of return for the plan. The accounting term is "smoothing," which recognizes the long-term nature of both the required funding and ultimate payout of a fund’s assets to retirees. It allows economic ups and downs to be averaged over a short period (three years). Such action allows companies to provide pensions without the roller coaster ride of returns in equity markets.

Today’s appraisals most nearly reflect forced liquidation values because, given the current state of the makret, nobody who can afford to hold onto an asset would sell it right now. Forced liquidation sales are not "market" sales. Trying to force banks and developers to change their historic relationships with short-term fixes on long-term assets will only continue to depress real estate values, decimate developers, and erode bank capital -- a poor result at any time.