Appraisal myths.

The secondary market has been actively seeking to promote equal opportunity and expanded access to mortgage credit. Providing guidelines instead of rigid decision rules to give lenders the flexibility to exercise their knowledge of local markets to serve targeted populations is crucial to the success of this effort. Current efforts are well under way to communicate the flexibilities available to lenders using secondary market underwriting guidelines. The secondary market agencies understand it is critical to dispel any misunderstandings about their guidelines that might prevent viable loans from being made.

For Freddie Mac, this had led to the creation of something called the Underwriting Barriers Outreach Groups (UNBOG). It is Freddie Mac's response to studies showing that lenders' perceptions of secondary market underwriting standards may affect lending patterns. Freddie Mac created UNBOG in 1993 to provide continual review and feedback on policies, perceptions and practices that might pose barriers to homeownership and to assure a process of ongoing clarification and change.

UNBOG consists of four regional groups of community activists, appraisers, minority and nonminority lenders, real estate brokers and Freddie Mac staff members. Each group meets several times each year to help Freddie Mac review its underwriting guidelines. Each working group member is asked to come to the meeting prepared to identify specific barriers that might arise through a misinterpretation of these guidelines. At each meeting, specific proposals are made for clarifications that might enhance a better understanding of the flexibility in the guidelines.

Freddie Mac then publicizes any clarifications it makes to the industry. In addition to the two sets of clarifications issued thus far, this column represents an added step to promote dialogue in the lending industry, increase understanding among industry professionals of potential barriers faced by low- and moderate-income and minority families and expand the secondary market to people and places that may have been underserved.

This column will focus on property, neighborhood- and appraisal-related issues. Our experience derives primarily from more than 600 telephone calls taken per month from lenders regarding specific collateral characteristics and from myths and facts identified by our working groups.

Myth: Freddie Mac has specific property standards that must be reflected in appraisal reports, such as those for building materials, aesthetic appeal and physical condition of the property.

Fact: Freddie Mac does not specify what materials may or may not be used in the construction or renovation of properties securing loans but relies upon the lender and appraiser to determine that the dwelling is marketable and provides adequate collateral for the loan. "Aesthetic appeal" is a subjective term that may reflect preconceived notions or personal preferences of an appraiser or underwriter rather than a fair market value. In fact, our groups have told us that properties are sometimes evaluated on the basis of where the appraiser or underwriter would choose to live rather than whether there is a market for the property. We've heard this more in connection with the evaluation of older properties and those located in central-city neighborhoods. Many borrowers, however, may prefer older, heterogeneous housing in established neighborhoods. The issue is to determine that the value of the property is supported by the potential market. It is equally important to recognize that in order to make this determination, the appraiser must understand the neighborhood being evaluated and convey how the specific property fits into the neighborhood. Then, it is important to understand the market of potential borrowers being served and their preferences, opportunities and alternatives.

Myth: Freddie Mac has specific limitations on the physical characteristics and incidental uses of properties securing loans that it purchases that go beyond marketability issues. For instance, homes with in-law apartments, small homes or homes in which owners conduct business or earn income (doctors, accountants, attorneys, piece workers, etc.) and homes with outbuildings (sheds, barns, kennels) are not allowed.

Fact: Properties such as these may be--for their neighborhoods--typical, marketable and acceptable. Unnecessary barriers may impose restrictions on borrowers with certain religious, ethnic, cultural or income characteristics. For example, in-law apartments may be important where it is typical for extended families to reside in one dwelling. Two kitchens may be typical for some cultural or religious groups or in very warm climates. Small dwellings may be the predominant housing stock in some markets and acceptable to the market of potential buyers. The ability to conduct business from home may be acceptable, provided that the use does not have a negative impact on value or marketability.

In all of these instances, the challenge for the lender and appraiser is to be familiar with not only the property but with the neighborhood and the market of potential borrowers willing and able to buy these properties. What may be unfamiliar to an underwriter may be an undiscovered opening to what a particular marketplace is demanding. The bottom line is that lenders and appraisers must know their local markets in determining value and marketability.

Myth: Freddie Mac has specific prohibitions on nonresidential use of properties securing the loans it purchases.

Fact: While Freddie Mac does not purchase mortgages secured by vacant land or property used primarily for agriculture, farming or commercial enterprise, Freddie Mac does expect the appraiser to consider a number of factors in making the decision of whether the property is residential, such as:

* the type of improvements on the property and neighboring properties;

* the current use of the subject property and neighboring properties;

* the type of development occurring in the neighborhood;

* pending zoning changes or changes in use of properties in the area;

* whether the subject property and neighboring properties are residential and marketable; and

* whether the land size and ratio of land value to total value are typical for residential properties in the area.

Myth: Freddie Mac won't buy mortgages on properties for which land value constitutes more than 30 percent of the total value of the property.

Fact: Land value is just one factor an appraiser or lender considers in determining whether the property is primarily residential, as opposed to a land loan or a speculative acquisition by the borrower. The criteria is whether the land size and land value to total value ratio are typical for the area. This "percentage limitation issue" is particularly important in high-cost areas and is exaggerated for affordably priced homes where the value of the land typically is high compared with the cost of the residential structure.

Myth: Freddie Mac will not allow properties with outdated designs or functional obsolescence such as homes with walk-through bedrooms or kitchens next to bathrooms.

Fact: Freddie Mac expects the appraiser to address functional obsolescence to the extent that it affects value. These property characteristics may be acceptable to the marketplace being served, even though the appraiser or underwriter may not be familiar with this type of property or neighborhood. The preferences and options available to the purchaser and to the market should provide objective data needed to make a determination of value and secondary market acceptability.

Myth: Freddie Mac has specific requirements concerning physical condition of the property. Where the appraisal notes cosmetic repairs, such as spot painting, the lender must require completion prior to the loan closing.

Fact: If cosmetic repairs do not affect the value or marketability of the property, the secondary market does not make completion a condition of closing or a post-closing requirement. Secondary market guidelines distinguish between repairs that affect value and cosmetic repairs that are merely noted on the appraisal report as desirable, but that have not been considered in appraiser's determination of value. In this latter case, there is no need to require the repairs at all; in fact, doing so as a precondition to making the loan, may present unnecessary barriers to affordable financing for the purchaser.

Myth: If the appraisal report notes required repairs that affect value--such as roof repair--full replacements are required, particularly where older properties or loans to low-income borrowers are concerned.

Fact: Freddie Mac requires that the property be structurally safe and sound. It is important that necessary repairs be distinguished from replacements and that the underwriter determine the extent to which repairs versus replacement are needed to ensure safety and structural integrity. The unnecessary cost associated with replacing an entire roof where only a portion is in disrepair or requiring that the entire exterior of a house be repainted where pictures show peeling paint on one portion, is a common barrier and is often applied unevenly to similar properties in different locations.

This column was written by Andrea Stowers, director of affordable credit policy and John Hemschoot, director of home mortgage standards with Freddie Mac, McLean, Virginia. The column will appear quarterly and cover topics central to promoting affordable housing.