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Preserving quality in the pressure cooker.

Regulatory pressure and increased lender caution are causing mortgage lending institutions to exercise greater quality control over staff and fee appraisals. Appraisal quality control is increasingly taking the form of appraisal auditing programs.

WHAT HAPPENS WHEN AN APPRAISAL department outgrows its ability to ensure consistent appraisal quality? The quality declines, of course.

In today's regulatory climate, unfortunately, lenders face sanctions for relying on poor-quality appraisals to make lending or investment decisions, regardless of whether the appraisals are prepared by staff or fee appraisers. It would behoove many government-regulate mortgage lending institutions to reexamine their appraisal quality control program prior to their next regulatory examination, because examinations have become increasingly strict with regard to appraisals.

More importantly, declining real estate values have considerably elevated the need for accurate appraisals. Appraisal quality management has become a vital part of a quality lending program.

A new order

A new order is now emerging in the appraisal profession--an order whose rules are written by regulators and lenders rather than by the fee appraisers who previously dominated the profession. Examiners with the Office of Thrift Supervision (OTS) and the Office of the Comptroller of the Currency (OCC), for instance, are now directing their regulated institutions to employ competent appraisal review staff and to contract with specific, preapproved, individual appraisers rather than appraisal firms. In addition, OTS Thrift Bulletin 55 (and similar real estate appraisal guidelines of other federal agencies) stipulates that "institutions should also test the substance of appraisals and evaluations through audit procedures." All of these efforts are specifically intended to improve a financial institution's appraisal quality control.

Definitions of appraisal quality

What is appraisal quality? Nowhere is it actually defined, although it is generally assumed that it is achieved by properly following accepted standards of professional appraisal practice. Nevertheless, reviewers have commonly observed the conduct of appraisal assignments by rote, fulfilling the letter of the Uniform Standards of Professional Appraisal Practice of the Appraisal Foundation (USPAP) while failing to accurately estimate current market value, particularly in the appraisal of poorly performing properties or properties in dedining markets.

Unfortunately, today's standards of professional appraisal practice much more specifically define proper format than proper depth of analysis. The mortgage lending institution's foremost concerns, though, are "what is this property worth today," "what is this property's expected performance in the future" and even "what is this property likely to be worth in future years." These concerns are satisfied only by dutiful analysis. Where the necessary analysis is lacking so much so that the institution's concerns go unanswered, true appraisal quality is not achieved.

Institutional appraisal quality control

For most institutions, the only quality control function is a chief appraiser. This can suffice for the small institution. Nevertheless, the institution faces some risk in putting its trust in just one person. Chief appraisers can have shortcomings, such as:

* Inadequate qualifications--They can lack the experience and training to handle every property type that their institution lends on.

* Inability to focus on what is important--Some chief appraisers can be more preoccupied with spelling errors and other minutiae than with errors in appraisal judgment.

* Exaggerated professional courtesy--Chief appraisers may be reluctant to correct a highly esteemed appraiser, or may not hold an appraiser to higher standards than what they would expect from themselves.

* The human factor--One of the most dangerous shortcomings in a chief appraiser is being reluctant to correct appraisers for fear of hurting their feelings or diminishing their reputations; a similar problem is when a chief appraiser wants to be liked more than anything else.

* Lack of independence--There is often pressure on appraisers to "make deals work." Just situating appraisers close to loan agents creates pressure. Loan agents often intimidate appraisers. The chief appraiser can be just as affected by this pressure, if not more.

Loan originators can stir up political fires, particularly if they have champions in high places in the institution, by casting doubts on a particular appraiser's competence or loyalty to the company. Loan originators may try to embarrass appraisers that they do not like. For some chief appraisers, as a result, the path of least resistance may be to accommodate a loan agent by adopting a more favorable outlook for a particular property.

The shortcomings of placing all responsibility for valuations on one individual suggest the need to have an independent appraisal auditing program.

An appraisal auditing program

For large appraisal organizations, an effective appraisal quality control program relies on appraisal audits of staff appraisals to ensure consistency and compliance with appraisal standards. At my institution, the nation's largest savings and loan association, there are independent departments that conduct appraisal audits and report to a separate senior vice president rather than the director of appraisal operations.

The advantages of an independent auditing system over the traditional "chief reviews all" system are several:

* Objectivity--Auditors can be detached and not concerned with whether people like them or not, particularly because they are only temporarily in any one appraisal office.

* Purpose--Auditors look for problems. They can also focus on appraisal quality, consistency and risk to the institution without being distracted by conflicting duties or priorities.

* Independence--Within the organizational structure, auditors are independent by definition. Auditors are expected to be objective enforcers. They have no incentive to accommodate rule breakers.

An appraisal quality control program should check for:

* the accuracy and reasonableness of appraised values;

* compliance with USPAP and federal regulations; and

* compliance with an institution's internal appraisal policies and office procedures.

Appropriate audit standards

Staff--The appraisal audit should be performed by individuals having adequate appraisal training and journeyman-level proficiency as appraisers. Such staff should have proven ability to follow instructions, understand the intent of formal policies and procedures and the ability to communicate with various levels of management.

All of the required skills for an appraisal audit should be available on the audit team. This may entail assembling appraisers of diverse experience in a complementary fashion to form a team. Junior appraisers should be teamed with senior appraisers for more effective audit management.

Objectivity--The object of the internal appraisal audit is not to prove a point or to "get people." The primary focus of the audit should be on the appraisal product and whether or not the mechanisms are in place to guarantee the highest quality of appraisal product.

Due professional care in the conduct of the audit and the preparation of an audit report--This means knowing when there is sufficient evidence collected to make clear-cut judgments and findings.

Ethics--The ethics of auditors must be beyond reproach to maintain the impeccable credibility of the appraisal auditing system.

Proper supervision is necessary in the planning, monitoring and conclusion phases qf the appraisal audit--Effective audit management requires involvement while the work is in progress, not after it is complete.

Reporting standards

The report must be a fair and lucid representation of the audit findings. It should define the scope of the auditor's research in order to let the reader know what areas may have not been covered.

For best reception, an appraisal audit report should present outstanding strengths as well as weaknesses observed in appraisals. Credit where credit is due lends credence to the report's objectivity and serves to put the subjects of the report (the appraisers) in a more receptive mood to receive constructive criticism.

An effective appraisal audit report should distinguish between "felonies" and "misdemeanors." The term "felony," of course, is a misnomer, but it illustrates the importance of focusing clearly on items that significantly affect value and compliance. I have seen well-researched audit reports negated by poor organization and nit-picking. One such report did not get to the serious valuation errors until page eight and, therefore, went unnoticed by senior management; no reader had been able to maintain consciousness through the first seven pages.

For some organizations, an audit report may also be useful in determining administrative effectiveness or cost effectiveness of an appraisal department. In other words, appraisal auditing may include management auditing.

Operational caveats for appraisal audits

One cannot overemphasize the importance of independence for the appraisal auditors. Without true independence, the appraisal audit may become no more than lip service to the ideal of appraisal quality. The auditor cannot be influenced by anyone in the group under review or the management of the group under review. This necessitates giving appraisal auditors' complete in-dependence from line management, whether it is a loan production manager or appraisal manager (other than the chief executive). The audit function must also be raised to a level ofauthority where its factual findings can never be blocked or hidden.

Proper allocation of resources (most notably time and staff) is critical. As the competition in the financial industry creates pressures to become more efficient, there is always the tendency to cram a three-week assignment into two weeks. This may look good to management, but it is a false economy that is more apt to leave loose ends or unwar-ranted exposure.

There should be effective two-way communication between general management and the audit manager as to what the expectations are of appraisal audits.

There must be cooperation. The audit team must encourage everyone to bring problems to their attention. To accomplish this, management must set the proper tone and make it understood that it wishes to find appraisal solutions rather than hide appraisal problems.

The audit manager must guard against auditors' abdication of responsibility (such as, "I don't cover that area"). When appraisal auditors have insufficient expertise and experience in a subject area, such as "hotels," "New York properties" or "discounted cash flow analysis," these areas will not be examined in an appraisal audit. Losses can occur in those areas that do not receive sufficient scrutiny. That it is why it is so critical to select highly trained and seasoned appraisers for the appraisal audit team.

The audit program should have effective written instructions to guide appraisal auditors as to the work to be performed.

Members of an audit team should meet frequently enough to enable identification of pertinent findings quickly.

The audit program should have effective scope and frequency of review. This includes the determination and implementation of an effective program of review, both as to scope of review and time intervals between reviews, before management has allocated staffing resources to the audit function. It compromises the auditors' effectiveness when the audit function has limited staff such that there are review voids or areas not adequately covered.

To defend the proper allocation of staffing resources, the audit manager must "sell" the audit function by proving its constructiveness and economic value through the prevention of losses (in financial institutions) or through increased client confidence in the firm's appraisal product (fee firms).

A grading system should be established to determine the frequency between reviews. The poorer the grade, the sooner the next audit. This is a more effective use of appraisal auditors than having all appraisal units audited on the same fixed time schedule (such as once per year). The more poorly rated units know that they will be visited much earlier than normal and will work harder to get an improved grade at the next audit.

Appraisal audit guidelines

An effective appraisal audit will steer away from trivia and focus on major valuation issues or chronic inadequacies. As previously described, "over-reviewing" wastes time, confuses issues, distracts attention from the real problems and should be guarded against. Furthermore, all audit exceptions need to be supported by fact and reason, rather than unsubstantiated opinion (such as, "I don't like your cap rate").

The following is a suggestion of appraisal areas to examine:

* A test of reasonableness--Consult listings of similar properties. This is the quickest, easiest and most effective way of determining the credibility of an appraisal report in today's declining markets. The reviewer will sometimes find the subject property or a similar property listed for sale at below the appraised value. For instance, when a property is appraised at $17 million and is found to have been listed for 180 days at $15 million, the appraisal has a serious credibility problem; it means that the comparable sales are no longer indicators of current market value.

* Property description--Items that are easily audited are size, condition, functionality and incompatible externalities. Mismeasurement or misidentification have serious consequences on value if most reliance is placed on indicators of value based on area (or volume or lineal foot). A visit to the property is highly recommended to determine habitability, deferred maintenance, extent of completion, functional inadequacies or obnoxious and incompatible neighboring land uses.

* Property rights--The auditor should review a preliminary title report that will disclose third-party rights that could possibly harm value, such as adverse easements, encroachments, liens and perhaps a ground lease. The title report may have other important information too. One such report, for example, had a disclaimer from the city of Los Angeles that it had no liability for the construction of an apartment building on uncertified landfill, alerting the auditor to the significantly greater risk of the improvements being damaged by seismic activity, such as witnessed in San Francisco's 1989 earthquake.

* The sales comparison--This is the heart of most appraisals. The auditor must focus on the comparability of sales data. There is a tendency among appraisers to give equal reliance to all comparable sales regardless of time of sale or other differences. Comparable sales are sometimes treated as identical substitutes for each other. Motives for sale are not often investigated. Many of today's markets have a lack of sales, but other possible indications of declining values, such as dedining rents, indicate the need to apply negative time adjustments to older sales data. The appraisal auditor must judge an appraisal on the critical task of reconciling it to its comparable sales data.

One clue to a poor sales comparison is that the appraiser does not explicitly quantify his or her adjustments to comparable sales data, instead making nebulous remarks as "adjusted upward for the perceived superiority of the subject." The former Federal Home Loan Bank Board memorandum R41c that formerly set the standards for the appraisal profession required quantitative adjustments. The sales comparison is at the heart of the appraisal; if the analysis is cryptic or missing in this vital part of the appraisal report, it may indicate a lack of analysis.

* Adjustment for market conditions--If an appraisal's regional, city and neighborhood descriptions mention a faltering local economy or excessively high vacancies, falling rents and costly tenant concessions in the subject property's market, the appraiser must then consider such factors in his or her later quantitative analyses. New federal regulations now stipulate that an appraisal "analyze and report on current market conditions and trends that will affect projected income."

* Cost approach--The most neglected portion of the cost approach is the failure to include the necessary amount of depreciation. Whereas physical depreciation is commonly subtracted, the two other notable types of depreciation, functional depreciation and economic depreciation (also known as external obsolescence), are sometimes mistakenly omitted.

* Sales history--The most recent regulations in response to the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA) now require that the appraiser analyze and report in reasonable detail any prior sales of the property being appraised that occurred within one year of the appraisal date for properties of one- to four-residential units and three years for all other properties. If a market is known to be in decline, for instance, one might expect a property's current value not to exceed its recent purchase price, unless significant improvements had been made.

The following appraisal areas should be examined for appraisals of incomeproducing properties:

Determination of market rent--Has the appraisal:

* compared the subject's space to other spaces of differing size, shape, use, accessibility or visibility;

* not adjusted for differences in the expenses that are passed through to the tenants;

* compared rents per rentable square foot to rents per usable square foot; and most importantly,

* ignored rental concessions at comparable properties?

Sometimes the rental situation at the appraised property can be misleading. Common situations include "pocketto-pocket" leases, in which the tenant is the landlord, and old leases with escalation clauses that have increased the contract rent past the market level.

Vacancy analysis--Despite severely overbuilt markets nationwide, some appraisers still estimate future vacancies to be 5 percent or less or may even ignore vacancies altogether.

Expense analysis--The most commonly observed error is when forecasted expenses differ greatly from the current and historical costs of the subject property.

Derivation of a capitalization rate--The previous remarks on sales comparisons hold true here, because capitalization rates (the ratio between annual net operating income and value or sales price) are generally extracted from the chosen comparable sales.

The selected capitalization rates should ideally have market support. Sometimes appraisers choose more abstract methods to derive a capitalization rate, though, such as the "band of investment" method or "mortgage-equity capitalization." These methods still depend upon specific market rates (equity dividend rates or equity yield rates); otherwise they are meaningless academic exercises.

Discounted cash flow analysis (DCF)--AIso called yield capitalization by appraisers, this technique discounts net income or cash flows over a period of several years to a present value according to an internal rate of return (equity yield rate), typically required by investors for similar properties. Examples of misleading DCF practices include:

* mismatched growth rates for income and expenses compounded over the projection period. Expenses generally increase faster than income for most properties;

* failure to use correct effective market rents ( net of abatements);

* failure to use lease-by-lease analysis, therefore, ignoring unfavorable leases;

* ignoring likely vacancies;

* incomplete expenses;

* terminal capitalization rate (used to convert the final year of income into a likely sales price) lower than the initial capitalization rate;

* ignoring or underestimating reversion sales costs, and;

* discounting with an unsupportable internal rate of return.

In addition to these specific items, "spot checking" should be conducted on other appraised items that the audit manager believes to be at risk of being mishandled. Needless to say, the same spot check should be done on each appraisal in the sample.

Use of fee appraisers

An institution's appraisal quality control program must necessarily extend to its fee appraisers, particularly because such appraisers have less accountability and loyalty to the hiring institution.

Unfortunately, the structure of the fee appraisal business pits quantity against quality in the mass production of appraisal reports. Ordinarily, an appraiser adds staff as business grows; he or she eventually becomes a manager who delegates most appraisal work to less-experienced junior staff. An "assembly line" mentality emerges, in which there is pressure to produce an appraisal report quickly to increase profitability. The use of prior material and standard semantics creates an illusion of effort. Slick packaging and graphics can disguise inadequate research and analysis.

Compounding recent problems of appraisal quality has been the traditional lack of scrutiny from lenders. Appraisals were often treated by lenders as file fillers or rubber stamps. Many lending officials were poorly trained and did not know what to look for in appraisals or appraisers. FIRREA has now changed the appraisal practices of mortgage lending institutions, however, so that lenders are being forced to elevate the professionalism of appraisers.

Appraisal quality at large firms

There is irony in the observation that appraisal firms will often boast in their advertising of their size and geographic diversity, yet review appraisers generally concur that the largest firms often have the most inconsistent appraisal quality.

Having personally solicited explanations for these inconsistencies from these firms' executives, a common response has been "but every appraisal is reviewed by an MAI" (Member, Appraisal Institute). This does not substitute for an in-house appraisal quality control program, for there is no guarantee that MAIs will review in a consistent or effective manner unless there is some form of internal standards and monitoring.

The latest regulatory recommendation that institutions approve only individual appraisers rather than firms is a sound one. Many institutions have now learned that the easiest way to ensure fee appraisal quality is to insist that the same appraiser within a firm do each subsequent assignment. Based on my institution's reviews of several hundred fee appraisals nationwide every year, I have observed that the single practice that has contributed most to reducing appraisal quality has been the delegation of assignments to subordinates or colleagues lacking the necessary expertise. This is already becoming a prohibited practice at some financial institutions, including our own.

The consequence of this change in contracting practices will be the proliferation of sole proprietorship appraisal firms that have established relationships with lenders. Such persons will be more likely to leave the employ of larger firms, taking clients with them. While this may seem unfair to the large appraisal firms, the intent is to best serve the ideal of appraisal quality.

In the review of fee appraisals, I do not agree with the axiom that "the reviewer should assume the report is acceptable until proven otherwise." The appraisal report, according to USPAP, should be a prima facie case in support of a particular estimate of value. Given all of the pressures and incentives in the fee industry to cut corners on research and analysis, it is a risky practice to give fee appraisers the benefit of the doubt. An appraiser's methods and reasoning should be explicit in the appraisal report.

Auditing fee appraisal reviews

Appraisal auditing of multiple reviewers is just as necessary as auditing appraisers. An effective audit program will improve review quality and consistency.

The culmination of an appraisal quality control program in a financial institution is the peace of mind that comes from knowing that appraisal practices and quality are consistent throughout the institution and that appraisal inadequacies are being identified and corrected. The institution will be less likely to suffer losses from appraisal errors and will be able to face regulators with confidence.

Vernon Martin III is vice president for appraisal quality control for Home Savings of America, Irwindale, California. The ideas presented in this article are solely those of the author and are not intended to represent the viewpoint of Home Savings of America.
COPYRIGHT 1993 Mortgage Bankers Association of America
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1993 Gale, Cengage Learning. All rights reserved.

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Title Annotation:mortgage banks' appraisal audits
Author:Martin, Vernon, III
Publication:Mortgage Banking
Date:Apr 1, 1993
Previous Article:Managing a slippery asset.
Next Article:Battling fiefdom mentality.

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