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Will bad appraisals drive out good?

The Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA) mandates the licensing of real estate appraisers. The initial motivation for licensing was the concern that "faulty and fraudulent" appraisals had contributed to the problems of the savings and loan institutions. In their note analyzing the impact of the regulatory changes on the appraisal industry, Colwell and Trefzger argue:

Those who expect the best appraisers to thrive in a competitive marketplace by exceeding the regulatory standards are likely to be disappointed. If minimum standards are needed because users of appraisal services cannot discern unacceptable quality from acceptable quality, then it must be conceded that clients cannot discern definitionally acceptable quality from truly good quality.(1)

Based on this argument they conclude that appraisers will provide only the minimal-quality appraisals(2) required by regulation. Because all appraisers will do only minimal-quality appraisals, voluntary designations, such as the Appraisal Institute's MAI and SRA designations, have no economic function and will disappear.

In this article, the tools provided by the economic theories of agency and imperfect information(3) are used to analyze the effectiveness of licensing and the role of voluntary designations. It is argued that licensing cannot prevent faulty and fraudulent appraisals as long as some users of appraisal services want numbers only to justify decisions that have already been made. At the same time, if there is a demand for high-quality appraisals, a market for these high-quality appraisals will exist. If the quality of an appraisal is not directly observable by a user of appraisal services, both licensing and voluntary designations can play important economic roles as signals of quality.

To understand the motivation for and the effect of licensing, three questions are addressed: Who is the principal? What does the principal want from the appraiser? What happens if the principal cannot tell the difference between high-quality appraisals and minimal-quality appraisals?


Traditionally, lenders have been considered the principals because lenders generally hire appraisers. Yet the driving force behind the regulatory changes in the appraisal industry has been the problems in the savings and loan industry. The portions of FIRREA that deal with appraisals were passed because Congress was concerned with the protection of deposit insurers and, ultimately, taxpayers. Thus, a deposit insurer might be seen as the principal.

If the purpose of an appraisal is to protect a deposit insurer, this purpose should be clearly linked with the hiring and the compensation of the appraiser. The requirement for licensing and the implementation of the Uniform Standards of Professional Appraisal Practice (USPAP) will not change the fundamental agency relationships in this market. As long as a lender controls which appraisers are hired, the lender will also control the kinds of appraisals that are delivered.


If a deposit insurer and a lender want exactly the same thing the identity of the principal is irrelevant; however, their preferences may not match. The lender could want an appraisal to justify a lending decision that has already been made or to provide an independent source of information. The deposit insurer's motivation is simply to protect itself from losses caused by loan defaults.

Potential conflicts between a lender and a deposit insurer arise when their goals diverge. For example, a lender may want an appraisal to justify a lending decision it has already made while the deposit insurer wants an appraisal to prevent the lender from taking on too much risk by making too large a loan. As long as the lender continues to hire the appraiser, the appraiser will see the lender as the principal and provide the type of appraisal that the lender prefers.

Not all lenders want appraisals only to justify their decisions. Richard Knitter surveyed lenders to find out what clients want from appraisal reports.(4) Survey instructions allowed respondents to check as many answers as applicable to the question, "Why do you hire an appraiser?" The most frequently chosen answer was "required," with 81%, but the second most chosen was "to obtain an independent, unbiased opinion of value," with 80%. As long as at least some lenders want high-quality appraisals that provide independent information to allow them to make good lending decisions, there should be a place in the market for appraisers who provide these high-quality appraisals.


If principals cannot judge quality, will high-quality appraisals become obsolete? The argument that only minimal-quality appraisals will be provided because clients can't tell the difference between high- and low-quality appraisals is an application of Akerlof's lemons argument.(5) Akerlof analyzes a market in which there are unobservable quality differences using the example of used cars.(6)

Suppose there are only two kinds of used cars: "cream puffs" and "lemons." There are an equal number of each. A cream puff is worth $5,000 and a lemon is only worth $2,000. Buyers cannot tell whether a car is a cream puff or a lemon. If a buyer asks a seller whether the car is a cream puff or a lemon, all sellers will respond with cream puff. Owners of cream puffs will tell the truth but owners of lemons will lie to obtain a higher price. In this situation, the buyer is only willing to pay the average of the prices--$3,500. Some buyers will pay too much and some will get a bargain, but on average $3,500 is the right price.

Sellers of cream puffs do not want to sell for $3,500 when a cream puff is worth $5,000, so the owners of cream puffs withdraw from the market leaving only lemons. Buyers know that owners of cream puffs are leaving so they assume that only lemons are available and are only willing to pay $2,000. Colwell and Trefzger cite Gresham's Law,(7) "Bad money drives out good," or in this case, lemons drive out cream puffs. If a buyer has no way to tell which cars are cream puffs and which are lemons, only lemons will be offered in the market. Cream puff owners want to sell their cars for $5,000, and while some buyers would be willing to pay that price, no cream puffs are offered in the market because of an information problem.

If a cream puff owner wants to sell the car for its true value, $5,000, the owner has to convey the information concerning the car's type in a way the buyer will believe. One possibility is to get a mechanic that everyone trusts to look at the car and provide a cream puff designation. If the mechanic is perceived to be truthful and able to judge quality, everyone will believe the mechanic's designation. The seller will have to pay the mechanic to inspect the car. If the cost of the inspection is not greater than the gain from selling the cream puff at its true value, it will be worthwhile for the cream puff owner to pay for the inspection.

How do cream puffs and lemons relate to appraisals? The point of Colwell and Trefzger's analysis is that the buyers of appraisal services are unwilling to pay more for a high-quality appraisal because they cannot tell whether the appraisal is really of high quality. A high-quality appraisal is worth more to a client, who would be willing to pay more for it if he or she knew for certain that it was a high-quality appraisal. Because buyers cannot tell the difference in the quality of an appraisal, they believe that some appraisers will do low-quality appraisals and say they are of high quality. To avoid paying too much, the buyer is only willing to pay for a minimal-quality appraisal. Consequently, because the buyer is willing to pay only for an appraisal of minimal acceptability, appraisers will only be motivated to perform minimal-quality appraisals. Appraisers who spend their time and effort to do more than the minimum will not be compensated and will lose money. Eventually, appraisals of only minimal acceptability will be performed.

The assumption that drives these conclusions is not only that buyers are unable to tell whether the appraisal is of high or minimal quality (i.e., a cream puff or a lemon), but also that appraisers cannot provide evidence of the quality of appraisals that buyers will trust. In the case of the used cars, the solution is to find a mechanic who is trusted by the buyer to provide a cream puff designation. In the appraisal case, the solution is similar--set up an external group to provide a screening mechanism--designations of quality for appraisers. In this context, licensing and voluntary designations play an important economic role: they provide a credible signal to buyers of appraisal services of the quality of those services.

Do licensing and voluntary designations send a believable signal? Licensing is so new that it is difficult to tell. The existence of a variety of appraisal designations seems to imply that they have an economic function. As any designated appraiser knows, acquiring the designation is expensive in terms of time and money. Yet many have worked to achieve the designations and continue to work to maintain them. Individuals incur these costs because clients are willing to pay them more. The market for appraisers provides confirmation that the designation provides information concerning quality.


As the appraisal market is currently structured, a lender chooses an appraiser and is seen by the appraiser as the principal. Appraisers who will do what the principal wants may drive out those who will not; however, this has nothing to do with the ability or inability of the lender to judge quality. Some lenders wanted appraisals to justify their lending decisions--the principals got what they wanted. While from the point of view of the federal agencies, the appraisals may be bad, from the point of view of lenders at the time the appraisals may have been good.

As long as some clients want high-quality appraisals there should be a market for these services. If a lender cannot differentiate between high- and minimal-quality appraisals, some external group can be hired to provide that information. Licensing and the voluntary appraisal designations provide information that a client will believe concerning the quality of appraisal services. The fact that appraisers are willing to spend time and money to achieve professional designations, and that some clients are willing to pay more to designated appraisers, is market verification that the designations provide valuable information.

1. Peter F. Colwell and Joseph W. Trefzger, "Impact of Regulation on Appraisal Quality," The Appraisal Journal (July 1992): 428.

2. In this article, the term appraisal is used to refer to an estimate of market value. In a high-quality appraisal, the best available methods have been used to analyze the best available information to estimate market value. Such an appraisal would exceed the requirements of the Uniform Standards of Professional Appraisal Practice (USPAP). A minimal-quality appraisal meets the requirements but does nothing beyond those requirements. A low-quality appraisal does not meet the USPAP.

3. For a basic discussion of the problems of imperfect information in the product market see Joseph E. Stiglitz, Economics (New York: Norton, 1993), 491-516. For a more technical discussion see Hal R. Varian, Intermediate Microeconomics: A Modern Approach (New York: Norton, 1993), 602-623.

4. Richard Knitter, "What Clients Want from Appraisal Reports," The Appraisal Journal (April 1993): 272-276.

5. G. Akerlof, "The Market for Lemons: Quality Uncertainty and the Market Mechanism," Quarterly Journal of Economics (1970): 488-500.

6. The used car example is the classic example of a market in which there is an information asymmetry between the buyer and the seller--sellers know something that buyers do not know about the quality of the product.

7. Akerlof's lemon argument seems more applicable in this case than Gresham's Law. The difference between bad money (paper money) and good money (gold) is observable. The problem in the appraisal market is not simply that high-quality and minimum-quality appraisals exist but that clients are unable to tell the difference.

Patricia M. Rudolph, MAI, PhD, is the Board of Visitors Research Professor of Finance at the University of Alabama. She has previously published several articles in real estate and finance journals, including the AREUEA Journal and the Journal of Financial Research.
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Author:Rudolph, Patricia M.
Publication:Appraisal Journal
Date:Jul 1, 1994
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