Appraisal Fraud

I enjoyed finding your blog today. It was enlightening, particularly in the area of real estate appraisals.

Mortgage fraud is something I've been reading about lately. Since the FBI says 80% of it involves collusion and usually with the appraiser, it made me wonder why underwriters don't just ask for second appraisals when a loan looks like it could be part of a flipping scheme (e.g., the owner hasn't had it for long and the new appraisal has it coming in much higher than the last one).

Have you looked at this area at all? I'd be interested in your point of view.

Appraisal Fraud is more of a problem than it was. A couple of years ago, the appraisal was treated and regarded differently than it is now. On the one hand, appraisers were regarded as gods sitting in judgment of a property, which never was true. They're human, subject to human foibles and tendencies. On the other hand, it has perhaps swung a too far in the opposite direction, with many appraisers doing whatever the loan provider wants in order to continue to attract business.

A good balance is somewhere in between. Appraisers don't want to work any harder than necessary, of course, but they've got to remember that they are, first and foremost, businessfolk selling a service. I agree with the law that says minimum appraisals are prohibited, as it protects everyone. On the other hand, when I ask an appraiser to reconfirm if comparables don't support a value of $X, what I'm trying to do is protect my client. This gives me a chance to re-work the loan, or re-open negotiations with the seller, before my client has wasted hundreds of dollars for an appraisal that doesn't help. Eighty to ninety percent of the time, the appraiser who tells me the value isn't there gets paid anyway, because I can re-work the loan or renegotiate the deal to the point where everybody's happy and the transaction proceeds. If the appraiser just goes out, takes the check, and drops an appraisal that's $20,000 low on my client, I have a screaming mad client on my hands who is poison to my business because in their eyes I was the one who "tricked" this money out of them, and perhaps a seller and seller's agent who are angry as well because I hired an "incompetent" appraiser, with repercussions next time I write an offer for one of my clients, and nobody is happy, least of all me.

On the other hand, an appraiser who is willing to manipulate the data to come up with value no matter what is one I want to stay away from, and it's because of fraud. If there's no default and the loan gets paid back in full, appraiser fraud doesn't matter. But that's not the usual thing that happens with appraiser fraud.

I keep writing that a certain percentage of all attempted real estate transactions are fraudulent, and a good agent and especially a good loan officer keeps their eyes peeled for evidence. Real Estate transactions are very large dollar amounts. A one bedroom condo around here goes for over $200,000. This is more than most families make in a couple of years. An average single family residence might be $500,000 or more. This makes the temptation level considerable, and there are always folks around who have an eye for the quick easy dollar and never mind the effects on others or the prospects of prison if caught. Sometimes the lender is the intended mark, sometimes the other party to the transaction. I could tell you about all varieties of scams, but appraisal fraud is one of the most common.

Before we go any further, let's examine what an appraisal is. Accountants value goods using a method called "Lesser of Cost or Market," or LCM for short. This means a given property is valued for accounting purposes at either the purchase price (cost) or appraised value (market), whichever is lower. But this has been modified from its original form for real estate lending purposes, because in the real world real estate appreciates in value. At purchase, the cost or value argument still applies. No matter what, the lender will not lend based upon a value greater than the purchase price. Later on, however, they will, because land does not depreciate, it does not in general vanish or get used up, and it does increase in value (Pretty much universally over time frames of a decade or more).

This gives scam artists all the leeway they need. Some of them are relatively harmless, in that all they're looking for is a better rate on a loan that they do intend to repay. This doesn't mean it's smart to cooperate with them, as many agents and loan officers who did are likely to discover quite soon, as the loans default and the lender investigates why. The balance sheet reads a little differently when you discover that cooperating with the guy who just wanted to cut a few corners is going to cost you your license.

Appraisal fraud, however, is usually aimed at a large quick score. I'm going to keep my examples basic, lest I inadvertently release a couple more ideas into the wild. Let's say you own a property that's worth (pinky finger extended) one million dollars. You owe $900,000. If you sell, you're going to net about $30,000. But if you can persuade a buyer that property values are increasing much faster than they are, many will bite off on an increased sales price. You tell the appraiser "Appraise it for $1,250,000 and it's worth $25,000 to you!" He does so. You pay him his $25,000 and your net is still around $235,000 to $240,000. It's fraud, but fraud that many folks have gotten away with because the buyer doesn't realize he's been had and keeps paying the bank. Or you can't keep up the payments but want to walk away with as much cash as possible. Instead of a distress sale, where you'd be very lucky to break even with a sharp buyer's agent, you pay the appraiser $25,000 to appraise it at $1.25 million, refinance for cash out to maybe 90 percent of that value, pay the appraiser and walk away with a cool $200k, never making a single payment on the new loan.

Appraisal fraud can also be intentionally low. A buyer wants to buy the property, pays the appraiser to appraise it low, and renegotiates the price. I had this tried on me about two years ago. It didn't work.

Now once upon a time, there were real constraints to keep an appraiser from pulling this, on residential properties at least. To a certain extent, there still are but those guidelines have been relaxed due to the hypercompetitive market we've had the last few years. For instance, it used to be that the lenders would accept a value for a property on a refinance no higher than an annualized increase of 10 percent for the first couple years. That's gone by the wayside, as lenders get used to the fact that values are increasing faster than that. With many lenders, it's whatever the appraiser says the day after the sale. This is an invitation to fraud. Invitations to fraud do not excuse fraud, but they certainly make it easier. It used to be that no matter what, you couldn't pull cash for six months after a sale. That's now changed.

Underwriting in many lenders no longer has to pass a "smell test," where the lender pulls up the local market and sees what similar properties have really sold for recently. They're competing for loans! First time they tell the folks "no" that loan officer may not give them any more chances to do loans, choosing instead other lenders with more accommodating employees and policies. They have to do loans to stay in business, and avoid layoffs, but those lenders with more accommodating employees and policies are going to be in a world of hurt if the local market cools much further.

Now appraisers that do this are subject to discipline and legal penalties, starting with the fact that the lender has the option of never accepting one of their appraisals again and going up through loss of license and jail time. I'm not up on the penalty structure, but fraud that costs in excess of $100,000 is a serious felony. They've got the appraiser's name, license number, and other identifying information. In my opinion, aiding and abetting fraud is stupid and if you can't get them to fly straight, walking away as quickly as possible is your best option, but real estate compensations (and the amounts at stake) are large enough that many will do it. If you're not a pro yourself, your best protection is a good agent that's working for you, not splitting loyalty between both sides of the transaction, and making sure somebody working for you is there at the property to meet the appraiser.

Caveat Emptor

UPDATED here