The REO Supplemental Addendum—Square Pegs and Round Holes

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The REO Supplemental
Addendum—Square Pegs
and Round Holes                                                                                   AbSTRAcT
                                                                                              Foreclosed listings have
by William G. Steinke, SRA                                                                    become a prominent
                                                                                              component of the
                                                                                              national real estate

                                                                                              market. The burgeon-
                                                                                              ing mortgage crisis and
                                                                                              resulting Wall Street
          eal estate owned (REO) assets are most often acquired through foreclosure,          meltdown have led to
a legal process that varies by state. Title is usually recovered by sheriff’s deed with       a long overdue return
temporary redemption rights. Transfer in lieu of foreclosure is an alternate means            to rational credit
of repossession. Ownership may revert to the lender, investor, mortgage insurer,              standards, with fewer
or government agency that guaranteed the loan, such as Freddie Mac, Fannie Mae,               qualified buyers ensur-
the U.S. Department of Housing and Urban Development, or the U.S. Department                  ing falling values in
of Veterans Affairs.                                                                          markets with surplus
     The REO appraisal can transpire at any time during delinquency, recovery,                development. Resulting
or resale. The analysis serves to inform the client as to repair issues and values            negative equities ensure
under alternate marketing scenarios. Repair estimates create additional chal-                 that secured lenders
lenges regarding the scale and scope of related determinations, introducing                   will need independent
additional subjectivity to the analysis.                                                      valuation advice for the
                                                                                              foreseeable future. The
A Distinct Market Segment                                                                     appraisal community
On the whole, REOs are a distinct market segment. While it may not be uncommon                must ensure that the
to find vacant properties marketed by absentee owners in any given market, the                established foreclosure

REO listing is distinguished by the real estate purchase addendum. This supple-               report format fulfills
                                                                                              their clients’ needs.
ment to the state-specific purchase agreement is universally mandated by the
secured lender’s legal counsel as a contingency of resale. The addendum stipulates
to the seller’s status as owner through foreclosure and disclaims liability for repairs,
overt or latent defects, building code or zoning enforcement, and prospective title
claims. These disclaimers are unilateral and onerous to the extent of requiring a
prospective buyer to prepay dewinterizing and rewinterizing expenses, if neces-
sary, to facilitate a third-party building inspection. As a rule, these disclaimers
supersede those of an arm’s-length sale, with fewer conveyed rights.
     An REO title is transferred by limited warranty or delivery deed or, if clouded,
by quit claim deed. Title insurance is not offered. In the event of a quit claim deed, a
lapse of time or lawsuit may be necessary to assure quiet title for resale with a war-

The REO Supplemental Addendum—Square Pegs and Round Holes                       The Appraisal Journal, Fall 2009
ranty deed. This contrasts with arm’s-length market                 client in collateral analysis for audit, repossession,
sales, which typically transfer with a warranty deed,               or marketing decisions, remains a discretionary
insured title, and, in many states, seller disclosures.             clarification. The function of the appraisal may
     The REO price stratification is apparent as these              include redemption and liquidation, short sale, or
are usually the lowest sales in any given market. In                renegotiation of the underlying mortgage.
the past, condition issues may have obscured related                     The definition of market value assumes knowl-
price distinctions. Now REO sales are sufficiently                  edgeable, typically motivated buyers and sellers,
prevalent so the impact of this limited conveyance can              no undue stimuli, and reasonable open market
no longer be overlooked. Beyond condition issues and                exposure. This definition precludes consideration of
marketing while vacant, lower pricing is attributable               the lender/owner’s motivation, unreasonable client-
to informed or well-advised purchasers recognizing                  imposed market exposures, or other undue stimuli
the added risks of an REO listing. All things being                 including the potential impact of the REO purchase
equal, fewer conveyed rights result in reduced pricing.             addendum. Further, REO appraisal guidelines state
Further, atypical seller motivation is often a valuation            that foreclosure sales are to be considered as com-
issue, particularly in soft or declining markets.                   parables only when these constitute a significant
                                                                    part of the market. As such, this approach does not
The Round Hole                                                      address likely market distinctions between REO and
The foreclosed sale confers a restricted bundle of                  arm’s-length sales, and promotes misleading results.
rights to a seller who may be motivated by repair                   There is no directive or procedure to address and
issues, competition, low demand, excess inventory,                  analyze inherent differences in conveyed rights or
or any combination thereof. The applicable market                   motivations associated with the REO sale.
value definition and existing guidelines prohibit ap-
propriate analysis of these issues and, as such, foster             The Square Peg
sloppy reasoning and inaccuracy.                                    To equate market sales and REO sales without analyz-
     A standardized residential REO appraisal re-                   ing disparate sale conditions invites error. Rarely is
quires a Supplemental Real Estate Owned Appraisal                   an REO sale useful in the arm’s-length market value
Addendum along with the property-specific form,                     appraisal, as a large and subjective credit is usually
such as Fannie Mae Form 1004, Uniform Residential                   appropriate to compensate varied rights of conveyance
Appraisal Report (URAR); Form 1073, Individual                      and seller stimuli, above and beyond that for repairs
Condominium Unit Appraisal Report; Form 1075,                       and entrepreneurial incentive. Further, REO sales
Exterior-Only Inspection Individual Condominium                     are unlikely to minimize the need for or amount of
Unit Appraisal Report; and Form 1025, Small Resi-                   adjustments so as to meet underwriting guidelines.
dential Income Property Appraisal Report.                           The REO appraisal promotes such a comparison with
     The appraisal supplement provides for an analy-                no guidelines to analyze the reduced bundle of rights
sis of three competing listings, recommended repairs                or distinct motivations inherent in REO sales.
with itemized estimates of the cost to cure, plus as-is                 Undue stimuli or distressed sale determination
and as-repaired values assuming both reasonable                     can be vague, as these terms are undefined in the
and client-imposed restricted market exposures. A                   context of the foreclosure appraisal. The REO listing—
competitive market analysis is developed with cor-                  vacant with potential repairs to be funded post closing,
relation and reconciliation of as many as four values               onerous sale terms, no disclosures or warranties, and
under various repair and marketing scenarios.                       potential market imbalances—conjures undue stimuli.
     The intended use of the URAR form “is for the                  As such, it is rarely appropriate to equate an REO
lender/client to evaluate the property that is the                  appraisal with an arm’s-length market sale without
subject of this appraisal for a mortgage finance                    recognition and adjustment for disparate marketing
transaction.”1 The REO analysis is determined to be                 conditions, whether or not these constitute a signifi-
an extension of the mortgage finance transaction                    cant component of the market.
and within the context of this statement. The                           Condition adjustments reflect recommended re-
actual intended use of REO appraisals, to aid the                   pairs and a buyer’s incentive when appropriate. This

1. Fannie Mae Form 1004, Uniform Residential Appraisal Report, 4.

366 The Appraisal Journal, Fall 2009                                 The REO Supplemental Addendum—Square Pegs and Round Holes
incentive is not prompted or developed in the existing                      to both the subject and comparables, is necessary
appraisal format. The prospective impact of marketing                       to ensure proper interpretation of the results. The
while vacant, prior market exposure, REO disclaimers,                       existing Supplemental Real Estate Owned Appraisal
or forecasting in the event of a transitional market, are                   Addendum format is deficient for this purpose.
not addressed. An arbitrary and often unsupported
catchall incentive allowance is commonly applied,                           Recommendations for Clarification
which may or may not include these other consid-                            A supplemental definition for real estate owned
erations. Supplemental assumptions and expository                           liquidation value is needed. Liquidation value
statements are needed to ensure a thorough analysis                         currently is defined as, “The most probable price
and proper interpretation of the appraisal results.                         that a specified interest in real property is likely to
                                                                            bring under all of the following conditions:
Form Deficiencies                                                             1. Consummation of a sale will occur within a
The current Supplemental Real Estate Owned                                       severely limited future exposure time specified
Appraisal Addendum is a patchwork approach                                       by the client.
that was developed in 1996 as an afterthought to
                                                                              2. The actual market conditions currently prevail-
URAR modifications, which addressed developing
                                                                                 ing are those to which the appraised property
professional standards. It was produced at a time
                                                                                 interest is subject.
when no one could foresee current affairs and the
                                                                              3. The buyer is acting prudently and knowledgeably.
prevalence of REO sales in many markets. The
established format compromises the stated use                                 4. The seller is under extreme compulsion to sell.
and market value definition, limits the appraisal                             5. The buyer is typically motivated.
analysis, and misdirects the comparable selection                             6. The buyer is acting in what he or she considers
process. Applicable definitions and guidelines do                                his or her best interest.
not address actual marketing issues or conveyed                               7. A limited marketing effort and time will be al-
rights, and promote abstract results that are prone                              lowed for the completion of a sale.
to mislead the reader of the report.
                                                                              8. Payment will be made in cash in U.S. dollars
      Appropriate clarifications to the existing Fannie
                                                                                 or in terms of financial arrangements compar-
Mae appraisal format, such as a supplemental defini-
                                                                                 able thereto.
tion of market value, are explicitly prohibited: “Modi-
                                                                              9. The price represents the normal consideration
fications, additions, or deletions to the intended use,
                                                                                 for the property sold, unaffected by special or
intended user, definition of market value, or assump-
                                                                                 creative financing or sales concessions granted
tions and limiting conditions are not permitted.”2
                                                                                 by anyone associated with the sale.”3
      The market value definition is deficient for the
purposes of a postforeclosure REO appraisal. It                                  In the event of a foreclosure, with the real estate
does not accommodate potentially unreasonable                               purchase addendum mandated in the event of resale,
client-mandated marketing times, distressed sale                            the following additional disclaimer is needed:
conditions, undue stimuli, or forecasting in a tran-                              A
                                                                              	 •		 	limited	conveyance	is	assumed	without	rep-
sitioning market. The intended use of aiding the                                  resentation or warranties to known or latent de-
client in collateral analysis for a foreclosure decision                          fects or prospective claims on title or zoning.
is not stated.
                                                                                In the event that forecasting adjustments are ap-
      While a market value analysis may be appropriate
                                                                            propriate to reflect market trends likely to play out
in a preforeclosure REO appraisal scenario, an
                                                                            during the projected market exposures, the following
analysis predicated on arm’s-length sales is of
                                                                            additional qualifier is needed:
little use to the seller of a distressed property that
must address onerous conditions in a potentially                                  F
                                                                              	 •		 orecasting	 may	 be	 applied	 to	 ref lect	 the	
unbalanced market. Such a value does not reflect                                  anticipated trend of market conditions and
likely pricing or serve the client’s needs. Analysis                              prices during the subject property’s prospective
of specific underlying marketing issues, in regard                                marketing period.4

2. Ibid.
3. Appraisal Institute, The Dictionary of Real Estate Appraisal, 4th ed. (Chicago: Appraisal Institute, 2002), 167.
4. Employee Relocation Council, The Relocation Appraisal Guide (Washington, DC: Employee Relocation Council, 2001).

The REO Supplemental Addendum—Square Pegs and Round Holes                                         The Appraisal Journal, Fall 2009
     The REO appraisal warrants a supplemental              to improve the analysis and conclusions, to specifically
value definition that addresses distinctions from           address the client’s needs, and to reduce the likelihood
arm’s-length sales. This would foster a thorough            of abstract and misleading results.
analysis of salient issues likely to impact marketability
and pricing. Therefore, the real estate owned               Conclusion
liquidation value definition is appropriate.                A thorough and accurate appraisal analysis is beyond
     The stated use of the REO appraisal should also be     the scope of the existing Supplemental Real Estate
modified to clarify the true function of the appraisal:     Owned Appraisal Addendum. The established format
to aid the client in collateral analysis in conjunction     and guidelines preclude appropriate analysis and
with a decision to foreclose, liquidate, short sell, or     engender sloppy reasoning and misleading results.
renegotiate mortgage terms.                                 Supplemental comments and definitions are needed
     Direct sales comparison of REO sales, when             to develop appropriate values in most markets, despite
available, together with arm’s-length sales should be       guidelines to the contrary.
promoted. REO comparables equate the conditions of               In the event of a postforeclosure appraisal for
sale in the event of redemption, thereby minimizing         marketing purposes, expanded analysis and com-
the need for adjustments and providing a basis for re-      mentary to the limited rights and warranties in the
lated adjustments to arm’s-length sales, if appropriate.    REO purchase agreement is necessary to provide
Analysis and commentary should be elicited to sup-          reliable results.
port the development of a repair incentive allowance.            A complete and accurate residential REO ap-
Projected and client-mandated market exposures              praisal analysis is not compatible with the established
should be contrasted and reconciled with current            format. A redesign of the Supplemental Real Estate
market standards to ensure proper interpretation of         Owned Appraisal Addendum is necessary to clarify the
the results. Discussions of the potential impact of prior   intended use of the appraisal, to supplement the ap-
market exposures or marketing while vacant should           propriate definitions of value, to refine the comparable
be prompted, as well as forecasting guidelines to ac-       selection process, and to develop clarifying supportive
count for market trends that are likely to manifest         reasoning. Restricted rights of conveyance and undue
during the projected market exposures.                      motivation inherent in REO sales must be recognized
     Defenders of the status quo may suggest that cli-      to ensure precise and thorough reasoning and accu-
ents are aware of deficiencies in the existing appraisal    rate results that address the client’s needs.
format, and are apt to make appropriate concessions
in their marketing decisions. This abrogates the ap-
praisal function and invites error. It is the appraiser         William G. Steinke, SRA, is a certified general
who is best informed of these conclusions based on                    appraiser and licensed broker in the state of
the underlying market study.                                   Michigan. He has been a member of the Appraisal
     The REO analysis is an immediate concern to the            Institute for twenty-five years. Active in the Detroit
appraisal profession as it competes with broker price             metropolitan area, Steinke has been on the front
opinions. The broker estimates a probable sale price            lines of a five-year regional recession/depression,
that recognizes market trends and specific property           confronting profligate mortgage fraud and a collapsed
issues. The established appraisal methodology does                  real estate market. Contact:
not. Modification of the appraisal format is necessary

368 The Appraisal Journal, Fall 2009                         The REO Supplemental Addendum—Square Pegs and Round Holes
   Web Connections
   Internet resources suggested by the Lum Library

   Bank Owned REO Database (Mortgage News Daily)
   Free Foreclosure Database
   Home Path (Fannie Mae)
   HomeSteps (Freddie Mac)
   National REO Brokers Association
   REO Properties

The REO Supplemental Addendum—Square Pegs and Round Holes         The Appraisal Journal, Fall 2009

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