Copyright © Michael N. Read 2010

The Law of Unintended Consequences is a law, like Murphy’s Law, which is always lurking in the background to foil the attempts we humans make to control the world around us. It is particularly true of government attempts to reduce crime. A couple of examples follow: 

I used to love air travel. I was a flight test engineer at Boeing and for many years I flew all over the world for both work and recreation. Then came the shoe bomber. Now I wait in long “security” lines while thousands of security workers peer at video screens as billions of pairs of shoes go by and more thousands of security workers watch as billions of travelers shuffle along in their stocking feet.  Do I feel safer now?

Then came the underwear bomber and now billions of travelers will have to suffer through crotch inspections by full body scans.  Am I even safer now?

Domestic airline passenger demand is expected to grow from 1.37 billion in 2006 to 1.77 billion in 2011 – International Air Transport Association 

I used to love appraising. Long before there was any appraiser regulation my clients came to me for valuation opinions because of my years of experience in real estate and their recognition of my accurate and reliable reports. Then came HVCC (Help Violators Cover Crimes). Now my clients of 24 years are not allowed to contact me. They have to order appraisals through a third party Appraisal Management Company (AMC) which takes up to 60% of my fee for their trouble. Is the consumer safer now?

 I have signed up with about a half dozen AMCs. One went out of business owing me over $7,000 dollars. Three asked for all my exhibits and I’ve never heard from them again. One expected me to complete a URAR for $90. My most recent AMC has not sent me an assignment in months due to their lack of volume. Am I happier now?

I recently testified before my State Legislature in support of a bill to regulate AMCs.  My first suggestion was to support the repeal HVCC at the federal level. Secondly to ensure that a certified appraiser is on staff at the AMC to do review work and third to require the AMC to have a surety bond of $500,000 to $1 Million so payment to appraisers is assured if the AMC defaults. Others recommended that AMCs become regulated by the State Appraiser Licensing Board. Will any of these recommendations solve the problem? I’m not hopeful.

So, why are these well-meaning regulatory actions so useless and demeaning? They are re-active and not pro-active. Instead of looking at billions of pairs of shoes the security personnel should be searching for terrorists and bringing them to justice. Likewise the financial services police should be looking for appraisal and mortgage fraud and punishing the offenders; not ruining the livelihood of many thousands of law abiding appraisers in the name of consumer protection.

Personally I have 24 years of appraising experience, am licensed in two states as a General Certified Real Estate Appraiser, have been HUD approved for the whole 24 years without any complaints and have completed hundreds of hours of special education. What good has that done for me?

So what is driving this patchwork quilt of ineffective appraiser regulation? Have you heard of “The Golden Rule”? The man with the gold rules! The greed of lenders is the source of the problem and always has been. They are the ones with the money to lend. They are the ones that establish the lending guidelines that have to be followed by everyone else in the lending chain. They are the ones with the “pipeline” to keep full and flowing. When they run out of borrowers with 20% down they reduce the requirements to encourage borrowers with 10% down. Keep that pipeline full. When they run out of borrowers with 10% down they reduce the requirements again to encourage borrowers with 5% down, then 0% down, then “no doc loans”. Keep that pipeline full.

What about the increased risk? Well, they just pack the loans up and sell them off to someone else in a mortgage backed security that is so far removed from the valuation process no one can figure out the value any more … not even the sophisticated investors. (Nobody thought to ask the appraisers!)

Now it’s time for me to say goodbye to my clients and friends in the residential real estate and financial service fields.  You’ve heard of the theory of “Trickle down economics”. Well here is how my exit from the business will trickle down to you all.

Dear MLS Provider, I will be cancelling my subscription for data services at the end of my current period ($105/Q).

Dear Title Company, I will be cancelling my subscription for data services at the end of my current period ($85/mo) 

Dear Software Company, I will not be renewing my annual software maintenance agreement at the end of my current period ($399/yr). 

Dear Board of Realtors, I will not be renewing my annual dues this year ($375/yr).

Dear Appraisal Institute, I will not be renewing my annual dues this year ($330/yr).

Dear E&O Insurance Company, I will not be renewing my policy at the renewal ($500/yr).

Dear State of Washington, I will not be renewing my Appraiser License at the end of the biennium ($500).

Dear State of Oregon, I will not be renewing my Appraiser License at the end of the biennium ($500).

Dear Education Provider, I will not be needing any more CE credits so will not need any more expensive classes ($500/yr).

Dear AMCs, Goodbye.

Dear Consumer, you are the only one I feel sorry for. I will no longer be in a position to provide you with an independent valuation for your largest lifetime investment. Your lender does not want you to know who I am, how to contact me, how much I charge, what value opinion I reach, they just want you to pay for some conforming paperwork. If they receive any bad news they just shoot the messenger.

The Systematic Destruction of Residential Appraising 

Copyright © Michael N. Read, April 1, 2009

Not so long ago I had multiple clients. They would call me if they needed my professional services and trusted me to perform a satisfactory service. I’m a streetwalker. I drive and walk the streets looking at houses and photographing them from the street (outcalls) and sometimes going inside to determine condition (in calls).

This worked well for many years until the Federal Government got involved in the late 1980s. The Feds discovered that a few streetwalkers had exaggerated their claims of professionalism and service and declared in the 1989 DIARRHEA that all streetwalkers must be licensed and regulated by the state in which they operate. The states got together and formulated a set of rules for streetwalkers they called USCRAP that outlined in minute detail how streetwalkers were to do business.

Well, we studied USCRAP, passed the tests and got our state certifications and went back to walking the streets like before. Unfortunately our clients, like typical JOHNS, wanted more and more for their money. They pressured us into providing service ‘over and above’ the typical service. If we refused they would blacklist us and no longer engage our services or pay us for services rendered. We would complain to the State regulators and they would do nothing since the JOHNS were not regulated by the States.

This continued to get worse over the years until 2008 when the financial system collapsed due to the JOHNS’ greed and over indulgence. Again the Feds stepped in, not to regulate the JOHNS but to stimulate them with more money and punish the streetwalkers with a new law HVCC (Help Violators Cover Crimes) so we will no longer be allowed to take calls from our clients.

Theoretically the JOHNS will no longer pressure us directly to provide ‘special services’ above and beyond USCRAP. Orders for our services will not be directed to any particular streetwalker but must be funneled through third parties known as Streetwalker Management Companies or PIMPS.  

This makes the JOHNS happy now they have more money and can call the PIMPS to order any type of extraordinary service they desire without breaking the law because the PIMPS are not regulated either.  With our access to our clients foreclosed we are now forced to use the PIMPS to get our business contacts and give up half or more of our fee in the process.

But wait, there’s more …

Now the PIMPS can relay messages to individual streetwalkers about servicing a particular JOHN who has requested a ‘special service’. If the JOHN does not like the service provided by a streetwalker he can ‘blacklist’ them with the PIMP, who can demand retribution or withhold payment for the service.

It seems to me like we’re back to square one, but with half or less of our fee.

Here’s my suggestion …

The 200,000 or so appraisers in the USA should form a union and call for a national strike. This will allow us to take DIARRHEA, USCRAP, HVCC, the JOHNS and the PIMPS and flush the whole mess down the WC.

http://en.wikipedia.org/wiki/Crystal_Palace_dinosaurs

Modern science and years of archaeological research has brought them into sharper focus and shown that the raptors were agile and voracious beasts designed to kill and eat the equally large vegetarian monsters. There is still some mystery and discussion as to why they suddenly disappeared from the face of the earth. One of the more feasible and supportable theories is that a giant asteroid exploded over what is now the Gulf of Mexico creating a cloud of dust that encircled the planet and blocked out the sun. The result was a blow to plant life causing the extinction of all that ate plants and then the carnivores. The scientists also know that dinosaurs were still around after the catastrophe and they morphed into different and smaller creatures.

I’ve always had a suspicion that as the dinosaurs reached their peak of size and aggressiveness they ate themselves into extinction. First eating all the vegetarian dinosaurs and then turning cannibalistic the raptors ate themselves out of existence.

This preamble leads me to my main point and introduces the ‘Virtual Monsters’ that we are all faced with in this most recent financial crisis. The banks and many Wall Street financial institutions became so huge and voracious (like the giant raptors) they ‘ate up’ the nation’s assets (the plantlike public) and when those assets were all gone they were forced to devour each other, but none were able to survive in their original form.

Now we are in the stage where they are morphing again into different forms, maybe nice furry little critters that are well behaved and well supervised. But don’t bet on it!

Virtual monsters have an advantage over the Jurassic versions, they can be instantly regenerated by computers and video screens. The greedy Wall Street types have not been destroyed; they’ve only gone into hiding. We will have to be vigilant and insist that they are kept under strict observation and control, or else we’ll be all eaten up again just like before.

This collapse has been exacerbated by the lenders essentially being in charge of the valuation process. They hire and pay appraisers or employ their own in-house appraisers, who are expected to do exactly what they are told. Independent appraisers have to apply to be on a lenders ‘Approved List’ in order to get assignments. This is part of a quality control process that is entirely managed by the lender and effectively insulates them from a true and independent valuation. When they ‘pay the judge’ how can we expect an independent verdict or value?

For instance, if an independent appraiser marks a little box with a check mark to indicate ‘Declining Market’, he/she would be instructed to remove it, put the check in the ‘Stable Market’ box or they would not get paid their fee, or they would be removed from the ‘approved’ list of the lender. I’m aware of lawsuits by appraisers over this practice and have had personal experiences that have been previously written about in appraiser related publications. Two of the lenders involved have since failed, one being the largest bank failure ever.

The practice of lenders controlling the remuneration and vendor approval process for appraisers is directly responsible for the corruption of the system. We have to build a new system that removes this corrupting link.

I remember well the ‘Savings and Loan’ crisis in the 1980s, I was an appraiser back then too, before appraiser licensing was in effect. The bad valuations got blamed on appraisers who became strictly regulated under FIRREA – 1989. There may have been a few bad appraisers but they were working directly for the lender involved. No appraiser was ever convicted of overstating value by billions or trillions of dollars!

The creation of the secondary market (Fannie Mae and Freddie Mac) turned portfolios of real estate into portfolios of paper and digital data that could be moved around the world on the Internet by computers on Wall Street.

Whose job was it to put a valuation on this newly created paper? Well the bond rating companies like Standard & Poor’s and Moody’s. They are a lot like appraisers. They examine the collateral underlying the bonds and rate them accordingly. Their independence is crucial.

When the sub-prime paper came into the picture and was presented to the bond rating agencies they must have been initially horrified at the thought of rating these products AAA. They may have suggested a more appropriate grade such as A or BAA, which is just above the junk classification. See Bond Rating Table below.

But no! They apparently rated them in the ‘Quality’ range, which of course had a higher price and was easier to sell for their Wall Street clients. How did Wall Street persuade the bond raters to overlook the higher risk of the Collateral Debt Obligations (CDOs)? All you have to do is follow the money trail. Let me suggest this scenario.

Stock Broker warns Bond Rater that if he issues a lower rating on the CDOs it results in a lower income for the Broker and thus lower income to the Rater. A lower income for the Rater, acknowledged by the broker, would necessitate the lowering of the Raters company stock value and thus a reduced company market valuation. Does this remind you of something we were discussing earlier about appraiser compensation?

The rising popularity of Appraisal Management Companies (AMCs) seems, at first blush, to create a system where appraisers are not in direct contact with the lender. Unfortunately the trend here is for the big lenders to buy a controlling interest in the AMC then gain control over the process and access to the appraisers’ data to form its own Automatic Valuation Models (AVMs). The independent valuation process is corrupted again.

The corrupting link again is the ‘Paying of the Judge’ and allocating the judge’s ‘caseload’. There has to be a better way.

Here’s a suggestion. Create an association of valuation professionals to act as a clearing house for valuation requests. The request orders are paid for up front according to a sliding scale or bid system and the assignments and results are anonymous to the requestor. Such an association would be like the old Craftsman’s Guilds but could operate on the Internet and be accessible to everyone 24/7. This company’s stock would not be on the ‘big board’.

For a quick overview of Washington State Condominium Law, refer to an excellent article by Elizabeth Rhodes of the Seattle Times.

For a complete and detailed look at the law itself, go to the Condominium Act at: http://apps.leg.wa.gov/RCW/default.aspx?cite=64.34 and scroll down to Section 64.34.380 through 64.34.390. The history of the new legislation is available at: http://www.leq.wa.qov/leqislature.  Click on ‘Bill Search’, type in “6215” and click ‘Search’ then go to the bottom of the page and click on ‘Original Bill’ and ‘Bill as passed in Legislature.’

The goal of the new law, sponsored by Senators Rodney Tom, Jim Honeyford and Bob McCaslin, is to enhance consumer protection in the purchase and ownership of a condominium.

In addition, new rules adopted by Fannie Mae and Freddie Mac, the two secondary mortgage market enterprises that purchase most residential loans, now require that lenders verify that the community association has a line item in its budget requiring annual reserve contributions equal to 10 percent of revenues. An article in the Community Associations Institute New England Chapter newsletter on July 25, 2008 (http://www.caine.org/HelpfulResources/MagazineFeaturesFull.asp) discusses the responsibilities of and potential liabilities for condominium home owners associations.

RCW 64.34.380 ‘encourages’ every Washington Home Owner Association (HOA) to establish a Reserve Account to fund major maintenance, repair and replacement of common elements, including limited (long term up to 30 years) common elements. The Reserve Account is to be established in the name of the Association and the board of directors of the HOA is responsible for administering the Reserve Account. The Reserve Account is to be separate from the HOA’s normal operating and maintenance budget.

‘Unless doing so would impose an unreasonable hardship’, the HOA must prepare and update a Reserve Study in accordance with the HOA’s governing documents and RCW 64.34.224 (1), which requires each unit to have a proportional undivided interest in the common elements.

The Reserve Study must be based on a ‘visual site inspection’ conducted by a ‘reserve study professional’. The Reserve Study must be updated annually and at least every 3 years be based on a ‘visual site inspection’ conducted by a ‘reserve study professional’.

This requirement does not apply to condominiums consisting solely of units that are restricted in the declaration to non-residential use.

In its definition of a Reserve Study, RCW 64.34.382 uses terminology that appraisers will immediately recognize from the Cost Approach. A Reserve Study must include:

(a) A reserve component list including quantities and estimates for useful life, remaining useful life and current repair and replacement cost for each reserve component.
(b) The date of the Reserve Study and a statement that the study meets the requirement of this section.
(c) The level of Reserve Study performed.
• Level l: Full Reserve Study, funding analysis and plan.
• Level II: Update with visual site inspection.
•    Level III: Update with no visual site inspection. 
(d) The association’s reserve account balance.
(e) The percentage of the fully funded balance that the reserve account contains.
(f) The special assessments already implemented or planned.
(g) Interest and inflation assumptions.
(h) Current Reserve Account contribution rate.
(i) Recommended Reserve Account contribution rate.
(j) Projected Reserve Account balance for thirty years and a funding plan to pay for projected costs from those reserves without reliance on future unplanned special assessments; and
(k) Whether the Reserve Study was prepared by a ‘reserve study professional’.

The Reserve Study must also include a disclosure that warns about the failure to include a particular component or to provide contributions to the Reserve Account for that component may result in the unit owner having to pay on demand a special assessment for that component.

RCW 64.34.384 allows the HOA to withdraw funds from the Reserve Account for unforeseen and unbudgeted items providing they notify the unit owners and repay the amount within 24 months, unless the 24 months would impose an ‘unreasonable burden’ on the unit owners.

RCW 64.34.386 gives unit owners legal recourse to demand of the HOA a Reserve Study if none has been completed within the past three years. The unit owner’s duty to pay for common expenses cannot be excused because of the HOA’s failure to comply.

RCW 64.34.388 relates to the preparation and updating of a Reserve Study at the discretion of the Board of Directors.

RCW 64.34.390 may be of particular interest and concern to appraisers (and real estate agents) as it states that monetary damages or any other liability MAY NOT BE AWARDED against or imposed upon the association, the officers or board of directors of the association, or those persons who may have provided advice or assistance to the association or its officers or directors, for failure to: Establish a Reserve Account; have a current reserve study prepared or updated in accordance with the RCW 64.34.380 through 64.34.388, or make the reserve disclosures in accordance with RCW 64.34.382 and other referenced RCW’s.

The legislation as written indemnifies all parties involved in the production, management and maintenance of a condominium but leaves the unit owners, purchasers and their advocates (the very parties who the legislative author’s goal was to protect) with little legal recourse.

A Reserve Study Professional is defined as ‘an independent person suitably qualified by knowledge, skill, experience, training or education to prepare a Reserve Study in accordance with Sections 1 and 2 of this act.’

This definition is not very definitive and could easily result in poorly prepared and ineffective Reserve Studies where the preparer is protected from any liability!

Because of the dearth of professionals currently providing Reserve Studies, community managers, CPAs, contractors and other related professionals are rushing in to fill the void. Appraisers and home inspectors may look upon this as an opportunity to provide a new fee service. Be careful!

Mike Read, the primary author of this article, states,
“I have personally assisted in the preparation of these studies in Oregon under the tutelage of a licensed architect and even though I am a degreed engineer (Mechanical, UK) and a Certified General Appraiser licensed in Washington and Oregon, I do not feel qualified to complete a Reserve Study without additional training and experience. At present I am not aware of any education available in this field, but a background in Building Sciences would be relevant. There is an organization, the Community Association Institute (CAI) www.caionline.org, which has some certifications, but I do not know the details of their educational path.”

Nena Groskind, the author of the article in the CAI New England Chapter newsletter referenced above, recommends that the Reserve Study be performed by an engineering firm “with expertise in this area.”

There are two main parts to a Reserve Study. The first requires the completion of a ‘Property Condition Assessment’ which is a detailed site inspection of the property and all its common areas and systems. This report identifies the immediate repairs and replacements required plus short and long term replacements required of all common area components. The second part is the number crunching, which places the work items in an orderly time and dollar budget (RCW 64.34.380 recommends a 30-year projection for major maintenance and replacement), to be presented to the HOA and its owners. In her article, Ms. Groskind also noted that IRS regulations require separation between operating funds for maintenance and reserve accounts for replacement and strongly cautioned against commingling funds.

If an appraiser (or real estate agent) is involved in the transfer of a condominium (in Washington State) where there is an action brought by a unit owner or purchaser for non¬disclosure of a pending assessment or large unfunded or undisclosed liability contained in a Reserve Study, they could be the only entity in the chain of responsibility that could be held liable. Likewise an appraisal that does not include in its value conclusion the amount and effect of such an assessment or unfunded liability could become the focus for recourse of action by an owner or purchaser.

In preparing a condominium appraisal report on the Fannie Mae form 1073, the appraiser must answer four questions in the “Project Analysis” section on page 2; two of those questions may now have more significance. The appraiser is expect to comment on the project budget for the current year and the adequacy of fees, reserves, etc. (Emphasis added.) and to opine how the unit charge compares to competitive projects of similar quality and design. Just stating that the budget was not analyzed because the documents were not provided and checking the “Average” box may not be an adequate defense.

Henceforth, when appraising a condominium, in addition to the other documents typically required (minutes of annual membership or monthly board meetings, resale certificate, etc.), it is incumbent upon the appraiser obtain a copy of the current Reserve Study. If none is available, the appraiser should clearly state in the report that:
1. A copy of the Reserve Study described under the provisions of RCW 64.34.380 was not provided to the appraiser (and describe the efforts made to obtain same);
2. Inadequate reserves for replacement of critical components of the building could result in special assessments that would financially impact the borrower;
3. The opinion of value is based on the Extraordinary Assumption that the HOA has adequate reserves and/or plans to address such expenses; and
4. If this assumption proves to be in error, the value of the property could be affected.

The authors of this article are both experienced appraisers and are aware of appraisers being sued for failure to disclose critical financial information or information on property conditions that impact value. With the changes to both Washington law and the lending requirements of Fannie Mae, more responsibilities are being placed on the appraiser.

Michael N. Read (mike@mikeread.com) has been appraising residential and commercial property in Washington, Oregon and Mexico since 1986.

Barry C. Wilson (bwilson@lambhansonlamb.com) has been appraising residential property in Washington since 1986.

Additional expertise concerning the items discussed above was provided by
Carson M. Horton, RS of HOA Services Group, LLC in Beaverton, Oregon.
carson@hoaservicesgroup.com
www.hoaservicesgroup.com