Many say “history always repeats itself” and in the case of appraisals, it may be for the best. We sat down with Edward Pinto, the Co-Director of AEI’s Center on Housing Markets and Finance as he shares with us his discoveries from the original FHA forms.
Dating back to the 1900’s Ed found the tools needed to bring the appraisal process back to how they were originally called for – based off of the market value and the information proved by the expert, the appraiser.
Buzz: Ed, you have a great grasp of history behind the appraisal process and how it has evolved over time. Share with us how you became involved with the appraisal process.
Ed: I was head of marketing and product management in the mid-1980s at Fannie Mae and noticed that appraisal policy mostly involved changing the forms. Valuation theory and risk principles were largely ignored or more likely unknown.
I always enjoy learning about the history of topics and one of my employees told me he collected old appraisal handbooks. He loaned me one authored by Stanley McMichael on a valuation methodology. I read it and then moved on to other topics. About 10 years ago during the financial crisis, my interest in valuation theory was piqued so I searched for and found McMichael’s Appraisal Manual online. As the saying goes, “Those who forget history are deemed to repeat it.” So, I was intrigued.
I began digging into valuation practice and theory – which is when I contacted Joan about 8 or 9 years ago. I was researching the German term “mortgage lending value” and came across a white paper written by Joan and the CRN. I called Joan and left a voicemail that her paper was the best thing I had read on this topic and to please call me. As Joan tells it—I had her at best. We’ve been collaborating ever since.
That triggered my interest in the history of the valuation theory and methodology again. I started looking at other old manuals and treatises and found a few additional books from the 1940s to the 1950s. And then hit a dead end. After about 2 years I took up the quest once again. About 5 years ago I found the mother lode—an article on appraisal history by Mark Weiss. The article traced valuation history back to about 1900. By following each footnote, I was able to use Google to research the entire history of valuation from the 1900’s to somewhere around the 1960’s. My conclusion was that while valuation theory and risk principles were once well developed and documented, over the last 6 decades these had been largely forgotten.
Buzz: What was the information you found from the first half of the twentieth century that informs on reengineering today’s valuation methods and process?
Ed: I came across the writings of Richard Hurd (1903), Ernest Fisher (1920s-1970s), Ernest Fisher (1920-1970s), Frederick Babcock (1920s-1930s). All but Hurd were instrumental in standing up the Federal Housing Administration (the FHA) in the 1930s). Hurd was the president of a private mortgage insurance company and the others not only set up the FHA but continued to write dozens of books on valuation and urban land economics.
Then I discovered six versions of the underwriting manual of the FHA covering from the 1930s to the 1950s. I was able to connect the earlier works of Babcock, Fisher, Ratcliff, and others to the valuation theories and risk principles contained in the manuals. In fact, it contained 26 pages on “Principles of Dwelling Valuation”, which by the way, I recommend to anyone involved in appraising, mortgage lending, or mortgage insurance. For example, the distinction between price and value was well-developed and supported. Price is the result of current conditions of supply and demand, while the value “refers to the capability of useful things to produce benefits which persons need or desire…. The future usefulness of a property is the source of any value it might have.” As an analogy, consider the difference between determining a company’s stock price (easily discernible from the last trade) and its value (what would it be worth paying today in present value for the future usefulness of a property?). FHA defined “value” as “a price which a purchaser is warranted in paying for a property rather than a price for which a property may be sold, and is defined as, the price which typical buyers would be warranted in paying for the property for long-term use or investment, if they were well informed, acted intelligently, voluntarily and without necessity.” It was the appraiser’s assignment to be that well informed and intelligent buyer.
Therefore the FHA considered today’s selling price to be relativity irrelevant to lending purposes, noting: “Inasmuch as valuation for mortgage insurance necessarily deals with the long-term aspect of the usefulness of a property, the discovery of only the price that may be obtained at the time the valuation is made would be inadequate as the sole conclusion on which to base the ‘worth’ of anticipated benefits.”
In the opening of a property’s value, the appraiser’s task is to determine the difference between market price and market value, forecasting what the market is going to look like and determine whether the price level is warranted under all the circumstances. The surrounding property, geographical knowledge and even predicting the future trends of market value are all things the appraiser was originally supposed to take into account. In particular, today’s price can be affected by market imbalances during a buyer’s or seller’s market. FHA noted: “Because situations of scarcity or over-supply do not last indefinitely, they cannot be considered as phenomena that affect valuations for long-term use.” FHA went on to say: “In an unusually active sales market, such as exists in ‘boom’ times, rising prices, stimulated by strongly competing buyers, reach a point where the prices obtained in sales are worthless as information in estimating value.” Note how relevant these statements from 1958 are to today’s market conditions.
It is fair to say that today’s appraisal form calls for none of this analysis. Ironically this approach dovetailed perfectly with Germany’s Mortgage Lending Value noted in Joan’s white paper.
Buzz: You gathered all this information and have been presenting to the appraisal industry, how do you hope that it is going to help the industry?
Ed: The goal is to bring forefront the core principles and practices for the appraisal industry. I have found FHA’s underwriting manuals and related works by the authors already mentioned to be the best source for that.
Buzz: Now fast forward to today. What do you see as the biggest impediment to “Reengineering the Appraisal Process”?
Ed: The biggest impediment would be Fannie Mae since it is the de facto source of appraisal practice since it controls the appraisal form. In the last cycle where we were in a similar situation as we are today, where no one was paying attention to the value, only to the price and look where that ended up.
I am not suggesting that the crash is going to happen again but what I am suggesting is that when you have house prices going up much faster than wages, inflation, and rents, the difference between price and value becomes paramount. In the 1930s when the FHA was set up, they asked two very precise questions of the appraiser – what the value is and document the process you used to arrive at that value.
Buzz: How do you think that the problem can be solved?
Ed: FHA called for an expert – that was the appraiser, who was to act as the well-informed seller and well-informed buyer. As the appraiser, you have the facts. You are supposed to take the facts, find the value of the property and inform the buyer, seller, and lender.
To do this we would need to…
First, define the task of the valuation process is to determine the market value (in the manner FHA meant it) – not the market price.
Second, get the government out of the mortgage refinance business. There are zero economic benefits to refinancing a mortgage. There is a lot of churning and volatility in volume that uses up a lot of resources, including appraisal, title, and lender capacity. The home purchase market will always have up’s and down’s, but it will always be less volatile than the refinance market.
Finally, appraiser independence. The VA panel has a good system, and I would not let the perfect get in the way of the good. The appraiser is vetted by the VA and assigned randomly.
Buzz: Ed, thank you for taking the time to speak with us. We appreciate it.
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