[Solid Masonry] If You Think A Few Little Boxes Can’t Cause Big Trouble Then You Don’t Know The Half Of It

_John Philip Mason is a residential appraiser with 20 years experience and covers the Hudson Valley region of New York. He’s a good friend and a true professional who believes that all appraisers need to have a macro-economic perspective in order to be effective. This week, he tries to check off the box we got ourselves into in his Solid Masonry column._ …Jonathan Miller

Almost everyone now acknowledges the world of real estate is in transition, nationally, regionally and locally. The debate has shifted from is the market cooling off or is it in decline, to how much or how far? I’m not talking about future predictions (I addressed that issue last week), but rather current and recent trends. Of course, a lot depends on who you talk to, how they measure market conditions (i.e. for some it’s no more than sticking a wet finger in the air to see which way the wind is blowing), and which markets we are referring to. These reports indicate everything from nearly flat market trends, all the way to those who say prices have dropped faster than a landslide. For most markets, however, there is little doubt reality lies somewhere in between.

So now that we have this general acceptance of a softer market, many would like to believe the worst has either past, or is not too much further into the future. There is just one little problem. Actually, it’s a problem of six simple questions, offering multiple choice answers of eighteen little boxes, and this set-up is found on the front page of nearly every residential appraisal form. These six questions help describe the neighborhood of the subject property and sound innocuous enough, until you understand how the secondary mortgage market works. Select a box from one of the first two columns, such as “property values” are increasing or stable, and all is well. But be one of the first appraisers to select almost any of the choices in the third column, or worse, several of the choices in the third column, and you’d better watch out. Suddenly you’re a popular guy, and it’s not because the paparazzi just spotted you canoodling with Brittney Spears. (I’ve told you all before this my post and I make the rules, so, if I say it’s me and Brittney canoodling, than so be it. So, where was I?) Oh yeahSuddenly the loan officer, underwriter and just about everyone over at the lending institution knows your name, and it’s mud, as in Mr. Mud.

As we all know (and for those who don’t), the primary purpose of an appraisal is to help lending institutions sell mortgages in the secondary market through Fannie Mae, Freddie Mac and many others. An appraisal can also be utilized to help some institutions meet banking or corporate guidelines for loans they wish to keep in house. Either way, the appraisal offers an independent opinion of the value of an asset, in the context of the market for which it is located, and meeting certain underwriting guidelines increases the marketability of these notes. The loans may then be sold at a profit, allowing the lender to replenish their cash on hand, which allows for more lending, and the cycle goes round and round.

So, here is the problem: almost no one in the secondary market wants to buy mortgages in communities with a large percentage of vacant land (i.e. rural or built up less than 25%), have declining property values, are over-supplied, or have marketing times over 6 months. Think about it. If you ran a mega-billion dollar bank, investment or pension fund, how would you explain your purchase of notes which were soon-to-be under-secured, with increasing risk, at a meager 6.5% rate of return? Suddenly, any such manager with half a brain is going to start turning away from these investment notes. The same can be said for little old ladies, foreign nations, and just about anyone else who thought of mortgage backed securities in American real estate as a safe bet. It may sound alarmist, but we’ve been there and it wasn’t pretty. It started in the residential sectors in the late 1980’s and before long had spilled over into every sector of the real estate market. Case in point, remember when Freddie Mac all but pulled out of the market some 15 years ago? It became a bloodbath for small investment property owners everywhere, especially for those stuck trying to refinance loans that came due.

The sad truth is we may not have seen the worst of it. That is, if appraisers have to start checking any of the “no-no” boxes, then all bets are off on a soft landing. And the way market trends are going, most of us appraisers have already held off too long. If the past downturn in the national real estate market is any indicator of what to expect (and I certainly hope it isn’t), then the problem becomes a trend that is very difficult to reverse. Especially since the federal government doesn’t like to interfere in free market enterprise. So, if you think a few little boxes can’t cause a lot of trouble, then you don’t know the half of it.