What I’m thinking about: The archaic, broken appraisal system that controls trillions of dollars in lending decisions…and why banks have their hands tied by regulations preventing internal underwriting capacity.
I had a meeting last week that legitimately stunned me.
We were talking with a regional bank about Land Pricer (the AI underwriting software we’ve been working on for the past couple years, now being transitioned to a new operating team).
The conversation was straightforward…exploring how our software might fit into their workflow for either pre-acquisition triage, or ongoing loan portfolio review.
After the demo, the head of their underwriting team mentioned that, “The software probably isn’t the best fit on the triage side since we’re required to have a formal third-party evaluation, and we might just pre-screen real estate opportunities for no more than 10 minutes.”
Wait…what?
This is a BANK. A lender. An institution with millions (possibly billions or more) in loan exposure. And they don’t do their own sophisticated, market-level underwriting from a comp perspective.
Let me break down what I learned…because this regulatory stranglehold is absolutely wild.
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The FDIC Has Banks in a Chokehold
Here’s how it actually works (as a fellow lender, albeit smaller, I’m offended on behalf of the banks):
The FDIC regulatory environment is so restrictive that banks are essentially prohibited from doing their own comp analysis.
They may do an initial cursory Zillow review, but when it comes to actually determining how much they can lend on a property (i.e. determining the Value in Loan-to-Value)…that’s outsourced to appraisal firms.
(To clarify, there’s nothing preventing a bank from doing a thorough analysis of comps on their own, but if they’re regulated to utilize a third-party regardless, why devote the resources? Never forget Munger, “Show me the incentive, and I’ll you the outcome.”)
It gets worse…
Banks don’t even get to pick the appraisal firm directly. There’s ANOTHER middleman called an “appraisal vendor” who sources bids from various appraisal firms. The bank doesn’t get to see who’s behind the report…they’re just looking at bids, trying to remove bias, or potential kickbacks/monopolies from the system.
(If it hasn’t become clear already, this is an example of good intentions creating bad policy.)
So if a bank takes the lowest bid (again, follow the incentives), there’s a good chance they’ll be getting the worst quality appraisal. But the bank’s hands are tied. They have to use that valuation for their lending decision (even more tricky when commercial/industrial properties are under consideration, which are notoriously more difficult to comp).
Less egregious, but still annoying, is that banks have to use approved vendors for due diligence items like flood zone determinations. It’s a conservative approach, but adds significant cost, and further incentivizes banks not to do their own research.
This is the system controlling TRILLIONS of dollars in assets under management.
Let that sink in for a second.
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The Appraisal Quality Problem
We all know appraisal quality varies wildly (there are some EXCELLENT appraisers out there, to be clear), and quality isn’t always tied to the size of the firm, or the resources it has at its disposal.
For example, I’ve seen a ~90-page land appraisal report from CBRE (a monster $40B revenue real estate firm) that was off by literally 5X on a potential subdivide’s value in Oklahoma. Millions of dollars in overestimated value. The comps they used were terrible (including comps from multiple states over), nor did they realize the subdivide potential…and it was a relatively simple market to analyze IMO.
A key issue is that there’s no solid standard for what constitutes a comp. Some appraisal firms use comps from last year. Some use two years ago. Three years ago. Or some place far too much value on active comps. The methodology is all over the place (an issue that runs rampant through the land investment industry as well).
And because banks can’t see behind the curtain on who’s doing the appraisal (thanks to the regulatory environment trying to eliminate bias), they can’t even evaluate the quality of the operators producing these reports, or align underwriting standards in a collaborative manner (similar to how we work with our land operator clients at Serious Land Capital).
Like a lot of careers in real estate, it’s not a massive lift to become a ‘qualified appraiser.’
Roughly 75-150 hours in education (of unknown quality, I’ve never seen the material TBH), and then ~1000-3000 hours working under a supervisor. All-in, this can be completed within 18-24 months, then it’s off to the races.
(Generally, I’m of the opinion that it takes ~5 years of dedicated effort to even begin to understand what it means to be ‘good’ at anything in life.)
It’s a backward system that creates massive inefficiencies and risks throughout the entire lending ecosystem.
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When Appraisals Blow Up Deals
This isn’t just a theoretical problem. This impacts deals on the dispo side constantly, of which I’m certain almost everyone reading this has experienced.
You get deep into negotiations with a buyer. You’ve agreed on a purchase price, which the market has determined as the current value. You’ve signed an offer…with a buyer utilizing third-party financing.
Then the appraisal may come back (often right before the close date, or forcing an extension due to delays) significantly below the negotiated price, with no rhyme or reason behind the pricing, and generally not visible to the seller.
Now the bank says they need the purchase price to come down (since they are restricted on the Loan-to-Value ratio), or the buyer has to come out of pocket to close the gap between the appraisal and the total loan amount they’re willing to underwrite.
Almost impossible to predict when this may occur, and a crap shoot when dealing with buyers using third-party financing.
We just dealt with this recently. An appraisal firm undervalued our land parcel by over 30% (when the purchase price we accepted from the buyer was already undercutting the market).
It legitimately threatened the entire deal, at the last minute. Fortunately, we worked through it, but that’s time, stress, and deal risk that shouldn’t exist if the underlying system allowed for transparency and reconciliation of land valuation standards between counterparties.
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My Property Tax Fight (Same Problem, Different Context)
This appraisal quality issue shows up everywhere, not just in lending.
Take property taxes. Counties often rely on these same appraisal firms (or internal appraisal departments) to determine valuations for tax assessments. And the incentives are obvious…higher valuations mean more tax revenue for the county.
(Caveat that lower property taxes, both from lower assessments and percentage taxed, can incentivize population growth, development, and tax revenue from business/personal income and sales.)
When my wife and I bought our house in Austin, we got hit with a massive appraisal jump in the first year. The appraisal firm valued our house ~$150K higher than what we paid for it, even though we purchased in late 2022, and the market was sharply declining.
Here’s the kicker: Our neighbor on the same street with an IDENTICAL floor plan bought just a few weeks after us January 2023. They didn’t get the same bump (their tax assessment was only increased by about $10K). We were attributed an ENTIRE year of appreciation when the time difference was literally less than a month.
While I’ve since learned to utilize the companies that specialize in fighting property tax increases (excellent business model), that year we took the county on personally and it escalated to a hearing.
The third-party appraisal firm was arguing in favor of the ~$150K assessment increase using comps from completely different neighborhoods, not even accounting for recent sold comps on the same street (and home price evaluations are WAY easier than land).
Meanwhile, I’m pointing out my same-street neighbor (with the same square footage) paid LESS than we did just weeks later and has a considerably lower tax bill.
The tax assessor fortunately took my side, but I was definitely sweating bullets before judgement was handed down. But I remember thinking…how can these appraisal firms take themselves seriously when a homeowner (granted, a more sophisticated one) can poke holes in their methodology this easily?
The system is broken. Period.
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Why This Matters for Land Pricer (and the Industry)
This revelation completely reframed our approach with Land Pricer (and credit to the new operating team that has taken the helm, they expanded the vision beyond what I had imagined, and boast an extensive rolodex of industry decision-makers).
Recently, we thought banks with land portfolios might be the initial target customer. But given how tied down they are by regulation…that’s going to be a much harder play. They literally can’t make their own underwriting decisions even if they wanted to (again, as a fellow lender, I find this to be patently absurd, and in OBVIOUS need of correction).
So now we’re stepping up the chain. If banks are forced to rely on appraisal firms, and those firms are all over the map in regard to reliability and validity, then that’s who we need to assist…and banks will still feel the positive effects downstream.
(Again, I don’t want to paint the picture that I think appraisal firms are operated by a bunch of nitwits. I’m certain there are many thoughtful, tech-forward teams in the appraisal industry, and I’m probably missing key nuances that I look forward to being educated about.)
Meetings with larger appraisal firms are already in the works.
This is an obvious problem…and a problem that impacts the bottom-line of many companies (Note: if a business problem doesn’t clearly connect to money, no one cares).
And as entrepreneurs, that’s exactly what we should be optimizing for..to tell a compelling story, and then provide the resolution.
The appraisal industry (and real estate lending as a whole) is ripe for transformation. The technology exists now to dramatically improve accuracy and efficiency.
Time to execute.
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