Blog #20: “What is so Important About the Damn Neighborhood Analysis that the Reviewer Nicked me for it?”

Question:  in a recent review of one of my appraisal reports, the reviewer said my neighborhood analysis was poor.  I asked what that meant and she indicated I should familiarize myself with Fannie Mae’s requirements for a NEIGHBORHOOD ANALYSIS.  She also indicated what I had in my report was just a recitation of facts, but (a) lacked any analysis of the neighborhood’s trends and (b) therefore, I did not analyze the neighborhood sufficiently to reconcile my conclusions of the neighborhood trends and its effect on both my highest and best use conclusion and my final value opinion.  I came in just over the contract price.  What does the reviewer want from me?  I did what I always do in an appraisal!  Help me!

Answer:  This is not a direct USPAP question.  However, when you sign the Certification, one of the bullet points promises you developed your value opinion, and then communicated it to the client, in compliance with Standards 1 and 2.  If you did not comply with these standards, and did not present a really good reason why you did not, then by signing the Certification, you misrepresented your scope of research, analysis, and communication to the client, a clear violation of SR2-1(b).  So, let’s examine each of these points separately to learn how not to make these mistakes again.

Fannie Mae’s Requirements for a Neighborhood Analysis

In the Selling Guide at B4-1.3-03, Neighborhood Section of the Appraisal Report, you’ll find exactly what it is F/M requires from this section of the 1004 form.  Frankly, there is not enough space in the Neighborhood Analysis section of the 1004 form to include everything F/M wants.  Therefore, the summary of your analyses and research will roll over into an addendum.  That’s OK.  If you cover all of the following topics in proper depth and with proper due diligence, you should not have a problem with a reviewer (or a state appraisal board, either, for that matter).

Neighborhood Boundaries:  F/M indicates the appraiser must provide “…an outline of the neighborhood boundaries…” (ibid) and should clearly delineate the north, south, east, and west boundaries.  This begs the question every street in every city, town, village, and/or burg in the US is laid out in a grid pattern.  They are not.  As a result, the appraiser may have to indicate the northwest or southeast boundaries.  This is acceptable, too.  It behooves the appraiser (a) to explain why s/he chose these boundaries and (b) why the properties within them are comparable/competitive with the subject.  This is a pre-answer to the state investigator’s question, “Why did you choose these boundaries?”.  In other words, plan your response so that you can defend your choice of these boundaries.

Neighborhood Characteristics:  Here F/M wants an examination, analysis, and explanation of the type of structures (detached, attached) and architectural styles there are in the neighborhood “…such as row or townhouses, colonial, ranch, or Victorian” (ibid – capitalization in original).  This, along with the photos and maps in the report, gives F/M a picture of the structures in the neighborhood.  For example, if most of the houses are Victorian in architecture and style, they then are likely old, since this currently is not a popular architecture/style.  That age may suggest the market is about to start buying old houses to raze them, and then develop the now-vacant site to its highest and best use.  This also means the purchase and sale of such a property may be nothing more than the purchase of the site, since the buyer planned to raze the improvements.

Therefore, F/M expects to see your comments on any land uses changing from residential to BnBs or offices, for example.  If developers/speculators are buying these old houses to develop the underlying site, F/M wants to know this, too, as well as why.  If this is true, then there should be plenty of vacant land sales.  Why?  If a speculator buys a property to raze the improvements, and then develop the now-vacant site, the speculator merely purchased the site.  Not only did the improvements have no value, they had a negative value since the speculator had to pay to raze them to be able to develop the site.  Thus to show a property in a neighborhood such as this one with a 50- or 60-year remaining economic life, is probably inconsistent with what is happening in the neighborhood (unless the speculators are renovating the dwellings instead of razing them).   

Then F/M ask for a summary of current land uses such as “…single-family residential, commercial, or industrial…” (ibid), typical site sizes, street designs and patterns, and so forth.  F/M needs to know this since changing land uses may render the improvements to a site obsolete long before the borrower fully amortizes the loan.  This exposes F/M to business risk it likely does not want to assume.  On the other hand, if speculators are renovating the properties here rather than razing them, this implies a growth stage of the neighborhood cycle, which, statistically speaking is a low-risk loan to make.  In either event, Fannie Mae wants to know what’s occurring in a neighborhood.  More importantly, however, it wants to know why something is going on and what the ramifications of that occurrence are on the marketability of the subject. 

Therefore, choose your summary of the neighborhood’s characteristics so that you can defend them if someone calls you on them.

Factors that Affect the Value and Marketability of Properties in the Neighborhood:  To address these variables, the appraiser analyzes such factors as “…the proximity of the property to employment and amenities, employment stability, appeal to the market, changes in land use, access to public transportation and [any] adverse environmental factors” (ibid). 

Therefore, in this part of the appraisal the appraiser researches and finds out why this particular neighborhood appeals/does not appeal to purchasers.  The same is true for adverse environmental factors.  An adverse environmental factor does not necessarily mean, for example, some type of contamination or pollution. 

Rather, it could refer to the frequency and strength of hurricanes (the entire southeast and Gulf Coasts of the US), severe weather (“tornado alley” in the south and mid-west), extreme winters (North Dakota, Minnesota, Wisconsin, Montana, Wyoming), forest fires (the western areas of the US), earthquakes (southern California and Nevada), and so forth.  Note an adverse environmental factor does not mean the area is not popular with the house-buying public.  The foothills to the north and east of Malibu have some of the most expensive real estate in the US.  They also have fires and mudslides just about every year.  Go figure.

Market Forces:  these would include economic, governmental, environmental, and other factors on property values in the neighborhood.  Economic forces would include such a sentence the existence of vacant or boarded-up properties, the level of essential local support services, the number of REO sales, and so forth.  It is important to answer the “Why?” question:  “Why do these market forces affect the subject and its marketability?”  This is what Fannie Mae wants to know.

Governmental forces: these would include the zoning, land use plan, taxation, building construction regulations, and so forth.  An especially important governmental force is what the zoning allows it to be built.  For example, if a property were to be 51% destroyed in a catastrophe, to what level would current zoning allow the improvements to be replaced?  For example, would the replacement improvements have to correspond to current setback requirements, or the setback requirements in place at the time of original construction?  It is important to answer the “Why?” question:  “Why to these governmental forces affect the subject and its marketability?”

Other forces: other forces that affect value can include changes in employment, changes in demographics, changes in land uses (especially in change results in lower densities of land use), changes in building and construction coats, and so forth.  It is important to answer the “Why?” question:  “Why do these other forces affect the subject and its marketability?”

In sum, the appraiser must report neighborhood conditions factually, listing specific terms relative to be positive and negative aspects of the neighborhood as it is now, as it is transitioning, and as it likely will be the future, as well as to be able to answer “Why?” these affect the subject and its marketability.  Not only do these factors affect a property’s value, they also affect a property’s highest and best use.  For example, if a neighborhood is transitioning from residential use to office use, there is the possibility that the highest and best use of a residential property is to raze[1] the existing improvements, then improve the now-vacant site to its highest and best use (which is likely a commercial-type use given the neighborhood’s transition).

So, the lesson to learn here is that Fannie Mae expects the appraiser to indicate (1) what the factors are that affect value in the subject’s neighborhood, as well as (2) why those factors affect value.  This, of course, takes due diligence, research, and analyses of these factors.

Degree of Development and Growth Rate: a neighborhood has a predictable and measurable lifecycle.  This is growth, stasis, decline, and renewal (which is the beginning of a new growth phase).  This is not the time for the place to go into the details of these four (4) stages of a neighborhood life cycle.  These are available elsewhere in the professional literature.

Nevertheless, a competent appraiser is able to measure not only which stage of the lifecycle in which a neighborhood finds itself, but where it is in that particular stage (and, even more importantly, why it is in that state).  For example, a neighborhood that finds its prices are stagnant, with few renovations, but significant changes in demographics, is likely in the decline stage.  If the appraiser also notices there is some speculation relative to the purchase and significant renovations of existing properties, then it is also likely in the end stages of the decline phase, with a growth stage to begin within the reasonably near future.

Understanding the subject neighborhood’s development and growth rates is an analysis that leads to a proper understanding of depreciation (which is a component of the Cost approach).   It helps in the H&BU analyses since a property’s H&BU can be (1) to leave it alone, (2) renovate it, or (3) raze the improvements.  These three are elements of the financially feasible component of the appraiser’s H&BU analysis of the property, both as if vacant, as well as in consideration of its current improvements.

Trends of Neighborhood Property Values, the Demand/Supply Dynamic, and Indicated Marketing Times:  on the 1004 form, this may be the most difficult area to analyze properly.  In it, the appraiser reports the primary indicators of market condition for properties in the subject’s neighborhood as of the effective date of the appraisal.  The 1004 form has three (3) main categories for this section of the report: trend of property values, supply of properties in the subject neighborhood, and marketing times for properties.  Then, under each of these subheadings, are three (3) further subheadings. For example under trend of property values, the appraiser must indicate whether trends are increasing, stable, or declining.  Under supply of properties in the subject neighborhood, the appraiser indicates that there is a shortage (meaning an excess of demand over supply), a balance between supply and demand, or an over-supply (which means an excess of supply over demand).  Finally, the form has a place for the appraiser to indicate if marketing times are under 3 months, 3 to 6 months, or over 6 months.

It is common for appraisers to indicate that property values are increasing, yet supply and demand are in balance and marketing times are 3 to 6 months.  In reality this is a logical impossibility if the reason property values are increasing is because there is an excess of demand over supply, which also implies marketing times should be 3 months or less. When an appraiser marks increasing property values, yet also indicates there is a balance between supply and demand, and marketing times of 3 to 6 months, the appraiser needs to indicate why, in this particular neighborhood, the basic laws of economics are failing to operate.

To fail to explain this rather common anomaly is an internal inconsistency, which suggests the appraiser is incompetent to recognize what the market data say relative to the overall trends in the subject‘s neighborhood.  In turn, this calls into question the appraiser’s ability to measure and recognize the highest and best use of the property both as if vacant, as well as improved.

Note this direct quote from the Fannie Mae Selling Guide,

“[W]hen completing the one-unit housing trends portion of the neighborhood section of the appraisal report forms, the trends must be reflective of those properties deemed to be competitive to the property being appraised. If the neighborhood contains properties that are truly competitive (that is, market participants make no distinction between the properties), than all the properties within the neighborhood would be reflected in the 1-unit housing trends section. However, when a segmented or bifurcated market is present, the one-unit trends portion must reflect those properties from the same segment of the market as the property being appraised.  This ensures that the analysis being performed is based on competitive properties…[T]he appraiser should also provide commentary on the other segment(s) of the neighborhood when segmentation is present”.

Because Fannie Mae makes 30-years loans, it depends on the appraiser to to indicate to it the trends of the neighborhood.  Thus, if the appraiser indicates prices are steady, Fannie Mae wants to why they are that way, not merely that they are.  This requires the appraiser’s analysis of the elements of those trends. 

Price Range and Predominant Price:  this does not refer to the absolute price ranges in the subject’s neighborhood.  Rather, it refers to the predominant price range and prices of properties in that neighborhood.  Assuming the subject is a 1-unit property, then the price range must reflect high and low prevailing prices for similar properties, not the absolute highs and lows of all of the sales in the neighborhood.  Therefore, isolated high and low extremes should be excluded from this range.  This means that the predominant price will be that which is most common or most frequently found in the neighborhood (i.e., the median or the mode).  It is possible to state the predominant price either as a single figure or as a range.

It is important here to indicate if the subject is over-improved for the neighborhood.  Fannie Mae defines an over improvement as an “improvement that is larger or costlier than what is typical for the neighborhood”.  For example, a 4,000 square residence in a neighborhood in which 2,000 square-foot residences are common is an over-improvement.  As such, the appraiser must be careful not to over-appraise the property simply because it is the largest one in the neighborhood.  It is likely that, after 2,000 square feet, the extra square footage, as a functional over-improvement, have a value per square foot less than that of the predominating square footage.  To ignore this curvilinear relationship, or not to be aware it is happening, is to demonstrate incompetency, something the appraiser wants to avoid.

Since Fannie Mae depends on the appraiser for an unvarnished picture of what happening the subject’s neighborhood, an accurate indication of the sales prices of properties competitive with and comparable to the subject is imperative.  Thus, the appraiser analyzes prices and their trends.

Age Range and Predominant Age: Fannie Mae expects the appraiser to indicate the age ranges of the properties comparable to the subject in the subject’s neighborhood; it does not expect to see the extreme a low or high ages.  In other words, if there is one new house in this subdivision, and one house that is 75 years old, Fannie Mae does not expect to see an age range of the 0-  to 75-years.  Rather, it would expect to see an age range of, say, 20-years to 50-years (if, indeed, this is the predominant age range).  If, as an aside, you wanted to add the absolute age range, too, in the narrative, that would be OK.

If the subject property has an age significantly different from this range, Fannie Mae expects the appraiser not only to explain this fact, but also to account for it in any of the three approaches the appraiser uses to conclude a value opinion. 

Present Land Use: this is an area providing significant confusion to residential real estate appraisers.  While, in most appraisals, the present land use is residential, there are the occasions in which the land use is transitioning to something else.  If this is true, then the appraiser must list not only the present land-use, but the land-use to which the neighborhood is transitioning.  Then, the appraiser must also explain why this transition is taking place, as well as what the forces are behind that change.

For example, the construction of a new regional hospital may motivate changes in the zoning of the surrounding residential neighborhoods to change from residential to a commercial zoning permitting medical offices.  In this case, it would be common for developers to purchase the houses here and then either raze them to get at the underlying land, or to re-purpose the existing houses to medical and medical-office space.  If this is true, then the residential appraiser needs to tread carefully because appraising commercial properties is likely outside of the licensure qualifications of residential property appraisers.  Such a land-use change will affect value by affecting the highest and best use of these properties, both as if vacant as well as improved.

As this monograph suggests, an analysis of the subject’s neighborhood consists of significantly more than merely checking the appropriate boxes on the 1004 form.  When an appraiser checks those boxes, the implication of that action is that the appraiser indeed has gone through those analyses. To check those boxes, implying these actions, but yet having failed to go through those analyses, is misleading.  Misleading the client and/or the intended users is a significant violation of USPAP’s SR2–1 (b).  (This is the second time this monograph has made this point, so maybe its important).

Now, to address your reviewer’s comments: you can see that the mere recitation of facts is not what the neighborhood analysis section of the 1004 form calls for.  Merely to state that the zoning is residential in nature is to recite a fact.  To indicate that the zoning is residential in nature, and permits specific types of land uses, is also merely to recite facts.  What the zoning permits as land uses is also public record.  However, to state the zoning, to indicate the land uses the zoning permits, then to indicate/understand how/why those affect the subject’s value, and then communicate that understanding to the client, is to engage in the analysis and communication that USPAP’s Standards 1 and 2 expects of an appraiser.

Conclusions

The model to follow is to state a fact or a conclusion (i.e., an opinion).  Then, follow that with the reason(s) why you stated that fact, and why/how you reached that conclusion.  That is really all the reviewer looks for.  It is also the minimum of what Fannie Mae demands as part of an appraiser’s analyses of the subject’s neighborhood.

So, to review, the reviewer looks for analyses in a neighborhood analysis.  To state the utilities present is merely to present facts.  To state the utilities present, and then explain how/why they affect the subject’s highest and best use, its marketability, and ultimately its market value, is to include your analyses of the utilities.  To answer the questions of “How?” and “Why?” first requires the appraiser’s analyses of the issues.  Then, include a summary of those analyses in the report.  That is what the reviewer wants, Fannie Mae looks for, and USPAP demands.

When you answer the “How?” and “Why?” questions, most everything else is details. 

Shameless Plug

If you have questions on any of these areas, or if you are in trouble with the state or a reviewer,  contact me at tim@theappraisersadvocate.com.   I look forward to working with you!

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[1]     Renovation is possible, too.  But I’m trying to keep this blog relatively short (and clearly not succeeding).