Copyright © 15 November 2014 by Bob Hurt. All rights reserved. Distribute intact freely.
Residential realty consists of
- The raw land;
- General amenities (roads, sidewalks, water, sewer, electricity, cable for phone/internet/tv, HOA deed restrictions, zoning restrictions);
- Specific improvements (the house, landscaping, garage and other outbuildings, sport facilities, pool, patio, etc);
- Community amenities (location, recreation facility, common area, economic stratum and quality of residents).
The lending process for such realty these days typically results in at least one note and one security instrument. The lender assigns an interest rate based on numerous factors, principally the conjectured ability and reliability of the borrower to repay, the volatility of the market, term of the loan, the Federal Reserve prime rate, and the likelihood that a foreclosure sale will equitably compensate the lender. In most loans, the lender lumps together all of the above-enumerated components in the mortgage, and the borrower pays the same interest rate over the same term for the land as for the improvements.
Innovative Bifurcated Loan Products
But, what if the lender charged a different interest rate for the land than for its improvements? After all, the house and grounds can fall into disrepair, and that will diminish the value in an emergency foreclosure sale. The raw land stays the same, and its value won't diminish unless a sink hole opens up under the house or the entire community value diminishes because of fracking or a massive demographic change. In other words, the raw land has much more stable and predictable value than the improvements to the property.
Lenders could break the loan apart into two amounts, one for the land and the other for the house and other improvements. Lenders could charge a lower interest rate on the land, and finance it for a different amount of time, than the improvements. This would allow borrowers to retire the debt early, reduce lender risk, and give the lender a fair return on investment.
SCOTUS Throws a Wrench in the Works
Finance specialists might develop such bifurcated loan products, but it seems doubtful that they will introduce any in the near future because of the US Supreme Court ruling in Alice v CLS Bank on 19 June 2014 (see arguments here). In the opinion, the SCOTUS invalidated hundreds of patents for financial products or business methods, claiming patent laws do not apply to them because they fit within the exception categories of "Laws of nature, natural phenomena, and abstract ideas" within the scope of 35 USC §101, in other words, "building blocks of human ingenuity." Simply put, the idea itself is not patentable. Justice Sotomayor summarized the principle nicely:
"I adhere to the view that any “claim that merely describes a method of doing business does not qualify as a ‘process’ under §101.” Bilski v. Kappos, 561 U. S. 593, 614 (2010) (Stevens, J., concurring in judgment); see also In re Bilski, 545 F. 3d 943, 972 (CA Fed. 2008) (Dyk, J., concurring) (“There is no suggestion in any of th[e] early [English] consideration of process patents that processes for organizing human activity were or ever had been patentable”). As in Bilski, however, I further believe that the method claims at issue are drawn to an abstract idea. Cf. 561 U. S., at 619 (opinion of Stevens, J.). I therefore join the opinion of the Court. "
How the Lenders Guarantee the Loan Benefits Them
Let us ever bear in mind the cogent reality that lenders do not care about the borrower's return on investment whatsoever. Lenders and their agents and associates do everything lawfully possible to maximize their own return on investment and minimize their cost. The note, the mortgage or deed of trust, the appraisal, the HUD1 report, the TILA disclosures and every other document related to the loan has but one purpose, from the lender's perspective - to make money. Therefore, they design NOTHING to benefit the borrower except as required by government. The lender wants the seller to sell the house for top dollar, the appraiser to value the collateral property for that same top dollar, the mortgage broker to qualify the borrower for repayment of a loan for that top dollar. All the legal forms are engineered to benefit the lender first and foremost.
How Appraisals Benefit the Lender, not the Borrower
I mentioned at the beginning of this essay the idea of separate loans for the land and for the improvements. Naturally, that implies separate appraisals. In speaking with a seasoned real estate professional and former appraiser on this very subject today, I began to see a significance of appraisals that I had not previously considered. The appraiser works for the lender, not for the borrower. The lender pays the appraiser and gives the appraiser an assignment. That assignment tells the appraiser how to focus the valuation. It normally seeks to justify the selling price, not the actual value of the property. Of course, the comparable sales constitute biggest indicator of price justification. The appraiser focuses mostly on whether similar properties have sold for an amount similar to the target property asking price.
This does not at all benefit the borrower. The borrower wants to know whether the property has the worth of the asking price, not whether other buyers have paid a similar price. The appraiser never answers that question because the borrower does not pay the appraiser or give the appraiser that assignment.
Yet, borrowers nearly universally believe that the appraised value of the realty constitutes its actual worth. It does not. And that means the lending and appraisal industry basically runs a scam of deception to fool the borrower into thinking the realty has a value at least as high as the selling price, or in the case of refinances, that the house has the worth of the appraised value.
Legislative Intervention Warranted
I believe the legislatures should intervene in this deception by mandating that appraisers must give equal balance to replacement cost, income capitalization, and market value approaches to property valuation, and estimate the actual worth of the property, not to estimate whether the selling price is justified. Ultimately, the borrower pays the cost of that appraisal, even if the lender orders it. Therefore, it should serve the borrower's interest at least as much as it serves the lender's.
Today, appraisers ignore income capitalization altogether, give scant weight to replacement cost, and focus mostly on market value - what people seem willing to pay for similar properties.
The main problem with market value lies in the vagaries of markets. If the FED lowers the interest rate, people will rush to refinance or buy realty on credit so as to get the most property possible for their monthly payments. This will create an artificial demand, and force up the market value through competition of many buyers for few houses. Ultimately, that will cause replacement cost to rise as builders seek to benefit from the windfall.
Additionally, as we saw in the financial crisis, widespread job loss causes widespread foreclosure which collapses housing prices, and consequently leaves other home loan borrowers with underwater loan balances - they owe more than the value of the house, and therefore they have lost their equity in the home and must sell it at a loss if they sell it at all. This means they cannot sell it to avert the foreclosure, and the deficiency leads many to seek bankruptcy protection. It has become a gargantuan disaster over the past decade. This provides further insight into the scam of market valuation method of appraisal.
Dramatic Importance of Income Capitalization Valuation
In reality, all real estate constitutes a business investment. The owner might use it as a residence or rent it out or convert it into a business site, zoning and deed restrictions permitting. As an investment, borrowers have good reason to look for a return. This makes the income capitalization approach to valuation intensely important to borrowers. Appraisers should always ask "How much money could this property produce if turned to business use?" Obviously, renting it out constitutes the most common such use. So the appraiser should evaluate the rental income of similar properties similarly situated.
Borrowers should consider this valuation carefully before agreeing to borrow the money. Why? Well, what if the borrower suffered a stroke and the family needed to rent out the house to pay for a care-giver? The rent and maintenance should exceed the monthly debt service, shouldn't it? If it doesn't, that means the property was overpriced or overvalued. That makes the typical appraised value a lie, from the borrower's viewpoint. Doesn't it?
Challenge to Financial Innovators
If inventors concoct some slick loan products with different interest rates and terms for land and improvements, then they should also concoct some new USPAP (Uniform Standards of Professional Appraisal Practice) guidelines in order to support the borrower's interest as well as the lender's. Of course, the lenders will never support such appraisal guidelines. But if they did, they would have far more secure collateral for their investments, and in the end everyone would win.