WASHINGTON, D.C. — Seasoned residential property appraisers are outraged over current industry practices that they claim allow conflicts of interest by major lenders and their affiliated appraisal management companies, and the appraisers warn that problems could spill over into commercial real estate valuations.

Veteran appraisers initially welcomed the new Home Valuation Code of Conduct adopted by Fannie Mae and Freddie Mac, which was intended to improve the integrity of the appraisal process in the mortgage finance industry. The code is essentially an agreement with Freddie and Fannie’s lenders requiring that appraisers be certified or licensed by the states in which they operate. It attempts to ensure that lenders and others do not unduly influence the appraisal process. The code went into effect on May 1.

Faulty appraisals contributed to the subprime housing crisis, which eventually led to the nation’s deepest recession since the Great Depression. The code of conduct, developed with the help of New York Attorney General Andrew Cuomo, former Secretary of Housing and Urban Development, is an effort to make the appraisal process more transparent and independent.

However, some appraisers say the code was amended early this year to allow lenders to retain the use of appraisal management companies with which they have financial ties, posing potential conflicts of interest. “The one thing about the [appraisal code] that was attractive was that lenders were going to be forbidden from owning appraisal management companies,” Richmond, Va.-based appraiser Pat Turner told a group of real estate editors this week.

However, the code was changed from its original wording of March 2008 to allow the lenders to use the management companies, said Turner. Because of serious financial problems related to faulty appraisals of properties underwritten by Washington Mutual, for one, appraisers had understood that the use of lender management companies would not be permitted, Turner added. In September 2008, Washington Mutual became the largest bank failure in U.S. financial history. Just a year earlier, it had assets of nearly $300 billion.

“What’s the cure? Forbid lenders from owning or even using just one appraisal management company,” says Turner. “Forbid them from owning an interest in an appraisal management company. But if they’re going to use one, make them use more than one, so they will have no undue influence over them. Let’s have some transparency.”

Besides appraisers, mortgage brokers also are unhappy with Fannie and Freddie’s valuation code. Marc Savitt, president of the National Association of Mortgage Brokers, says the new code is having a significant and negative impact on the mortgage market.

It has created conflicts with other appraisal regulations and has led to a decline in appraisal quality, he contends. “Of everything that’s facing the housing industry and the mortgage finance industry, this is probably the most pressing issue that’s out there right now, the most dangerous issue to consumers and industry.”

However, creating the code was a necessary step toward making appraisals less biased, says Bill Garber, director of government affairs for the Chicago-based Appraisal Institute, which provides training and helps to set national standards for commercial and residential appraisers.

“It was the Wild West. Brokers were running wild,” Garber says. The government began to take steps over the past year and a half to enforce regulations and curb abuses in the appraisal process, including influence by brokers as well as lenders. Brokers want to sell property, and that affects broker-originated proposals, Garber says. “I wish the mortgage broker community had been regulated 15 years ago.”

Residential appraisals differ from commercial property valuations in that residential examinations rely on evaluating the cost to replace a property from scratch, while commercial valuations rely on analysis of a property’s income-related performance such as income from rent rolls.

But residential appraisals affect an area’s economic climate, says Garber. Diminished residential values in an area ultimately hurt commercial real estate, he says. “In a lot of markets they are seeing [commercial] declines.”

In Congress, a new bill recently passed by the House of Representatives and sent to the Senate banking committee for consideration would require appraisal management companies to be registered. That’s a step toward enforcement of regulations governing potential conflicts, says Don Kelly, a consultant with the Appraisal Institute.

Next shoe …commercial?

The extent to which commercial valuations could be affected isn’t yet known, but there is a potential for spillover, says Kelly. “The rumor is that the next shoe to drop is the commercial, because they’ve got tons of real estate tied up with mortgage-backed securities. So, are we going to find the same problems? Are we going to have inadequate valuations on those properties? It very well could be.”

Like a number of other professionals, Kelly expressed concern about “automated” residential appraisals, which he says can mislead consumers, who often believe they are paying for a full appraisal. With the automated model, statistics and data are used to generate a home’s value, but it is not based on a thorough inspection of the property.

The number of appraisers in the U.S. has grown to about 125,000 in 2009 from about 40,000 in 1989, but only about 25,000 of them are members of the Appraisal Institute, says Turner.

He runs the largest appraisal firm in the Richmond, Va. area, and like other senior appraisers contends that thousands of currently practicing appraisers in the U.S. lack the training and experience to conduct proper appraisals. The resulting faulty valuations can undermine the mortgage industry, he says.

Automated appraisals can also be faulty, he says. One study of about 400 appraisals conducted for a bank that later failed revealed that 100% of the appraisals were wrong. “They overvalued the properties by 40% to 70%, 100% of the time.”