REQUIRED READING: As long as lenders have relied on property valuation to make lending decisions, there have been criminals who have manipulated this value to their own benefit. Part of the reason valuation fraud has cost so much over the years is that it has been too easy to find willing accomplices.
Many alliances for fraud were forged in the heat of the recent refinance boom. Another reason for increased fraud is that the industry has historically based its collateral valuation decisions on only a portion of the data required to reach a meaningful and unclouded conclusion. By considering a larger picture and including data from additional sources, the industry can take a big step toward stopping valuation fraud.
According to a recently published report covering data collected during the fourth quarter of 2009, the property valuation fraud risk index is up 40% over 2008 and up more than 100% from 2007. Despite the fact that lower loan volumes contributed to a slight quarter-over-quarter drop at the end of 2009, the risk of valuation fraud is extremely high for lenders right now. A number of schemes are currently being perpetrated against institutions, mostly centered on one of two basic valuation strategies: illegal flipping or flopping.
Illegal property flipping, in which an improperly high collateral value is used to facilitate a sale for profit, and flopping, in which an improperly low collateral value is used to facilitate a fraudulent sale followed by a sale or financing for illegitimate profit, are both made possible by collateral-valuation methods that rely on lagging indicators and backward-looking analytics. Although the falsification of condition is sometimes a factor, the most common culprit is comparable property sales data that is old or otherwise skewed to falsely represent the market position of the subject property.
Of course, it didn't start out that way.
Years ago, flipping didn't have the negative reputation it has today. It was called arbitrage buying, and many legitimate businesses engaged in this practice. It was just another example of buying low and selling high. You'd find a distressed property, by virtue of a foreclosure or by being in need of improvement, and then you'd put some money into it, get it into shape and sell it for a profit. That's the legal type of flipping, and there is still nothing wrong with it.
Success hinged on proving to the lending institution for the new buyer that the investments made in the property significantly increased the value. Otherwise, the new buyer wouldn't get financing – at least not at the level required to turn a profit for the flipper – even if the new buyer loved the home.
Executives working the collateral-valuation space have always had to consider two aspects of the valuation problem. First, they had to evaluate the subject property itself to determine its marketability in terms of an approximate value. Second, and perhaps even more importantly, it was necessary to evaluate the marketplace surrounding the property in order to put the subject property's value in perspective.
As long as someone took this 360-degree view of the subject property, the system worked fine. But when business really started to heat up early in this century, many people – not just appraisers who took this view – had trouble keeping up.
Somewhere along the line, a comprehensive view of the environment surrounding the subject property was reduced to simply finding three comparable sales. That, combined with constantly increasing property values, opened the door to a belief that all factors should be considered average or better and that all neighborhoods were at least stable.
Proponents of pure production argued quite successfully during this time period that even if problems did exist, the "market" would cure them. This combination of attitude and rationalization gave birth to the idea of the "average neighborhood" in a community and the "average home" within the neighborhood. It also opened the door to many types of valuation fraud, including illegal flipping and flopping.
Full market view
Appraising real estate is a local function. It requires local expertise, because over the years, it has become clear that there is no such thing as an "average neighborhood." So many elements go into the socioeconomic makeup of a community that it cannot accurately be compared to others around the country, except on a macro scale.
Recent strides in data-collection technology have enabled savvy modelers to combine groups of data with advanced analytics that provide good tools and a 360-degree view of neighborhoods and properties within them. Unfortunately, much of this data has remained difficult for appraisers and modelers to ascertain.
The solution lies in combining the past, present and future by utilizing a combination of sales within Multiple-Listing Service's (MLS) current offerings, and predictive models that examine transfer times, real estate owned activity and other pertinent factors. Instead of three comparable sales, why not look at 30 detailed sales with the MLS notes stored in the database by professionals, such as real estate agents and brokers, who worked with the properties during the sale?
A valuation that could be dangerously skewed by one bad comp out of three will not be negatively impacted nearly as much as by one bad comp out of 30. Consequently, it would be much more difficult for a fraudster to manipulate enough data to skew the value of a property in his favor. Faced with a collateral-valuation tool that utilizes MLS data for a community, a criminal is more likely to abandon the neighborhood in favor of one that is not as well protected.
MLS data is only one element that must be considered in order to achieve accurate property valuations, but once it is employed, it empowers the financial services firm in a number of ways.
As a tool utilized at the inception of a loan, one could quickly determine the validity of a proposed deal and mitigate the cost of lost opportunity. If the loan does proceed, the same tool would assist in validating any appraisal performed and empower the underwriter when he questions why certain noted community elements were not mentioned in the report.
For instance, average exposure time to sell property from MLS provides a quick snapshot of the health of the market in that area and a comparative basis for the subject property. Examining that data, alongside the various types of non-arm's-length sales in that area, could provide insight into competition and the subject property's ability to maintain value into the foreseeable future.
Beyond that, the same type of collateral-valuation tool enables due-diligence and capital-markets personnel to have good intelligence when either prepping a pool of loans for sale or examining a pool of loans for purchase. In either arena, the 360-degree approach and overall market-intelligence data allow for better decision-making and added protection against losses from many types of fraud, including the previously mentioned flipping and flopping scenarios.
The bottom line is simple: It is a new battlefield out there, and everyone needs to ensure that we are moving forward equipped with the tools that will both streamline production and help protect against fraud and bad decisions from insufficient information. In the near future, the idea of evaluating a subject property without the additional value and information provided by MLS data will be similar to looking at a market with one eye closed.
Mark Chapin is chief valuation officer for Interthinx, based in Agoura Hills, Calif. He can be reached at (800) 333-4510.