Valuing Properties for the Non-Conforming Loan
By Charlie Elliott, MAI, SRA

An appraisal is an appraisal regardless of the type property or type loan to be made on the property, right? Does the non-conforming loan not speak to the loan, as opposed to the appraisal or the property?

There very well may be confusion on some of the above because we do have a somewhat complex system as it relates to whether a loan is conforming. The first question may be, “conforming to what or who?”. Typically in today’s lending environment the term conforming applies to that of the Government Sponsored Enterprises or GSEs.

We have two primary GSEs in the United States, Federal National Mortgage Association (FNMA or Fannie Mae) and Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac).

While there may be some differing opinions, depending upon whom one may be talking to, these are the two organizations that set the tone for the residential mortgage market in the United States, by buying packages of loans from mortgage companies and banks. This provides liquidity for the banks to make a lot more loans when their capital has been exhausted. The GSEs do have standards under which they are expected to operate. These regulations may exclude certain borrowers or properties from the loan process, because they fall outside the conforming loan category into that of the non-conforming loan category.

Generally in our lending community when the term non-conforming is used, it is used within the context of meeting the underwriting guidelines of the GSEs. A variety of conditions may apply that rule out a potential loan as a conforming loan, including borrower credit, borrower employment, the down payment, the amount of the loan or the state of the property used for collateral.

One of the main conforming loan criteria, of which much is heard, is that of maximum loan amount. Recently Congress and the Bush administration increased the maximum loan amount under the Economic Stimulus Package to $729,750 in some markets. This is a huge increase over that of 2007, which was $417,000. Historically, this amount has been much lower in many markets. Loans above the GSE maximum threshold are said to be a jumbo loans. This non-conforming product has been made available by some banks and by Wall Street investors to fill a void of generally high-quality loans not covered by the GSEs.

The sub-prime meltdown has caused many of the alternative-secondary-market buyers of loans on Wall Street to dry up, leaving many borrowers with few choices. One popular alternative has been the FHA loan, which has basically been the government sponsored sub-prime loan alternative. This loan typically caters to the lower-end buyer and is currently one of the more popular non-conforming loans.

For purposes of this article, we will focus on the non-conforming aspects of the property and/or the appraisal that reflects the state of the property. This may include the appraised value, location, design and condition, as they relate to a qualifying conforming loan.

As a principal in an appraisal management company and one who is routinely involved in appraisal-problem solving, I often hear from lenders who have received appraisals that do not support the loan amounts applied for by the borrower. In cases like this the lenders most often say that there is something wrong with the appraisal. While there have been times when this is true, all too often rather than something being wrong with the appraisal, there is something wrong with the property. An example of this would be a circumstance where a property has significant amounts of deferred physical maintenance or where it has major functional obsolescence. In cases of deferred maintenance, examples may include a roof that has outlived its useful life, a wet basement requiring major repairs or a complete paint or floor-covering job. Functional obsolesce may exist when it is necessary for one to pass through a bedroom to reach a bathroom or where there are too few bedrooms, such as one or two, in an otherwise large home. In these cases it is necessary for the appraiser to disclose these conditions in the appraisal, which may disqualify the property as a candidate for a conforming loan.

Government regulations require at a minimum, that loans on all federally related transactions, with a transaction value of $250,000 or over, have an appraisal prepared by a state certified real estate appraisal. Appraisers are further required to conform to Uniform Standards of Professional Appraisal Practice or USPAP. Fannie Mae and Freddie Mac also require appraisals on many transactions below the $250,000 threshold on loans that they purchase, depending upon various factors, such as credit worthiness and down payments. This would be considered the conforming market, as opposed to the non-conforming. Automated valuations and tax assessors’ records are generally accepted evaluation methods in the conforming market under certain conditions. This is usually on low-risk transactions, where the collateral is considered to be a secondary issue.

In general, the standards applied to a conforming loan, relating to an appraisal of the property, require that it demonstrate that the property conforms to the market. This means that the property is one that will be in demand and able to be sold, in the event that it becomes necessary to foreclose upon the property, an event we have lately been experiencing more often than we would like to.

Said another way, properties having qualities, in which the mainstream buyer may have a problem with, many times do not qualify for a non-conforming loan. It may mean that the property contains deficiencies, but not always. Some properties are superior to the mainstream and these, many times, are ruled out as a candidate as collateral for a conforming loan. An example of this would be a 10,000-square-foot log cabin on 40 acres of land, located in the mountains. This property on the surface may sound like the perfect retreat and an excellent property upon which to make a loan. That may be true, but it may also not be non-conforming when put under the microscope of Fannie and Freddie. If it is far superior to other properties in the neighborhood it may be what is called in appraisal terminology “super adequate.” Yes, it may be a property that will have a very narrow appeal to only a few people; therefore, its marketability may suffer from the lack of qualified buyers. Also, this type property, depending upon the loan-to-value ratio, may qualify as collateral for a jumbo loan. In this case, there would not necessarily be anything wrong with the property, however, it may exceed the loan limit for the geographic area by the GSEs, and may require funding elsewhere as non-conforming.

In conclusion, the conforming loan is just that, one that conforms to the general market. This means that the transaction must be a fairly typical transaction that equates to one of low risk. Loans that fall out of the mainstream are accompanied many times with increased risk. That is what conforming is about, reducing risk. Not only must the transaction qualify as low risk from the standpoint of the qualifications of the borrower, but the property must also qualify as low-risk collateral for the particular transaction.

Many properties are found to be non-conforming by the GSEs because of the risk factor that they represent in their portfolio. Sometimes this risk is manifested in defects in a property, which are reflected in an appraisal. Not always is a non-conforming property to be considered a defective one. It may be a super-adequate one. In such cases, it does not mean that the borrower cannot qualify for a loan. It just means that a non-conforming source must be found. This source may be the local bank willing to carry it in its own portfolio. Other sources may be a special funding through investors, willing to invest in less-than-typical loans.

The non-conforming loan may be associated with the negative in that it will be a poor investment, however, this is not always the case. It may be a very positive thing for the right investor, particularly if the investor is able to charge a premium to offset the additional risk associated with the transaction.