Scott Roller: Rising Construction Costs – The Appraisal Dilemma

(Scott Roller founded 3W Partners LLC and is Co-Founder of Vendor Surf LLC (www.VendorSurf.com), each dedicated to revolutionizing sourcing of vendors in the mortgage and credit union ecosystems. The companies monitor and report on the service provider market to provide participants what they need to excel in today’s market. He is a regular contributor to MBA NewsLink.)

The domino effect – an endless run of falling dominos winding through the residential home construction industry. That’s a vision we can easily conjure up when witnessing the ongoing impacts of steadily rising construction costs.  And guess who is at the end of the domino chain, having to deal with the residual mess?  Residential home appraisers and their lender clients.

It is incredibly challenging to appraise newly constructed homes right now, primarily for these three reasons:

1. Residential construction material and labor costs have skyrocketed
2. Most appraisers do not have adequate access to the underlying data
3. Appraisal standards have major limitations on incorporating these rising costs

Virtually everything that goes into building a house has seen substantial price increases since the global coronavirus pandemic arrived, raw materials and labor included.  Lumber, copper, aluminum, steel, gypsum, doors and trim, roofing, windows and siding, concrete and other items are all more expensive.  Lumber prices, for example, have nearly doubled.  According to a report last month from the National Association of Home Builders, the price of lumber hit a record high in early February and is up more than 170% over the prior ten months.

NAHB says that rising lumber prices alone, not including all of the other materials and labor costs, have added $24,000 to the cost of building the average single-family home and about $9,000 per apartment.

In August 2020, the Producer Price Index report released by the Bureau of Labor Statistics advised of a four-month consecutive increase, exceeding 50%, in the prices paid for goods used in residential construction, the most significant hike since first being tracked 70-years prior.

Much of the problem stemmed from mill and plant shutdowns in the early days of the pandemic, causing major backlogs (supply shortages), although not the only cause.  Tariffs have played a part, as have historically low mortgage interest rates, which have driven unprecedented demand for new homes.  Not surprisingly, there are reports of hoarding materials as ongoing fears and challenges drive such behavior.   

“Lumber price spikes are not only sidelining buyers during a period of high demand, they are causing many sales to fall through and forcing builders to put projects on hold at a time when home inventories are available at a record low,” NAHB reported.  According to a Wall Street Journal article this month (Commodities Boom Hits Home) Brant Chesson, CEO of Homes by Dickerson, Raleigh, N.C., said that after raising prices in February, just to cover higher lumber costs, he lost six customers in a single day.

Builders are now contending with increased costs and timeframes to build homes.  So, when the exact same house (floor plan) now costs 20% more than its neighbor on the same street, appraisers are often put in a precarious situation.  The dilemma – how to arrive at an appraised value that can adequately reflect increased builder costs yet assure home buyers that the home is worth the sale price.  The sales price for that ‘comparable’ existing home a few doors down is often considerably less than the cost of building the new one.  This can also leave lenders in a tough spot, especially when builders will often lower prices once raw material costs return to normal, causing risk to recently funded loans at higher values.

Appraisal Standards

Appraisal standards make it very hard to incorporate the full impact of building material and labor increases.  Furthermore, in many cases, the appraisers don’t even have access to all of the data impacting rising costs, making it challenging to assess home values accurately.  It is imperative that lenders partner with Appraisal Management Companies with the capabilities and experience to work through these situations effectively. 

Some home builders will provide appraisers with an ‘appraisal binder’ when they arrive to inspect the property, generally citing a cost breakdown of all materials used in building the home.  The binder intends to help the appraiser balance market value with the builder’s materials costs.

Appraisers can use one of three different appraisal methods, including sales comparison, cost method, and income capitalization method.  Consumers are most familiar with sales comparison methodology, whereby nearby sales’ comps’ are used to help establish value – assessing what similar (comparable) properties in a nearby area have sold for in the recent past.  In the rising new home construction cost scenarios, the cost method is usually more appropriate since it contemplates the costs to rebuild the structure.  Still, Fannie Mae and Freddie Mac guidelines require appraisers to consider sales comparisons, to a very substantial degree, in the cost approach.  Challenges can grow even more prominent in rural areas, where it’s not always easy to find reasonable comps.

When using the cost approach, appraisers can use one of two models:

1. Reproduction Cost – The cost of producing a true replica of the subject property, using the same design and materials
2. Replacement Cost – The cost of producing a home of similar usefulness, based on current design and materials. An appraiser usually makes more adjustments to a reproduction cost estimate to account for differences in usefulness between older and newer structures

Appraisers rely on a variety of resources to calculate reproduction and replacement costs. Actual construction costs for subject or similar buildings can be the best basis for a cost estimate adjusted for changed market conditions.

Something’s Gotta Give

When appraisals for new construction are based on comparing the proposed new home to recently sold homes similar in size and features (existing stock), appraisals for new homes are often less than the cost to build them.  Builders either must absorb the difference – holding prices steady while reducing their own profit margins – or ask home buyers to cover the shortfall through higher down payments or home prices.  Banks usually won’t lend on the total amount needed by the buyer.

Net Message – construction cost is an impactful component of value, but it is not the established value.

When builders construct a new development in an area with nothing similar around, they need to demonstrate buyers are willing to pay those prices.  There may be several properties under contract but no closed sales.  Per current appraisal rules, appraisers cannot use pending sales to demonstrate that type of marketability.  The potential for fraud is high.  A developer can have accomplices contract homes with no intention of ever really purchasing them – just a means to inflate values. 

Some industry participants would like to see Fannie Mae and Freddie Mac bring proposed solutions to the table, including a process to allow pending sales contracts to be used to demonstrate value in new construction scenarios.  Participants concede, though, significant anti-fraud measures must be incorporated whereby lenders and appraisers conduct due diligence to ensure the pending transactions are arms-length.  Some participants also want to see strictly enforced laws, with prosecution, for such fraud cases.  

“The market is having to take significant jumps in prices right now to accommodate the increases in material costs, and there is just no system in place to account for that,” said Rick Garrie, Chief Valuation Officer at United States Appraisals (www.unitedstatesappraisals.com).  Garrie went on to say that he has seen some builders that were proactive in their increases in values and imposed incremental increases over 6-to-8 months.  But Garrie said he has also seen other builders that initially worked from pre-ordered supplies to keep prices low, and as those initial supplies ran out, the price increases at re-order were huge, and the builders are currently trying to make the leap all at once. 

Garrie said, “In several areas, I can piece together historical data to show the increases, but in a situation where the increase over everything else in the area is so significant, there is no historical data to support that increase.” He continued, “I don’t have problems with most of the larger national builders because they understood what was happening and started the process months ago.  I see the issues in some of the smaller builders and developers that saw an opportunity with larger builders making increases to undercut their prices, but are now struggling to make the leap to cover the higher material costs.”

In Summary

Appraisers have a long history of perseverance, determination and grit.  This is not the first major challenge they have faced, and it certainly won’t be the last.  They will survive this, but it would be a blessing to see industry policymakers jump in and lay a foundation to ‘thrive in’ versus merely survive – something similar to the policies recently enacted to pave the way for eClosings.

Don’t expect this problem to disappear anytime soon.  With The Fed signaling holding interest rates at or near zero, mortgage lending rates remaining near historic lows, a good economic forecast, and federal stimulus payments putting down payment money in people’s pockets, the ‘short supply – high demand’ environment will continue well into 2022. 

(Views expressed in this article do not necessarily reflect policy of the Mortgage Bankers Association, nor do they connote an MBA endorsement of a specific company, product or service. MBA NewsLink welcomes your submissions. Inquiries can be sent to Mike Sorohan, editor, at msorohan@mba.org; or Michael Tucker, editorial manager, at mtucker@mba.org.)