Risk, Regulation and Residential Appraisals

Many of the same environmental issues that create problems at commercial properties can create headaches on residential loans. A former meth lab operating out of a house that a buyer unknowingly purchases. A high-end residential development sitting atop a former landfill. Vapors from a contaminated plume migrating from a former dry cleaner underneath a neighborhood. These types of stories are surfacing in communities across the U.S. as past property contamination rears its ugly head at residential properties.

Forces are converging that pressure lenders to manage the risks associated with residential properties. This topic was the focus of EDR Insight’s July 17th webinar, titled Emerging Risk: Heading Off Regulatory Scrutiny on Residential Appraisals. Our panelists were:

  • Jack Huntress, EDR, Managing Director, Residential Services
  • Liz Green, rel-e-vant, Principal Consultant
  • Larry Schnapf, Schnapf LLC, Attorney

More Data, More Awareness

 “There are numerous cases where residential properties are impacted by contamination. Sources are often everyday things like landfills, gas stations and dry cleaners.Newly-understood effects beyond soil and groundwater such as issues caused by vapor intrusion are emerging as key drivers of residential due diligence. The time has come for this information to be included as a standard part of the process.” —Jack Huntress, EDR, Managing Director, Residential Services

Since 1990, there have been 23 million records of property contamination documented. These include Superfund sites, brownfields, old gas stations, landfills, state hazardous waste sites and more. The world’s evolved. What was once impossible is now just a click away in the world of mortgage originations.

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The Risks They Are A-Changin’

First, there’s compliance risk. The list of regulatory changes hitting lenders is a long one. Everything now points to consumer protection, disclosure and transparency. The changes from Dodd-Frank are taking shape. The CFPB is putting a keen focus specifically on protecting the consumer. And pressure on lenders to comply with older but largely ignored regulations is heating up.

“Post Dodd-Frank, we have seen the biggest and broadest amount of regulatory change in nearly 30 years.”  Liz Green

Banks also need to be concerned about operational risk. Like it or not, banks play a role in consumer protection and there is reputational risk that is at stake if environmental issues are not being addressed.

Tighter scrutiny by regulators and the secondary market (e.g., OCC, USPAP, HUD, FDIC, Fannie Mae, Freddie Mac, CFPB, etc.) are bringing regulations directed at single-family lending to the forefront. With this comes scrutiny by examiners to ensure that financial institutions have the policies and processes in place to comply. The good news for lenders is that many of the requirements related to environmental risk came out in the 1990s when the inexpensive screening options did not exist as they do today. Meeting these requirements back then would have been costly and time consuming. Changes in technology and the proliferation of property risk data has changed the definition of what is known quite dramatically.

Appraisals and Environmental Hazards

On the residential side, numerous references exist regarding the consideration of environmental contamination at residential properties.These requirements largely revolve around the valuation process and involve the appraiser, who is viewed as the “eyes and ears” of the lender at the property.The appraiser has the ability to, not only through direct observations of the property during the inspection, but also through other data sources, to determine if there may be an environmental hazard. When information is provided and an adverse environmental condition is detected, the appraiser needs to comment on that, which may then lead to additional steps taking place (e.g.,assessment, remediation or ineligibility for a particular loan program).  “The appraiser,” noted Green, “doesn’t necessarily have all the answers, but he does have the responsibility to indicate when there is a concern. He needs to at least report it.” Too often, however, appraisers are just checking “n/a” and effectively ignoring environmental risks during appraisals.

Particularly in the secondary markets, there is the expectation that both on-site and proximate environmental contamination must be considered as part of the single family lending process (e.g., Freddie Mac Single Family Seller/Servicer Guide). “For the lender, this risk has to do primarily with saleability risk. For appraisers, it has to do with compliance,”noted Huntress. “As such, it is very different from the way that lenders consider environmental loss risk when they have a Phase I environmental site assessment or other type of due diligence conducted prior to originating a commercial property loan.”

“Environmental data is one of the most progressive and underutilized elements that is within our reach today. I think that one of the key drivers of why considering environmental hazards during appraisals is so important is that we are faced with a lot of properties that have come through the foreclosure cycle. We have a lot of empty houses and a lot of problems with them that could be lurking under the surface. As these homes enter the food chain and get put back on the market, there’s a whole new risk that we’ve never seen before.” Liz Green, REL-E-VANT SOLUTIONS

How Contamination Impacts Residences

Recent tragedies like plant explosions near residential neighborhoods in Massachusetts, Texas and Louisiana highlight why environmental issues as they relate to bank consumers are so important today. These types of events are forcing are-examination of what it means to have residents living so close to hazardsthat are industrial in nature.

Attention on vapor intrusion risk in particular has been a game changer. “What it has shown us is that the plumes are a lot longer than we originally thought…. We’re seeing plumes now a mile long, often the result of VI or contamination from dry cleaners and gas stations in urban areas.” —Larry Schnapf

While environmental due diligence is common in commercial real estate lending, it is less so on residential properties, yet the risks are essentially the same. Often there is historic contamination that is only discovered when there is a new use of the property (e.g., a new subdivision). There may be contamination underground that is not obvious, or property reuse in a former industrial area could lead to problems later for residents.

Consider a few recent cases involving contamination at residential properties:

  • Maryland Square (Las Vegas) is a major lawsuit involving a release from a dry cleaner at a shopping center. The plume, more than a mile long, traveled into a high-end residential neighborhood and created vapor intrusion issues for occupants.
  • For owners in Jacksonville, Maryland, it is virtually impossible to sell their homes after a leak from a gas station went undetected for 37 days in 2006, spilling about 26,000 gallons of gasoline into the groundwater, resulting in significant property damage claims.
  • In Oak Park, IL, a bank foreclosed on a home right next to a dry cleaner with a known plume. Vapors were discovered in the home after foreclosure, impeding the bank’s ability to sell and leading to a lawsuit.
  • A very highly publicized, and ongoing, case in Pompton Lakes, NJ involves 435 homes with the potential for vapor intrusion from contaminated groundwater as the result of nearby manufacturing activity from 1902-1994.

“…it’s much easier to look around the property that you’re either buying or going to be lending on, and you need to find out not only what is there now but what was in the past. Often it’s historic uses that pose risks to the properties so lenders really need to start thinking about doing some sort of screen not just for the property itself but around the property.”  —Larry Schnapf

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Action Steps for Lenders

In a post-Dodd Frank world where there is more intense scrutiny and heightened consumer protection issues, it is critical for banks to be proactive in ensuring that their policies and procedures are protective of all types of risk (operational, reputational, compliance, etc.).

Key Takeaways:

Residential properties are not immune to environmental health hazards.

Dramatic advances in the availability of property risk information and technology make environmental screening of residential properties more efficient than in the past.

The valuation is largely where environmental hazards come into play.

Consumer protection is the name of the game and like it or not, banks have a role to play and reputational risk could be at stake.

Action Items for Lenders

-Take a proactive stance – Consider the ‘retroactive view’ of the relative collateral risk. Think about how business decisions today will be perceived a few years down the road.

-Scrutinize your choices of how appraisal procurement and collateral risk assessment is executed.

-Where 3rd party agents are concerned, do your homework.

-Review your current policy to make sure it is up to date including internal audit & enforcement. This is always a good idea, but and even more so now.

-Leverage technology and data commensurate not only to operational capabilities of today but with an eye towards ever increasing availability. Best practices are changing and the bar of expectation is being raised.

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FOR MORE INFORMATION

A replay to the call and Q&A session is available here, and includes useful regulatory references, case studies and practical tips for lenders.

The seminal piece on this topic, titled Summary Report: Land Contamination and Residential Properties Summit, provides detailed information on the nature and effects of environmental contamination on residential properties, potential liabilities for various stakeholders, and the agencies and organizations that require environmental screening.