Understanding Hybrid Appraisals: A Modern Approach to Valuation

The desire to use Hybrid Appraisals has become increasingly prevalent in the mortgage origination industry.  The use of Hybrids offer a streamlined approach to property valuation. This method requires a clear understanding from users and readers of the appraisal report regarding the real estate appraiser's responsibilities.

What is a Hybrid Appraisal?

For years, traditional appraisals, where the appraiser is responsible for managing the entire appraisal process, from scheduling an appointment, collecting specific data on the property to be appraised, completing the appropriate level of analysis and issuing the completed appraisal report.  A Hybrid Appraisal is a valuation where the Scope of Work is different from the Traditional Appraisal and the appraiser does not personally inspect the property. Instead, the appraiser relies on property data collected and provided by a third party.  While the concept of using third-party data has existed for a long time, this scope of work was primarily used in situations where physical access was limited and the appraisal wasn't for first mortgage loan originations.  Recent policy changes by Fannie Mae and Freddie Mac, the two largest purchasers of mortgages for 1-4 unit housing, has significantly broadened the demand for Hybrids.  In the Hybrid Appraisal, the appraiser’s role remains the same - to provide an independent valuation with the required level of professional competency using appropriate analysis and reporting of the appraisal results.  

Why Hybrid Appraisal for mortgage originations? 

Mortgage originations demand is highly dependent on interest rate levels and general economic conditions.  Typically, when the economy is stable or increasing, interest rates become affordable to the consumer and demand for mortgage products increases.  The majority of mortgage transactions require an underwriting process that relies on the use of human underwriters and appraisers.   Presented in a production model format, the more origination volume, the more hours needed for both underwriters and appraisers.  When capacity is stressed, decision times elongate, creating friction in the system.  This friction manifests in the form of delays, missed financial opportunities and additional costs.  When interest rates are volatile, both lenders and consumers become very focused on expired rate locks and rate lock extensions.  Rate locks have limited time frames to mitigate risk exposure, and the benefits are only achieved  when the entire process is completed within the timeframe set by the rate lock terms.  On the consumer side, rate volatility can impact loan affordability and on the lender side movement in rates can impact the profitability of originating the loan.  Delayed closings, particularly for purchase transactions, can result in additional unplanned costs and inconveniences (i.e. contract non-performance penalties, physical move delays, accommodating housing needs of the parties involved) as well as many other disruptions to the parties involved.    

In many business models, when resources are limited, capacity is increased.  For mortgage transactions, underwriter resources can be adjusted, by increasing the number of underwriters (an unlicensed workforce), or increasing underwriter productivity by investing in automation.  Increasing appraiser resources offer more challenges.  As a licensed profession, the ability to respond to short-term increases in demand is extremely limited.  Adding licensees takes time, often years to attain, and existing appraisers seeking to retain client satisfaction are faced with two choices:  1) work more hours; or 2) turn away assignments.  Neither one of those choices are optimal and often have serious implications.  The challenges created by limitations to appraiser capacity is often a contributing factor in a breakdown of the consumer-lender or lender-appraiser relationship.    

The Hybrid Appraisal model is designed to reduce the number of hours required of the appraiser to complete the appraisal.  In the mathematical equation, reducing hours creates capacity.  More capacity increases the ability to address stress points when demand and supply are out of balance in low rate environments.   

The Shift in Policy and Market Demand

A pivotal change occurred when Fannie Mae and Freddie Mac adjusted their policies to allow the purchase of loans originated using hybrid appraisals. In July 2020, they adjusted policies and published specific forms (Fannie Mae 1004H and Freddie Mac 70H) to accommodate the limited scope of work associated with hybrid appraisals for loan originations. Further policy shifts have fueled a substantial increase in market demand for the use of hybrid appraisals, driven by rapid technological advancements in the loan origination process, which have shortened loan decision completion times and shifted lender and consumer expectations.  Additionally, Fannie Mae and Freddie Mac have published the Uniform Property Data Set (UPD), specifying a standardized approach to the data collection process bringing uniformity to the property data collection process.    

Appraiser's Professional Standards and USPAP Compliance - Hybrid Appraisals

Real estate appraisers are licensed professionals governed by the Uniform Standards of Professional Appraisal Practice (USPAP). As service providers held to a professional standard, appraisers must always balance client needs with regulatory compliance. While conflicts arise, compliance always comes out on top.

USPAP does not prohibit hybrid appraisals but it does require appraisers to:

• Determine and perform the necessary scope of work to develop credible assignment results and properly disclose the scope of work performed (SCOPE OF WORK RULE).
• Identify characteristics of the property relevant to the value type, definition, and intended use, using sources the appraiser reasonably believes to be reliable (STANDARDS RULE 1-2 (d)).
• Summarize the scope of work used to develop property characteristics (STANDARDS RULE 2-2 (a) (viii)).

Additionally, The Appraisal Standards Board (ASB) offers guidance on the appraiser’s reliance on inspections by third parties (See ADVISORY OPINION 2).  Advisory opinions do not establish new standards or interpret existing standards but represent advice from the ASB for the resolution of appraisal issues and problems.   

USPAP also permits the use of extraordinary assumptions, in accordance with SR 1-2(f) and with SR 2-1 

(c).    An extraordinary assumption may be used in an assignment only if:

• The extraordinary assumption is required to properly develop credible opinions and conclusions.
• The appraiser has a reasonable basis for the extraordinary assumption.
• Use of the extraordinary assumption results in a credible analysis.
• An extraordinary assumption must be reported “clearly and conspicuously” and state that the use of an extraordinary assumption may have affected the assignment results.

Generally, extraordinary assumptions are not necessary nor are they permitted by the lender or investor for the loan.  The role of the data collector and appraiser is to report on the observed facts.  If there is a material condition or deficiency present that impacts the marketability and/or value of the property, it is to be addressed by the appraiser, preferably after discussion with the client and prior to final issuance of the appraisal report.  Often, these situations result in a “Subject To” condition of the appraisal. 

For example, the property data reports cites physical evidence of foundation settlement, with substantial cracks in the exterior wall masonry finish, and evidence of a compromised structural column in the basement.  In this case, just as would be the case if the appraiser completed a traditional appraisal, the appraiser would require a “Subject To” condition requiring a structural inspection by a qualified professional to show no material deficiency, or if deficiencies exist, they are corrected.  The lender would then follow their process to fulfill the appraisal condition.  

Lastly, USPAP allows the use of hypothetical conditions in development of appraisals.  Hypothetical conditions are most common in the development of appraisals of proposed construction, as improvements do not exist at the time of the appraisal.  Generally, property with proposed construction, will not be eligible for hybrid appraisal assignments.  

Data Reliance and Validation

Appraisers frequently rely on third-party data for various aspects of the appraisal process, including ownership history, property descriptions, market conditions, comparable sale information, cost data, and income data.  

As the hybrid appraisal utilizes property property data about the property collected by a third party, when an appraiser, through their experience, knowledge, and judgment, questions the reliability of data (e.g., ownership history, property rights, property size or age as stated in assessment records), they are required to implement validation steps for key data. This might involve additional research which might include researching records of deeds or plans, on-line imagery sources such as aerials, mapping and GIS, municipal records, or other data sources.

If validation is not possible and the appraiser cannot confirm or refute the key data elements in a property data collection report either through information contained in the property data report or other sources of reliable data, it is recommended an appropriate extraordinary assumption be used, consistent with typical practices in any other appraisal assignments after discussion with the client and, of course, with the requirements of USPAP as noted above.  

The one benefit of the UPD created by both Fannie Mae and Freddie Mac and the rigorous Quality Assurance process of property data reports, is the process defines what and how data data is collected and reported, how floor plans are constructed and presented, and how photographs are to be composed.  UPD has been designed to create a robust consistent process to obtain objective, factual data about a property and the improvements to that property.  These requirements go above and beyond the requirements placed upon appraisers when reporting property data for Traditional Appraisals and are an added measure to reduce risk when the person providing the factual data about a property is not an experienced appraiser.    

Specific Language in Fannie Mae and Freddie Mac Forms addressing USPAP

To address these considerations, the Fannie Mae 1004H and Freddie Mac 70H forms include specific language outlining the limitations of hybrid appraisals and reinforcing the appraiser's compliance requirements with USPAP. Key points from the FNMA forms include language and content specific to:

• Scope of Work: The stated Scope of Work requires that the appraiser obtain and review adequate and reliable information for the subject property.  Some of the cited sources include property data based on interior and exterior property data collection, public and/or private data records, and information as described by the appraiser in the appraisal report.  The appraiser is not limited to the cited sources.  (See SCOPE OF WORK)
• Floor Plan: A floor plan from the property data report is included to assist the reader in visualizing the property and understanding the appraisers source for determining size (See ASSUMPTIONS AND LIMITING CONDITIONS #2)
• Reliance on Third-Party Data: For the development of the appraisal, the appraiser relies on third-party data (e.g., flood maps, MLS, tax records, satellite imagery) and uses only data considered reliable after examination. Specific language cites that the appraiser makes no guarantees regarding the accuracy of this data. (See ASSUMPTIONS AND LIMITING CONDITIONS #3)
• Property Characteristics: The appraiser relies on interior and exterior property data from a property data report, assuming no material omissions and no changes to characteristics since the report date. (See ASSUMPTIONS AND LIMITING CONDITIONS #4)
• Adverse Conditions: The appraiser reports any adverse conditions discovered during research but assumes no knowledge of hidden deficiencies. The appraisal report is not an environmental assessment. (See ASSUMPTIONS AND LIMITING CONDITIONS #6)
• Appraiser's Certification: The appraiser certifies they did not perform a personal visual inspection and relied on the property data report for condition reporting. (See APPRAISERS CERTIFICATION #2)

Other Considerations

While several states have offered commentary on appraisers completing hybrid appraisal assignments, specific rules for conducting these assignments beyond USPAP adherence have not been issued.   

One question raised is if hybrid appraisals are covered under Professional Errors & Omission insurance?  While it is best to check your coverage with your individual insurance carrier,  discussions with local insurance professionals cite that most professional error’s and omission policies provide coverage for professional services, and the services covered will be identified in the policy.  It is not common for language in a policy to get down into the specific appraisal products being provided (full scope or limited scope), unless specifically named as an excluded service.  While not a comprehensive study, our research revealed no knowledge of any carriers excluding hybrid appraisals from coverage - the biggest exclusion to services address appraisers practicing outside of licensing limitations, and unlawful activity.     

What happens when the appraiser finds errors in the property data report?  

Perfection in the appraisal and data collection process is not a reasonable expectation, regardless of the scope of the appraisal assignment.  USPAP cites that competency does not require perfection of the appraiser.  The same holds true for the data collector process. Discrepancies between data sources of the property being appraised, or data being analyzed, often arise in any appraisal assignment and it is incumbent upon the appraiser to address the  discrepancies.  Many appraisers will often cite data discrepancies found in the data collection process and provide the basis for reconciliation in the appraisal report.  There needs to be clear understanding between the appraiser and the lender on what constitutes material factual discrepancies with property data reports as opposed to differences in individual approaches or interpretations.  Material discrepancies or errors that will create a circumstance that jeopardizes the credibility of the appraisal results, may prevent an appraiser from completing the assignment.  Proper communication and well-defined processes are required to manage such instances.  

Let’s walk through a possible scenario that may present itself when a discrepancy presents itself.  The property data report cites items of minor deferred maintenance (i.e. soffit damage, cracked (not broken) window in basement).   These items are documented in both photographs and reporting in the property data report reviewed by the appraiser.   As part of the appraiser’s required process of reviewing the property data report and reporting on the physical improvements to the property, the appraiser notes areas in the photographs of faded, cracked and peeling paint on the east-facing exterior wall and windows that were not called to attention in the property data report.   

The appraiser is required to clearly present their findings and how those findings are addressed in the development of the appraisal.   One possible way to phrase this is as follows:  Upon review of the property data report, the data collector cites the following items of deferred maintenance:   In addition to the property data report findings of deferred maintenance (soffit damage along the front roof line and cracked (not broken) window in the basement window), the appraiser notes from the photographs in the property condition report, there are areas of apparent faded, chipped and peeling paint on the east-facing exterior wall and windows of the structure.  The appraiser determines these conditions to be minor and this appraisal considers only those items cited in the property condition report and the appraiser's analysis of that property data report.  No additional information regarding the condition of the improvements  has been made available to the appraiser.  

The Future of Valuation Services

As the mortgage industry continues to modernize and seek higher levels of effectiveness and efficiency in the loan manufacturing process, there is continued focus on reducing the cycle time of the process.  The increasing demand for Hybrid Appraisal products signifies a commitment to integrating the professional real estate appraiser's role in providing accurate and reliable valuations. The profession's response to these changes will be crucial in shaping the future demand of valuation services and the role of the appraiser in the process.

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Learn more about Reggora's 24-hour hybrid appraisal solution, Streamlined Appraisal.