As a certified general appraiser and licensed real estate broker, I often feel I have the opportunity to view property appraisal from two different views: that of the analytical appraiser and that of the optimistic real estate agent. Most recently, however, within the past four years, the art and science of appraisal, as well as the real estate market in general, has seen both ends of the spectrum. This created extreme anxiety for the appraiser who attempted to remain competent as well as insightful into all aspects of the market. Add in the adverse aspects of the Wisconsin market and conservative thinking of the old-world mentality — and those who remain after the purge now face the ingredients for a challenging occupation.

As the bank-owned (REO) market quickly became the mainstay of both appraisers and real estate agents, a whole new set of market factors came into play as well as a whole new skill set. The specific topic for this article is the cost-to-cure section of the REO appraisal as well as in the BPO and CMA for brokers and agents also dealing with the onslaught of bank-owned properties.

It would have been easy for the final owner of a foreclosed property — say Fannie Mae, the first mortgage lender or a successful bidder at a sheriff’s sale — to just cut losses and let the property go at a hugely discounted price. Since this was easier said than done, some methodology was needed to allow the final disposition of the acquisition to maximize the selling price, even if that meant putting additional money into a property in order to get top dollar. Thus to allow some measure of potential return, the cost-to-cure analysis was born.

Purpose of cost-to-cure analysis

The intended purpose of the cost-to-cure section in the REO addendum was to present an estimate of repairs, if needed or feasible, in order to put a distressed property on the market to compete with other listings. This would maximize the return at sale and hopefully recoup some of the lost principal due to the lagging values. The cost-to-cure estimate is used by the current property owner and/or seller to make the decision to either: (1) “dump” the property in an “as-is” condition and take the loss as a write-down, or (2) put money into the needed repairs to bring the property to a moderate habitable condition where it can again qualify for a first mortgage by a potential buyer. But for the appraiser or agent, what costs should be used? The goal is to maximize the return for the seller and leave enough room for at least a break-even with moderate return for the investor-buyer or the new owner. This analysis should take all costs to the point of sale into consideration.

Sample home

For example, say “Sample Home” is on the market:

• The house is 85 years old.
• It’s 1,600 square feet with 1.5 or 2 stories. 
• It includes 3 bedrooms and 1.5 bathrooms.
• It’s located in a typical Wisconsin residential community.

At the end of 2014, Sample Home may have had a moderate condition market value of $85,000.00. At that price point, the home may have newer siding, windows and a roof within the past 15 years or so. Also assume that Sample Home had upgrades of mechanicals and cabinets within the past 25 years. And in average condition, Sample Home would qualify for an FHA, VA or first mortgage through a secondary market lender assuming the buyer has qualifying credit and income history. 

In 2005 through 2007, Sample Home may have sold for somewhere in the $110,000.00 to $125,000.00 range. 

Now enter 2008: the homeowner cannot make payments, perform maintenance, replace or repair minor damage, and may possibly have the mindset that things “went south” out of their control. After the foreclosure is settled and the mortgagee takes possession, Sample Home is not even close to being habitable upon inspection. Now the assigned REALTOR^® is tasked to complete a CMA and the appraiser is retained to complete a full REO appraisal, both including cost-to-cure estimates. The property may be worth more than a vacant lot if the cost to cure exceeds the potential value upon completion of the estimated repairs.

Time for estimates

During your initial walkthrough of Sample Home, you find all walls and ceilings are soiled with holes likely from moving accidents, the flooring is beyond cleaning or salvage, and several items — fixtures, toilets, the furnace — are missing. If you’ve been involved in the hands-on joy of rehabbing an REO property on your own checkbook, you likely have the invaluable working knowledge of not only the work involved in the repair of the damage that’s visible, but also those hidden repairs — rotting subfloor under a leaking toilet, frozen piping, cracked heat exchangers on a furnace, or concrete in sewer pipes and toilets. 

Say you ask seasoned rehabbers to look at Sample Home. Your walkthrough typically goes like this:

• The property needs all new paint: $5,000.00.
• The property needs all new flooring: $10,000.00.
• The kitchen needs some new cabinet faces, light fixtures, and doors and hardware: $10,000.00. 
• Miscellaneous repairs include some new windows, aluminum storms on all upper units, deck repairs, and garage door replacement/trim: $5,000.00.
• Thus, Sample Home needs roughly $30,000 in repairs prior to listing.

What’s the return on investment (ROI) of Sample Home’s repairs? An investor-buyer will likely calculate ROI like this: to max out at $85,000.00 with $30,000.000 in needed repairs, the investor-buyer needs to buy the property under $50,000.00, plus he’ll need some profit and slush to cover the expenses of the sale. You now have a potentially $85,000.00 home in a slumping market needing $30,000.00 in repairs with room for sale expenses and some return on investment. Theoretically, the “as-is” value is $55,000.00 with $30,000.00 in cost to cures and $85,000.00 upon completion to minimal HUD safety and sanitary standards. Spell out typical market time of 90 days and estimate expenses of sale. Life should be good, send out the appraisal or CMA and get the listing, call one of your pocketed investor-buyers, and get rid of the property for the new owner. 

Cost of repairs not so clear 

The asset manager and portfolio reviewer have also determined costs for repairing Sample Home. Both have their own bids and can find contractors to do the necessary repairs for $9,500.00 total — much cheaper than the rehabbers’ $30,000.00 estimate.

In addition, the asset manager and portfolio reviewer want the appraisal adjusted and the home listed at $75,000.00 because they feel someone is getting overly enriched at the target value. Sample Home, though, never gets repaired nor does it sell. Everybody is upset with every participant in the deal, the client re-lists with another REALTOR®, and the appraiser never sees another assignment from this client. 

The parties in the transaction need to understand that the cost to repair is also reflective of the “impact value” of a particular repair. The impact value of a repair is the actual amount the market will pay for or bear for a particular upgrade. Take the paint as an example: you can paint the 1,600 sq. ft. home by yourself with the cheapest paint for $450.00; you can hire a semi-professional with moderate paint for about $1,750.00; or you can hire a professional using quality materials and workmanship for the estimated $5,000.00. In the end, the home will still have the same return for the full $5,000.00 in the mind of the buyer. Repairs and upgrades can only add so much to a property’s value no matter how little or how much you pay toward repairs.

This $5,000.00 does not include entrepreneurial profit, which is the profit the new owner could sell the property for above and beyond the market value estimate of $85,000.00 once the home is complete and back on the market. Moral of the story: when estimating the cost to cure, use the highest amount/cost as the most reasonable cost, which allows for the unknown externalities. You could go beyond the typical repair for the paint and instead use wallpaper or hire qualified professionals at two to three times higher than the typical cost or impact value; on the other end of the scale, a homeowner could slap a coat of paint on the soiled walls for $250.00 and be perfectly happy.

Finding accurate costs

So where can a REALTOR^®, appraiser or potential buyer get accurate costs? Cost manuals can give a moderate starting point, but I find them extremely out of the ballpark as they do not take into account the unforeseen potential additional damage caused from the initial defect. The best teachers for determining accurate repair costs are contractors or buyers who have actually taken on a similar project and know what goes into the project. Follow around a contractor who will agree to provide you with bids in exchange for your submission of their name for a potential shot at the actual award of the repair contract (provided the contractor is not considered a settlement service provider under RESPA under the circumstances). The best way to understand the costs involved is to take on an REO project to the point of sale using your own money. This option, though, is not in the cards for most agents or appraisers — hopefully because we are all too busy! 

The REALTOR^® Code of Ethics and the Uniform Standards of Professional Appraiser Practice (USPAP) require competency for REALTORS^® and appraisers, respectively, when preparing any valuation report for a client, whether it’s a CMA or a full appraisal. If the licensee lacks the proper experience, this must be disclosed prior to accepting the assignment. In addition, the REALTOR^® or appraiser should either obtain the needed education or employ the assistance of a professional who has the necessary experience and credentials. The extent of the role the contributing expert will play in the process should be disclosed in writing to any potential client.

The REO market is a cornucopia of potential income for appraisers, real estate agents and real estate brokers, and should not be avoided just because it involves some additional research, reporting and/or rethinking the norm. Once you get the procedure down, know the proper sources for cost estimates, and build up a listing and buyer base for your REO property, you’ll find your flow — and you’ll keep flowing — to which most successful REO specialists can attest. REO properties are most likely going to be around for quite some time, and getting into the groove may take time and effort, but can be very rewarding for all parties involved once the knowledge is obtained and applied.

Tim Freudenthal is a certified general appraiser in both Wisconsin and Minnesota and a Wisconsin-licensed real estate broker since 1984. Tim currently works as a commercial consultant and sales advisor for Newmark-Grubb/Pfefferle out of the Appleton and Wausau offices. He owns and operates Wisconsin Real Estate Services LLC out of Wautoma, Wis. As an active pilot and outdoorsman, Tim has written for Flying Magazine, Midwest Flyer, and Badger Sportsmen as well as numerous local newspapers and trade publications.