February 17, 2021 For families ...innovating to improve the liquidity, stability and affordability of mortgage markets

For customers ...competing to earn their business

For taxpayers ...reducing their exposure to mortgage risks A Better Freddie Mac …and a better housing finance system Appraisal Review at Freddie Mac

Alex Chang Martin A. Skolnik, MAI (Marty) Michael Donovan Vice President Chief Appraiser Senior Analyst Risk Distribution & Credit Appraisal Team Appraisal Team [email protected] [email protected] [email protected] Topics

• Quick philosophy on Freddie Mac appraisals

Key • Results from 2020 appraisal reviews

Discussion • Tips and Hints; Do’s and Don’ts for 2021, including: ‒ Sales adjustments Topics ‒ Capitalization rate development ‒ COVID-19 considerations ‒ Property taxes Appraisals at Freddie Mac

Many of you have heard this material before, but we have the advantage today of reaching out to a large percentage of the multifamily appraisal community, so it’s worth talking about these topics again… 1 The underlying exercise of a Freddie Mac review of a third-party real estate appraisal review is to determine if the appraiser has adequately supported his/her opinion of market value. Appraisal Report Content

We want to know: • What the appraiser knows about the subject property and its market • How they know it • The impact it has on the subject’s market value

Not: “…based on my years of experience and knowledge of the area…” Categories We Review

• Issues that might have an impact on Market Value • Issues that might not affect Market Value but have an impact on the validity / credibility / veracity of the appraisal • Issues that do not have an impact on Market Value or validity of the appraisal but are still “things” Process Overview – Optigo® Lenders

Optigo lenders (formerly known as Seller/Servicers) Third-party appraisals come to Freddie Mac through the Optigo lender network for a loan acquisition: Freddie Mac does not originate loans … but, we purchase loans from our Optigo lender network

Freddie Mac does not have an approved appraiser list We rely on the Optigo lender to engage appraisers that meet our qualifications and requirements Freddie Mac bundles loans for securitization Appraisals for Freddie Mac

We are very interested in what you are saying about the local market and the subject property. We actually read your appraisals, and our lending decisions are based on your data, discussions and conclusions. Part of the underwriting process is to understand the valuation risk of using your appraisal in our lending decision, so we want more than just a reiteration of property and market facts. We want your analysis of the property and the market. Saves everyone time and money…and frees up more time for everyone in the lending chain to do additional quality Best Practices transactions!

• Difference between a reasonably well-written appraisal and a below- Materiality Matters average appraisal is the addition of a short/concise summary at the Transparency Matters conclusion of each section • The addition of this verbiage can dramatically improve the efficiency of our review process by reducing the need for “go-backs” to clarify the appraiser’s narrative Items to Call Out

Call out/note/discuss the report’s deficiencies so we can evaluate the valuation risk • Sales ‒ Older or a wide geographic area ‒ Poor or missing financial data ‒ Poor comparability or quantity • Income ‒ Poor rent roll from the property manager ‒ Not a substantial operating history ‒ Capitalization rate is dependent on the quality of the sales information • Market: In flux or other issues • General: Lack of cooperation by the property management Results of Appraisal Reviews

2 Transparency is key Appraisal Review Process

• Annually, we sample 5-10 appraisals from each Optigo lender • The focus of our review: ‒ Did the appraiser adequately support their opinion of market value? ‒ Are there issues that might affect the validity of the appraiser’s data, analyses and conclusions? • The results are shared with the lender, the appraisal firm, and with our underwriting team • A copy of our review form/questions can be found at: https://mf.freddiemac.com/lenders/uw/#Appraisals 2020 Results 2020 Results 2020 Results – Most Frequent Issues

Most Frequent Appraisal Issues Without Adequate Support (2020)

% of reports in Rank Appraisal Review Item compliance 1 The appraiser considered “unit mix” as a comparative adjustment. 19% Are the capitalization rates developed for the comparable sales calculated similarly (i.e., T-12, Find this under 2 proforma, actual)? If not, does the appraiser provide an adequate explanation of how they 24% the Appraisals considered these mathematical differences in their analysis of the sales’ capitalization rates? Easement discussions or statements are documented by a plat reference, title policy, or other tab of the 3 25% documentation Freddie Mac 4 Financial assumptions of the Band of Investment calculations should be supported 36% Multifamily The equity dividend rate in the Band of Investment should make sense, is adequately explained, and 5 40% website adequately supported

Replacement reserve should be supported by the property condition report or otherwise supported 6 42% by market data Historical income and expense statements should be added to the Addenda 7 42% (Three years and YTD are required -- 60.20) 8 Published sources of capitalization rates should be documented (sources identified) and relevant 47% 9 Adjustments in the sales grid are adequately explained and supported (S/S 60.14b) 49% Capitalization rate should be supported by the appraiser’s most similar sales identified in the Sales 10 50% Comparison Approach The Good, the Bad and the Ugly Suggestions for Improvements in 2021 3 Leased Fee vs. Fee Simple

This issue is a “canary in the coal mine” indicator that the rest of the appraisal report might have issues! Many times, an appraiser will state that the appraisal in the valuation is of the “fee simple” interest, and this is not correct!

• The Appraisal of Real Estate (14th edition, page 72) states that leased fee ownership is the ownership interest held by the lessor “regardless of the duration of the lease, the specified rent, the parties to the lease, or any of the terms in the lease contract.”

If the appraiser gets this terminology wrong, there will be material issues in the report Customer Service

• If Freddie Mac or Optigo lenders have questions, take them seriously – we wouldn’t be taking the time to ask if it wasn’t something that matters to us. Don’t blow it off. • If Freddie Mac raises a question, it is an issue with underwriting, the valuation risk, consistency with other documentation on this or other loans, or some other concern, and we need a serious answer Appraiser’s Mythical Assumptions

Sales Comparison Approach: Economies of Scale • Is/are Economies of Scale a thing? • What factors are affected as property size changes, say from a 50-unit property to a 200-unit property? To a 300-unit property? ‒ The number of assistant managers ‒ The number of maintenance personnel ‒ Bulk pricing of light bulbs ‒ What else? Do these really affect pricing by 5%? 10%?

Is there proof that Economies of Scale materially affects sales pricing, or is this mythology a remnant of an appraiser’s “rule of thumb” from the 1960s? Appraiser’s Mythical Assumptions (cont’d)

Sales Comparison Approach: Unit Size Is unit size a factor in sales pricing or is unit mix a determinant of price?

• Most appraisers imply the sales’ rents/income generation is based on their units’ raw square footage, but is there something else? • Even with the plethora of available data, we never see support of unit size having a material impact on value

Is it the size of the unit that affects value? OR Is it the utility of a two-bedroom (or three-bedroom) vs. a one-bedroom unit that generates higher rents? Valuations of Property with Recent Sale

Be aware of value growth in a short period of time and of your responsibility to explain and support that growth in terms of: • Rent growth • NOI growth • Capitalization rate changes • Capital improvements / renovation • Examples of value growth with period-over-period re-sales in your market This is both a USPAP and Freddie Mac requirement Property Taxes What we want to know: 1. Description of the local assessment process and the next date of revaluation ‒ Property tax assessment values may or may not be static – it depends on the laws of the local jurisdiction ‒ Even with static assessment values, property taxes might be materially variable from year to year

2. Are the tax comparables appropriate? ‒ Why not use the rental comparables as tax comparables, too? 3. Is the tax assessment value similar to the appraiser’s value? If not, why not?

4. Risk of reassessment at the appraiser’s value: ‒ It is not appropriate to estimate the risk of reassessment by merely applying an unsupported bump to the capitalization rate Incorporating Risk of Assessment

One way to estimate property taxes in a jurisdiction where a reassessment is likely in the near future: 1. Select several sales within the same or similar taxing jurisdiction that have been reassessed after the sale 2. A comparability chart can be constructed to compare each sales price with the new tax assessment Incorporating Risk of Assessment Incorporating Risk of Assessment

At this link: https://cbreemai l.com/rv/ff011ee 33dd2b5986eb0 349dd24583d84 26e749c Incorporating Risk of Assessment A closer look:

This type of information helps us answer the questions: • What is the re-assessment methodology of the local assessor? • If the property is due for re-assessment in the near future, what is the risk that the assessor will be similar to the property’s market value or recent sales price? Ground Leases Freddie Mac purchases loans on the leasehold interest in a subject property; i.e., the ownership interest receiving the monthly rent from the property’s tenants

The appraiser should: • Model the financial impact of the ground lease payments on the multifamily operations component • Consider all aspects of the valuation risk associated with the ground lease on the subject property • The presentation of Market Data is key to a transparent and adequately supported ground lease analysis; not just the reiteration of the borrower’s interpretation of the financial impact Ground Leases (cont’d) We have been seeing a difference in the way an appraiser considers an existing ground lease with a prospective ground lease. We need the appraiser to consider and discuss: • Would that prospective ground survive a transfer/sale of the subject property? Is it between related entities? • Is there a ‘buy-back’ during the lease term that suggests that the lease might not survive a transfer/sale? • Are the terms of the prospective ground lease market-oriented? ‒ If so, show us ‒ If not, why not? Other Reminders

• Three years and year-to-date of financial data are required in the report • Call out rent roll issues within the report (date, content, format, etc.) The validity, quality, dependability and risk of an appraisal is directly related to the quality of data the appraiser receives.

Please review Chapter 60.6 of the Freddie Mac Guide for current rent roll requirements! Capitalization Rate Development

• Inconsistent capitalization rate calculations from the sales

‒ A capitalization rate calculated using T-12 or in-place net operating income (NOI) typically is 25-75 bps more aggressive than one based on pro forma NOI ‒ This could have a material affect and an overvaluation • If there are mixed calculation methods among the comparable sales, we would expect the appraiser to provide an explanation of how they correlated these to the application of the subject’s pro forma NOI Capitalization Rate Development (cont’d)

Supplemental sales • It is not acceptable for the appraiser to include supplemental sales without providing full outlines – i.e., similar to the primary sales discussed in the Sales Comparison Approach

‒ Without full sales outlines, the reader cannot validate or verify that these sales are actual transactions or comparable to the subject • If these sales were actually good comparables, why wouldn’t they have been included in the Sales Comparison Approach as primary value indicators? Transparency is key COVID-19 • The inspection protocols we put in place in April 2020 can be found here: https://mf.freddiemac.com/lenders/uw/#Appraisals

• We are seeing more sales transactions as market participants are getting their arms around the issues of investing during these unusual times. ‒ It is important that the appraiser transparently discuss their search for sales and how they analyzed the subject property, especially if there is little market data

• Put yourselves in the shoes of a buyer of the subject property: ‒ How would they get comfortable with the condition of the property? ‒ What types of data would they use to set an offering price? State Certification

All the appraisers signing the appraisal must be certified in the state in which the property is located. • You cannot use a New York certification to appraise or co-sign an appraisal on a property in New Jersey – we just saw one of these. • Also, recently we had a New York appraiser try to use their certification in Maryland. • In addition to the specific laws of each state in which you do business (your home state and the state in which the property is located), refer to Freddie Mac Guide Section 60.5b. If you sign it, you must be certified in that state! Recap Appraisals for SBL Small Balance Loans 50 Pages or Less

4 Areas for More Efficiency

• Letter of Transmittal • Executive Summary • Regional Description • Property Tax • Zoning • Less boiler plate and repetition: ‒ Sales Comparison Approach ‒ Income Approach

Do not just dump all the regular report stuff in the Addenda, like a 20-page Market Area Analysis or the Description of Improvements or Zoning, or comparable sales map, or comparable sales analysis. We are looking for a report that is efficient to use. Summarize Shorten Focus Appraisal Resources New link for the Appraisal tab on the Multifamily website: https://mf.freddiemac.com/lenders/uw/#Appraisals Data Standardization for Third-Party Reports Technology Update – Appraisal coming soon!

September 2020: Freddie Mac announced new structured data supplement requirements for Property Condition Assessment reports. October 2020: Freddie Mac enhanced the myOptigo application with an integrated workflow for submission by consultants and review of third-party reports by lender and Freddie Mac underwriters. 2021: Freddie Mac plans to announce new data standardization requirements for Environmental Reports and Appraisal Reports. Benefits For Third-Party Consultants • Greater transparency into each report’s compliance with Guide requirements • Report data is more accessible to clients, elevating the utility of third- party report data for each transaction For Lenders • Greater transparency into each report’s compliance with Guide requirements • Centralized tooling maximizes the value of each revision • Improved communication with the Freddie Mac Underwriting team For Freddie Mac • Improved report quality with each report revision • Report data is more accessible, elevating the utility of third-party report data for each transaction PCA Data Standardization in Practice Today

1 3

2 Report Excel Template (provided by Freddie) w/ seamless data file generation feature

OR Report Data Supplement File

Full PDF Report Report Webform in myOptigo Proprietary Report Writing System Visualizes data supplement w/ w/ seamless data file generation feature automated compliance feedback and submission/review workflow Appraisal Data Standardization: Next Steps

• Give us your thoughts! Take the post-event survey to help shape the direction of Freddie Mac’s appraisal data requirements. • Stay tuned! Freddie Mac plans to announce new appraisal data standardization requirements in early summer 2021.