We need to hack appraisal-based lending

Nearly all real estate lending relies on “appraised value”—an estimate of a property’s value based on comparable sales or income. It is used to determine project feasibility, acquiring or constructing buildings and financing the built environment. It’s the sanctioned underwriting tool used by banks, regulators and government for real estate loans.

Appraised value lending is also the textbook definition of structural racism. And creating thriving communities for all Chicagoans won’t be possible until we chip away at this pillar of systemic racism and reverse its legacy of disinvestment in communities of color.

Here’s the problem: The National Housing Act of 1934, which established the Federal Housing Administration, also opened the door for banks and real estate professionals to create “residential security” maps that designated, with red lines, communities of color that were viewed as too risky to make loans—giving birth to the legal practice of redlining.

Even though redlining only applied to FHA-insured home mortgages, appraisers and banks used the maps to set value for all types of lending. Capital became much scarcer in redlined communities—and when supply drops, price increases. Higher prices deterred investment, deflating real estate values and initiating a decades-long cycle of wealth extraction.

Now, fast forward to 2022. Redlining was outlawed by the 1968 Fair Housing Act, and banks are now obligated to serve formerly redlined communities under the 1977 Community Reinvestment Act. But a child care provider applying for a loan to build a new center in a once redlined community will need an appraisal. Due to the lack of market investment, however, comparable sales—if any—are unlikely to support the building’s future “as-built” value. Some banks still might make a loan, but only for a lower amount (loan-to-value ratio limits) and/or at a higher interest rate (risk-based pricing). In the end, this child care provider will be forced to pay more, upfront or over time.

Simply put, old bank regulations like redlining drove down real estate values for decades in communities of color, and current bank regulations, such as appraisals and risk-based pricing, which still rely on those deflated values, have continued as barriers to investment. Legal or not, the outcome is the same. Communities are denied critical investment capital that doesn’t just contribute to racial wealth gaps, but also to racial gaps in educational attainment, health outcomes and food deserts, according to recent studies.

Breaking this cycle requires that we hack appraisal-based lending. Is that possible? I think so. The community development financial institution that I lead, IFF, threw out appraisals from the start. Founded to ensure that nonprofits serving low-income communities with health, human services and housing had capital to own and improve their facilities, we had no choice. Banks wouldn’t lend to these nonprofits, and without capital to purchase their facilities, they couldn’t build equity and invest in their neighborhoods.

To make these loans, we obsessed over what determined successful loan repayment—government reimbursements, financial management, board strength and fundraising—not on appraisals. By identifying these factors, we found a workaround to appraised value and the economics of foreclosure. And over the past 34 years, we’ve made more than $1 billion in loans, with a charge-off rate in line with that of commercial banks.

Other CDFIs are engaged in similar hacks. Allies for Community Business, a small-business lender, no longer uses credit scores or collateral value for its microloans, both of which adversely affected business owners of color. Instead, they now focus on the credit report components they have learned best predict loan repayment.

Can banks do the same? To some degree, they already do. They are the primary investors in CDFIs that are leading the effort to hack our financial system and align it with justice. But the big opportunity may be with corporations and hospitals, like Starbucks and Rush University Medical Center, who are investing in CDFIs as part of their focus on racial equity. If more socially minded investors do the same, we can remove barriers like appraised value and level the playing field for communities of color.

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