In the wake of the subprime mortgage crisis, real estate lending practices of U.S. financial institutions have continued to come under intense scrutiny. As a result, many financial institutions have reassessed their business practices to ensure they are in full compliance with applicable law. This has led many lenders to require real property appraisals in connection with secured loans, whereby the borrower grants the lender a security interest in its assets, including real property. Many lenders now take the position that the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) requires such appraisals even when the primary basis for the underwriting decision is the business's cash flow and not the value of the real estate itself.
Congress passed FIRREA in the aftermath of the savings and loan crisis of the 1980s, when there was a dramatic increase in loan defaults and the value of the real property collateralizing such loans was below the value of the defaulted loans. FIRREA applies to lending transactions with real property collateral that, among other things, involve the FDIC, National Credit Union Administration, Federal Reserve System, Office of the Comptroller of the Currency, Office of Thrift Supervision, or financial institutions regulated by these agencies.
Through regulations promulgated under FIRREA, the government has sought to protect lenders when a real property lien is granted, in order to counterbalance the risk of a borrower defaulting on a loan. Without an accurate valuation of the real property, a lender cannot accurately assess the risk of a loan. If the lender overvalues the real property and a default occurs, the lender bears the burden of the differential in value. When this happens, there is concern that a federal agency insuring such an institution would be called on to meet its insurance requirement, doing so at taxpayer expense. FIRREA was enacted to protect the federal government and the public's financial interests in these types of situations.
It should be noted that FIRREA requires real estate appraisals to be obtained by the lender; the borrower must not be involved in the process of obtaining an appraisal. Therefore, from the lender's perspective, one of the most important issues is the cost associated with obtaining appraisals -- this could potentially create disincentives for lenders to take security in real property when the decision to extend a loan is not primarily related to the value of real property. The most obvious cost is the actual expense associated with hiring an appraiser to evaluate the real property. However, the time it would take to obtain such an appraisal is a potentially more important cost; appraisals can often delay a deal by several months, which may impact the eventual availability (or prudence) of the loan. These costs often weigh heavily in a lender's decision as to whether to take a lien on real estate in a secured lending transaction -- if the lender determines these costs to be too high, it may very well decide not to take a security interest in the real property, in order not to run afoul of FIRREA.