June 24 (Bloomberg) -- There may be another culprit scuttling a U.S. housing recovery: low home appraisals.

Flawed appraisals are derailing real estate sales and depressing values across the U.S., the National Association of Realtors said yesterday as it reported that existing home prices declined 17 percent in May from a year earlier.

“It’s pointing to thousands of delayed or canceled transactions,” Lawrence Yun, chief economist of the Chicago- based Realtors group, said in an interview. “We’ve had a massive inundation from members saying this is a big problem.”

Appraisal rules that went into effect on May 1 require lenders that sell loans to Fannie Mae or Freddie Mac to set up a firewall between appraisers and loan officers to prevent improper influence. The rules are the result of an agreement between the mortgage buyers and New York Attorney General Andrew Cuomo, who said an investigation found appraisers inflated values under pressure from lenders.

The agreement mandates that banks order a second appraisal on 10 percent of the loans they sell to Fannie Mae and Freddie Mac, and warns against accepting the higher of any two valuations. The guidelines have led to more conservative valuations by many appraisers and a “chill” in lending, according to John Brennan, research director at the Appraisal Foundation, a Washington-based trade group. A low appraisal is one that comes in under the price a prospective buyer has agreed to pay for a property.

‘Unintended Consequences’

“Sometimes policy can lead to unintended consequences,” Yun said.

Low appraisals have become a focus of the California Office of Real Estate Appraisers, which oversees licensed appraisers in the state. Investigations by the Sacramento-based agency rose 36 percent to 418 at the end of May from the same period last year, said Bob Clark, director of the office. The probes are looking into allegations including flawed valuations and use of comparable sales too far from the subject property, he said.

The new guidelines require lenders to order valuations through third-party vendors called appraisal management companies that increase costs to prospective home buyers, said Brandon Chamberlin, president of Ashcroft & Associates PC Real Estate Appraisal Services in Vancouver, Washington.

Deals Collapse

Appraisal management companies hire valuators who use automated systems and work at a discount, instead of experienced appraisers who have knowledge of neighborhoods and include factors that can increase a property’s value, such as home improvements or proximity to schools, Chamberlain said.

At Universal Mortgage Inc. in Brooklyn, New York, brokers reported at least 15 sales that fell apart due to appraisals that came in below the agreed upon price.

Broker Isaac Shalom, who reported at least four deals collapsed, said one buyer who wanted to buy a home at $850,000, delayed the purchase after an appraisal came in at $750,000.

Real estate broker Vince Saragosa had an $185,000 offer in April for a three-bedroom home in Royal Oak, Michigan. An appraiser valued the property at $128,000 and the deal fell through.

Interfering With Market?

“It’s almost like appraisers are interfering with the market,” Saragosa, owner of World Showcase Realty in Shelby Township, a Detroit suburb, said in an interview.

The discrepancy between pending home sales and the actual number of home resales reported yesterday partially illustrates how flawed appraisals are thwarting home sales, said Walter Molony, a spokesman for the National Association of Realtors. The Pending Home Sales Index rose 3.2 percent in March and 6.7 percent in April. Completed sales of existing homes in May rose 2.4 percent.

“March and April contracts suggested that we should be seeing higher levels of sales than we’re seeing,” Molony said, citing longer times between contracts and closings, due in part to appraisals that come in low.

Cuomo said in December when the appraisal agreement was reached that the deal “preserves the core goals of ensuring appraiser independence and eliminating systemic conflicts of interest.”

Alex Detrick, a spokesman for Cuomo, didn’t immediately respond yesterday to a request for comment.

When home values come in below the sales price, that’s not the appraiser’s fault, it’s a reflection of the market, the Appraisal Institute, a Chicago-based professional group that represents more than 25,000 appraisers, said in a statement yesterday.

Wrong View?

“We take offense with the notion that an appraisal is only good if it happens to come in at the sales price,” the group said. “That mentality helped cause the mortgage meltdown to begin with.”

More deals are falling apart in a housing market that needs transactions to recover from a three-year slump that has dragged the U.S. into a recession. Low appraisals join a list of suspected obstacles standing in the way of a rebound that includes rising interest rates, a glut of foreclosed properties, and the highest unemployment rate since 1983.

Sales in May were 3.6 percent lower than a year earlier, the Realtors said yesterday. U.S. home prices fell 6.8 percent in April from a year earlier, the Federal Housing Finance Agency said yesterday in Washington.

The number of houses on the market dropped 3.5 percent to 3.8 million in May, NAR said. At the current sales pace, it would take 9.6 months to sell those homes, compared with 10.1 months in April.

Refinancing Risk

California real estate investor Bruce Norris renovated a three-bedroom home in the Riverside-San Bernardino metropolitan area in January and found two buyers willing to pay $165,000. An appraiser put the value 15 percent lower. The prospective purchasers walked away and now he’s renting the house instead.

Low appraisals that lead to a sale reduce comparable prices in a neighborhood and make it “impossible for another group of people to refinance,” Norris said.

“Appraisers provide lenders with objective information and value opinions that help protect them from making questionable loans and investments and help them minimize risk,” the Appraisal Institute said in its statement. “However, that should not suggest a bias toward lower valuation. Appraisers reflect the market, and sometimes the markets don’t act like we want them to or hope they will.”

Cuomo Probe

Cuomo, a Democrat elected three years ago, sued title company First American Corp. in November 2007, accusing its appraisal unit of inflating home values under pressure from Washington Mutual Inc. JPMorgan Chase & Co. bought WaMu’s deposits and branches in September after the Federal Deposit Insurance Corp. took over the company.

The lawsuit followed an investigation that Cuomo said showed conflicts of interest between appraisers, credit rating companies, lenders and investment banks.

Artificially high appraisals contributed to record foreclosures because borrowers ended up owing more than their houses were worth. Now, critics say, low appraisals are hindering sales.

“When prices are down, appraisers tend to depress values because they don’t want to look bad in front of the lenders who are ultimately hiring them,” said Ron D’Vari, chief executive officer of NewOak Capital LLC in New York, an investment advisory firm specializing in fixed income and real estate. “They over-extrapolate the current psychology.”

Trade groups including the Mortgage Bankers Association and the Appraisal Institute opposed the agreement with Cuomo because they say it was written without industry input and harms relationships between “reputable and ethical” mortgage brokers and appraisers.

The U.S. Office of Thrift Supervision last May called the deal “flawed” and said it should be reconsidered. The Federal Reserve said it should be scrapped in a June 2008 letter to the Office of Federal Housing Enterprise Oversight, now called the Federal Housing Finance Agency, that oversees Fannie Mae and Freddie Mac.

In the first quarter, loans eligible for purchase by Fannie or Freddie account for 70 percent of all lending, according to newsletter Bethesda, Maryland-based Inside Mortgage Finance.

“Just as the lack of careful regulation led to inflated prices, the return to regulation is reinforcing the downturn,” said Susan Wachter, a real estate professor at the University of Pennsylvania’s Wharton School in Philadelphia. “It’s making the cycle worse.”

To contact the reporter on this story: Dan Levy in San Francisco at dlevy13@bloomberg.net

Last Updated: June 24, 2009 15:45 EDT