Geographies | May 7, 2019

Hacking community lending to interrupt racial bias in ‘appraised value’

Joe Neri
Guest Author

Joe Neri

ImpactAlpha, May 7 – No nonprofit or small business should have to raise more money to serve kids in communities of color than they would have to raise to serve kids in white communities.

Lending inequities have starved communities of color from needed capital for decades. Standard underwriting practices based on the appraised value of real estate continue to entrench that historic racism today.

IFF, a Chicago-based community development financial institution, or CDFI, has hacked an alternative way of lending for community facilities. The lessons from that approach may provide perspective on how to lend more broadly – and lower the cost of capital – in communities of color.

We offer non-appraisal-based lending. Instead of asking about the value of the property, IFF asks whether that property is suitable for the nonprofit’s needs and whether the nonprofit can afford the loan payments on our flexible debt. Yes, IFF is an enterprise cash flow lender on real estate.

Today’s national conversations on racial equity raise questions for community investors like us. Can we make loans without appraisals? What equitable approaches can we use to underwrite our loans? Are there other lending barriers based in racist disinvestment or stereotypes that can be hacked? Would that increase pipeline in communities of color?

When we began this practice more than 30 years ago, we weren’t explicitly using the lens of racial equity. Instead, we were using a kind of “nonprofits equity” lens. That forced us to deconstruct the challenge of lending to facilities that serve lower-income communities. You can’t build a CDFI by saying “no” to all your clients that are creating justice. Since 1988, IFF has provided more than $700 million in flexible financing for affordable housing, health care, education, community development and other nonprofit organizations.

IFF hasn’t figured out how to solve for racial equity. But we do think that if we remove the barriers that “appraised value” lending creates in our communities, we could move the needle toward greater justice.

Higher cost (and scarcer) capital

The difference in capital costs to build the same facility in a community of color versus a white community can be dramatic.

Consider the child care provider that wants to construct a new center on donated land in a formerly redlined community. When they apply for a loan, the bank orders an appraisal, which requires “comparables.” But due to long-standing lack of formal market investment, the comps (if any) and land values are very low.

Simply put: Old bank regulations (redlining) drove down the property/land value for decades, because scarcity drives up price and deters investment. That, in turn, deflates prices and drive down values. And now current bank regulations prevent investment in those areas where appraised-values are low. The cycle is vicious.*

For the child care center seeking financing, the bank might still make a loan – or a 75% loan-to-value ratio where the determined “value” is unjustly low. Construction costs will be the same, but the as-built value will be lower, forcing a lower loan amount. That requires a much higher down payment that may be out of reach.

This isn’t a 1956 scenario; this is a 2019 scenario. The historical legal racism of redlining creates economic and legacy externalities of devaluation. While outright discrimination is outlawed, past practices have been encoded into policies and regulations – such as risk-based pricing and appraisals. Those practices further extract capital from communities of color.

Hacking lending

Legal or not, the outcome is the same – not as much capital is reaching communities of color as should. That difference in cost of capital can mean the difference between a viable enterprise and no enterprise at all.

When IFF entered the scene in 1988, banks weren’t lending to small- and mid-sized nonprofits or wouldn’t lend in the low-income communities where they worked. That’s because conventional lending was – and still is – filtered through an appraisal lens that makes it harder and more expensive for lower-income communities to access affordable debt.

We knew we had to design products around the needs of nonprofits. None of those products had greater intensity, weight, and success than our non-appraisal based lending.

Essentially, we created a new “credit box” that did not allow appraisals to determine the value of the invaluable. We became obsessed with understanding revenue projections, government contracting and public policy, fundraising experience and financial management, board governance and more. Basing loans on the ability of an enterprise to repay the loan means that more nonprofits and other enterprises in lower-income communities could access capital.

That capital would, among other things, allow them to purchase the facilities they need to achieve their missions.

IFF’s income-based approach is not perfect. We sometimes get it wrong and have a default, like any other financial institution. But for 31 years, our losses have generally bested mainstream lenders (0.88% last year). And some of the very criteria listed above need to be further deconstructed to make sure that other past biases are not preventing our communities from accessing capital.

Last month, I introduced a continuum of activities for CDFIs to build a pipeline of “investible” community development projects and reach their goal of aligning capital with justice. Along the continuum are activities that entail a lot of CDFI control, and others that don’t. Non-appraisal-based lending is very much within CDFIs’ control.

Given the effects today of the historic racism of redlining, we think it’s important to raise the question of whether other lending institutions can move the needle toward greater justice by ditching appraisals in favor of more equitable underwriting methods. My questions for ImpactAlpha readers and leaders who invest in communities – are this:

  • Do you think you could make loans without appraisals? If not, why?
  • If so, what approach would you use to underwrite the loans?
  • What other hacks do you have to remove lending barriers based in racist disinvestment?
  • Would that increase lending pipelines in communities?

We cannot invest our way out of racism. But we can, and must, do more by challenging approaches to community lending that perpetuate destructive past practices.

*For a much deeper dive into the history of residential segregation and redlining and how they shaped our modern neighborhoods, see:

  •  The Color of Law A Forgotten History of How Our Government Segregated America. By Richard Rothstein;
  • How Redlining’s Racist Effects Lasted for Decades, Emily Badger New York Times, Aug. 24, 2017; and
  • The Racist Housing Policy That Made Your Neighborhood, Alexis C. Madrigal, May 22, 2014

Joe Neri is CEO of IFF.