Thursday, January 22, 2015

Founder’s Welcome: How to prevent speculative Real Estate bubbles

America and other free market countries are still reeling from the devastating real estate market value collapse from the great recession of 2007-2009. The bursting of this undetected real estate speculative bubble cost many trillions in lost wealth to both private citizens and countries treasure and prestige. Capitalism, once again received another black eye and is perceived as an outdated economic model that promotes greed at the expense of the poor and the middle class. The rebound from this tragedy has increased the net worth of America’s wealthiest citizens by 25% due to aftermath buying opportunities, and reduced the poor and middle class net worth by 25% that didn't have the resources to take advantage of buying opportunities. The losses in tax revenue has caused governments to borrow (or print) more money to keep government service operational. The only way governments can ever attempt to reduce this national debt is to either inflate their way out of debt by paying debt with cheaper money and at the same time try to stimulate their economies by inadvertently planting the seeds for another speculative bubble to form.

How did this speculative bubble happen in the mid 2000’s? Better yet, how do we keep this from occurring again? The United States and other developed countries have four levels of risk analysis to evaluate sales prices that buyers and sellers put together and want to finance.

The Real Estate Market “Food Chain”

The market (buyers & sellers) puts deals together with the help of the business space that includes Realtors, architects, etc. Once these deals are submitted for financing the first line of defense in evaluating the deals overall risk are the appraisers. Once approved by the appraiser, banks lend on the deal. The next line of defense are the bank examiners. Once the bank examiners give the bank a clean bill of health, the banks will sell some or all of their loans into the secondary market (Fannie Mae, CMBS, etc.). These markets bundle similar property loans together into a bond like financial instrument. Consequently, the third line of defense are the bond rating companies (Moody’s). The bond rating companies look at the risks of borrower defaults and the strength of collateral (market value of properties). If the borrower’s credit is acceptable and the market values of the collateral are assumed to be sustainable, the bond rating companies rate these bundles with very high ratings. Once rated, these bonds will be sold to bond investors and find their way into retirement funds, pension funds, etc. To oversee all of this activity is the federal government as the fourth and final line of defense in evaluating risk. The government guarantees the loans in many of these secondary markets and legislates regulations in an attempt to prevent financial disasters, maintain a “level playing field” and all the while trying to keep the economy moving forward.

The major flaw in this food chain starts with market values of properties put together by buyers or sellers. For example, let’s say a buyer or seller has negotiated and are in escrow for $500,000 (this example could be a residential or commercial property). There are 5 back-up offers on the property for $500,000+ and all recent comparable sales are being sold for $500,000+ in the area. The buyer solicits a loan from a bank and orders an appraisal. Appraisers will verify that the sale represents a market value sale by checking off the elements of the definition of market value.

  1. Arms-length Sale
  1. Willing seller and willing buyer
  1. Each under no duress to buy or sell
  1. The buyer and seller are equally knowledgeable of the market
  1. The property has been exposed on the market for a reasonable length of time
  1. Property is sold for cash or cash equivalent
If the appraiser verifies that the transaction represents a market value sale, he proceeds with the development of the appraisal by doing his due diligence, collecting data, applying appropriate valuation methodologies and arriving at the property’s single-point-in-time market value, typically as of the date the appraiser’s inspection. By law, licensed appraisers are required to reflect a market value estimate that represents the market’s conclusion based on supply and demand. The appraiser cannot dictate to the market what he would pay for the property if he was purchasing, but rather what a typical buyer would pay for the property. In our example, appraisers will be obligated to appraise the property for $500,000 without risking ethical violations from the state license board for steering the value above or below the property’s current market value. Even though the appraiser might feel uncomfortable with this market value, due to irrational exuberance in the marketplace, unless he can support a lower value, the obligation is to confirm the $500,000 sale price as a market value. If the appraiser feels this market value is unsustainable during a typical ownership holding period, and reports this to his client, he risks violating licensing law by reporting a misleading appraisal with an unsubstantiated value sustainable forecast. Also, the appraiser is well aware the client will potentially not use his services in the future due to the appraisers perceived competency problem. Many appraisers who were communicating their unsupported biased values and feelings of value sustainability to their clients were blacklisted during the mid 2000’s. After the bubble burst, they felt somewhat vindicated but nevertheless remained bitter at other appraisers that were simply reporting market value without unsupported value sustainability comments. As a result , today’s appraisers in today’s market are “gun shy” in concluding, in our previous example, that the property’s negotiated sale price of $500,000 represents market value. Appraisers fear a future lawsuit if they appraise the property for $500,000 and the value collapses sometime in the future. Consequently, appraisers are imputing unsupported feelings into the appraisal process in an attempt to be “conservative”. What’s worse, the licensing board is turning a blind eye to these ethical breaches even after an avalanche of complaints from market participants. Turning a blind eye to this behavior is very dangerous by allowing “conservative” appraisers to dictate the free markets. This policy can be as bad or worse than turning a blind eye to appraisers that appraising properties above market value. Both of these policies are a drag on economic growth either now on in the future.

Getting back to our mid 2,000’s $500,000 sale price, the bank would make the loan, once this sale price was verified by the appraiser as the property’s market value. Bank examiners looking at the banks loan verified the borrowers credit and the market value collateral that backs up the loan and gives both a clean bill of health. The bank would either keep the loan as a portfolio loan or sell the loan into the secondary markets. The bond rating companies are then hired to yield rate the bundles of loans as they compare to other financial instruments in the market place. If the borrower’s credit was reasonable and the loan collateral market value was verified by the appraiser, the bond rating companies give these bonds high ratings. Consequently, these bond were sold into the bond markets.

Here’s the problem: until now, all along the “food chain” there has never been a quantitative process and methodology to detect the formation of speculative real estate bubbles. Warren Buffett’s famous sage advice says, “Price is what you pay, value is what you get.” Mr. Buffett instinctively knows every property has an intrinsic or fundamental value as well as a market value. Any market value deviation from this intrinsic value is due to irrational exuberance in the market place in the form of irrational price speculation. Built into every market value is an expectation or forecast of the economic benefits while owning the property as well as an expectation of what the property will sell for at the end of the ownership holding period (called reversion). Because value is the present value of the future benefits, this mostly hidden reversion expectation of what the property’s ending sale price value must be is what pushes the current market value away than the property’s current fundamental value. Without knowing this hidden risk, the market and its related food chain is vulnerable to reoccurring booms and busts resulting in devastating financial consequences. Without knowing these hidden risks, booms and bust are going to become more frequent and more intense eventually destabilizing citizens and entire countries.

This is why I created Valuexpose TM, an enterprise cloud based software that can easily be used by all participants in the food chain, not only buyers and sellers that put deals together, but all the business verticals down the food chain line all the way to government legislators. This new patent pending technology goes many steps beyond the Dodd/ Frank financial reform by allowing users to be proactive, not reactive in flushing out hidden risks in the market place and identifying bubble formations on a property-by-property micro basis, not on an unsupported national macro basis.

Now market participants will know if it’s a good time to buy or sell a specific property without being blinded by the property’s super demand or lack of demand and current market value selling prices of comparable properties. Appraisers or any food chain participants can now report whatever the market indicates as a property’s current market value without letting there unsupported personal prejudice leak into their market value conclusion. They can simply impute into Valuexpose their concluded single-point-in-time market value and let Valuexpose automatically digest this value and print out a report that indicates the following:

  • What forecasts (or bets) is the market expecting in the future to support the property’s current market value. These forecasts also include what the market is expecting the property to sell for at the end of the ownership period.

  • How much, if any, has the property’s current market value detached from the property’s intrinsic or fundamental value.

  • Where does the property’s current market value lies on the business cycle giving an indication if this is a good time to buy, sell, start a development/ remodel or lend on this property.

  • If the property’s current market value is sustainable over an ownership holding period and at what future market value reversion the property will most likely gravitate towards.

  • If you currently own the property, what specific level of debt you should not exceed without putting yourself in danger of becoming an “underwater” mortgagor.

For appraisers, after they have derived the market value estimate, the printable Valuexpose report can be added to their normal appraisal report giving their client all the risks associated with the property’s current market value. This added report will substantially reduce the future liability of being sued or turned into the state licensing board because injured parties are trying to “claw back” their losses by playing “Monday morning quarterback.” This ruse is meant to imply that the appraiser should have known the value of this property would not be sustainable. The Valuexpose report gives all users of the appraisal, after the report is delivered, an opportunity to impute his personal forecasts if he disagrees with the market’s forecasts that make up the property’s appraised market value. The clients’ forecasts can easily and instantly indicate an “investment value” that lets them impute their own risk tolerance. This added service to the client will be appreciated as well as protecting appraisers from future lawsuits, and other liabilities. For instance, if the client does not call the appraiser with his concerns about the market’s forecasts regarding the property’s current market value, the inference is that he thinks there is a reasonable probability these forecasts are achievable in the future. If for any reason these forecasts substantially change in the future causing the property’s future market value to substantially differ from the appraised current market value, the client will have a difficult time proving the appraised market value was incorrect at that point in time.

As you can see, once the food chain receives more than the traditional single-point-in-time market value estimate, greater reliance on these values can be counted on and appropriate loans and risk rate can be formulated by risk analysis (bank examiner, bond rating companies, and the federal government). Capitalism can be stabilized with steady economic growth based on the country’s merit, not speculative values that can disappear in an instant.

Valuexpose standardizes this whole process and makes it easy for the entire food chain to be used with a “Wizard Questionnaire” format, allowing the user to simply answer basic questions. Valuexpose does all the “heavy lifting” of creating complex discounted cash flows (DCF’s) and other valuation methodologies that in the past were only performed by experts that were found further down the food chain.

Not only was Valuexpose designed for ease of use and efficiency, but is inexpensive to use on a subscription basis (cancel at anytime-no questions asked) and can be used on any fixed or mobile device anywhere in the world. Also, Valuexpose can be used in any foreign currency without currency exchange.

Don’t get left behind by ignoring these advancements in valuation tools, value sustainability and economic feasibility of proposed developments. For years, business verticals in the food chain have been clamoring for this information. The appraisal Institute’s guidenote 12 (link) and subsequent Beyond Guidenote 12 are initial evidence of the problems we face and the answers demanded. This guidenote and whitepaper are the direct results of surveys conducted by the Appraisal Institute of frequent users of valuation reports and what they are demanding from valuation experts.

Please join me and the Valuexpose team in the most advanced productive solution in solving the results of “irrational exuberance” and preventing devastating economic collapses. Help stabilize developed countries and give the greatest chance of success to developing countries that are experimenting with capitalistic economic models. A stabilized capitalistic model based on a free market leveled playing field can distribute the economic success of a nation to the greatest number of people no matter what their economic status might be. Greater world wide economic stability leads to greater cooperation. Greater efficiency in the appropriate distribution of capital leads to a better management of natural resources and conservation.

I look forward to your constructive comments and I am certainly open to suggestions to further advance this important new technology.

Raymond L. Dozier, MAI