Sunday, November 15, 2015

The dangers of appraising properties in a vacuum

When we were in school and before a scheduled exam, we had two choice to prepare. We could either  study the principles required to pass the exam, or we could simply copy the answers off our fellow student's test paper. If the latter was your strategy, you had to make sure you sat next to the student that had the greatest chance of passing the exam. After selecting your fellow student and coping his test answers, what if you were unaware he to had copied his answers from another fellow students test paper.

This is essentially how real estate appraisals are still being conducted today. It is still acceptable for an appraiser to simply use recent comparable sales in comparing to his subject property in order to arrive at the property's current market value. The most competent appraiser will research the market and find the most recent and similar comparable sales in arriving at subject's current market value. These type of sales will give a third party reader of the appraisal report the most confidence in the appraiser's final opinion of value. But what if this current market value is laced with the market's "irrational exuberance" (will explain later).

This traditional "sales comparison method" worked very well in the twentieth century until the late 1960's and early 1970's. Before these decades, property values were relatively stable and coincided with economic fundamentals (property users demographic personal and business income that translated into what they could reasonably pay in terms of rent for the specific property). For example, in years prior to these decades, the typical demographic for a specific residential neighborhood might have had a household income of say $20,000 annually. Back then, approximately 30% to 35% of this income was first used for housing costs. This housing cost potential translated into the value of houses in that neighborhood. The relationship of the housing cost potential (or rent) and the risk of single family housing to an owner/user or investor created the property's market value. If this value coincided with the property's economic fundamentals, the market value had a greater chance of sustainability during a typical ownership holding period.

From the early 1970's forward, property values have escalated at an unprecedented rate mainly as a result of expanding demographic personal household/business income from owners and users of these properties. However, the market still assumes comparable sales have the same economic fundamentals associated with the comps sale price as it was pre-1970.  We have learned this is not always the case as we saw in the mid to late 2000's "Great Recession".

By continuing to "copy off our fellow students test paper" in predominately using the sales comparison appraisal methodology, we have learned that comparable sales prices can be laced with "irrational exuberance" by the faulty forecasts of the collective market participants. These faulty forecasts move the sale price of the comparable sale away from the property's economic fundamentals adding greater risk of the sale price not being sustainable during a typical ownership holding period.  These faulty forecasts generally revolve around expectations of what a property will sell for at the end of an ownership holding period and/or an unsustainable percentage of the property user demographic personal/business income used as an estimate of the property's "market rent".

Consequently, the users of valuation products are demanding more than a single-point-in-time market value estimate that is derived from comparable sales or other methodologies using current market data and units of comparison. They want two other bits of information after the appraiser has expressed his opinion of the subject's current market value. First, they want to know the forecasts or "bets" associated with the appraiser's current market value and Second, they want to know how far, if any,  the appraiser's current market value has detached from the property's current fundamental value (sometimes called intrinsic value). These two added bits of information will flush out any hidden risks of whether or not the appraiser's current market value opinion is sustainable during a typical ownership holding period.

The widespread use of the new valuation tool call Valuexpose is specifically answering these two bits of information the market is demanding. Once the appraiser formulates his opinion of a property's current market value (either residential or commercial), this value can be inserted into Valuexpose indicating all the forecasts or "bet" associated with the property's current market value. In addition, Valuexpose will also compare the current market value to the property's current fundamental value indicating whether or not the subject's current market value is sustainable during a typical ownership holding period. If a property's current market value is not sustainable, Valuexpose will indicate whether it is due to irrational forecasts of the property's ending sale price at the end of the ownership holding period and/or whether or not the current forecasted market rent for subject property is outside the typical percentage range a user can afford to pay.  If the demographic that typically uses the subject property is paying too much of its personal/business income for rent, the subject's current market value could be artificially inflated and also unsustainable.

Continuing to appraise properties in a vacuum and not indicating the additional bits of information the users of valuation products are demanding will certainly lead to more and more severe bubbles that will cost individuals and our nation trillions of dollars of unnecessary losses now that we have advanced valuation tools.