For the past 18 months, give or take, the mood across the U.S. real estate market has been decidedly somber; a far cry from the party atmosphere of a few years ago. Back in the heady days of the turn of the decade, credit flowed like wine, buyers and mortgage brokers conjured “creative financing” scenarios, sellers cashed out or traded up, and investors’ risk was mitigated by the rapid appreciation that paid dividends even in a short time period and made just about every deal worthwhile. Secure in the notion that “you cannot go wrong in real estate,” anyone who could buy into the game, bought in quickly.
The Wake-up Call
Yes, things are quite different today. And for broker agents and appraisers, the normal market indicators—supply and demand, absorption, the principal of substitution, and good old common sense—are more important than ever. If these indicators are ignored or misread, accuracy (or the efforts to attain as much accuracy as possible) can be compromised significantly.
Existing supply of homes in relation to demand and in-turn local absorption rates is the foundation for establishing market conditions. Coupled with price-trending, absorption rates are the backbone of good “microanalysis.”
But it does not stop there. The principle of substitution is fundamental in determining the options that exist for buyers in your market. Historical data (closed sales) is relevant to confirm trends and extract adjustments, but the recent and more current indicators of active and pending sales data is where the gold is located.
The reason is simple: why would a buyer pay your estimated, anticipated sales price for the subject property when a less expensive alternative exists?
Maybe you are in a sub-market that does not yield many truly comparable listings. Although Worldwide ERC® guidelines do not call for “adjustment” of competing properties, it can be a sound practice as a high benchmark check, and some relocation companies have asked for such. The trend of requiring and adjusting listings also is becoming more commonplace in the lending environment. Clearly, the times have changed. As they say, though, “the more things change, the more they stay the same.”
In my day-to-day role, I require that competing listings be adjusted, and I allow some flexibility on how that can be accomplished. For the most part, the appraisers I work with are diligent and understanding of this prerequisite. But I also have witnessed situations where this basic concept is misunderstood.
In those rare instances that I have had to question appraisers whose final value is well above all adjusted listings, the responses I have received range from “they are just listings” to “they have not sold, so they mean nothing.” My response is that they do mean something—that this particular appraisal professional does not clearly understand the principle of substitution. Often, I say, “remember, a buyer cannot buy the closed sales but can buy the listings.” This concept holds true in a depreciating or appreciating market and can be illustrated easily.
Consider, for example, a homogeneous area where listing and sales data are readily available and market conditions indicate REO and short sales as non-dominating factors. The client requests that the appraiser “adjust” the listings using the adjustments derived from the sales in terms of GLA, relevant characteristics, and applying a sales-to-list-price ratio and a forecast.
Once this exercise has been completed, the lowest adjusted listing(s) should be greater than the appraiser’s anticipated sales price. Let us say competing listing number one had an adjusted list price of $100,000, competing listing number two had an adjusted list price of $100,000, and competing listing number three had an adjusted list price of $105,000. If the anticipated sales price was $101,000 or higher, it would beg the question, “why would a buyer pay more for a truly comparable product when a less expensive alternative exists?”
Like all theories, this one has a soft spot. First and foremost, we must remember that we still are talking about a homogeneous example in which there are not many variables between the comparables. However, the more variables between the comparables and the subject, the more questionable the comparability factor, which, in turn, makes the entire valuation more questionable.
A soft spot would be that in markets where vast differences in housing characteristics exist, the actual adjustments are more difficult to extract. Further, adjusting the listings as if they have sold using the average sales-to-list-price ratio established via the closed sales presents the possibility of artificial deflation of the adjusted list price if the listing sells at a sales-to-list-price ratio that is higher than the average sales-to-list-price ratio used in the analysis. A $100,000 listing using a 96 percent sales-to-list-price ratio would yield a $96,000 net result from which all other adjustments would be made. But should the home sell for $98,000, the analysis for that comparable would be lowered by 2 percent, which generally is not a large margin but perhaps can be viewed as overly conservative.
This soft spot can be overcome by simply not applying any sales-to-list-price ratios to the listing. Logically, there would need to be some “wiggle room” after all adjustments are applied because most listings are unlikely to sell for 100 percent of the list price. In other words, if the adjusted sales price and the adjusted listing price were the same or very close, with no wiggle room, a red flag situation would be identified.
Another soft spot is failure to consider the “bigger picture.” The final anticipated sales price is an opinion based on a minimum of six value indicators and, these days, often more. So, having one piece of information that does not “fit well” should not lead one to believe that something is always wrong. This is where the soft spots can be conquered by the appraiser with descriptive narrative. Discussion of such listings, comparability factors, and local nuances of listings and markets can provide insight to an intended user. Even outside this example, in markets where REO and short sales exist, there must be a determination of meaningful competition merits rather than the mere citation of data.
Getting Back to Basics
Appraising is far from a perfect science. In fact, my favorite line in USPAP (Uniform Standards of Professional Appraisal Practice) is one I wish more appraisers and users of appraisals would take note of. The comment to Standard 1-1 (c) reads: “Perfection is impossible to attain and competence does not require perfection.”
I had a mentor who once told me, “Don’t be smarter than the market; let it tell you what is happening.” It is a lot like football when you think about it; no matter how complex the situation, winning a game can come down to the execution of the basics. To that end, I join my fellow appraiser professionals in a concerted effort to get back to the basics in real estate appraising: the principle of substitution, your block, tackle, and pass concept.
Joseph Palumbo, SRA, is director of appraisal management with Weichert Relocation Resources, Morris Plains, New Jersey. He can be reached at +1 973 630 5380 or firstname.lastname@example.org.