A good friend of mine, Mark Stockton of Valuations Unlimited, LLC, has developed a powerful research tool to aid in valuation. Mark is a sharp unassuming guy who has sold technology to Wall Street before. Here is a simple overview. It addresses the significant elements of the technology. It’s not an AVM and better yet…it actually works! At least it worked when I tested it on my house in CT (a 200 year old 3 story Salt Box) and on a number of my friends’ and relatives’ properties in various parts of the US.
His technology develops the replacement cost, market analysis, land residual analysis, assessment analysis, sale price index and rental analysis and allows the user to weight the applicability of each approach.
He’s got several very interested parties at this point. As Mark has told me: “We certainly need to make decision makers aware that there is at least one solution available that can help them make better decisions and monitor their investments over time.”
He’s entered the vortex on Matrix (he wrote a guest post). It’s about a different kind of “sustainability”. A good read.
Sustainability of Property Values
By Mark L. Stockton
May 16, 2012
There has been a lot of discussion in recent months about the need to reengineer the appraisal process. There is no denying the fact that the process as it currently exists is antiquated and inadequate. Methodology is purely subjective; there is a lack of adequate analytics.
These deficiencies can be corrected. Comprehensive analytics are available to those who would demand them. Much of the subjectivity can be replaced by objective processes that will support reasonable value conclusions. However, fixing the means by which value conclusions are developed addresses only part of the problem. Those conclusions must be examined for sustainability in order to be used to make prudent lending and investing decisions.
A friend recently lost her home. She purchased it new in May of 2002 for $234,500, and at the time the price was reasonable when compared to the other 1,000+ newly constructed homes in the immediate area. I have not seen the appraisal that was done at purchase, but I imagine the value conclusion was reasonable in light of the fact that there were so many similar homes in the subdivision that were selling at the same time. There is little doubt that the appraised value was extremely close to the contract price of $234,500.
I cannot deny that the appraised value of the property in May of 2002 was – and should have been – approximately $234,500. What I can say with authority is that the appraised value at the time of purchase was unsustainable.
There are meaningful relationships in real estate markets just as there are in other markets (stocks, commodities, etc.) that must be monitored to support prudent lending and investing decisions. For example, we know there is a relationship between rents and sale prices that should be considered. From a lender’s perspective, if a buyer should have difficulty paying the mortgage, it would be comforting to know the home would bring in enough income in the form of rents to pay its own way.
There is another important relationship that has been long overlooked, and that helps us understand the sustainability of property values. It is the relationship between the market value of a home and its depreciated replacement cost (RCNLD). There is an old (often forgotten) adage that no prudent buyer would pay substantially more for a home than the cost to rebuild it on a similar site. This concept was once recognized by the appraisal industry and acknowledged in the cost approach to value. There was a time, not long ago, when appraisers had to provide commentary to support any cost approach in which the site value represented an excessive portion of the overall value. It was recognized at the time that a large disparity between the value of the improvements (depreciated replacement value) and the value conclusion (the market estimate derived from the cost approach) could be indicative of an unsustainable market value. History has, in fact, shown us that when the gap between RCNLD and sale price in traditional housing markets grows beyond 120%, market values are approaching unsustainable levels. When that ratio reaches 130%, we can be certain that a correction in home prices is imminent.
When my friend purchased her house in 2002, the ratio between RCNLD and home prices (Market Experience Ratio©, or MER©) in the immediate area was 135%. Her home and the neighboring homes were being built and sold at the high point of what would become known as the housing bubble. For those of us who watch relationships closely and have developed a means of monitoring them on both a broad scale and granular basis, this was obvious. Each time this occurs, as it has on several occasions in the past 30 years, market prices respond by declining to a level that more closely approximates depreciated replacement cost. The current MER for homes in the area of my friend’s house is 106%. The ratio is still declining slowly, but prices have reached reasonably sustainable levels.
Here’s the bad news. My friend was able to secure a 100% loan in 2002, with payments structured to start off small and increase over time as her income and her equity grew. Ecstatic at the prospect of being able to own a brand new home with no down payment, she was unaware of danger that lay ahead. So too was her lender, apparently. She can be forgiven; she was not, and is not, what is sometimes referred to as a “sophisticated investor”. How can an average consumer be expected to understand market dynamics and complex financial dealings? Isn’t that why they rely on professionals?
The lender, however, should have known better. What happened to real estate markets nationwide a few years thereafter was not an anomaly. It has happened often in the past, and it will happen again in the future. Every time investment dollars become more abundant and credit restrictions relax, you can bet this same scenario will play out in real estate markets across the country.
About a year ago, my friend lost her job. She was forced to confront the fact that she was unemployed and would have to compete with tens of thousands of other unemployed individuals for a position that would probably pay less than her old job – if she could find employment at all. The value of her home had declined by more than 12% in the decade since she had made her purchase. Instead of building equity, she was “under-water” on her mortgage. Recently, her home was foreclosed and she found herself in a position that is all too common today. While not homeless, she is facing bankruptcy and the attendant emotional and financial difficulties that are inevitable.
If the proper tools and analytics had been available to the lender in 2002, chances are things would have turned out better for all parties. It is reasonable to assume that the lender, recognizing the instability in the housing market, would have modified its lending practices and terms offered to borrowers would have become more restrictive. In fact, there is a high probability that the instability would have never reached such extremes; lenders might have acted promptly and prudently to insure that sustainability was protected, and their subsequent losses might have been significantly reduced.
My friend might not have qualified for a loan at all, and would have perhaps been forced to continue renting until she accumulated a suitable down payment. If and when she was ready to make a purchase, she might have had to settle for a “starter home” rather than opting to buy her dream house. These, by the way, are not bad things. Until recently, this was regarded as the appropriate path to home ownership in America.
So here’s the message. Prudent lending and investing must be based on more than just accurate appraised values. Values must be scrutinized for their sustainability as well. As my friend and her lender discovered, an accurate value for a home yesterday might vary substantially from an accurate value for the same home today. That does not make either value conclusion less accurate, but it does reveal that markets fluctuate and values must be viewed within the context of current market trends and long term sustainability.
If your valuation professional cannot provide you with both a reasonably accurate value conclusion, supported by industry standard analytics, and a reasonable measure of sustainability, you need a solution that does.
- ‘Sustainability’ of Property Values [Valuations Unlimited, LLC] *
Tags: Mark Stockton, Valuations Unlimited
So, you’re saying that this product will prevent future housing bubbles?
No, bubbles are embedded into human nature. By expanding the scope of valuation, perhaps better decisions can be made to reduce the extent of the damage.
However, if homebuyers had access to these analytics and understood their meaning, perhaps they would be reluctant to pay high (unsustainable) prices, and their actions would therefore temper bubbles. And, if lenders had access to this information, perhaps they would modify underwriting criteria to mitigate risk when values appear to be approaching unsustainable levels, thereby recognizing and minimizing the “bubble effect”. And, if investors had access to this information, perhaps they would be reluctant to invest in securities backed by mortgages on properties with unsustainable values. Perhaps this really would minimize (if not prevent) the impact of future housing bubbles.