October 29, 2013 - Post No. 32 – In response to a Letter to the Editor in the Summer 2012 edition of The Appraisal Journal, I first mentioned my Theory of Valuetivity. It is summarized as follows:
• Price only equals value when a market is in equilibrium.
• Real estate markets are rarely in equilibrium.
• Therefore, price rarely equals value.
I went on to state “As such, market transactions should only be given consideration when a market is at or very near equilibrium. At all other times, fundamental market analysis is going to provide a better indication of value than market transactions. The real estate valuation industry will become more useful when it gets away from writing price confirmation reports and starts providing opinions of value based on solid supply and demand analysis.”
For the past 80 years, the American appraisal industry has provided market price opinions, not market value opinions. As the public has recognized, appraisals simply go up and down with price fluctuations.
Ed Pinto provided the following excerpts from the FHA back in the 1930’s. It is sad to think that in the beginning the valuation industry understood that sales prices were not useful in arriving at market value. However, with constant pressure from NAR, the industry soon defined market value in relation to price. With Ed’s permission, I provide those excerpts below.
FHA’s Underwriting Manual of 1936 said this about the utility of sales prices in “boom” times:
307 (1.) Use of Sales Prices. Included in data the Valuator must obtain is information regarding sales transactions in evolving residences similar to those which he must appraise. In the past, and to a large extent still, great importance has been attached to sales prices. They are frequently not as important as has been believed. This is because the price in a given real estate sale results to the transaction, either or both of whom may have been poorly informed, or motivated by unusual or compelling circumstances. Before the sales price in any case can be of any substantial use, the Valuator must obtain certain information regarding the conditions and circumstances which existed when the sale was made. Such information includes:
(a) The actuating motives of buyer and seller;
(b) The relative intelligence of buyer and seller in negotiating the sale;
(c) The relative skill in bargaining of the buyer and seller;
(d) The fairness of the price paid in view of prices asked for available properties affording equal advantages and subject to equal possibilities of enhancement or loss of value ;
(e) The date of the sale and the general and specific environing and economic conditions which then existed and whether or not such conditions have changed since that date.
307 (2.) It must be noted, too, that sales prices are of varying usefulness and importance according to the rapidity with which price levels of real property may be changing. In an unusually active sales market, such as exists in “boom” times, accompanied by rapidly rising prices, the stimulus given to prices by strongly competing buyers becomes such that fairness, as regards the prices paid, disappears. Stability and permanence are nonexistent at such times, as well as in times of rapidly declining prices, and the prices then obtained in sales are almost worthless as useful information in estimating value, though their frequency, coupled with pyramiding prices, constitutes a warning of the imminence of a reversal of the price trend. Only in times of comparative stability of the price structure are sales prices of substantial worth in valuation work. Thus after a price decline has set in, developed, and finally spent its force, as at the end of a period of economic distress, and voluntary sales transactions begin to occur, it is probable that the sales prices in such transactions will be equal to or closely approximate warranted prices, i. e., value, provided the parties are well-informed and act intelligently. A Valuator will generally overvalue property unless he recognizes the changing relationships between sales prices and value. He should understand that in certain periods sales prices may generally exceed value, while during other periods the prices may be below value. Only in times of comparative stability of the general economic structure, and during periods when there is a fairly well-balanced relation between the factors of supply and demand, will sales prices approximate or actually equal value. If a Valuator does not understand these considerations he will appraise incorrectly. As sales prices increase in a rising market, his value estimates will accompany the prices in their climb to a peak. Before they reach their peak, however, they may have outstripped value. Later when a leak occurs and prices start down, his point of view will cause him to maintain his value estimates at higher levels, although the value levels are below the sales prices at the peak and stay below them in the early stages of the decline. In the later stages they will become equal to the prices and then, for a time, exceed them. It is apparent that Valuators must understand sales-price and value relationships under varying general economic conditions and under varying directions or trends of price changes.
307 (3.) As a general observation, it may be said that the rate of change of real estate prices will indicate the relative usefulness and importance of sales prices; the greater the rate of price change, the lesser the significance of sales prices, and vice versa.
Ed concludes with a thought that is exactly in line with my own – “Unfortunately, we have yet to relearn this lesson. Appraisals continue to be based on point-in-time comparable prices no matter the relationship to fundamentals.”
One of the more memorable quotes on this subject appeared in a New York Times article last year:
“Bill Garber, the director of government and external relations for the Appraisal Institute, a group that represents about 23,000 appraisers nationally, questioned how the study had been conducted. ‘The sale price isn’t a good way to evaluate the accuracy of an appraisal,’ Mr. Garber said.”
It is refreshing to see that the Appraisal Institute itself recognizes that you cannot compare prices and values.
I will end this, and all future posts, with my mantra that I hope to see come true before the end of my career:
Ban The Sales Comparison Approach!
George R. Mann, CRE, FRICS, MAI
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