1903 to Present - Part 1
This is the first in a series of articles on property valuation theory and practice from 1903 to the present. Land economics developed as a discipline in the early part of the 20th century because the United States was rapidly urbanizing and homeownership rates and mortgage debt levels were increasing.
The urban population increased from 35.1 percent in 1890 to 51.2 percent in 1920.[i] The homeownership rate for nonfarm families increased from 36.9 percent in 1890 to 40.9 percent in 1920.[ii] Finally, the percentage of mortgaged nonfarm properties increased from 27.7 percent in 1890 to 39.7 percent in 1920.[iii] Thus, the percentage of households living in an urban area with a mortgage increased from 10.2 percent in 1890 to 16.2 percent in 1920.
As leverage increased, interest developed in determining value for lending purposes rather than value based on point-in-time prices. As the FHA noted in 1936, "Speculative elements of value cannot be considered as enhancing the security of residential loans."[iv] This is because the loan investor or guarantor retains the downside risk with no participation in upside potential.
There were only two periods when no-money-down home purchase lending became prevalent in the United States:
- First, in the 1920s: "Thus the point was reached in [the inflated market of] 1928 where 100 percent loans were made on first mortgages in many cases, and where an additional 20 percent was obtained on a second mortgage."[v]
- And again beginning in 2000: "Nearly half of first-time home buyers nationwide [in 2006] put down no money, according to the National Association of Realtors, compared with fewer than one in five repeat buyers. The remaining first-time buyers put down a median of just 2% of the purchase price."[vi]
These two periods had something else in common; appraisals were generally based on the sales comparison approach using the sales price of similar homes—also known as a point-in-time valuation or exchange value appraisal.
- 1920s: "Individual homes are appraised by the comparison process."[vii]
- 1996 onward: "The purpose of this appraisal is to estimate the market value of the real property that is the subject of this report based on a quantitative sales comparison analysis for use in a mortgage finance transaction."[viii]
These experiences show that relying only on sales comparison analysis in periods of loosened lending standards will likely lead to disastrous consequences. During speculative booms, the latest comparable sales are used to support new-purchase and cash-out-refinance transactions, regardless of the relationship to fundamentals such as construction costs, rents, or income growth.
By the 1930s, most appraisers, academics, and policymakers had concluded that appraisal practices of the 1920s had been based on misconceptions such as these:
- "The market price is synonymous with market value."[ix]
- "That speculative sales are a criterion of value."[x]
New viewpoints took their place:
- "That the appraiser most often finds it necessary and desirable to ascertain the market or warranted value of a property, which represents the present worth or rights to future benefits arising from ownership."[xi]
- "That value is largely based on these expected future benefits and that past performances are for the most part simply interesting history which possibly indicates certain future trends."[xii]
The FHA put these new viewpoints into practice in the 1930s largely because of the efforts of Frederick M. Babcock, appointed chief of the FHA’s underwriting division in 1934, and Homer Hoyt, appointed principal housing economist in 1934. They developed many boom-resistant practices, illustrated by the following excerpts from the 1936 FHA Underwriting Manual:
There is no virtue in undervaluation of properties, and great risk of loss is introduced by overvaluation. Federal Housing Administration Valuators must avoid both undervaluation and overvaluation. Their attention is directed to the fact that speculative elements of value cannot be considered as enhancing the security of residential loans; rather do such elements enhance the risk of loss to mortgagees who permit them to creep into the valuations of properties upon which they make loans. Valuators shall not report valuations that cannot be justified by existing conditions which they find and of which they are aware, and by reasonable and plausible estimates with regard to the effects of conditions which may reasonably be expected to prevail, in the near future subsequent to the date of valuation.[xiii]
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. . . . 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. . . . 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. 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.[xiv]
This new understanding of the relationship between market value and sales price played a significant role in reducing the FHA’s claim rate in the following two decades. As noted in the same Underwriting Manual, accurately valued properties—when combined with sound borrower characteristics—result in "a mortgage transaction [that] is mutually advantageous to the borrower, the mortgagee, and the Federal Housing Administration."[xv]
The success of this underwriting approach was demonstrated by the FHA’s claim rate of 0.2 percent on its first 2.9 million loans insured from 1934 to 1954. That stands in stark contrast to the one in eight FHA families suffering foreclosure on home loans issued between 1975 and 2011. Correctly valuing properties better protected homebuyers from the risk of purchasing a home that was priced higher than its actual long-term value. That, in turn, better protected FHA families from the risk that the future sales price for their home would fall below the value of their mortgage—and the accompanying risk of default. That benefited all parties involved.
Some have dismissed the whole of these early appraisal guidelines because the FHA condoned segregation based on race and national origin and followed local customs and practices including racial covenants. It was right to discard the policies condoning segregation and based on long-outdated attitudes. However, many of the FHA’s valid guidelines were also thrown out—and underwriting deteriorated as a result.
Unfortunately, as reported at NightmareatFHA.com and in last month’s FHA Watch, low-income and minority borrowers have continued to suffer disproportionately high rates of default and foreclosure.
As the preceding discussion demonstrates, improving valuation practices is one key step toward reversing this trend. Unfortunately, as the next article in this issue documents, the FHA continues policies that sell hope but deliver harm to working-class families.
As noted earlier, market value determined solely by the sales comparison approach reappeared during the run-up to the great housing crash that began in 2006. In 2009, some in the appraisal industry recognized the shortcomings of the sales comparison approach:
Appraisers didn’t directly cause values to decline. They weren’t the catalyst for homeowners to cease paying their mortgage. But they did help create fictitious equity and were complicit in facilitating trillions of dollars of loans that never should have been made. There are varying degrees of valuation inflation performed by appraisers. . . . And then, somewhere in the mix, was the failure to recognize an overheated market and report trends and risk to their clients.[xvi]
While the 1930s saw the adoption of appraisal practices consistent with value fundamentals and alert to the risks of overheated markets, in the aftermath of the recent boom/bust cycle there has yet to be an acknowledgement of the shortcomings of the sales comparison approach.
Stay tuned for part 2 of this interesting history of property valuation practices which will be published soon. You can find this and other articles from Ed Pinto at AEI.org or for more from the FHA Watch visit NightmareatFHA.com. Have any comments or would you like to submit content of your own? Email firstname.lastname@example.org
[i] US Census Bureau, "37. Urban and Rural Population, and by State," 1990 Census of Population and Housing, Population and Housing Unit Counts (1990 CPH-2), www.allcountries.org/uscensus/37_urban_and_rural_population_and_by.html.
[ii] Thomas J. Fitzgerald and Richard T. Ely, Mortgages on Homes (Washington, DC: Government Printing Office, 1923), 40.
[iii] Ibid., 41.
[iv] Federal Housing Administration, FHA Underwriting Manual, section 303 (2).
[v] Homer Hoyt, One Hundred Years of Land Values in Chicago (Chicago: University of Chicago, 1933), 446.
[vi] Noelle Knox, "First Rung on Property Ladder Gets Harder to Reach," USA Today, July 17, 2007, www.usatoday.com/money/economy/housing/2007-07-16-first-time-buyers_N.htm.
[vii] Frederick M. Babcock, The Appraisal of Real Estate, (New York: Macmillan, 1924), 206–07: "The comparison method when applied to individual family dwellings consists of the collection of facts concerning all recent sales of homes in the district. Each transfer is compared with the property in question and a value is given based upon its points of superiority or inferiority."
[viii] Fannie Mae, Desktop Underwriter Quantitative Analysis Appraisal Report (exterior and interior/exterior), Forms 2055, September 1996, .www.dallasappraisal.com/images/fmae2055.pdf.
[ix] Stanley L. McMichael, McMichael’s Appraising Manual, 2nd ed. (Upper Saddle River, NJ: Prentice Hall, 1937), 1.
[x] Ibid., 1.
[xi] Ibid., 2.
[xii] Ibid., 2.
[xiii] Federal Housing Administration, FHA Underwriting Manual, section 303 (2).
[xiv] Ibid., sections 307 (2) and (3).
[xv] Ibid., section 206.
[xvi] Joan N. Trice, "Reengineering the Appraisal Process," Collateral Risk Network, April 1, 2009, http://www.collateralrisknetwork.com/sites/default/files/white%20paper_04_01_09-CRN.pdf.