Twin Markets

There was a classic buried lead in an article in today’s Chronicle real estate section. The article is about challenges currently facing real estate appraisers. About half way down, you’ll see a brief bit about how short sales and foreclosures are affecting appraisals. It isn’t much, but we found this section particularly interesting.

An appraisal, after all, is really only one person’s opinion of value. Nevertheless, lenders rely heavily on appraisals to determine the “market value” of a particular property on which they may loan money. It comes as no surprise then, that in a declining market, the appraisal is the sticky wicket that causes many real estate transactions to fall apart.

A quick overview of this process: Mr. Buyer agrees to buy 123 Main Street from Mr. Seller for $1,000,000. Mr. Buyer plans to borrow 80% of the funds necessarily to buy the property. He goes to a lender and fills out a loan application. Based on his credit score and income verification, the lender agrees to lend Mr. Buyer 80% of the property’s value. The lender sends an appraiser out to the property to determine the market value. Said appraiser reports that the current market value of the property is $900,000. The lender may very well be willing, as promised, to lend Mr. Buyer $720,000, which is 80% of the property’s newly determined market value. The problem, of course, is that Mr. Buyer needs to borrow $800,000 to buy the property at the agreed upon purchase price. Now, if Mr. Buyer was working with us, we would have advised him to have an appraisal contingency, which would allow him to walk away from this transaction right here and now. If not, Mr. Buyer might well have to find $80,000 to make up the difference between what the lender will loan and what he agreed to pay. Without an appraisal contingency, Mr. Buyer could well be in default if he does not buy the property, thereby putting his deposit at risk.

But here’s the thing. The fact that appraisals are coming up short is not exactly shocking to anyone who has been following the real estate market for the past 18 months. Which brings us back to our buried lead.

Drive 45 minutes away from San Francisco in nearly any direction and you will find communities in which upwards of 50% of the homes for sale are either short sales or foreclosures. The other 50% of listings are, of course, owned by ordinary people who have equity in their homes and are selling for “normal” reasons (job transfers, kids moved away, retirement, moving up, downsizing, etc.).

Regular readers know that we often harp on the importance of looking at a specific market to determine what a property is worth or which way its value is moving. Real estate is a local business. Examining national, state, or even regional trends is often a waste of time. But what do we do when two distinct markets emerge within a single location? How do we determine value when, even within the smallest of communities, two marketplaces exist? We’re only just learning the answers.

To help find those answers, it’s worth looking at a textbook definition of market value. Literally. We went back and looked at an old real estate textbook to shed some light on the subject. We must allow for five key elements to determine if a property is selling for market value:
1. Neither buyer nor seller is acting under duress.
2. The real estate has been on the market for a reasonable length of time for a property of its type.
3. Both buyer and seller are acting with full knowledge of the property’s assets and defects.
4. No unusual circumstances exist, such as a sale involving related parties.
5. The price represents the normal consideration for the property sold, unaffected by creative financing or sales concessions granted by anyone associated with the sale.

In a short sale, 1, 4, and 5 are arguably not present. At a minimum, the seller is acting under duress (1) and the lien holder is granting concessions to facilitate the sale (5). In a foreclosure sale, the lender, who is also the seller, has probably never seen the property and has no knowledge of the property’s assets and defects (3).

Clearly, short sales and foreclosures sales do not meet the definition of “fair market value.” So what do you do if you want to sell your house and the house three doors down sold six months ago in a foreclosure sale? It is unlikely that the neighbor’s house sold for fair market value. Nevertheless, that sale will be used to determine the value of your house.

This is the challenge facing everyone in the residential real estate world right now: appraisers, lenders, buyers, sellers, and Realtors. And that’s why it’s essential to work with a Realtor who is aware of these factors and uses them in advising you on your decisions.

Interesting times, these.