Thursday, December 15, 2011

Principle of Substitution

    I was considering what topic to write about, when I came across this email from Chris A. Graham.  Chris is the new President of the Kentucky Association of Real Estate Appraisers.  When the market is in a downturn, some builders do not have the financial awareness to realize that the market is not willing to pay full price for a new construction; yet they continue to build homes.  This email is a rebuttal issued by John S. Brenan of the Appraisal Institue, and I could not have said it better.  

December 13, 2011
Paul Lopez
National Association of Home Builders (NAHB)
1201 15th Street, NW
Washington, DC 20005
Sent Via Electronic Mail:

Dear Mr. Lopez:

    We are contacting you in reference to the attached NAHB press release dated Thursday, December 8, 2011, entitled, Flawed Appraisals Killing Home Sales, Hampering Housing Recovery.
    As the Congressionally-authorized organization that establishes appraisal standards and appraiser qualifications in the United States, we feel compelled to address aspects of the press release we feel need clarification.  The press release quotes NAHB Chairman Bob Nielsen as stating, “The inappropriate use of distressed and foreclosed sales as comparables in determining new home values is needlessly driving down home prices, killing home sales, causing more workers to lose their jobs, and delaying a housing and economic recovery.” Mr. Nielsen is also quoted as stating, “This is not only unfair and unreasonable, but it perpetuates the cycle of declining home values, drives more home owners underwater, harms local economic activity, and acts as an obstacle to the recovery of the housing market.”
    It is critical to understand that appraisers do not determine property values; they simply reflect the actions of buyers and sellers in the marketplace. An appraiser’s role is to “mirror the market” by analyzing the actions of buyers and sellers in the marketplace to produce a credible opinion of value. The press release also refers to “faulty appraisal practices,” where “brand new homes with sparkling appliances and interior upgrades get compared to a distressed property that has been sitting vacant and in disrepair.” All things being equal, it is certainly true that the more similar a competing property is to the subject property, the better a comparable it is likely to be. However, there are often reasons why an appraiser may have to consider comparables that are not as physically similar to the subject property as may be desired.
    One key component in appraisal theory is the Principle of Substitution, which essentially states that knowledgeable and typically motivated buyers would not pay more for a property if a similar property could be built (or if competing properties are available in that marketplace at a lower price). The press release claims that 53 percent of builders surveyed reported appraised values that National Association of Home Builders came in lower than the cost to construct. A concept many builders often fail to recognize is that cost does not equal value. In “depressed” markets, it may be common for buyers to be unwilling to pay the full cost to construct a home; in appraisal, this is known as external obsolescence, which is a loss in value due to factors outside the subject property. In these cases, that loss is attributed to a market where buyers have set a “limit” on the amount they are willing to pay, regardless of the cost to build.
    While few would argue that a new home is not physically similar to a home that is in “disrepair,” the effect of such properties on new home sales must be analyzed by the appraiser. For example, in marketplaces where many of the properties being bought are distress sales (e.g., foreclosures, bank-owned properties, short sales, etc.), it is not only permissible for appraisers to consider and potentially use these sales as comparables (or “comps”) but appraisers are required to determine the impact this activity is having in the marketplace. This is due to the fact that distress sales may very well impact the value of more “conventional” sales, because in several markets buyers may be reluctant to pay more for any property than the price level set by the distress sales (note the reference to the Principle of Substitution made previously). Further, if the number of distress sales (or distress properties available for sale) becomes so significant in a marketplace that it represents virtually the only activity occurring, the distress activity may actually become the marketplace.
    The press release also states, “These appraisal practices are a major contributing factor to the current acquisition, development and construction (AD&C) lending crisis that has choked off credit for home builders and threatens to prolong the current housing downturn.  Falling appraised values for land and subdivisions under development have led some financial institutions to stop lending to developers and builders, to demand additional equity and even to call performing loans.”  It is important to recognize that all state licensed and certified real estate appraisers in the U.S. are required by the Uniform Standards of Professional Appraisal Practice (USPAP)1 to be independent, impartial, and objective, and to perform assignments without bias.  Furthermore, the Dodd-Frank Act passed by Congress and enacted in 2010 mandates appraiser independence, and establishes penalties for lenders and other parties who attempt to unduly influence an appraiser. To even suggest that appraisers are subjective in the performance of their appraisals is contrary to an appraiser’s most basic ethical obligations under USPAP.
    Lastly, the press release states, “Since Sept. 2009, NAHB has held four appraisal summits in
Washington with representatives of federal banking regulators, the appraisal industry, the housing finance industry, the real estate, and housing sectors and others to find solutions that will allow appraisers to develop realistic valuations based on sales that are truly comparable.” The press release also adds, “The need to give top priority to addressing the complexity of property valuations in distressed markets and impediments to the flow of appropriate information on homes between appraisers and interested parties was discussed during the most recent summit, which occurred on Oct. 19.”
    We wish to emphasize that, in response to your invitations, The Appraisal Foundation has
participated in each of the four appraisal summits referenced in the press release. In addition, The Appraisal Foundation stands ready to continue to work with NAHB to assist in understanding and resolving any appraisal-related issues.


John S. Brenan
Director of Appraisal Issues
The Appraisal Foundation
(202) 624-3044

1 USPAP is developed, amended, and promulgated by the Appraisal Standards Board of The Appraisal
Foundation, as authorized by Congress.

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