Fall 1994 Edition of Property Valuation Monitor

Appraisers Turning to Economics in Unstable Real Estate Markets

Copyright © 1994 Property Valuation Advisors

The following is a summary of an article written by Stephen Traub, ASA, that appeared in Banker & Tradesman on 8/24/94.

Today, lenders, the major users of appraisals, are questioning traditional appraisal philosophies because of the losses they have incurred. They want appraisals that protect their collateral beyond the next fifteen minutes. One of the constraints under which appraisers work, however, stems from an old legal maxim: If everyone is wrong at the same time, they are right.

Real Estate Nirvana

Most appraisers were taught: Don't make the news, only report it. When this approach was first devised, however, real estate markets were stable. No one had to deal with naive buyers who soared to altered states of bliss and thought they had found real estate nirvana, only to end up detoxing at the RTC and RECOLL, wondering what went wrong.

To find answers, increasingly appraisers are turning to economics. When conditions are askew, economic tools can at least help appraisers answer the question: What is wrong with this picture?

Buyer Overconfidence

During the 1980s, appraisers often found that comparable sales were higher than the values developed by their cost or income approaches. This shows -- what economists call -- excess demand. In stable periods (equilibrium), the cost approach usually sets the upper limit of value for existing properties. But 1980's buyers who were so hot to buy, often cared little about what they paid. Considering their immediate experience, they knew they could resell the property for more later: Everyone knew that.

Similarly, when appraisers checked their income approach, they often found results that differed from the comparable sales. Disparities often indicated that exceedingly optimistic or pessimistic buyers have swarmed into or fled from the marketplace.

Psychedelic Glasses

Traditionally, in a market presumed to be rational, appraisal assumptions and values were supposed to mirror the activity and the perceptions of the participants. But, what if the market were wrong? What if most current buyers were not prudent (as the textbook said they were)? What if they were all wearing rose-colored glasses, or worse psychedelic glasses?

Among the lessons to be learned from economics (metaphorically speaking) is that when the tide is high, don't expect it to get higher. When it is low, don't expect it to get lower. Moreover, the tide will not stay high or low for long: it will turn!

Therefore, when performing the income approach during euphoric periods of excess demand, appraisers might temper their forecasts in relation to the overoptimism of the current market players, and bolster forecasts during desperate periods of excess supply. In either case, objective supply and demand factors should be the basis for any fine tuning.

Appraisers should forecast change, when appropriate, by looking at and analyzing the major forces underlying the value of real estate. These forces are economic, social, governmental and environmental. Each is capable of creating or destroying value. Of these four forces, economic forces change most often, though they are often least apparent.

Fortunately, economic training is now beginning to be included in appraisal classes and on exams. Market analysis seminars and similar topics, which focus on the use of micro-economics in analyzing real estate markets, increasingly are available to appraisers.

Are They Right?

So, back to the original question: If everyone in the market is wrong at the same time, are they right? The answer is still yes. Nevertheless, we should examine the basis of the perceptions that create value. We should place those assumptions under the microscopes of economic theory and statistical law. Through the intelligent use of quantitative economic analysis, one can uncover excesses and at least identify the risks associated with a property. By recognizing these larger forces, it will enable appraisers to add dimension to their appraisal reports, strengthen the reliability of their forecasts and, therefore, improve the accuracy of their appraised values.

Stephen G. Traub, ASA is chief commercial appraiser for Property Valuation Advisors in Newburyport, MA. Mr. Traub has a B.A. from Harvard University in social science/economics. He holds the Accredited Senior Appraiser, ASA, national designation from the American Society of Appraisers He can be reached at (508) 462-4347 or by e-mail at: straub@shore.net.

Other articles in this Fall 1994 issue of PVM include: Supply Still High; My Summer of '94; Commercial Mortgage Survey; Northern New England Vacancy Survey.

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