Wednesday, July 22, 2009

Real Estate Values, Uncertainty, and Anchoring

Everyone knows that real estate values today are much different than the values assigned to the same real estate two or three years ago. Elena Panaritis argues that value uncertainty is the underlying cause of our crisis in her Financial Times post “The Real Estate Roots of the Crisis in the US”. Some excerpts:

Traditionally, economists are trained to assume that pricing in general is a point of equilibrium defined by almost perfect market forces, where the demand and supply meet and neither the buyer or seller has a huge informational advantage. The traditional model also assumes that markets are frictionless and transaction costs are near zero especially when we deal with the supply side. From that they continue to assume that systems (rules, regulations, norms) that define the tradability of assets are given and near perfect. But this is rarely the case. In reality the systems that define supply of land and real estate tend to be full of transactions costs and information leakages, and that makes it really difficult to follow the old maxim that a price or value based on how much one is willing to pay is necessarily the right price.

Until the United States accepts that it has a badly flawed approach to establishing and verifying real estate property rights and to determining the valuation of property, until it puts in place a system that homogenizes and standardizes the underlying securitized assets of real estate and housing - the same way securities are required to be homogeneous prior to being traded in bundles - these underlying real estate assets will continue to be toxic.

That’s all true, but how do you improve a market that is illiquid and thinly traded, and how do you homogenize assets as heterogeneous as real estate?

I like the approach advocated by Richard Green in his post “Two Ideas for Appraisal Reform”; acknowledge the uncertainty and disclose it right in the appraisal. An excerpt:

Appraisers should use valuation techniques that allow them to report a standard deviation of their estimate. Subdivision tract houses will have small standard deviations; architect designed villas will have large standard deviations.
We could then move to a pricing rule where Mortgage Insurance will be required if (1) the LTV based on appraised value is greater than 80 percent or (2) there is a greater than five percent chance that the true value of the house implies an LTV of 95 percent…
We need to stop kidding ourselves that we can measure house prices precisely. We need to start measuring the level of imprecision.

Richard’s other idea is also a good one:

Appraisers should not be allowed to see the offer price of a house. This is the only way their valuation will be truly independent.

Appraisers use the contract sales price as an anchor point, where there is an anchor there’s a good chance there will be anchor bias.

Of course, back in the old days underwriters and review appraisers did this work themselves. Appraisers conclude a value, but they also report the raw comparable data. Generally, appraisers try to bracket a property by selecting some comparables worth less and some worth more. Part of the underwriter’s job was to look at these comparables and assess the implied uncertainty. For example, if the contract sales price and the appraiser’s concluded value was $400/sf and the comparables were all $350/sf or lower, you knew your value had a high degree of uncertainty.

Some CRE lenders still do this work, but I doubt it happens much on residential transactions. Richard’s suggestions are a good substitute.