Is It Right To Use Different Style Houses For Appraisals Real Estate Appraisal – Bring Back the Cost Approach

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Real Estate Appraisal – Bring Back the Cost Approach

In the last few years, there has been a trend towards a complete discounting of the cost approach to value when evaluating housing. For owner-occupied homes, the only technique now is comparative sales analysis, which involves selecting and comparing the sales of individual properties to the real estate.

Many lenders and government agencies no longer require the cost approach technique, even on new or near-new construction, and appraisers are often instructed to omit it entirely or not rely on the results. When a lender requires that a cost approach be completed, it appears that it is only so that the appropriate amount of homeowner’s insurance can be determined. This is of course a critical point for the lender as well as the homeowner, but should not be the only criterion for using cost and depreciation analysis.

Years ago, a cost-based approach was always required for a valuation report. The basis of this approach was the principle of substitution, which states that a prudent buyer will not pay more for a house than the purchase price of an equally desirable replacement house. Accordingly, the cost to reproduce or replace a new home sets the upper limit of possible value, especially for an existing second-hand home. So this analysis served not only as an additional means of assessing the value, but also as a regulator of sharp housing prices.

The cost approach also served an important function as a training tool for evaluators. To take this approach, the appraiser had to have at least a minimal knowledge of residential construction and carefully observe the quality and condition of the various components of the home. Cost data services that still exist today provide constantly updated information on the various costs of building a home, and some of them are quite accurate.

One service publishes a guide with lots of good data and information, as well as descriptions and photos that illustrate the differences in quality and appearance for different types of homes, which is a great way for novice or inexperienced appraisers to familiarize themselves with these characteristics. Lately I’ve come across reports from relatively new appraisers that didn’t use the cost approach and it was painfully obvious that the appraiser knew very little about construction or how to value the differences between their subject and the comparable sales they were using to compare sales Analysis. I suspect we have a new generation of appraisers who have this flaw, and that bodes poorly for the future. The best appraisers know the construction industry and can immediately tell the difference between the houses in terms of quality. This ability is also critical for a reviewer.

The spending approach is not without its drawbacks. The main weakness is in the assessment of depreciation, be it physical, functional or external in nature. These things are difficult to appraise, but again, an appraiser who learns to do so becomes more knowledgeable and competent in both cost comparison and sales comparison techniques. Another weakness is land valuation. Actual sales are often not available as a means of determining what buyers will pay for a similar lot, so market abstraction (also called foreclosure) is used to estimate the ratio of land value to home value based on market sales of already built homes. This technique, done incorrectly, is prone to serious errors. A general rule of thumb for the cost approach is that it is most accurate when the home is not very old and similar lots are available for sale nearby.

I believe most foreclosures are on relatively new homes and that’s where the biggest loan losses occur. At least that is the case in my local market, where there has always been a lot of new construction. There are many reasons for redemption, but of course one of them is to upgrade.

Builders usually offer different house models at “base” prices and offer upgrades to both the house and the lot. Buyers can choose from a wide variety of home improvement options and can select lots that vary in size or have more trees or other desirable aspects. That’s great for the buyer, but can be a nightmare for the lender when a foreclosure occurs, because many of these nice upgrades don’t hold their value in subsequent foreclosure sales, and often don’t hold their value as a distraught homeowner is desperate to sell the home. to avoid foreclosure.

The homeowner finds that they are “inverted,” meaning the home cannot be sold for the amount of the mortgage, especially if the down payment was very low or when financing costs were included (included) in the mortgage, necessitating an increase in the sale price. Another issue is the inflated cost of upgrades, with some builders charging upgrade prices well above the regular retail prices consumers pay, even with additional installation. This is similar to what many contractors (plumbers, auto mechanics, etc.) do because they want to make a profit on both “parts” and labor. The problem arises when the markup is excessive.

There is little an appraiser can do about upgrades when it can be shown that buyers often choose to upgrade their new home. In the absence of current resales or redemptions for comparison, it is not possible to estimate the resale value of upgrades, and the value is estimated as of this date, not into the future.

The cost approach has long served as a reasonable basis for market sales adjustments in line-by-line sales comparisons. If the house needed a new roof, the appraiser had a handy source for determining the cost of that. Ditto for appliances, HVAC equipment, garage, etc. Eliminating the cost approach and the good data it provides leaves too many appraisers guessing at these adjustments, and results can vary widely from appraiser to appraiser.

Once upon a time, houses were evaluated only by the cost approach. Sales benchmarking (formerly known as the market approach) came later. I don’t think it’s a coincidence that the rate of foreclosures and personal bankruptcies caused by unaffordable mortgages and high home prices seem to have increased so much in recent years, while the use of the expense approach has decreased at the same time. I don’t think it’s a coincidence that the de-emphasis on costs minus depreciation started around the same time that a huge influx of capital into the market encouraged a variety of easy-money credit schemes that allowed so many people to buy homes that they couldn’t and that caused a serious damage not only to the US economy, but also to the entire world. Mountains of money in debt, as a rule, push aside caution.

I believe that sales benchmarking is certainly a good valuation technique, but its downside is that market participants have too many clever ways to inject hidden costs, fees, and even fraud into sales contracts that silently creep into the market. data. services and evaluation reports. The same can be true for undisclosed costs, such as a loan discounting fee paid by the seller and other funds paid for the buyer’s closing costs. At a minimum, an accurate value approach serves as a useful check on the results of even the most thorough and detailed comparative sales analysis when the appraiser carefully searches for and analyzes such things. Unwanted things can and do happen in real estate, and some of them can slip past even the best sales benchmarks because they happen quietly and gradually.

An example of this is what I call terminal costing. The real estate agent provides the seller with a pricing analysis, where the agent finds the 20 most recent sales of similar homes in the area and averages the prices to arrive at a figure he or she thinks is right for the home. The house is then sold at that price. Along comes a cash-strapped buyer (perhaps from a higher-priced market) who needs help with his closing costs and is making an offer at or very close to asking price. The seller responds with an offer in which he adds to the price the amount of assistance requested by the buyer.

But what if this type of assistance turns out to be normal for the region and is already reflected in the sale prices of the 20 homes used to set the asking price? The new sale closes at an upwardly adjusted price and is then used as a “comp” by other agents and appraisers, and the process continues with each re-emergence of a needy buyer, causing home prices to rise, affordability to decline, creating new needy buyers and causing a snowball effect. bullets, when prices will eventually rise to the point where they will exceed even the cost of a new one. It’s not much different than earning interest on your savings account. Over time, your balance grows faster and faster. Combine that with other inflationary market trends and you have a nasty bubble that will one day burst at the peril of us all…again.

Obviously, this could be avoided by competent sales agents who realize that those 20 sales have already involved big seller costs and inform their clients of this, but many don’t, and there is a built-in incentive to raise prices as high as possible among people who work over the commission. An accurate value approach would tend to detect this anomaly immediately, or at least reduce its impact on future sales, because when home prices begin to exceed the cost of building an equally desirable replacement home, brand new, a competent appraiser knows something is wrong and that they need dig deeper into market data.

The value approach is also a great lie detector for fraud. If the estimator has included a cost approach and uses a known cost source or guide that others can subscribe to or review, then the estimated costs shown in the estimate can be reproduced from the same source by those viewing the report. So, if the appraiser got the value wrong, it can be discovered simply by examining the source of the value and the parameters the appraiser described. Moreover, even if the appraiser has shown the correct costs, a fraudulently inflated appraisal will show an overestimated land value in a cost approach with little or no evidence of where the land value estimate comes from or why it is so high. In a fraudulent valuation, the cost approach is “plugged in” with numbers that match the sales benchmark. This is because an honest approach to value would indicate a much lower home value.

There are other examples of how a cost-effective approach can eliminate or reduce skyrocketing house prices and even detect fraud. I believe it is a silly mistake to discourage or encourage the non-use of any type of analysis or tool from appraisers based on market data. An analyst in any field of research must be willing and able to use as many ways of looking at a problem as possible. Focusing on just one method encourages tunnel vision. What I’m saying is to bring back the cost-based approach and let appraisers decide how useful and accurate it is on a case-by-case basis. It’s not a blanket solution, but it’s a valuable tool worth considering.

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