Bringing Value To The Property Appraisal Process
Originators and other market participants have developed alternative
means of valuation to supplement or replace full appraisals.
By Susan Kulakowski
Mortgage lenders traditionally have relied on the “three Cs”
of lending - credit, capacity and collateral - when approving or declining
a mortgage application. The accurate valuation of the third “C,”
collateral, is a crucial component in originating a mortgage.
Traditionally, a “full” appraisal is centered around an inspection
of the property, a comparison to similar properties in the vicinity that
have recently sold, and an understanding of current local market economics.
The purpose of this appraisal is to confirm the market value of the property,
which the lender uses to verify that the loan balance is permitted under
the applicable guidelines. In this way, the lender can fund the mortgage
with the expectation that the property is not overvalued and, should the
lender foreclose on the property, it can be sold without a loss.
For a purchase money mortgage, the buyer and the seller have already set
the “de facto” value of a property by agreeing to a purchase
price. Assuming that the sale of the property is an “arm’s length”
transaction between independent buyer and seller, the selling price usually
is the most accurate estimate of the “true value” of a home.
It is unusual for an appraisal to differ greatly from this sales price
(although somewhat more likely for properties that have atypical features
and/or are very expensive).
However, for non-purchase money mortgages, accurate appraisals become
much more difficult. With a refinance mortgage, for example, where there
is no confirmation of value by an independent buyer, the appraiser must
rely on the sales prices of recently sold, similar or “comparable”
properties, and recent sales trends in the local market.
This lack of an objective sales price increases the variance of the appraisal
and may result in a lower than anticipated sales price after foreclosure.
Risk is minimal for rate/term refinances, where the borrower is simply
refinancing an existing mortgage to obtain a better rate or term. However,
risk is much more pronounced with cash-out refinances, where the borrower
intends to take equity out of the property.
If the equity that the borrower takes out of his property has accumulated
through housing price appreciation, the lender faces the task of accurately
estimating that appreciation, absent an independent sales price and the
risk that the appreciation is overestimated.
In addition, the value of a property mortgaged as a cash-out refinance
to a borrower with a blemished credit history becomes much more important
because that property is more likely to become a real estate owned (REO)
property.
Finally, other origination guidelines may not require a full appraisal
or any appraisal at all. Under “125 mortgage” or “high
loan-to-value ratio (LTV) mortgage” programs, which require limited
or no equity from the borrower, a lender may rely on only the borrower’s
credit and capacity when approving or declining a mortgage application.
Because the lender is not relying on the property value in the event of
foreclosure, the expense of an appraisal may be too great to justify these
lending programs.
Supplementing appraisals
During the past several years, originators and other market participants,
such as mortgage insurers, have developed alternative means of valuation
to supplement or replace full appraisals.
Originators have done so because appraisals are not always appropriate
and because automated alternatives can provide more consistent, objective
results at a substantial cost savings over full appraisals.
In addition, the best automated systems provide not only a valuation for
the subject property, but also an indication of the “confidence”
of the valuation. This indication of the accuracy of the automated valuation
provides the originator with the likely range of values for the subject
property. It will be a narrow range when the model can provide a highly
accurate estimate and a wide range when the model cannot.
The three most commonly used valuation methods are:
- comparable sales analysis,
- “repeat sales” housing price indexing, and
- hedonic models.
Housing price indices match the recent sale of many properties to their prior sales and use the changes in the sale prices to calculate an index for the local market. This market index is then used to update the value of the subject property.
Hedonic models relate the characteristics of properties to their sale prices and assign a dollar value to those characteristics. Each of these techniques estimates the current value of the subject property. Especially in combination, these methods can provide estimates of value that are equally or more accurate than appraisals.
Of the three common valuation methods, comparable sales analysis most closely resembles the traditional appraisal.
Relying on comparables
An important component of the traditional appraisal is the documentation of the characteristics of the subject property, as well as the features of other recently sold properties that are physically close to the subject property and of similar age, characteristic, and condition.
The sales prices of these “comparables” support the appraiser’s opinion of the value of the subject property. In a similar fashion, comparable sales databases are culled to find properties similar to the subject property in age, characteristic, and condition.
Based on analysis of actual sales, the value of each characteristic is determined and applied to the subject property, providing a current estimate of the value of the subject property.
Comparable sales analysis can provide some benefits over traditional appraisals. First, if the database of recently sold properties and their sales prices is extensive, more comparables will be available for comparison.
Additionally, if the characteristic information on each property is exhaustive, comparables may be chosen more selectively, limiting the comparison to those properties that are most similar to the subject property.
Finally, when combined with indexing methods (discussed below), comparable sales models can use values from property sales more than several months old, expanding the universe of comparables from which to choose.
However, comparable sales models may be limited by the quality of the databases supporting them. If the databases are not extensive or accurate enough, it may be difficult to find appropriate comparison properties. In addition, because county records may not be updated immediately, input of new sales data into the databases will always lag actual sales, sometimes by six months or more. Finally, appraisers have knowledge of current market conditions and expectations of future developments that models do not have. Because appraisers can anticipate future market conditions, they may value properties differently than do the comparable sales models, which are limited to historical experience.
Repeat sales indexing
An essential form of statistical estimation of property values relies on a repeat sales methodology to create an index of the housing price trend in local markets. The repeat sales methodology matches the recent sale of a property to the sale of the same property sometime in the past and calculates the appreciation or depreciation from the prior sale to the recent sale.
With enough matched pairs, accurate indices of market appreciation can be charted at various geographic levels. The indices can then be used to “bring forward” the value of the subject property from the time of its last sale to the present.
The most important advantage that housing price indices provide is that they reflect the performance of the entire market. Because the indices are built using market data, they accurately track the broad trends of the entire market. These indices are also easy to use when evaluating an overall market and when valuations on individual properties are simple and inexpensive to obtain.
However, care must be exercised at several levels. First, the number of repeat sales must be large enough to form a statistically valid sample. Second, to create an index, the properties represented by those sales must be homogeneous. Third, the index should maintain at least three component indices that represent relatively expensive, average, and relatively inexpensive properties. This is particularly important because changes in property values in these three price tiers will not necessarily move in tandem. Also, different types of properties can follow different appreciation paths. In addition, indices may be less accurate in those non-disclosure states in which sales data may be more difficult to obtain.
Feature details
Hedonic models are the third commonly used valuation method. These models are built on property characteristic databases that contain detailed information about the features of each property, as well as each property’s sales price.
Regression analysis is performed to build a model that compares the monetary contribution of each property feature to the overall price of a property. Because homes with similar features generally bring similar prices, the relative value of features and, consequently the overall value of a property, can be accurately established.
In comparison to comparable sales and housing price index analysis, hedonic models are more flexible in estimating a value for unique combinations of features. For example, with a comparable sales approach, it is more difficult to estimate the value of a property with three bedrooms and two and one-half baths if there are no recent sales of properties with that combination of features. Because repeat sales indices generally distinguish properties at a gross level of detail (single-family versus condominium, for instance), it is not possible to identify unique combinations of characteristics for a particular type of property. In contrast, if given enough data, a hedonic model can estimate the value of that combination of features based on the values of three-bedroom and of two and one-half bath properties.
The automated valuation methods described provide several advantages over full appraisals. Not only are they more convenient and less expensive to lender and mortgagor but, if properly developed, are also statistically unbiased.
Powerful approach
The most powerful approach to property valuation combines the three automated approaches - comparable sales, housing price indices, and hedonic models - to obtain accurate, unbiased estimates of value.
None of these approaches is foolproof; all are limited by the quality and quantity of the available data, as well as the statistical skills of the model developers. Particularly in rapidly changing markets, the savvy appraiser brings an informed, current understanding of market developments to the appraisal process.
An automated process cannot easily duplicate that understanding. However, property valuation is a process that lends itself well to a statistical approach. Given the appropriate data and models, automated valuation systems can offer reliable and timely estimates of value at a lower cost than does the traditional full appraisal process.
Although few originators have moved to an entirely automated appraisal process, many use automated valuations for less risky mortgage applications and as part of a quality control review of appraisal quality.
For these purposes, automated valuation models provide less expensive, unbiased and potentially more accurate valuations, especially for non-purchase money mortgages. In addition, because the automated systems provide confidence measures, the lender receives a more balanced picture of the realistic range of a property’s true value.
Automated valuations may be less appropriate in those instances where the data are limited or unavailable, the property to be valued is unusual in some aspect, or significant improvements have been made to the property since its last sale.
In addition, full appraisals will provide more accurate valuations in rapidly changing markets because of the delay in data collection and because appraisers, knowing their markets, can react to changes far more quickly.
Kulakowski is a director in Fitch's residential mortgage
group, New York, where she is responsible for analytic and programming
support for the residential mortgage group.
This article was previously published in the September 2000 Issue of Secondary
Marketing Executive.
