A Guaranteed Way to Halt Home Value Declines

Posted on March 14, 2009

There’s been a lot of talk lately about reforming Mark to Market valuation policies in securities markets. The theory behind the proposal is that Mark to Market reflects market fears and expectations in security valuation and not necessarily the book value or likely performance of the securities. It’s a proposal that seems to be gaining traction on Wall Street and in Washington because business- and policy-makers are clamoring for something to put a floor on stock prices.

As a Real Estate consultant, I propose something similar for real estate valuation. My proposal will put an immediate halt to home-value declines and will likely stop the free-fall in Bank stocks and the devaluation of derivatives and mortgage backed securities that caused all this mess to begin with.

My proposal is that we end the Mark to Market approach to real estate valuation. “Is there such a thing,” you ask? Of course there is – it’s called the Comparable Sales approach. This approach – the only standard of residential real estate valuation approved by the Uniform Standards of Professional Appraisal Practice (USPAP) – states that residential real estate should be valued almost solely by Comparable Sales, or “comps”. In practice, this means that if your neighbor sold a home that is similar in size, function and location to yours, your home’s market value is roughly the same as your neighbor’s.

The problem with the Comparable Sales approach to real estate valuation is the same problem that so many have to the Mark to Market approach in securities valuation. The Comparable Sales approach in today’s market considers the price of foreclosed homes on par with conventional sales. This – just like securities valuation – reflects market fears, expectations and the out-of-control dumping of foreclosed homes on the market by Lenders, and not necessarily the actual value of the property in question.

This is problematic for a host of reasons. In an up-market, the Comparable Sales approach allows irrational exuberance to bid-up the price of real estate. It claims that your property is increasing in value solely because your neighbor was able to sell his similar home for more than you paid for yours. In a down market, the method forces down values solely because a bank foreclosed on your neighbor and the sold the home for pennies on the dollar. Neither outcome accounts for the intrinsic (or book) value of the home. In fact, the entire theory relies on the premise that the market always acts in a reasonable fashion and run-ups and run-downs in price are because the home is appreciating or depreciating rationally.  If the events of the last 5 years taught us anything, it’s that expectations of rational behavior from the market are themselves irrational.

“What other approach could we take to real estate valuation”, you ask. The Replacement Cost Estimator, is one. This measure of value is commonly used by your insurance company in estimating an appropriate amount of insurance coverage for you to have on your property. Regardless of what you paid for your home, your Insurance Company values your property at what it will cost to replace the home should it burn to the ground – a much truer reflection of the value of your property than what you paid for it, according to them.

Here in Tampa Bay, Replacement Cost is rarely less than $120/sq.ft. So if you purchase a 1,000 sq.ft home, you shouldn’t expect your Replacement Cost estimator to come in much below $120,000. Let’s say you find a 1,000 sq.ft foreclosed home for $50,000. The Comparable Sales (Mark to Market) approach will likely value this bargain home – and all similar homes within a two mile radius – at $50,000. The Replacement Cost approach will estimate value much higher.

Policy makers seem oh-so-eager to make changes to Wall Street that will prevent what has transpired in the markets over the last 6 months from reoccurring. Yet it is what happened on Main Street that started this downward cycle. One way to ensure that nothing like this happens again is to implement a valuation methodology for real estate that can’t be manipulated by extra-market forces. If Mark to Market isn’t right for securities in today’s market, perhaps it’s wrong for real estate too. So while we’re rewriting the rules by which we value securities, let’s take a close look at the way we value real estate. If we change one, shouldn’t we change the other? Real Estate is, after all, the commodity that precipitated the market decline in the first place.

***

The author, Peter Murphy, is Co-Founder and Head Broker at Home Encounter, a Tampa-based real estate Consultancy with specialties in Residential & Rental Properties, Investment Real Estate, Property Management and Land & Commercial Properties. Murphy’s analysis of the Tampa Bay housing market is featured extensively in local media and in trade publications, including the St. Petersburg Times, the Tampa Tribune, the Tampa Bay Business Journal, the Lakeland Ledger, and the Orlando Sentinel. He has appeared on ABC Action News and Bay News 9 for his reporting on significant local developments in the real estate market. He is a regular contributor to Fox’s 970 WFLA news broadcasts and is a guest panelist on Fox 13s “Your Turn”, where he consults on local and national real estate market issues. Murphy has a B.S. in Economics from the University of South Florida and an MBA with an emphasis in Finance, Economics and Marketing from the University of South Florida School of Business. He resides in Tampa with his wife and child.