Way Over Priced or What a Great Value

by PJ Grube | January 17th, 2011

The Great Calamity and Pricing of Real Estate

How did we get here?

That property is way too high! That one is a bargain! How do we know what ‘Fair Market Value’ is?

Right at the moment, cash is king. Because the banks are not lending, a buyer with the cash is in the drivers seat. The seller that needs to sell will take less to make the sale. This substantial feature drives the value of any asset. Who has the money? During this financial crisis, only those with creative transactions, seller financing, cash and the very best credit scores have been able to buy.

Financing provides an increase in purchasing power while at the same time it increases demand and value. As this crisis has shown, financing availability drove valuations, up, up, and away. Unlimited, un-restricted lending practice (and a little bank fraud) gave us run-away values, with so many dollars chasing so few properties. The bidding wars turned into the greater fools theory of value.

Not surprising we have experienced the highest percentage of home ownership in the nation’s history. However, it is doubtful we can hold that number or break that record anytime soon.

‘Fair Market Value’ infers stability. Moreover, stability is breed by long-term reasonable and consistent practice. These abnormal and unique market circumstances are anything but fair, stable or ethical.

The IRS defines fair market value as, ‘The price at which property would change hands between a willing buyer and a willing seller, neither having to buy or sell, and both having reasonable knowledge of all the relevant facts.’

Racing values over the past decades have come about through modern day credit schemes and deregulation. Lending expansion, demand for more loan fees and development of more lenient loan products, ultimately fed, misused and defrauded the ‘derivatives markets.’

Ironically, these same ‘derivatives markets’ will be use to bring us out of our current difficulties. The “Troubled Assets Relief Program” (TARP) will capitalize the original culprits in these schemes to re-package and reshuffle these troubled assets into new investment instruments that will then be re-valued and re-sold to investors creating additional fees and profits while the taxpayers experience foreclosures, bankruptcies and  lack of capitalization. If we didn’t capitalize the banks they wouldn’t have survived, if we don’t capitalize the people neither will they. After all Capitalism requires availability of capital.

How did this all start?

Track-homes of the fifties had two-foot wide clothes closet. Just enough room for a ‘marrying and burying’ suit, some collared shirts and that ‘out-on-the-town’ dress. Who would need anything more? Who could afford anything more? Everyone paid cash. Remember grandpa saying, ‘If you can’t afford it, don’t buy it.’ or ‘Pay that house off.’

In 1958, Bank of America came to the rescue by making available freely accessible un-secured credit. The advent of this new signature credit was in the form of the first revolving credit card (BankAmericard). The ever-expanding credit brought us the larger closets of today.

I remember in the 70’s, real estate agents would joke, “This home comes with a master bed closet big enough to park your Volkswagen Bug.” An interesting analysis of the suburbia phenomenon is the movie “End of Suburbia” by Gregory Greene.

Buyers had more dollars available than ever before to spend and that spending created jobs. More jobs came more income and more spending. The 60’s revolution also led to the creation of the ‘Two Income Family.’ Forget ‘ban the bra’, here comes the pantsuit. That’s right, momma’s going to work.

Other benefits of these new suburban neighborhoods were, and still are, the advent of the  shopping mall. Eastridge Shopping Center in San Jose, CA, was the state of the art in 1970. All of these developments were not just a revolution in spending and spending habits, they were the credit and bonding of credit coming of age.

The demand for new financing instruments and bonding of debt created the demand for Banking deregulation and competition with other financial institutions. These non-bank competitors began amassing large deposits by offering higher interest rates through money markets and mutual funds. Brokerage houses became very popular operating more like banks offering checking and new ATM services on their money market accounts. These activities led to the collapse of many banks and to further deregulation in the 80’s. (“Now and Then” with Dick Kovacevich: Leadership in a Time of Financial Crisis 10/21/08 http://www.commonwealthclub.org/)

The creation of FNMA and later FMAC was an effort to increase and broaden home ownership, addressing some of the inequities of home financing markets (such as ‘Red Lining’ – the practice of denying financing and other services, in curtain neighborhoods, typically racially based decisions). Standardization and blindfolding of loan applications, eliminating racial bias, spread the perceived risk across large numbers of bundled loans. FNMA and FMAC were very instrumental in increasing home mortgage availability by buying up these bundled mortgage loan packages from banks, creating mortgage backed security funds and selling stock in the funds. So successful was the government insured venture in raising capital to buy more mortgage backed securities the private sector brokerage firms began to do the same. This non-bank competition, increased insurability, the expansion of derivatives market, the advent of new and sophisticated computing technologies and resulting bank consolidations, all converged to create the disaster we are experiencing today.

Seeking to profit on the seeming ever increasing real estate values, borrowers demanded and lenders provided ever more liberal and lenient financing. People were living off the re-re-re-finance of over inflated and unsustainable values. They were living like millionaires in a spending frenzy fantasy. The intoxicating heights, of which, had a disastrous and predictable end.

The Cataclysmic Collapse

The peak of the real estate market was probably best signaled by the efforts of real estate agents. In a desire to obtain greater sales, agents employed such practices as smudging, feng shui, burying religious statues on properties for sale and placing  pictures of religious figures in their real estate listing files.

In addition, the crunch has culminated in raffling and auctioning properties to the highest bidder. You can buy blocks of foreclosed or bank owned homes for dimes on the dollar. Seminars abound on short sales, auction methods and foreclosure lists. Desperate sellers paying additional thousands to would-be mortgage saviors who provided little more information than what was being offered by the confused and chaotic banking system itself. Of course, much of this activity  was hyperbole, created by quick buck, short sighted, charlatans. You name it, scammers have come up with it. These extraordinary activities created an even more desperate and chaotic market.

The false economy and inflated values that were generated by an unregulated ‘free credit’ lending practice has now given us a new false economy of deflated values. The flood of foreclosures and bank owned properties entering the market place has place an undue burden on the rational market. They are lowering the median price and creating unfair competition. For the banks, remuneration comes in other forms than strictly sales price. They not only have to sell, they have incentive to sell, at any price, and receive recapitalization funds from the federal government. These additional benefits are not factored into the market data and create a false impression of “Fair Market Value.”

What is the Fair Market Value?

The real estate industry has formulas and standards to determine real value. Collectively and appropriately applied these standards represent the best shot at ‘Fair Market Value.’

The question of value is best answered by the tried and true principle of ‘Highest and Best Use.’

Highest value is directly related to, the most reasonable and probable use of the property, which may not be the current use.

The economic concepts of utility and substitution help create the ‘Highest and Best Use’ valuation. This ‘Highest and Best Use’ principle determines the properties utility to a Buyer.

The Buyer will pay no more than that of competing properties with the same utility. A Seller will accept no less than what Sellers of comparable properties will sell for in the same neighborhood.

In addition, the use must be legally,  physically and financially feasible, creating the greatest productivity possible.

As a list, it looks like this:

  • A willing Seller and willing Buyer
  • Who buy/sell freely, unencumbered and under no duress, neither having to buy or sell
  • Both able to consummate the sale
  • With usual and ordinary circumstances
  • Having exposed the property to the broadest open market for a reasonable time
  • Providing both Buyer and Seller have full knowledge of the property’s legal use and purpose with a reasonable understanding of the material facts
  • And of course, able to pay cash or its equivalence (the availability of financing)

Many factors lead to the proper valuation of real estate including the property location, age, lot size, condition, local market demand, and financing.

Do we really have that kind of market place today? Is there ‘No duress’? What is cash or equivalent today? Are these ‘usual and ordinary circumstances?

Cash or equivalent is hard if there is no cash. Driven by little financing availability, a property in this market, is worthless if the banks wont loan money. An example of this situation from years back are units in an apartment coop on the westside of Santa Cruz that regularly sold for 50 to 70% less than other like units because banks would not finance ‘apartment coop’ purchases. At some point a lender started to lend on these individual units (selling the loans into the derivatives market) and the values in that complex shot up substantially.

People who have little cash still may qualify for financing. When banks are unwilling to lend, lack of financing puts a downward pressure on values. This is the crunch today; we still have lots of Buyers and Sellers, however, there is little cash, no financing and diminished belief in the values.

With no duress? To say there is no duress in this market is to re-define the word. Like when the Bush Administration redefined torture. Is this really duress? Or is it actually just stress? “Let’s do a stress test.” Raise your monthly house payment to that, equal to your entire salary; or try to refinance when there is no financing; or lose your job; or face a balloon payment of the entire loan amount; isn’t that really duress?

The unusual and extraordinary circumstances that are currently defining our market are actually creating conditions of duress.

Brokers generally provide “competitive market analysis” commonly referred to as a CMA. They typically compare your property with recent sales of other like properties in the same neighborhood. They may also show properties that did not sell and properties that are for sale now, ‘your competition.’

Each broker is different and will produce differing valuations from different resources, so it’s important to know how the valuation is obtained. Obtaining at least three opinions is a good idea and a comparison of the opinions will create a range of values that provides a greater since of reality.

CMA’s are not appraisals. Appraisers are independent, separately licensed, third party entities, with the specific purpose of appraising and require a fee.

Establishing the market value is highly important. A property priced inappropriately, may languish on the market or sell so quickly the question of ‘full value’ arises. Did all possible Buyers have a chance to buy?

Additional tips:

  • provide the needed financing
  • expand the properties market exposure
  • price the property to the market
  • lower price to reflect current neighborhood sales of  like properties
  • clean out the obtrusive clutter
  • provide reports that answer Buyer questions
  • provide rational for value
  • remove the decaying rat from the wall

Originally posted February 10th, 2009

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