Beyond The Silly Years

We’ve come through the real estate storm which I have called in these pages the “silly years”. We haven’t recovered, but clearly the storm is over. I sat in a committee of very smart people during those years, considering requests for development loans, each for millions of dollars.

Today, because too many of those loans have gone bad, that committee doesn’t feel so smart. The question we all have to ask is, “What went wrong”? Did we learn anything that will help us avoid the same outcome when the situation is presented again?

Certainly we learned that nobody, not mortgage company, bank, realtor, or investor, is satisfied with a little profit if there is hope of more. Chasing that greater profit, all the aggressive players were willing to take risks that they had no business taking. Like General Custer and his cavalry, the lesson is obvious, but too late coming.

Since this “more is better” attitude is so much a part of human nature, and is at the same time so destructive, not one of us “smart folks” should have needed a reminder. I once saw a picture of a python that tried to swallow a small pig. He couldn’t get the pig down, and he couldn’t get him out, and he eventually died of starvation. The same python that had eaten hundreds of small things found one bigger than he could swallow, and paid the price. There’s a lesson in that for all of us.

During the silly years most of us were not blinded to the possibility that the real estate values might very well be artificial. I was taken in by appraisals that told banks and purchasers that the values were real. In retrospect, we know that many of the appraisals were based purely upon “comparable sales, called “comps”, in the trade. To qualify as a comp, a sale merely had to be recent and similar.

Now we know that the comps were actually other sales at artificial prices, sometimes by design, and sometimes because of exploding “market” prices. Both the income approach to valuation (in which condo units could be valued by their income potential), and the cost approach (in which the cost to construct would be determinative), were diminished or disregarded in order to support escalated values based upon comparable sales.

The appraisals given during the silly years accommodated the industry. Unfortunately, if all real estate transactions are available on the internet, as they are, and if the only criteria for an appraisal is similar property sold recently, then all one needs to be an appraiser is a computer and an internet connection. In fact, if appraising is based purely on a statistical average, most of the ninth grade math class could be an appraiser.

The truth is that real estate appraising requires judgment. The industry pretends that there is no element of subjective opinion in appraising, and therefore, appraisers are like sorcerers whose methods are unknown and unknowable by the rest of the world.

I buy the opposite logic. I want an appraisal based not merely on the most recent sales, but upon the judgment of someone wise enough to understand when those sales are artificial or misleading. Today’s appraisals are often based upon short sale prices, foreclosure resales, or sales made under financial necessity. Those comps are no more useful to the subject of value than the comps we used four years ago. Often the appraisal results today are reactionary and skewed. They are just as wrong today as they were during the silly years, and for all the same reasons.

Those interested in purchasing in today’s market can use their own good sense about as reliably as they can use today’s appraisal. I continue to believe the cost to build is a fair place to begin the valuation of an improvement. In addition, one who buys a rental unit ought to be very concerned about its probable income stream. Recent similar sales will not reveal income stream, and only that information will determine value.

Buyers and sellers need not be fixed upon appraisal prices from four years ago, or many of the ones they see today. Appraisal reports should be tempered by the use of common sense, and the parties should not feel bound to follow a statistical model of current prices which the appraisal report so often represents.

Please do not understand my comments to say that all appraisals are bad or that appraisers are bad people. I do mean though to say that statistical appraisals made without the use of common sense give wrong information and should not dissuade one from acting in real estate.