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   ARTICLE   |   From Scotsman Guide Residential Edition   |   May 2013

How Do Distressed Properties Compare?

Learn how comparable sales work in distressed markets

How Do Distressed Properties Compare?

Although there have been numerous signs of improvement in the residential real estate arena, many areas of the market remain depressed. In fact, sales of distressed property accounted for 43 percent of total 2012 home sales, according to RealtyTrac.

Despite recent declines in foreclosure inventories, distressed properties remain prevalent in today’s market and likely will for some time. Because distressed properties make up a relatively large portion of recent home sales, appraisers often must consider these homes when examining comparable sales. Knowing more about how appraisers approach these situations can help mortgage brokers and originators successfully communicate with clients about the value of their homes — or future homes. 

Learn what you need to know to stop your apple of a deal from turning into a lemon.

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The term “comparable sales” — or comps — simply refers to other home sales that are most similar to the subject property in terms of their location, size, condition and other features that buyers and sellers believe make a difference to price. As many mortgage professionals already know, distressed assets generally are defined as properties that are owned by a lending institution, have been foreclosed on or are otherwise in a state of distress.

In a distressed market, many potential comparable sales are foreclosed properties or short sales. Some mortgage brokers and originators may have heard certain clients complain that their homes’ values have fallen recently because appraisers have used such sales as comparables, but it’s important to realize that comps — and the distressed market’s perceived effect on comps — aren’t always the culprit in this respect. With that in mind, it can be helpful for mortgage brokers and originators to understand how appraisers choose and analyze comparable sales. Likewise, it can be enlightening to familiarize yourself with some of the rules and regulations that appraisers must adhere to when undertaking their work.

Value and selection

When it comes to determining market value, most residential appraisal reports cite the definition from the Uniform Standards of Professional Appraisal Practice (USPAP): “The most probable price which a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus.” This definition goes on to state that a sale’s consummation and the property’s transfer of title will imply several conditions:

  • The buyer and the seller are typically motivated.
  • Both parties are well-informed or well-advised, and each is acting in its own best interest.
  • A reasonable time is allowed for exposure in the open market.
  • Payment is made in terms of cash in U.S. dollars or in terms of financial arrangements comparable thereto.
  • The price represents the normal consideration for the property sold unaffected by special or creative financing, or sales concessions granted by anyone associated with the sale.

To arrive at a credible opinion of market value that meets the conditions set forth in the definition, an appraiser must consider all relevant transactions that have occurred in the market area and then determine which of those should be used in the sales-comparison analysis. Ideal comps are ones that are most similar to the subject property in terms of size, location and condition, as well as those that meet the conditions set forth in the market-value definition being used.

Considering that, mortgage professionals should know that appraisers simply cannot rule out distressed sales, assuming that they meet all of these prerequisites. It can be useful, however, for brokers and originators to take a closer look at the exact processes that appraisers use when it comes to comps taking place in distressed markets.

Distressed sales as comps

Distressed sales — which include foreclosures and short sales — are relatively prevalent in depressed or declining markets. According to the National Association of Realtors (NAR), distressed sales accounted for about one third of all sales in 2011 and roughly one fourth of all sales in 2012. NAR also has argued that one reason for so-called “low” appraisals was appraisers not taking into account the difference between distressed and non-distressed homes when making comparisons.

It’s important, however, for mortgage professionals to realize one key concept: To a large extent, appraisers don’t set the values within a real estate market; they simply portray what’s happening in that market. In fact, the role that appraisers play could be considered like that of a mirror. Appraisals reflect a given market, and currently, many markets are depressed, as home prices have fallen far below the values of a few years ago. 

"To a large extent, appraisers don’t set the values within a real estate market; they simply portray what’s happening in that market."

Regardless, reliable and credible opinions of value can help to stabilize real estate loans and investments, promoting socially desirable real estate development. This is why, when working with appraisers, it’s important for mortgage brokers and bankers to be aware of the rules and standards that appraisers must follow when selecting comps to form their opinion of value.

Depending on the location and the severity of the regional market, distressed sales may make up some, many or even all of the sales that are available for comparison. In some markets today, it would be improper not to use those sales as comparables. For appraisers, however, the key lies in making proper adjustments.

As mentioned earlier, appraisers cannot completely disregard foreclosures and short sales as potential comps, particularly at a time when distressed sales are as common as they are in today’s market. That said, the conditions outlined in market value — as defined by USPAP — do establish market perspectives, and these generally fall into three categories:

  1. The relationship, knowledge and motivation of the parties (i.e., seller and buyer)
  2. The terms of sale (e.g., cash, cash equivalents or other terms)
  3. The conditions of sale (e.g., exposure in a competitive market for a reasonable time prior to sale)

Because of the conditions of sale and those previously mentioned, some distressed properties may not be acceptable as comps or may need adjustments if they are used. In short, mortgage brokers and originators can rest assured that appraisers investigate the circumstances of each potential comparable sale in any given market.

Adjustments may be necessary because of the condition of the property, sales concessions or atypical selling motivations, exposure time or the property’s marketing program.

For instance, a short sale or other sale prior to an impending foreclosure may have caused a highly motivated seller, resulting in atypical seller motivations. On the other hand, the sale of a bank-owned property may have involved typical motivations, so the fact that it was foreclosed on would not necessarily cause it to be considered ineligible as a comp. If that same foreclosed property was sold without marketing or was stigmatized for being a foreclosure, however, it may need to be adjusted as a comp. Adjustments also may be necessary for distressed properties sold in inferior conditions.

Taking these adjustments into consideration, mortgage brokers and bankers must realize that the condition of the region and the market affect the appraised value of a property — not an appraiser’s comps selection. An appraiser must analyze current local market conditions to determine if an adjustment is necessary when using a distressed sale as a comp, and if an adjustment is not necessary, the appraiser must explain the lack of any adjustment..

Due diligence

Mortgage professionals also should know that, because of the compliance standards appraisers must follow, the level of investigation needed to meet requirements for sufficient diligence generally is more intensive when dealing with distressed properties as comps than it is when dealing with non-distressed market circumstances. Supporting such adjustments can be particularly challenging when so few current transactions are available for analysis.

As directed by USPAP, appraisers must possess geographic and market-area competency when carrying out their appraisal assignments. An appraiser also must have sufficient understanding of local market conditions — including supply-and-demand factors relating to the specific property type — to make reasonable judgments about what factors influence value. In other words, qualified and competent appraisers with local market knowledge often are fully capable of using their experience and education to determine when and how to use distressed sales as comparables.

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It can be useful for mortgage originators to realize the full extent of the stringent requirements and processes that certified appraisers adhere to, as this may help originators reassure their clients about the credibility of a property’s appraised value. This sense of credibility is in the best interest of all parties involved in a transaction and ultimately can facilitate a smoother closing for the deal.


 


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