Tuesday, November 24, 2009

House Appraisals: How They Get It Wrong

When we were making our ill-fated attempt to buy a house a couple of months ago, as part of our mortgage application process we had our target house appraised. The appraisal came in about $40K higher than the sale purchase price on which my wife and I agreed with the seller. How strange is that?

Unlike the stock market, where all transaction prices are immediately made known to the public at large, real estate is one of those inefficient markets, where prices are not immediately apparent. To add complexity, prices are very much location based, such that identical houses can fetch wildly different prices only a few miles from each other. In addition, months can pass between similar transactions in a close enough location. With all this in mind, a real estate appraisal strikes me more as black magic or art, than science. Yet, the appraiser provides a POINT appraisal. He doesn't say "the house is worth between 0.9X and 1.1X", he says, "the house is worth x". An exact dollar figure... pseudo-scientific accuracy... delightful.

Clearly the bank needs an appraisal to make sure that buyer and seller aren't in cahoots (yeah, I said it) to defraud the bank. Buyer and seller could, for example, agree on a much higher purchase price than the true market price and then take the money and run, leaving the bank to hold a crappy asset.

With all of that in mind, it seems to me that the best way to determine the market value of a house is to look at... the price the buyer and the seller have actually agreed upon. Our appraiser gave the house a value that was $40K above the agreed upon price. If this appraisal was true, would the seller have been willing to sell the house to us for a lower price? Wouldn't other buyers have come in to give a better offer? Clearly the seller agreed to take that price because he couldn't get anyone to bite at a higher price.

It seems to me that appraisers should focus primarily on two things: (i) is the sale an arms-length transaction, i.e. are the buyer and seller each truly trying to get the best price that they can for the house (each from their own perspective) or are there some unique circumstances (fraud, family connection etc.); and (ii) is there something that makes the property uniquely valuable to the buyer to make him willing to pay more than others would for the same house (e.g. maybe the house belonged to his great-grandfather). Unless something fishy is going on, the sale price IS the market value for the house.

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Edwin said...

I think the bursting of the housing bubble really highlights the issue with appraising house prices.

I don't know the specific formulas they use to come up with a houses value but clearly it is not accurate.

Anonymous said...

any opinions on the value/accuracy of using zillow.com and the like?

Shadox said...

Edwin - to be intellectually honest, I must admit that the real estate bubble actually makes the opposite case to mine: clearly the buyer and the seller agreed on a sale price, which was completely disconnected from the true economic value of the property. Of course, at that time, that WAS the market price, and then you have to ask yourself: did the appraisals actually help the banks or was this simply an expensive game of pretend...

Anon - My experience with these services has not been very good. Data about actual previous sales appears to be mostly correct, but estimates of current value and possible sales price (e.g. "Zestimate") have been way, way, waaay off. The best estimate of house values: go to some open houses and see what these houses sell for subsequently.

Edwin said...

Shadox - You are totally right, what was not accurate was the true economic value. The appraisals clearly did not calculate the true value. And as you say, this was the market price, but the flaw is assuming the markets reflect true value when they in fact don't.