At some point in time all markets shift, right?
While it may have seemed like the bull run we have experienced in the real estate market over the last few years would last forever, the reality is that it can’t.
Whether it happens now, or sometime soon, we are due for a real estate pullback in many markets across the country.
Home prices have outpaced salaries in many markets, and many buyers are feeling more and more like they can’t afford the house they want or need.
This is due to a number of factors including low inventory levels, low interest rates (up until recently), and the presence of large numbers of investors who are buying up homes that typically would have been purchased by owner-occupants.
Thanks to this we have seen multiple offer scenarios with large appraisal gaps and a number of other ridiculous promises being made by buyers, in hopes that it will allow them to win the contract for the home.
The reality is, a market like this can’t keep going forever. There has to be a crash or pullback at some point. We know that.
What we don’t know is how big that crash or pullback will be.
Will it be 10%?
During the Great Recession, between 2007 and 2009, we saw home values drop by 1/3 for the average home here in the United States.
While there are many things that are extremely different in the real estate market now as compared to then, and a crash of that size seems unlikely at this point, it’s important to realize that none of us have a crystal ball.
Since we can’t see into the future, the best thing we can do is to analyze the market at its current time and value homes accordingly.
But that’s easier said than done, right?
In this post we are going to talk about the three most important things you need to consider when valuing homes as the market shifts.
Select the Best Comparables
Regardless of what is happening in the market at any given time the most important thing you can do is pick the best comparables available. While that is easier in some cases than others, there are three types of criteria you need to look for to select the best comps:
- Time of Sale
- Physical Characteristics
Ideally, every comp you pick would be extremely similar to your subject property in each of these three categories.
Unfortunately, that’s not always possible.
However, the more similar the comps are, the less adjustments that have to be made, and the more confident you can be with your value estimate.
Most times people only think of comps being similar in regard to the physical characteristics, which makes sense as these are the visible aspects of the home that the buyers and sellers are most likely to focus on.
The good news is that even if a home is slightly different, adjustments can be made for physical characteristics.
Does the subject property have more square footage than the comp? No problem. You can adjust for that.
The same is true for other features such as a fireplace, central a/c, a wet bar, walkout basement, stucco exterior, tile roof, decks, patios, etc.
There are a number of ways to calculate these types of adjustments. You can read more about the method we recommend here.
So hopefully by now, it’s obvious that we need the most similar overall comps, right? But what happens when there are no comps – or enough comps – that are similar to the subject property that sold recently in a similar location?
Sometimes, to pick a comp that is similar in physical characteristics, you may have to go to a less similar time of sale or a less similar location. And while that may not be ideal, it may still be one of the better comps that you can pick.
We can easily calculate adjustments that are needed for the time of sale, and even for location – although they can be a bit tougher, and then we can confirm these adjustments by comparing the resulting adjusted sales price of the comparable to other comps that did not require the same adjustment.
Here is an example:
Let’s say we find a comp that is extremely similar to our subject but it sold 6 months ago, but we are also able to find one that is equally similar that sold this month, we can make a time adjustment to the older sale – based on a calculated market trend time adjustment – and compare it to the adjusted price of the more recent sale that did not require a time adjustment or at least a much smaller time adjustment.
If the adjusted values of these sales now fall closely in line with each other, we have confirmed the time adjustment that was made. If not, it shows us whether we need to increase or decrease the time adjustment to help them fall more closely in line with each other.
Note: It is unlikely that the values fall directly in line with each other. Especially when this adjustment is applied to multiple comps. You ideally want to find the time adjustment that brings all the comps most closely in line with each other, and therefore it may underestimate the increase/decrease on one comp and overestimate it slightly on another.
Location adjustments can be the hardest to estimate and may require additional analysis of other paired sales to fully highlight the needed adjustments. For this reason, it is easier to try to find homes that fall into the first two criteria, but at times you may have to go to a less similar overall area to find a similar home.
Let’s look at an example of how to calculate a location adjustment:
If you have a comp that is from the location of the subject and is similar, and also a comp that is not from the location of the subject but is also a similar home, you can make all other adjustments for physical characteristics, as well as time adjustments, and the resulting value difference between the two comps would represent the location difference.
So, if your comp from the subjects’ area is adjusting to $505,000 and the comparable from the less similar location is adjusting to $525,000, we can see that the location difference was likely $20,000 and this adjustment could be applied to bring the comps more in line with each other.
That’s a simple example though…
What happens if there are no good comps in your location, and the only similar comp is from a less similar area?
In this case, the best way to approach it is to identify 2 or 3 paired sales (they don’t even have to be similar homes) where one comp in the pair is in the location of the subject, and the other comp is in the location of the less similar area comp you are wanting to use.
You can then make adjustments to one comp in the pair to ideally bring them in line with the other comp in the pair for everything other than the location. The resulting value difference is the approximate location value.
Do this for 2 or 3 pairs, and then take the average % difference and apply it to your comps.
Let’s say pair one shows a 5% premium for the further away location, pair two shows an 8% premium, and pair three shows a 3% premium. In this case, the average premium would be 5.33% for that location.
If we take this and apply it to our example from above, we would need to make a $28,000 adjustment for the difference in location.
While this method is not the preferred method, it is potentially your only choice if there are no similar comps in your subject’s area.
Analyzing the Market Trends
Analyzing market trends and determining required time adjustments is most likely the most important analysis you can do when pricing a property, and it becomes even more important in a shifting market.
The most common thing you’ll hear cited is how much the market is increasing or decreasing.
Terms like “the market is up 18% this year” are commonly thrown around in real estate.
Assuming that the trend is consistent and unchanging, this kind of statistic can work out alright. But as the market begins to change and home prices start moving in the opposite direction, or even when the trend breaks and the increasing percentage or decreasing percentage either becomes higher or lower than it has been, it highlights the importance of a more in-depth analysis.
So how do you do this?
We believe that the best way to do this is to run a trend analysis on 3-month, 6-month, and 12-month time periods. This allows you to see what is happening with prices in shorter time frames while still taking the overall trend into consideration.
For example, let’s say that the year-over-year statistics being quoted in your market say that home prices have increased 18% over the past year, but the market is now appearing to decline. What kind of time adjustment should you make?
Do you still use the 18%?
Do you use a decreasing percentage?
Well…. it depends.
It depends on when your comps were sold.
Did they all sell in the last month? Are they mainly from the last 3 months? Or maybe the last 6?
When the market begins to shift it is likely that you will still need to give comps an increasing time adjustment.
Why is that?
Because it is likely that your comps sold when the market was still increasing. And while the time adjustment may need to be less than it would have been a few months ago, it may still need to be a positive adjustment.
Let’s say that your comps were mainly from 4 to 6 months ago, you may not need the 18% adjustment that the year-over-year type analysis shows, but you may still need a 10% or 12% adjustment.
Or maybe the shift means that the market is back down to the median price level of those comps (it increased after they sold but has now decreased back to that level) and therefore no adjustment is needed at all.
If you simply look at the year-over-year type statistics that are published you won’t be able to identify this.
This is why we recommend analyzing the time trends broken down into smaller increments.
This will also help you to be able to identify if – and when – time adjustments need to start changing from increasing to decreasing.
Understanding the Difference Between Appraisal & Market Value
While the goal of any appraisal or valuation is to determine the market value of the property, as we have talked about before, at times these two values may be different.
In a rapidly increasing market, like the one we have experienced over the last few years, it is likely that the market value may be higher than the appraisal value, meaning that you are likely to be able to obtain a buyer at a higher price than can be supported by the appraisal. While this is a problem, it is one that can potentially be overcome by requiring an appraisal gap – or offering one as a buyer.
But how do things change when the market shifts?
The difference between these two values tend to flip-flop, and as the market begins to decrease you are actually more likely to be able to get a home appraised for a value that is more than you may be able to get a contract for.
This is due to the fact that an appraisal is based on past data, and even though a time adjustment can be used to account for the market changes, it can only estimate those changes to a certain extent (obviously the better the analysis, the more fully this can be estimated).
So what does this mean for pricing a home as the market shifts?
It means that not only do you need to estimate the appraisal value as best as possible (by picking comps, making adjustments, and estimating the likely opinion of value), you also need to take other factors into consideration much more than you have in the past. Things such as the number of comparable properties currently listed for sale, the average days on market, list-to-sale price ratios, and other overall market factors may affect the willingness of a buyer to make an offer that matches the potential appraisal value.
Here is an example:
Let’s say you have a home that sold comparables would dictate could sell for $500,000 (after adjustments have been made to those comps) but there are currently 10 other comps listed in the market, with many of them being between $485,000 and $495,000, with a current list-to-sale price ratio of 98%.
In this case, you are unlikely to be able to list for $500,000 and actually get a contract, right?
Even though the sold comps show a value of $500,000, the listings would indicate that the value is likely between $475,000 and $485,000. And maybe even lower than that if all of those listings are not yet under contract and therefore may be listed for more than the market is willing to pay.
Nobody wants to overprice a home and watch it sit on the market requiring price reduction after price reduction. And while it is always important to do the best job possible estimating the value of a property before putting it on the market, as the market shifts it will become even more important than ever before.
I would encourage you to take the time to do a full valuation analysis on every property you list or write an offer on, to make sure you have the best picture of value possible.
There are a number of ways to do this.
You can break down the numbers on a piece of paper, you can put it in excel and run your own formulas, you can use a CMA tool through your MLS and make some of the bigger adjustments at least, or you can use a tool like Comp Adjuster to do the full analysis quickly and easily.
Regardless of which route you choose to go, I just hope you use one.
Whether the market shift has already started, or whether it takes another year or more to happen, the better you can get at property valuation the better (and easier) your job will be when it happens.