Soon it will be possible for civilians to travel to space for pleasure. While that sounds awesome, is it probable that many will take the trip in the near future? How probable is it that the majority will be willing and able to pony up the tens of thousands of dollars needed to purchase a ticket for the ride? Just because something is possible doesn’t make it probable. How does that translate to real estate?
POSSIBLE & MOST PROBABLE
When appraising a home, an appraiser is estimating the market value of a home. On most appraisals you will find a definition of what market value means. On page 4 of the Fannie Mae Form 1004 March 2005 form, a definition of market value is stated. It states that market value is "The most probable price which a property should bring in a competitive and open market under all conditions requisite to be a fair sale, the buyer and seller, each acting prudently, knowledgably and assuming the price is not affected by undue stimulus. Implicit in this definition is the consummation of a sale as a specified date and the passing of title from seller to buyer under the conditions whereby: (1) buyer and seller are typically motivated; (2) both parties are well informed or well advised, and each acting in what or she considers his or her own best interest; (3) a reasonable time is allowed for exposure in the open market; (4) payment is made in terms of cash in U.S. dollars or in terms of financial arrangements comparable thereto; (5) the price represents the normal consideration for the property sold unaffected by special or creative financing or sales concessions granted by someone associated with the sale."
Let's think about the term market. One or two people do not necessarily reflect the market. The market is made up of hundreds even thousands of people. So when estimating market value, the appraiser has to consider what the typical buyer's reaction is. Not just that of one or two individuals. That's why an appraiser will use at least three comparable sales in the report. Those three sales are generally not the only sales considered.
In determining what is a possible value, the appraiser analyzes a larger pool of potentially comparable sales and then chooses what they feel to be the most comparable sales that fall under the definition of market value. The search will provide the appraiser with relatively comparable sales that sold for the lowest and the highest price, and all of the sales in between. This is called the range. This establishes what is the possible value of the subject. But according to the definition of market value, the appraiser is looking for not just what is possible. The appraiser is trying to determine what is most probable. That narrows down what comparable sales are reflective of the market. Typically, the very highest and very lowest sales are not reflective of the market value of a property. In real estate we call those outliers.
In my experience, many people tend to gravitate to the outliers as indicators of the market value of their home. Why? It's because they are more focused on what is possible rather than what is most probable. That is because they are not disinterested parties. For instance, in a divorce, one party might want the appraisal to come in high and the opposing party may want it to come in low. When a person wants to lower their taxes, they want the appraisal to come in low. When they are selling their home, they want it to come in high. A good appraiser will estimate the market value as a disinterested party who is not influenced by the client's desired value or any other agenda. Because of that, sometimes the appraised value does not match up with the anticipated value of the client and/or intended user.
There is a popular misconception that the agreed upon sales price, by two market participants, is market value. That is market price, not market value. There is a difference in the meaning of the two terms. Market value can be the same as the market price. But, not always! I think that many people feel as though the appraiser is the person who is hired to simply justify or support whatever purchase price has already been agreed upon. This is not true. Sometimes, when my estimated market value is lower than what my client anticipates, they may ask why I didn't use a particular sale that may have sold much higher, or in some cases much lower, than the majority of the comparable sales in the neighborhood. Usually the reason is that sale may not be reflective of the most probable sales price of their home in that market.
PROBABILITY IS NOT ROCKET SCIENCE
My oldest son is in the 10th grade and just finished studying the principles of probability in his math class. Understanding probability is not rock science. It's really pretty easy to understand. What does it mean to be probable? To be probable means that there is a strong likelihood or chance of something happening. To be most probable is even more specific.
For an example, if a person was to sell their home 10 times on the same day, what is the price it would sell for most of the time? That is the most probable price and is reflective of its market value.
Think of it another way. Say there are five comparable sales that all recently sold in the neighborhood of the property being appraised. They all offer the same condition, upgrades, gross living area, room counts and so on. One sold for $300K. Three sold for $350K and one sold for $450K. What is the most probable sales price of the home going to be? It's clear that it is $350K since that is what 3 of the 5 homes sold for. (I realize that this is probably over-simplifying the situation. However, the principal is applicable) Why would someone pay $450K for that home when they could buy it for $350? And yet, this seems to be going on everywhere right now. Many people are willing to pay more than market value for some homes. Why? One reason may be that some people in our current market are feeling the pressure to buy because of the current shortage of inventory. When we think about the definition of market value, a buyer that feels the pressure to pay a price that is higher than the market value may succeed in buying that home. But that sale is likely not a sale that is reflective of the market value based upon the definition. If a person is willing to spend more than market value for a home, is that wise? Is that using sound judgement? Are they really acting in their own best interest? When considering comparable sales, those sales that are outliers may be more reflective of someone who does not reflect the typical buyer. Therefore, that sale may not be a good reflection of market value.
WHEN AN OUTLIER MAY BE AN INDICATOR
Are there ever times when an outlier may be a better indicator of the most probable sales price of a property? Yes. For instance, a property may have a unique amenity, location or view that may demand the upper end of the sales price range. An appraiser has to be able to prove that this is the case by the use of other comparable sales. Or a property may be in poor condition. In this case, the most probable sale price may be at the lower or bottom end of the range. The comparable sales must still meet the definition of market value in order to be reliable indicators of market value. However, generally speaking, the market value of a property is not reflected by the very highest sale price nor the very lowest. Sometimes, home owners feel like their home offers an amenity that makes their home worth more than others. That can be true, but often it does not translate into a much higher value.
APPRAISALS THAT COME IN EXACTLY AT THE SALES PRICE
Sometimes my value estimate is exactly what the sales price is. However, usually it is not. It is usually higher or lower. Even if by just a relatively small amount. There are two schools of thought on this. Some appraiser's feel that if the sales price is supportable and the comparable sales adjust to within a close range of the purchase price, and the adjusted sales prices bracket the purchase price, they just come in right at the purchase price. I think an appraiser can make a good argument in doing so in some cases. However, when thinking about probability, what is the probability that the market value is exactly what the purchase price is every time? Even if the purchase price is supportable? When I do the math and complete my analysis, the number I arrive at is typically not exactly the same as the purchase price, even if it is close. If an appraiser's opinion of value is always exactly what the purchase price is (even when supported by the market), this may be indicative of the appraiser's being unduly influenced by the purchase price. Whether that is the case or not, there is an additional negative consequence. If appraisals always come in at exactly what the purchase price is, even when supportable, it creates a market perception that the appraisal was just completed to justify the sales price. As stated earlier, that is not the case. So as appraiser's we must carefully consider this situation. That perception is out there, and sadly, in large quantity.
Odds are that most of us will not be flying into space for leisure anytime soon. However, after reading this article, hopefully chances are that you will better understand the difference between market price and market value. If you are ever the intended user of an appraisal report in which the value is higher or lower than what you anticipated, chances are the chasm between the numbers might just be understanding these differences.
I grew up watching Buck Rogers in The 25th Century. It's as close to space travel as I am probably going to get, at least anytime soon. Enjoy the original intro to this show that was ahead of its time in many ways. Don't worry! This trip to space is free.
Here are some other appraisal blogs and podcasts that I recently enjoyed.