Real Estate Appraisal – Bring Back the Cost Approach
In the last few years there has been a trend toward a complete discounting of the Cost Approach to value in residential appraisal. For owner occupied homes, the only technique is now the Sales Comparison examination, which involves selecting and comparing individual character sales to a subject character.
Many lenders and government agencies no longer require the Cost Approach technique, already on new or nearly new construction, and appraisers are often instructed to neglect it completely, or not to place any reliance on the results. When a lender does require that the Cost Approach be completed, it seems that this is only so that a proper amount of homeowner insurance can be determined. This is, of course, something critically important to the lender in addition as the homeowner, but should not be the only criteria for the use of a cost-depreciation examination.
Years ago a Cost Approach was always required for an appraisal report. The basis of this approach was the rule of Substitution, which holds that a prudent buyer will not pay more for a home than the cost to acquire an equally desirable substitute home. consequently, the reproduction or substitute cost new of a home set the upper possible limit on value, particularly for an existing preowned home. So this examination served not only as an additional method of estimating value, but also as a governor on runaway home prices.
The cost approach also served an important function as an educational tool for appraisers. To perform this approach, an appraiser had to have at the minimum a minimal working knowledge of residential construction and to carefully observe the quality and condition of the various elements of the home. Cost data sets, which nevertheless exist today, provide continuously updated information on the various costs of construction involved in a home and some are quite accurate.
One service publishes a manual with a wealth of good data and information, complete with descriptions and photographs that illustrate the differences in quality and turn up for different types of homes, which is a great way for new or inexperienced appraisers to familiarize themselves with these features. In recent times I have come across reports by comparatively new appraisers where no cost approach was done and it was painfully obvious that the appraiser knew very little about construction or how to estimate the differences between their subject and the comparable sales they used in the Sales Comparison examination. I speculate we have a new generation of appraisers out there who have this deficiency and that’s a bad sign for the future. The best appraisers know something about construction and can closest identify differences among homes as to their quality level. This ability is also basic for the appraisal reviewer.
The Cost Approach is not without its weaknesses. The dominant weakness is in the calculate of depreciation, be it physical, functional or external in character. These things are difficult to calculate, but again, the appraiser who learns how to do this becomes more knowledgeable and competent, both in the Cost and Sales Comparison methods. Another weakness is in estimating the land value. Actual sales are often not obtainable as a method to determine what buyers are paying for a similar lot and so market abstraction (also called extraction) is used to calculate the ratio of land value to dwelling value from market sales of already built homes. Improperly done, this technique is unprotected to serious errors. The general rule for the Cost Approach is that it is most accurate when the dwelling is not very old and sales of nearby similar lots are obtainable.
I am of the opinion that the majority of foreclosures include comparatively new homes and that this is where the largest amount of lending losses occur. at the minimum, that’s how it is in my local market which has always had a lot of new construction. There are many reasons for foreclosures, but certainly one is upgrades.
Builders typically offer various home models at “base” prices and offer upgrades for both the home and the lot. Buyers can choose from a wide variety of options to enhance the home and can choose lots that are different in size or that have more trees or other desirable aspects. This is great for the buyer but can become a nightmare for the lender when a foreclosure happens because so many of those nice upgrades do not keep up their value in later foreclosure sales, and often do not keep up their value as the distressed homeowner desperately tries to sell the home to avoid foreclosure.
The homeowner finds out they are “upside down” meaning the home cannot be sold for as much as the mortgage amount, especially when the initial down payment was very low or when financing costs were included (rolled into) the mortgage, necessitating an increase in the sale price. Another problem is inflated upgrade cost where some builders mark up the prices of upgrades well beyond normal prices that consumers pay at retail stores, already with installation additional on. This is similar to what many service contractors (plumbers, car mechanics, etc.) do because they want to make a profit on the “parts” in addition as the labor. The problem comes when the markup is excessive.
There is little an appraiser can do about upgrades when it can be shown that buyers often do select upgrades with their new home buy. In the absence of current resales or foreclosures to compare with, it is not possible to calculate the resale value of upgrades, and values are estimated as of a given date, not the future.
The Cost Approach long served as a reasonable basis for making adjustments to market sales in the Sales Comparison examination for individual items. If a home needed a new roof, the appraiser had a handy source for calculating the cost for this. Likewise for appliances, HVAC equipment, a garage and the like. Removing the Cost Approach and the good data that comes with it forces too many appraisers to have to guess at these kinds of adjustments and the results can vary wildly from one appraiser to the next.
Long ago homes were valued only by a Cost Approach. The Sales Comparison examination (formerly known as the Market Approach) came later. I don’t believe it is a coincidence that foreclosure rates and personal bankruptcies caused by unaffordable mortgage amounts and runaway home prices seem to have increased so much in recent years while the use of the Cost Approach has declined at the same time. Not do I believe it is a coincidence that the decline in emphasis on cost minus depreciation began about the same time as tremendous inflows of capital into the marketplace promoted every sort of easy money credit scheme that allowed so many people to buy homes they couldn’t truly provide and that has severely damaged not only the US economy, but the complete world. Mountains of money to lend tend to push caution to the side.
I believe that the Sales Comparison examination is surely a good valuation technique, but its down side is that there are too many clever ways for market participants to smuggle hidden costs, fees and already fraud into sales contracts, which make their way silently into market data sets and onto appraisal reports. The same can be true for unhidden costs like seller paid loan discount fees and other monies paid toward buyer closing costs. At a minimum, an accurate Cost Approach serves as a useful check on the results of already the most thorough and detailed Sales Comparison examination where the appraiser is carefully searching for and analyzing such things. Undesirable things can and do happen in real estate and some can slip past already the best Sales Comparison examination because they happen quietly and incrementally.
An example of this is what I call closing cost price compounding. A real estate agent provides a seller a pricing examination where the agent has found 20 recent sales of similar homes in the area and averaged the prices to arrive at a figure he or she believes is correct for the home. The home is then marketed at that price. Along comes a buyer (perhaps from a higher cost market) who lacks cash, needs some assistance with his closing costs, and makes an offer at or very near the asking price. The seller counters with an offer in which he adds the amount of assistance the buyer asked for to the price.
But what if this kind of assistance turns out to be normal for the area and is already reflected in the selling prices of those 20 homes used to set the asking price to begin with? The new sale closes at the upwardly modificated price and is then used as a “comp” by other agents and by appraisers and the time of action continues with every repeat occurrence of the needy buyer, causing home prices to rise, affordability to lessen, creating more needy buyers, and setting in motion a snowball effect where prices to rise ultimately to the point that they go beyond already cost new. This is not unlike interest compounding on your savings account. Over time your balance goes up faster and faster. Combine this with other inflationary market tendencies and you get a nasty bubble that will some day burst to the peril of us all…again.
clearly, this could be avoided by competent sales agents who understand that those 20 sales already included heavy seller costs and inform their clients of this, but many do not and there is a built in motive to push prices as high as possible among people working on commission. An accurate Cost Approach would tend to catch this anomaly closest or at the minimum decline its effects down the line in future sales because when home prices begin to go beyond what it would cost to build an equally desirable substitute home brand new, the competent appraiser knows that something is wrong and that they need to dig deeper into the market data.
A Cost Approach is also a great lie detector for fraudulent appraisals. If an appraiser included a Cost Approach and is using a known cost source or manual that others can subscribe or view, then the estimated costs shown in the appraisal can be reproduced from that same source by someone reviewing the report. So if the appraiser has fudged on cost, that can be detected simply by examining the cost source and parameters the appraiser had described. additionally, already if the appraiser showed the correct costs, the fraudulently inflated appraisal will characterize inflated land value in the Cost Approach with little or no sustain as to where the land value calculate comes from or why it is so high. In fraudulent appraisals, the Cost Approach is “plugged in” with numbers to match the Sales Comparison examination. That’s because an honest Cost Approach would have indicated a considerably lower value for the home.
There are other examples of how the Cost Approach could eliminate or reduce runaway home prices, and already detect fraud. I believe it is a foolish mistake to take away or encourage the disuse of any kind of examination or tool from appraisers that has a basis in market data. An analyst in any field of study should be willing and enabled to use as many ways as possible of looking at a problem. Focusing on just one method encourages tunnel vision. I say bring back the Cost Approach and let appraisers decide how useful or accurate it is on a case by case basis. It is not the end-all be-all solution but it is a valuable and worthwhile tool.