Editor’s Note: Is the Definition of Market Value Outdated? is a Guest Post from Bruce Hahn, SRA, MAI, CRE, CCIM.
Why has the current definition of market value been around without change for so long? Many decades in fact! Not much of it seems applicable to the realities of at least the last decade nor the rest of this decade. Consider the definition from page 4 of the current FNMA 1004 – the URAR form.
“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, knowledgeably and assuming the price is not affected by undue stimulus. Implicit in this definition is the consummation of a sale as of a specified date and the passing of title from seller to buyer under conditions whereby:
- buyer and seller are typically motivated;
- both parties are well informed or well advised, and each acting in what he or she considers his or her 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; and
- 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.”
There are problems with just about every element of this definition because they have not described the market conditions for the last decade plus in America. Item 4 stands out in particular. Why don’t appraisals consider the impact of financing on market value? Payment in terms of cash in US dollars or financial arrangements comparable thereto…..
At the end of the first week of January 2021 the 30 year mortgage rate averaged 2.65% in the United States. As of the beginning of November 2022 the 30 year rate was around 7.12% – a nearly 450 basis point increase in the cost of borrowing due to a 168% increase in mortgage rates. Furthermore, inflation as of the beginning of 2021 was running at 1.4% as of January 2021. It quickly climbed to 5% in May 2021 and as of August 2022 it was at 8.3% and steady at 8.2% in September 2022. So the current 30 year mortgage rate is actually remains negative in real terms at -1.2% (mortgage rate – inflation rate or 8.3% – 7.1%)! How is a negative real mortgage rate equivalent to cash? It isn’t! The negative real rate reflects that you will not have to repay all of the mortgage principal back – due to the debasement of the value of the dollar thanks to the inflation rate. This does NOT equal cash!
Forget the other problems with the definition of market value! It is very clear that financing terms have not been equal to cash recently. The first line after the definition of value on page 4 of the URAR has the following comment: “*Adjustments to the comparables must be made for special or creative financing or sales concessions.” Isn’t a mortgage interest rate that is negative in real terms special financing? Lenders may choose not to underwrite to true market value definition standards but shouldn’t appraisers analyze the true impact of the cost of debt service relative to cash on market value of these factors? Real estate values would be very different without the highly stimulative impacts of negative interest rates (in real terms) if buyers truly paid all cash!
Isn’t the first discussion a potential buyer has with a realtor about the PITI (principal, interest, real estate taxes and insurance) they can afford? This discussion gets translated to how much home they can afford in terms of total purchase price. A two thirds increase in the cost of debt service will certainly impact the maximum purchase price that a potential buyer can pay. Given that virtually no one is seeing a 66% raise in income, the only part of that equation that can change is price. Yes those negative real interest rates in the last couple years did not create a true market value!
More ominously, there is a major change now evident. Consider the following trend chart for the 30 year mortgage rate – the data is from FRED – the St Louis Federal Reserve web site.
For the last four decades interest rates were trending downward. They bumped up a small amount from time to time, but they marched ever lower from the high teens in late 1981 to only 2.65% at the beginning of 2021. It is apparent that this four decade downtrend has now reversed, and that interest rates have begun a long term uptrend. As much as the declining cost of borrowing helped values increase the last forty years, won’t the reversed trend in interest rates have similar longer term negative impacts on real estate value?
So why is the definition of market value so hopelessly out of date? And why do appraisers not consider the impact of financing/leverage on market value? Clearly it matters!
November 22, 2022 @ 6:12 am
Bruce, thanks for an insightful post. I would take issue, however, with a discussion of “THE current definition of market value.” While the definition you cite is the one contained in Title 12 of the Code of Federal Regulations relative to mortgage lending, it is by no means the only definition in common use. In my litigation practice, I NEVER use this definition, and I’m always critical of litigation appraisers who unknowingly do so. I will often recommend to counsel to file a motion in limine before trial to exclude the testimony of an opposing appraiser who uses the wrong value definition, and in rare instances, an appraiser has been excluded for that reason.
The definition cited above is one of only two that I’m aware of that use the value standard of “most probable price,” and contains more normative conditions than most other definitions. The disconnect between the referenced definition and the marketplace during the subprime mortgage crisis and Great Recession, in markets where virtually all sales were distressed (REO or short pay transactions), it would have been technically impossible in many cases to deliver an appraisal that would have met the standards imposed in that definition. The requirement for reasonable exposure time on the open market apparently disqualifies off-market but otherwise arm’s length transactions.
I authored an article in The Appraisal Journal back in 2018 that squarely addressed the issue of market value, and particularly the plethora of definitions were have to work with. I’m not one who believes that different definitions give appraisers license to come up with different values, but there are those out there who don’t agree. I had proposed that the Appraisal Institute examine this issue, and short of coming up with a single new definition (which is obviously impossible), at least provide guidance as to the proper interpretation of the various definitions, which all relate to the same concept. If you have a few minutes, give it a read (the article won the Swango Award in 2018):
https://coastlinerealtyadvisors.com/wp-content/uploads/2018/10/Market_Value.pdf
November 22, 2022 @ 6:43 am
Market value should be an Estimate of worth as a function of Effective Demand and NOT an Opinion of wokeness market appeal.
November 22, 2022 @ 8:45 am
I can remember when the definition was HIGHEST PRICE. It leaves too much open to interpretation or misunderstanding. One could make the argument that many, maybe even most, of the transactions over the past several years did not conform to the definition regarding duress or exposure in the open market.
November 22, 2022 @ 9:00 am
Your terms are a little vague to me. How would you define effective demand? Would you add to the old Demand, Utility, Scarcity, and Transferability or create a new definition? What is wokeness market appeal?
November 22, 2022 @ 9:42 am
This is a good article. I’ve always thought we should adjust for financing, ultimately we do because the rates have an impact on price and that makes its way into our value opinion. That being said since market conditions are variable, shouldn’t rates and their impact be an adjustment and maintain a definition separate from market value? For example, We do time adjustments, but we don’t include time as a definition of market value.
November 22, 2022 @ 9:53 am
I remember Bob Englestadt of Freddie Mac who said in 1982 or so, that appraisers did not seem to understand the concept of Most Probable Price, while they easily understood the Highest Price concept..
November 22, 2022 @ 10:16 am
Can I see an example of the market value definition that Michael Sandwrs is referencing?
November 22, 2022 @ 10:35 am
I would also be most grateful for a copy of the Market Value definition Michael Sanders is speaking of. Thanks so much.
November 22, 2022 @ 4:10 pm
Many articles about this in The Appraisal Journal over the past 50 years. One in the past few years.
Yes, All Cash is NOT equal to market financing. I have long argued that if houses had to be purchased with 100% cash the average price of a house today would be $30,000 or such. We invented creative financing and the more you leverage the higher the prices go. As we all know, people do not buy a price, they buy a monthly loan payment. Which their buying power is down 33% from a year ago due to higher interest rates.
I recall 15 years ago in the crisis where Real Capital Analytics showed sales of similar commercial properties where one was all cash and one was financed. The financed prices were 100% higher than the all cash prices. It was great proof that cash is not the same as market financing.
I recall a bank back then had a bad land loan in Florida. The loan was $23 million. The property appraised at $3 million. The bank took it to auction and said they would provide 100% LTV financing. The property sold for over $20 million!!! Why? Because the buyer had $0 equity in the deal. They could have paid $100 million for it. It was still the bank’s property essentially!
Lastly, I have long taught that the definition of Market Value is totally ridiculous in the first few words….you don’t define value using the word price!!!!!!!! These are two totally different items. Before 1940 when NAR got their hands on our profession, Market Value did not rely on price. In fact, the original FHA gurus in the 1930s did not allow the Sales Comparison Approach in their appraisals!!!!!! One of my quotes is ‘Ban The Sales Comparison Approach!’ It is only a brief moment in time every so many years or decades that Market Value and Market Price are equal.
In my 30+ years of reviewing, I can say that only one appraiser I know of in the USA has every done a Market Value appraisal. Everyone else does Market Price appraisals.
I think appraiser students should have to write the definition of value without using the words price or cost. Cost, price, and value are three different things.
Lastly, I joke that using the word ‘price’ in the definition of value is like defining an orange as ‘An apple….’ Just plain stupid. Thank you NAR for ruining our definition.
Good article Bruce.
November 25, 2022 @ 9:43 am
I don’t think we should dissect each word of the definition and argue its merit or lack thereof. While not perfect, I think the definition in use today is reasonable, widely understood, and provides a measure of consistency across a broad spectrum of market participants. Is it perfect? No, it is not, just as real estate itself is not perfect. Market value is a concept and not a certainty under all requisites and criteria because those that rely upon it have differing regulatory or legal needs that impact how it will be viewed and applied to a particular problem.
If interest rates rise, sellers lower prices. We are seeing this now. According to the definition, the appraiser must now consider the changes in the market and identify the most probable price based on their observations of the data, including closed sales, listings, properties in escrow, rising inventory trends, etc.
If the appraiser is following good appraisal practice, they would have considered the change in interest rates and the impact that change is having on the market. As the article suggests, the borrower’s buying power has changed considerably. While the market’s reaction (as evidenced by closed sales) will lag, the reaction is there (today and historically), as evidenced by the drop in sale volume, the increase in inventory, prices of homes in escrow, and sellers adjusting prices.
There will always be those questioning the “letters of the law” (so to speak). No matter what rule is proposed, there will be exceptions. Therein is the nature of the problem. Real estate is an imperfect market, and because of its imperfection, it is impossible to define its concepts in such a way the definition is universally understood, accepted, and applied. If rules, regulations, laws, and principles could be drafted in such a way they are universally understood, there would be no lawyers, and Shakespeare would be happy.
November 28, 2022 @ 3:54 pm
Agreed. We use the State’s Civil Jury Instruction’s definition for market value in public acquisition appraisals under threat of eminent domain and for condemnation. This is a willing seller, willing buyer definition, without a most probable or highest price. It is also the definition we have our contract appraisers use.
November 28, 2022 @ 6:06 pm
There is a common belief among appraisers that market value is somehow a more durable and stable value opinion that should not be affected by sudden changes in interest rates or other vagaries of the market such as civil unrest, or a sudden fall in the stock market. I have seen countless properties sell twice in a short time period with double digit price increases. What changed? We inquire and get an answer. “Well, how could I have predicted that?” you say. And that is the point. We cannot have perfect knowledge. Real estate presents the illusion of stability. We operate as appraisers fully invested into this illusion. The honest thing to do would be to say that this value is good for at least for a day or two, barring any “black swan” events. We do our clients no favors by understating the potential of market risks. We reflect the market’s illusion of stability. Perhaps we just need to state that up front.
November 29, 2022 @ 5:29 am
Appraisers are supposed to adjust for financing if warranted, period. What is required now for an FRT. Also, if it is typical and readily available and driving the sales market, then it is not special financing because rate is low and exhibits a negative real interest rate. If most restaurants in a market sell with SBA financing, 10% down owner occupied, and it is readily available, that is not favorable financing, it is the market. So, I actually agree with much of what you, but in the context of what we should be doing that I call “valuation underwriting”, and risk assessment, using OG data collection and analysis tools, and statistics, data science etc., to “size up” the risk etc.
Is the Definition of Market Value Outdated? Part II - George Dell, SRA, MAI, ASA, CRE
March 29, 2023 @ 1:15 am
[…] Editor’s Note: This is Part Two of a discussion of the definition of market value by Bruce Hahn, CCIM, CRE, MAI, SRA. Read Part One Here. […]
Is the Definition of Market Value Outdated? Part III - George Dell, SRA, MAI, ASA, CRE
April 5, 2023 @ 1:16 am
[…] Part One and Part Two we asked why the current definition of market value has been around without change for […]
October 6, 2023 @ 7:17 am
The definition of market value is not out of date. Proper adjustments are necessary to convert the sale price or rent to the defined market value. Appraisers routinely adjust the sale price for financing and time. However, I have not read any appraisal reports that adjust for transaction conditions. Market value includes typical motivation of buyers and sellers. Sale prices rarely reflect typical motivations because of the individual emotions of buyers and sellers.
October 30, 2023 @ 11:24 am
Good Grief. — This is an exercise in idiocy. On the day of the sale, whatever that is, with a sale price of $X. That sale price minus any concessions is the Market Value. If the buyer gets a bank loan for whatever rate, that has nothing to do with market value. ( FRT? WTF? ) Neither does inflation. Suppose the seller sells his property by providing the buyer a loan for Y%. You would compare that to the average loan rate and conditions for the same period loan for average buyer credit (hopefully you can figure that out) rating with discounting to net present value and then modify the transaction value the same as with any other concession or price adjustment.
Too many appraisers getting old and over the hill. Hope I am not one!!
October 30, 2023 @ 2:04 pm
and the selling price of the property is a reflection of the market’s effective demand, which is net less costs of the funds to purchase. If the effective demand for properties in Watts, Lomita, Compton et al is less than the effective demand for properties in Bel Air, Claremont, and Diamond Bar, then those whose income is able to meet the market price will purchase the property that meets or slightly exceeds the buyer’s effective demand.