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Valuation

The “Why” of Valuation

Building Valuation Discipline by Michael Greene and Alex Villacorta Business school classes often demonstrate concepts like “the wisdom of crowds” or “the Winner’s Curse” by asking students to guess the number of jelly beans in a jar. Miraculously, the average guess of the class is typically quite close to the actual number of beans, while the range of guesses is distributed broadly. Never in question, however, is the precise number of jelly beans that represents the RIGHT answer. There is a finite and knowable amount of jelly beans, and whoever is “closest to the pin” has the best estimate. One would expect that valuing a home would work similarly. While it may be challenging for an individual appraiser, broker, or automated valuation model (AVM) to nail the value of a home, at least we can know ex post facto who made the closest estimate. It is as easy as determining who was “closest to the pin” when the home trades. But is it? What makes the definition of accuracy in the valuation space different from counting jelly beans is not only the “what” but the “why.” That is to say that the business objective the valuation supports is highly relevant to how one should measure that valuation’s accuracy. For example, a mortgage lender wants to know what value for the home is supported by its surrounding market, so that it does not face idiosyncratic risk from an overvalued individual asset relative to its MSA-level risk models. In this case, an accurate point estimate of the price at which a home will transact is less important than the most probable minimum value supported by enough comparable properties to imply a liquid resale market. A home seller or their agent would like to know what the highest bidder might be willing to pay for their home to formulate a listing and marketing strategy. Especially in times of tight inventory or when in possession of a unique home, this number is likely to be different from the mortgage lender’s number. Similarly, a retail home buyer wants to buy the house of their dreams as cheaply as possible. What matters to that buyer is not the intrinsic value of the home, relative to its neighborhood comps, but figuring out how to bid one penny more than the seller will accept (or competing bids). For these retail market participants, the most probable point-estimate of transaction price is what matters. An investor would like to know the after-repaired resale value or rental rate to determine whether the property will deliver the returns they expect. This requires not only an understanding of the home’s value today, but also both the average price and market depth of peer assets in the neighborhood with similar hedonic characteristics but an upgraded fit and finish. Customizing Valuation Discipline to Business Needs The consumers of home valuations face an increasingly broad array of product choices around which to build their valuation discipline. In the last decade, the availability of cheap computing and storage power has unlocked previously unimaginable datasets for use in automated valuations (AVMs). Richer data has allowed for better attribution of value to an expanded list of property attributes and as a result has led to significantly tighter error bands. This increase in accuracy has been so significant over the last decade that AVMs have evolved from offering limited use cases around free-to-the-consumer marketing to offering credible, underwrite worthy valuations at the asset level. Recently, the industry has focused innovation around clever combinations of man and machine, with a spectrum of options from condition-informed AVMs to hybrid appraisals. The physical constraints imposed by the COVID 19 pandemic have accelerated the adoption of these “cyborg” valuations by realtors, lenders, and investors, funding further vendor innovation. It is no longer sufficient to rely on industry-accepted best practices when choosing how to value homes. Instead, each practitioner must create a valuation discipline that maps their company’s unique “whys” to the “whats” that the market is offering. As Peter Drucker said, “what gets measured gets managed.” While human providers of appraisals and BPOs are typically measured against client outcomes, such as revision requests, automated or computer-assisted valuations lend themselves to systematic measurement and comparison. In constructing a valuation discipline, this is an enormous advantage to those of us steeped in interpreting these data, but presents dangerous pitfalls to those who are not. Vendors and Appraisal Management Companies (AMCs) aim to serve as many market participants as possible, each of whom, as described above, wants something different. In competing for business, these vendors aim to achieve good scores against universal benchmarks across national averages. For automated solutions, these may include accuracy (usually measured by median absolute percentage error, or MdAPE), systematic bias, hit rate, or large error risk (measured by percent of valuations within 5, 10, or 20 percent of the ultimate sale price), each of which is more or less important to a different client. In the case of human-powered valuation, revision request frequency and turn time become important considerations, and everyone is sensitive to cost. A client’s “whys” determine which of these benchmarks should define their evaluation process. Which Model is Best For You If you are the buyer or seller of an individual home (or their agent) looking for a quick independent source of value to corroborate your comparable market analysis, an “accurate” AVM, as defined by a low national average error rate (MdAPE) is probably less useful to you than a “not wrong” AVM, defined by a low probability of major error (PPE5 or PPE10). After all, what is the point of being right on average if the client is only buying one house? By contrast, an institutional investor using AVMs to conduct macroeconomic research and backtests may favor an AVM with no systematic bias and a high hit rate, rather than one that has a low probability of major errors. Being right on average is precisely this investor’s goal. Along the same lines, a mortgage lender looking to determine

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Fast and Accurate Valuations Are Key for Real Estate Investors

New and Improving Tools Are Arriving Just in Time by Katie Brewer In a buyer’s market, the advantage goes to the purchaser who can make a wise decision faster than other potential buyers. So, for investors in today’s market, time has become the crucial obstacle to success. Some have called it a modern-day Gold Rush, and just as in olden days, prospectors who can sift through the national inventory of properties faster and spot the hidden nuggets more clearly are the ones who will prosper. The combination of historically low interest rates and shifting demographics has triggered a buying spree in single family homes that has accelerated during the coronavirus pandemic. As a result, inventories are low across the country. According to the Radian Home Price Index, there are currently 40 percent fewer homes on the market, on average, than any time over the past decade. High demand and low supply have inevitably driven prices skyward. During the month of April, the Radian Home Price Index rose 10.4 percent, with the median home in the U.S. now costing $277,365. But perhaps the most illustrative measure of the real estate market’s velocity is the time between the listing of a property and a pending purchase offer. According to Zillow, in April, nearly half (47 percent) the homes for sale in the United States were on the market for less than a week before going under contract and more than three quarters (76 percent) were on the market less than a month. Evaluating any property in days—or even hours—adds a level of risk that many would be unwilling to take in a normal market. Doing it at scale locally, regionally, or nationally requires either a prospector’s instinct or a technological edge. Most choose the technology. AVMs, AI, Machine Learning One solution is to use an automated valuation model (AVM) that applies mathematical models to a database of real estate information such as current and historical prices, number of bedrooms, and property improvements. With an AVM you can run estimated values on properties in a matter of moments. When a new property hits the market, an investor can quickly identify its essential characteristics and make a judgment about its suitability for their real estate portfolio. But AVMs are only as good as their data inputs. While they have the potential to deliver objective valuations without human bias, most models analyze data that has been collected in-person, and that can result in a distorted valuation. This is most consequential when the owner of the property is a member of a historically marginalized group. According to the Urban Institute, a Washington, D.C.-based think tank focused on social and economic policy research, AVMs have produced larger pricing errors in majority-Black neighborhoods than those in majority-white neighborhoods, “potentially contributing to the wide housing wealth gap between Black and white homeowners.” To correct for bias, AVM operators often look for ways to expand or augment the data sets their model is analyzing. The more data that is available, the more accurate the final analysis will be.  But a new approach, using artificial intelligence (AI), promises the fastest and most accurate analysis and valuations short of an in-person inspection. Modern AI can analyze an enormous amount of structured data such as price histories, property attributes and surrounding market data, but also unstructured data like photographs, floor plan sketches and text or speech.  Analysis of images in particular can help to establish the condition of a property and objects that differentiate value using consistent and repeatable tools without the in-person challenges. These tools can also evaluate newly built properties that have no price histories or recent comparables.  One of the most intriguing benefits of AI and Machine Learning (ML) is a model’s ability to refine and improve the process of identifying the best sales comparables to help establish a current price. Reinforcement learning allows models to improve accuracy simply through use and more data. And, unlike the human-based valuations, models can be independently tested in very large samples to ensure bias and other unintended consequences are limited or mitigated. Considering how many billions of photographs of properties there are on MLS listings nationally alone, the possibility of “better than in-person” accuracy through AI is a very real possibility.    The real estate Gold Rush shows no signs of diminishing. The Commerce Department recently reported that the median price of a new home sold in April of this year was 20.1 percent higher than a year earlier, the strongest annual gain since 1988. At the same time, the majority (54.6 percent) of homes in the middle price tier and almost half (48.0 percent) of homes in the top price tier went under contract in a week or less, up 60 percent and 71 percent year-over-year, respectively. Just like prospectors for gold, Investors looking for fleeting opportunities in this scorching hot market need faster and more accurate ways to judge the true value of their finds. Fortunately, new and improving tools are arriving just in time. 

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Valuing Your Rental Opportunities

How the Industry is Shifting to Help Investors Reduce Their Risk by Frank Guarnera After what has been a unique year to say the least, the future is looking like it may be ripe with opportunity and risk. Which is why it is so important to understand your assets now more than ever. As we may have some volatility or changes over the next year, it will be important to understand long term investment potentials. Anticipating this, the valuation industry has continued to evolve to provide solutions that can deliver valuable intel to help investors make more informed decisions. By integrating local rental data into traditional valuation products, it helps paint a clearer picture of whether an asset may be better suited as a short-term or long-term investment, or one to avoid altogether. Understanding the intrinsic value of a property is the cornerstone of the decision-making process along with knowing your Net Operating Income and Capitalization Rate. Several different products are available in the industry to provide important data in addition to the typical FNMA 1004+1007. The Desktop Appraisal Desktop appraisals, sometimes referred to as hybrid appraisals have been available to home equity lenders, servicers, and loss mitigation for several years. These products are fast becoming the preferred valuation tool with private lenders for fix and flip, long term lending and single-family rentals. While the products have a lower price point and faster turn times, the reliability and quality are on par with traditional appraisal products. Many of these desktop appraisals are USPAP (Uniform Standards of Professional Appraisal Practice) compliant and the data contained in them is much more user friendly than the traditional GSE format. The desktop appraisal bifurcates the appraisal process by leveraging a third-party data collector and the expertise of the local appraiser creating significant efficiency resulting in quicker turn times and lower appraisal cost without sacrificing quality. Valuable insight is also gained when these products provide additional forecasting data that considers both historical data trends and economic factors. This allows you to get a general idea of the expected appreciation/depreciation in an area. Combining all this data in an easy-to-read format helps investors make better informed decisions on these types of long-term decisions. Knowing the market value of the asset will help direct your investment strategy. Is this an asset I should sell now, rent for a period, and then sell, or keep as a rental property indefinitely? A desktop/hybrid appraisal can help answer those questions for less money and time than a traditional appraisal without compromising the quality. The Broker Price Opinion A Broker Price Opinion with a rental addendum has also shown to be a reliable source of information. In many situations, they are used as a low cost and fast resource to secure an inspection, property data, and rental information for the area. Leveraging the expertise of a local real estate agent, these are a valuable resource for anyone looking to secure more relevant data and get feedback from an agent in the area. By also receiving a BPO, you are gaining insight about the asset itself. With the rental addendum, you can pull in intel to perform a market-extraction which can help inform a reasonable capitalization rate for the area and your property. AVMs for Rental Market Trends Rental AVM’s have also continued to improve and can provide good insight of rental market trends. A robust dataset that can provide both historical and current rental trends can help establish what would be a credible rent price for an asset which will in turn, when combined with a property valuation, can help shine light on how good the investment may be based on the equity in the property and the future potential of the area. These will typically require you to do much of the deep diving but to the savvier investor, these tools have shown to be valuable. When it comes to identifying potential rental rates, there can be many challenges as the rental market is less liquid and transparent than the traditional real estate market. Rental data continues to become more reliable, but validation remains an important component of rental valuations. Getting a clear picture of what is occurring in the local market is a powerful indicator of what local market renters are interested in, willing to pay, and how long they stay. Further investigating vacancy rates and other value influencing features is paramount in reducing risk for long term investment strategies. Focus on what is going on in the local area regarding city migration and real estate development, inventory, economic conditions, and overall rates of appreciation. Do not let a lack of data be the reason you miss out on a great property or choose a strategy that does not yield the best return. Valuations continue to be an essential component with investment properties and there are a host of products to get you the information you need to make the best decision.    

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The Emergence of Alternative Valuation Products

The days of a one-size-fits-all solution are in the past. Over the years, many things have changed in the real estate industry. That rings true for valuations as well. With the advent of the appraisal management company (AMC) and changes in regulatory compliance, your valuation options may seem limited. However, there are many alternative valuation products available. Many offer lower costs, faster turnaround times and robust data sets to support their accuracy. Conventional appraisals are still required for some transactions, but some of the newer products are backed not only by powerful data sets but also by valuable human expertise. Growing user base sophistication and the dissemination of property data has challenged the status quo of the conventional valuation methodology. This development has ensured that valuations don’t remain stagnant but continue to evolve so that needs are met in an ever- changing environment. This commitment to create customer-centric valuation products that meet needs has been interesting to watch. The various elements of a valuation report are being spliced in order to create something new yet familiar. Valuation Cascades The introduction of the valuation cascade, built on risk factors users set up to account for tolerances based on complexity, allow users to choose the right valuation product for any given asset. That means the user has several options, ranging from a lower- cost desktop valuation all the way to a conventional appraisal. Many different types of hybrid products exist and are suitable for a wide range of needs. Some offer additional sales and active comparables in the immediate area, providing insights into the broader market and giving the user a better understanding of local activity. This is valuable in the investment space because of the unique nature of acquiring and strategically remarketing assets. If you have a low-risk asset with a few repairs located in an extremely homogeneous data-rich area, you may need a desktop valuation. On the other hand, if the area is a little more complex, due to the nature of the asset or the location, a full appraisal may be necessary. Not all properties are the same, and not all deals require the same product. Let’s explore some of these products so you can determine whether any might give you an edge. Bifurcated Appraisals The first of the new wave of products to review is the bifurcated appraisal. Bifurcated appraisals provide a lower-cost option while leveraging appraiser expertise. This streamlined tool allows for an option when a traditional appraisal is not necessary and leverages local market appraisers for both the inspection and the valuation. Considered just a step down from a conventional appraisal, a bifurcated appraisal is a great option to use in many lower-risk scenarios and when a sketch is necessary. Hybrid Appraisals Hybrid appraisals are similar to bifurcated appraisals. The difference is they rely on a non- appraiser to supply the inspection. This allows for a lower cost and often a faster turn-around time while still leveraging the valuation expertise of a local market appraiser. Additional Expertise Types Another change in evaluation options is the entrance of additional expertise types in origination transactions. Evaluations can be completed by local market real estate agents and other valuation professionals in the space. These products come in a variety of options. The requirements are standard, but the forms are not universal, allowing for custom options. Evaluations can be used for value determination in conventional lending transactions with less risk in many states. They can be used for any portfolio lending you perform. They exist in traditional form with the local market expert performing the inspection and valuation component. Or, they are available in a hybrid fashion that leverages a local professional performing the inspection while a specialist at the desk completes the valuation. These options provide a variety of price points, giving borrowers more economical solutions. This kind of flexibility allows the user to make decisions on what works for them and their portfolio. Combining Products The other interesting thing occurring in the valuation space is the combination of different products. In the world of investment projects, whether it be fix-and-flip or long-term rental, understanding the potential value of a property is critical. Not all projects are the same, and valuation professionals are not always well-versed in repair costs. This has historically presented a problem in the valuation space. That’s why additional options that rely on consuming external data have become more and more important. Being able to combine repair bids with valuation products has increased the ability to estimate an asset’s “as-is” value. This has been the largest challenge when it comes to assets that need significant rehabilitation. Combining multiple products and providing valuable insight to the valuation specialists allows professionals to focus on their expertise without having to fill in the blanks. This kind of consolidation means users aren’t left making decisions based on a valuation that doesn’t have all the necessary information. Other hybrid products that are offered consume the repair bid/property inspection as the means of seeing the property for the purpose of the valuation. This affords users even further reductions in price and allows them to pay only for what they need. Having options for managing your cost, time and portfolio needs is important for creating a competitive edge and getting accurate data for analysis and decision-making. The days of a one-size-fits-all solution are over. To stay ahead of the curve, you must discover different means to achieve the same or better result. Doing so can make all the difference. As times continue to change, your options will continue to evolve as well. Be diligent about reviewing your needs and staying on top of the tools that are available. Challenge the norms to discover what works best for your organization.

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