I realize that what I am about to say is not going to be welcomed by many in the appraisal community, and many in the world of real estate sales. However, dislike for a particular set of facts does not change the validity of the argument. Comparable sales appraisals are deeply flawed in the area of rural real estate. Perhaps this method fits the urban and suburban real estate markets well, but there are many aspects of it’s methodology that are far from being in concert with the realities of the rural real estate market. However, the entire real estate industry seems to blindly follow this method because it’s the standard. Sub-prime mortgages based off of the upward nature of the value of suburban real estate was the standard that everyone subscribed to a few years ago too.

The very nature of the rural real estate transaction is just completely different than it’s suburban counterpart. In suburbia, buyer and seller are not likely to know one another or have undisclosed reasons for making a particular purchase; thus giving credence to the notion of most transactions being “arm’s length.” Further, it is likely, even in seller’s markets, that the buyer will have several choices in a given area that fit their basic needs. The more transient nature of our suburban, home-buying population also means that it in a given area it is likely that several other similar properties, in terms of functional usage, have recently sold. None of this holds true in the rural real estate market. The principals in a rural real estate transaction are much more likely to know one another and have reasons for buying and selling that are not dollars and cents. This kind of thing is seldom known by the appraiser, and cannot be accounted for logically. Rural real estate does not change hands nearly as frequently. Often a cattle farm south of Montgomery, Alabama is more comparable to a cattle farm in Florida than it is the property immediately adjacent to it. Currently accepted comparable sales guidelines cannot account for this. Combine the lack of similarity with lack of transactions in a market area and intangible reasoning for purchase decisions and the whole notion of comparable sales appraisal breaks down.

I’ve got friends that practice comparable sales appraisal in my rural market area. Almost without fail, they back into an appraisal rather than moving forward through it. Let me explain myself. They start with a value opinion and then set about to prove it. Conventional thought on the matter is that appraisers base their value opinions on “the market” and move forward to a value determination. As you can see, rural real estate appraisers, in practice, base their valuations off the subject property and work backwards to “the market.” Now, I’m not calling them out on this. They do the best they can to work within the system accepted by our industry today. They are given a flawed system and told to fit a property into it.

Let’s look at some of the aspects above. Buyers and sellers in rural real estate markets are much more likely to know or “know of” one another than in suburban markets. This can have positive or negative impacts on the price at which a transaction occurs, dependent on your viewpoint. For instance, Farmer John who is retiring and selling his farm knows Bill Smith. They’ve been in the same community for 25 years, and they go to church with one another. Bill’s son, Thomas, just graduated and wants to try his hand at farming. John is sympathetic to Thomas, especially since Thomas has worked for him the last three years while finishing college. John knows he can get $500,000 for his operation but agrees to finance it for Thomas at a purchase price of $400,000. Thomas jumps on the opportunity and a transaction has occurred. The appraiser sees that the farming operation transacted at $400,000 and not that Farmer John was sympathetic to Thomas and agreed to sell him the operation for less than the open market would have allowed. Appraisers cannot account for this in the comparables approach. Let’s say the shoe was on the other foot. Now, Farmer John is retiring and he knows Bill, but Bill is a developer. Farmer John thinks that if Bill’s son is interested in the property then it must be for development purposes, and now is not sympathetic to him. Farmer John sees his life’s work being turned into something he despises and says, if Bill’s son is going to buy this place, he’s going to have to pay me $600,000. Now Bill knows the farm will not bring this on the open market, but he is sympathetic to his son’s desire to begin farming and will help him pay more than the property is worth to keep his son in the community. Now the same farm has transacted for $600,000 for sympathetic reasons. Where on the comparable sale appraisal form can the appraiser account for sympathy?

Choices between properties are much, much more limited in rural real estate. Often a buyer may span multiple markets when searching out a fitting property, which means they are comparing properties that the comparables approach to value would have very different basic values. Dirt values on the properties they compare may vary hundreds of percent. A forty acre farm in rural East Central Alabama will have a different dirt value, in the comparables approach, than a forty acre farm in the panhandle of Florida…even though the buyer is comparing them for the same end-use.

Rural Americans are much more likely to stay put. This results in less action in the rural real estate market than in nearby suburban markets. This means that comparable sales for the rural real estate appraisal must span a much longer period of time, which makes the comparables method less responsive to changing market conditions than the same method used in town. That creates a lag in the upward and downward mobility of a market that often results in a wild swing in values when the market realizes that it’s “off.” Here in my home county, there was a great deal of resistance to the downward pressure of the market a few years ago. Comparable appraisals, while not solely responsible, played a part in this. The market eventually slowed to a standstill until some sellers eventually realized their property would not bring what was suggested by the “comparables,” and began selling at prices that were not even close. If you can’t picture this graphically, it resulted in a cliff on the market curve. The comparable sales approach is backwards reaching, not forward reaching.

Many, many times in rural real estate the feeling that a buyer has when looking at a property trumps function. Comparable sales appraisals are built around similarity in function, not buyer’s feelings.

Now that I have roundly blasted this approach, I would be doing a disservice not to suggest better methodology. Land holds productive capacity that can be measured. In timberland, that manifests itself as a site index. When a property’s highest and best use (HBU) is timberland, then an appraisal based on the land’s production capacity and income-producing ability is much more measurable and verifiable. The production capacity of a farm can be measured similarly with yields, and soil quality. Yes, these things take a much more specialized appraiser and more work. In rural properties where the HBU is not an agricultural endeavor, then a hybrid approach is probably more applicable. A cost approach appraisal for improvements with an underlying comparable sales approach for the dirt would more accurately reflect value. None of our current systems are perfect, but I think we can improve upon the use of the comparable sales approach in rural property.

This approach adjusts a property’s TAV up or down in light of recent sales for similar properties to find current market value. TAV analysis is not an appraisal or a Competitive Market Analysis (CMA). It doesn’t try to find a target property’s value by tweaking the specifics of recent comparable sales.

It starts with a base-line valuation (provided free via periodic reassessments for tax purposes) and calculates an adjustment factor based on recent sales. If sales of roughly comparable properties are 25 percent higher than their most recent TAVS, increase the TAV of the target property by 25 percent to get a current market value. It’s quick, easy and free (if you go into the courthouse yourself).

One LandThink commentator suggested that TAV analysis does not factor into its valuation the current value of timber as a discrete and independent asset. That is true, and it’s an important point to understand. Let me explain.

A current market valuation of land (and to differing extents other types of property) — as estimated by appraisal, CMA or TAV analysis — may or may not have much to do with its actual net intrinsic worth, that is, the sum of all of its assets less their liabilities, risks and uncertainties.  Market value, as I’m using it in terms of TAV analysis, is simply an estimate of how the current local market of buyers is likely to value a property. TAV analysis is not an estimate of net intrinsic worth, which is the net value, or price, of a property’s important assets and improvements.

Net intrinsic worth is determined by a careful valuation of a property’s individual assets. These will include a mix of things—economic assets like merchantable and pre-merchantable timber and cropland; environmental assets (which can have both an environmental value and a monetized value as in a conservation-easement, solar rights or wind rights); improvements (residence, farm facilities); minerals and other resources. Each asset should be discounted to the extent that it can’t be used, must be altered, is inefficient, or requires additional investment and so on. Liabilities affecting the property generally, such as a residence in a floodplain or the presence of a federally listed ETS species, should also be factored in as value discounters.

Appraisers do not value property this way. They do not try to estimate the values – let alone the net values — of discrete assets, such as timber. Appraisals and CMAs work up their estimate of value based on a whole-property assessment rather than one that proceeds part by part. Tweaking in appraisals applies to residences, not differences in value in land assets.

Appraisals in my opinion are best suited to residential properties, particularly where the target property is one of many of its type in a particular neighborhood. Appraisal methodology may not well-suited for land in its various forms, particularly when a property combines several different types of assets and multiple discounting conditions.

Specialized farm appraisers are available. But I’ve found that a buyer must often obtain several different consultant evaluations of assets on one target property to get to a net intrinsic worth figure. A common combination of consultants is forester, mineral economist and environmentalist.

Appraisers who do the county’s assessment every few years generally use a fixed value that they apply to all timberland of a certain type. This straight-through value doesn’t take into account the actual market value of the merchantable timber on the tract or whether the tract has been cut recently, among other factors. I’ve seen a reassessment figure of $600/a applied to all timberland in a county regardless of whether the merchantable timber on the acre was $0 or $2,000.

With land, a buyer should use a TAV analysis to get a general sense of how buyers would value it compared with its own assessment value adjusted for recent price trends.

But to determine its worth involves in my opinion going through the property’s individual assets, netting out each asset’s value, then summing a net worth.

From a buyer’s perspective, a good deal presents itself when property can be purchased below its net intrinsic worth, regardless of the TAV number.

Sellers typically use several approaches to set an asking price. If an agent is involved, a seller might base price on a Competitive Market Analysis (CMA), which looks at recent selling prices of comparable properties. CMAs are not as comprehensive and technical as appraisals, but they will generate a market value based on the comps used. An appraisal is a second option.

Some agents recommend a listing price based on their recent experience with sales of similar properties in the same area.

Sellers often use their “own devices” to find an asking price. These are usually nothing more than their own opinions, or opinions of friends or opinion expressed as hope. I have seen sellers set prices in this fashion that were wildly off in both directions.

Some sellers simply announce, “This is my price.” Market analysis plays a minor role in their decision-making. Intestines rule.

On the opposite side, buyers, too, can avail themselves of an appraisal and a CMA. The buyer is, of course, better off obtaining value analyses before putting a price on an offer than after.

Buyers may avoid estimating market value altogether and offer what they think the seller will take, or some arbitrary percentage of the asking price, or some other number that’s easy to get to but may be totally unrelated to current value.

All of these valuation methods rely heavily on opinions to get to an opinion.

Appraisals are the “hardest” of these methods, but they too rely on subjective judgments for the choice of comparables, the type of tweaking that is applied and other matters. I have seen a second appraisal done within two weeks of the first but using different comps come in more than 50 percent higher. An extreme example, I agree, but it illustrates the variability that can arise.

I’ve found that buyers and sellers can work up a little “harder” market-value number by starting with numbers that are themselves a bit harder.

First, get the current tax-assessed value (TAV) of the target property. This is available in the public tax records in the assessor’s office.

TAVs are produced by the methods of the appraisal firm that the county (or other jurisdiction) employs every few years to revise assessment values of all real property. From these values, various rates are applied to different types of property (land, improvements, minerals, etc.) to determine each property’s total annual property tax. States decide the time between assessments.

Each reassessment applies consistent valuing criteria to all properties, with adjustments for neighborhood and other factors. (Reassessment values, I know, are also opinions and often deserve the criticism they bear. But, once all appeals are resolved, they are both comprehensive and reasonably consistent.) The county’s most recent reassessment is the hardest data available in a semi-soft world.

The target property’s TAV may be several years old, which can put it out of line with current values. Don’t do anything yet; we’ll adjust for it.

Make sure that the TAV represents 100 percent of value. Some states carry TAV as a percentage of 100 percent valuation; West Virginia, for example, uses 60 percent as its TAV.

Land-use classification for agriculture or managed timberland also reduces TAV. Land-use provides significant tax breaks to encourage certain uses.

Land with a conservation easement should have a TAV that’s been lowered to reflect the sale or donation of development rights.

The second step is to calculate a factor that can be used to adjust the property’s current TAV to recent selling prices of comparable properties.

Most of the time in most places I know, TAV has lagged market value, sometimes by more than 100 percent. In today’s market, a property’s TAV may exceed market value.

The need, then, is to find a TAV adjustment factor that can be used to raise or lower the property’s TAV to reflect its value in current market conditions.

One way to do this is to use comps from a current appraisal or CMA to compare their TAVs against their recent selling prices. This method provides a harder number than opinion.

Derive an average sales price for the three current comps used in a CMA or appraisal. Match that average sales price against their average TAV. The difference, whether plus or minus, is the current local TAV adjustment factor, expressed as a percentage.

If you lack access to comps from an appraisal or CMA, go into the county’s office where deeds are recorded and find three to five broadly comparable properties that have sold recently in the same general area as your target. Calculate an adjustment factor based on their average TAV against their average sales price.

The last step is easy. If a property’s TAV is, for example, $500,000, and the adjustment factor is plus 20 percent of TAV, then its current market value can be estimated at $600,000.

A TAV valuation costs nothing when based on courthouse research or an agent’s CMA. Both are readily done. The TAV valuation gives the seller another estimate of worth to consider before setting a price and, similarly, helps a buyer with making an offer.

TAV valuation is a layman’s tool that I’ve found works in all market conditions.

Melissa is one of two lawyers in the county. This is one of our county’s major cools.

She recently bought a 90-year-old house to use as her office. It’s a simple two-story, two-over-two design with an enclosed back porch. She paid a little over $90,000 and put $50,000 into the conversion. Many of the renovations were specifically done to accommodate her clients and her law practice–extending the porch and making it handicap-accessible was about $10,000 alone. She moved the kitchen from one of the two large rooms downstairs back into one of the two small rooms in the enclosed porch. It’s a serviceable kitchen for an office, but too tight and unwieldy for a residence. The former kitchen/dining room area is now the legal secretary’s office. All of the wiring was replaced, made computer capable. All of the phone system was replaced to handle office lines and Internet service. Parking area, lighting, security measures, shelves, painting, floor refinishing, plumbing etc.–most of the money went for office-related purposes, not aesthetics. Had she bought it for a residence, no money would have been needed.

She wanted to refinance her loan to cover the improvements, much of which upped her basis in the property. She needed an new appraisal.

The appraiser, who had done the original appraisal when she borrowed for the purchase, came by again. His original valuation was about $115,000. He noted all the changes.

The new appraisal came back at $130,000, despite the more than $50,000 in documented expenditures, most of which were for office-conversion purposes. He said the highest and best use of this building was as a single-family residence. The conversion to an office had lowered its market value. The kitchen was too small and imposed a substantial discount. He noted the porch extension, but did not note that it was done to make the office handicap-accessible. The appraisal was not enough to cover the amount of refi wanted.

So what happened here? Our county is so small that he had no other house-to-office conversions with which to make a comparison. A couple of examples are available, but they were done several years back. They could not be used. The only set of comps the appraiser could find were residential houses, which were non-comps.

The appraiser was stuck with a method that didn’t fit the property he was asked to appraise. The bank was stuck with having to have a comp-based appraisal to document value for a refi. Melissa was stuck with a nonsensical valuation that didn’t fit her property.

Commonsense and flexibility are called for. Unfortunately, everyone is locked into a one-size-fits-all system that occasionally produces dumb results.

Over the years, I’ve run across a number of examples of properties in rural areas that while not unique in the sense that they are one-of-a-kind on a state or national basis, are either different from other properties in the county, or idiosyncratic or have some combination of assets and liabilities that make them difficult to compare to much of anything. A geodesic dome as a second home on 50 acres was the one dome that I knew of in four counties. Can that dome be fairly compared on a square-foot basis to the vernacular brick rancher? A lodge I knew had about 500 acres. It was located in a profoundly remote location, accessible by a somewhat tortuous 4WD trip that took at least an hour from the closest paved road. It was pretty much a stand-alone property. On an acreage basis, three comps could be found. On a truthful basis, none were available.

Several questions occurred to me from watching this play unfold.

How can lenders and appraisers make an exception for the odd-duck property that, in truth, has no local comps? Wouldn’t a sensible solution be to establish an exception-to-the-comp rule? How might the exception be protected from abuse? An exception would have to be crafted by the federal bank regulators: Fat chance, huh?

What should a borrower do in this situation? Was there anything Melissa could have done before the appraisal to protect her interest in getting a fair appraisal for her building as an office? Using residences as comps took us by surprise.

Once the bogus appraisal is on the lender’s desk, what can the borrower do? A second appraisal will run into the same methodological handcuffs as the first.

I’m sure others have had, or at least witnessed, this predicament. What are your thoughts?

What’s going on? What exactly do appraisers do?

An appraiser forms an opinion of a property’s current Fair Market Value (FMV) by judging its attributes in relation to recent selling prices of nearby comparable properties. Adjustments are made for differences between the target and the “comps” to arrive at a dollar valuation for the target.

Appraisers get into the buy-sell process during escrow, after the buyer and seller have agreed on price and terms. If the buyer wants a mortgage from an institutional lender, he should have a financing contingency in his contract that allows him to back out of the deal if acceptable financing cannot be arranged.

That contingency often includes, among other items, a provision that the appraisal’s FMV be at least equal to the agreed contract price. Accordingly, buyer, seller and lender become invested in having the appraiser hit that contract number.

The lender has a list of approved appraisers. Small lenders often allow the buyer to choose from among them. Large lenders generally assign appraisers. In either case, the buyer pays the appraiser for estimating the property’s current market value.

The main criticism of appraisers has focused on the practice of deliberately inflating FMVs. Inflation allows a buyer to borrow more than the property’s true market worth. Appraisers are supposed to give honest and accurate valuations.

One version of inflation is a cash-back scheme, where the borrower puts the extra money not used for purchase in his pocket. If the buyer then defaults, the lender takes over a property that is likely to sell for less than the mortgage principal. Lenders don’t like cash-back schemes. Buyers have been known to pay appraisers on the side for their cooperation.

The more common inflation criticism is that appraisers play ball with lenders, sellers and borrowers—all of whom want the appraisal to hit the contract price, which is often higher than an honest FMV.

A 2007 study by October Research reported that almost 90 percent of appraisers surveyed reported pressure for inflated valuations from lenders, real-estate agents, mortgage brokers, borrowers and others. Three-quarters reported “negative ramifications” –  blacklisting; fewer referrals; less business — if they didn’t play ball.

So what’s wrong with everyone working together toward the same end? What’s wrong with an appraiser adding phantom value when everyone wants it?

From the seller’s perspective, it’s just fine. The sale goes through.

From the buyer’s perspective, it looks fine, because the purchase goes through.

If, however, the buyer is being allowed to borrow too much in relation to the property’s real value and his ability to pay the note, then the mortgage payment and other expenses can easily swamp him in the muck of unpaid debt.

When properties are purchased for more than they’re worth, a downturn in real-estate prices can make them worth less than the amount of principal owed on their mortgages. This is called, “being upside down,” which is not where any borrower wants to be.

From the lender’s perspective, lending more than a property’s true worth based on a pumped-up appraisal works only if the lender quickly sells the risky steroidal mortgage.

Such lenders have turned themselves into middlemen between borrower and note buyer. They had no incentive to insist on honest appraisals. The higher the loan, the more they made on the flip. These lenders shifted the risk of loss from default to the guy who bought the loan.

Small lenders, country banks, credit unions and others — those who kept their loans in their own portfolios — did not play this game. Many big lenders did.

Inflated FMVs lead to many buyers paying too much. The general public, one study estimated, paid about $135 billion for appraisal baloney — phantom value — in 2006 alone.

As in a pyramid scheme, a few people were winning until everybody started losing.

Phony valuations also destabilize the entire mortgage market and, eventually, much of the economy. An economic downturn cascades through these tricked-up mortgages, which produces defaults and foreclosures, slows real-estate sales, tightens credit and clobbers those who bought the notes.

This is where America is today.

Appraisers are in the middle of this mess.

Ethical appraisers — those who follow state and federal law and the rules of their profession –  lose work to those who don’t. Once appraisers start giving in to pressure, it’s very difficult to stop.

With country property, several other appraisals can be involved in a purchase.

Consulting foresters do cruises that estimate timber volumes and dollar values. Sellers can pressure foresters to inflate volumes to show more “money in the timber” than is actually there. Ethical foresters don’t do this.

I’ve been given seller-paid-for cruises that more than doubled actual timber value. Inflation of 25 to 50 percent is not uncommon.

Mineral geologists estimate the volume of underground resources—minerals, coal, oil and gas. Bogus reports prepared for sellers that inflate the resource or fail to mention important discounting factors are not unknown.

Farm appraisers are subject to the same pressures.

Landowners may also lean on appraisers to come up with inflated values when they donate a conservation easement or historic-preservation easement. Higher valuations mean more tax benefits.

What can be done to protect appraisers—and, ultimately, consumers?

Jennifer Wertz, a California appraiser, fought back on her own. She recently sued Washington Mutual Bank (WaMu), America’s biggest thrift, alleging that she was blacklisted from work for not cranking up appraisals to the Bank’s target number.

States can investigate and sue. New York sued an appraisal company, First American, in November for doing what WaMu wanted.

Buyer-oriented real-estate organizations might bring legal and political pressure.

Professional groups — appraisers, consulting foresters, geologists and others –  may be able to do more to stand up to lenders and sellers. At the same time, they should back up their own members better and enforce their own ethical codes.

Their standards are not the problem. Look at the Appraisal Institute’s Code of Professional Ethics at www.appraisalinstitute.org; Click on About Us; Click on Ethics and Standards. Excellent information is also available from Appraisal Scoop at www.appraisalnewsonline.typepad.com

Perhaps code enforcement should be changed from a peer-review process to
totally independent boards.

It’s always easy to say, “There oughta be a law.” Well, maybe there oughta be.

Many appraisers have been under pressure to choose between making a living and being honest. They need to help themselves, but they also need a hand.