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The Pseudoscience of Real Estate Appraisal

As of December 31st, 2016 there were 73,731 licensed, active real estate appraisers in the United States.

Last year there was approximately $488.6 billion in commercial real estate transactions, according to Real Capital Analytics.

Consider, for a minute, the fact that just about every single real estate loan made for a residential or commercial property acquisition, anywhere in the country, requires a certified appraisal by at least one licensed real estate appraiser. The arbiters of truth, the appraisers, must have a rigorous and exacting approach to evaluating real estate investment potential.

Today, they do not.

This is not an attack on the appraiser. It is a call-to-action to correct the current process of an appraisal.

Here are a few issues we have with the appraisal process:

Dated Information

Appraisers can only use closed sales transactions to estimate value in the sales comparison approach and for deriving cap rates. This means that by definition, they need to use outdated information.

Pro: It prevents them from overestimating market growth and getting too aggressive on valuations.

Con: It means that in markets with limited information (e.g. no comparable property sales in the last year), it is possible that they will not have enough data to effectively provide price comps and cap rates. If an appraisal is based on old data because that is all that is available in a market, how would they account for a broad surge in listing prices that will (in time) lead to higher sales prices.

Limited Information

The standards to which appraisers are held prevent certain types of information from being used in an appraisal such as active listings, demographic shifts and market trends.

Pro: It prevents them from overestimating market growth and getting too aggressive on valuations.

Con: Appraisers can’t truly leverage demographic and economic market trends to inform value estimates. This is by design – appraisals are not meant to be forward-looking. However, the reality of any market is that the participants consider future growth when making a purchase. Utilizing the Akerson approach to estimating cap rates, future rent growth and capital appreciation play a significant role in the cap rates, and therefore prices, that market participants are willing to offer.

Human Subjectivity

The biggest and most important drawback to appraisers is that they are, at the end of the day, human, and certainly not immune to being influenced and/or drawing subjective conclusions.

Pro: N/A

Con: Human subjectivity, itself.

Before I co-founded Enodo, I myself attempted to sway the conclusions of appraisers. For example, in accompanying a commercial appraiser on a walkthrough for a building we owned, I pulled my own comp set beforehand, stacked with the highest priced transactions in the market, and handed it to them along with a summary of improvements we made and the dollars invested in each of those improvements. I then walked through with the appraiser and highlighted the best portions of the building, purposely steering them away from anything we didn’t invest in improving.

At the end of that appraisal, the value came in approximately 12% higher than I estimated using conservative metrics and both good and bad comps in the comp set. Did my guidance during the walkthrough have any impact on the appraiser’s opinion of value? It’s impossible to say… which is precisely the problem with any subjective approach to real estate valuation.

Also related to this topic is the assumptions appraisers make of the incremental value from additional square footage, bedrooms, bathrooms, and amenities like garages, fireplaces, renovated kitchens and baths, etc. In studying for certification, appraisers are taught to use regression analysis to calculate the incremental value of various characteristics. In practice, this rarely happens. Appraisers draw completely unscientific conclusions about the contribution of each factor toward value, and lenders and investors rely on these conclusions to inform massive investment decisions. Granted this is a bigger issue in single-family valuation than commercial, but it is crazy to think how much capital is allocated based on such a subjective approach to analysis.

For each of these reasons, it is not entirely safe to rely on the opinions of appraisers in estimating value, yet it is done this way everywhere, all the time. How many millions, nay billions, of dollars are inefficiently allocated every year because of this?

It’s difficult to say precisely, but a 2012 study by KC Conway, an executive managing director at the brokerage firm Colliers International, and Brian F. Olasov, a managing director at the law firm McKenna Long & Aldridge, found a wide discrepancy between the appraisal values and the eventual sales prices of the properties.

According to a New York Times article on the study, of the 2,076 properties analyzed, 64 percent were appraised at values that exceeded the sale price, by a total of $1.4 billion, while 35.5 percent were appraised at less than the sale price, by a total of $661 million.

In extreme instances (121 of the properties), the appraised value in this study was more than double the sale price, and in 132 examples, the appraisal was less than 70 percent of the sale price.

These results were mirrored in a 2011 study by Cannon and Cole which analyzed the accuracy of appraisals for the U.S. commercial real estate sector, using 1984–2010 data from the National Council of Real Estate Investment Fiduciaries (NCREIF).

Comparing property appraisals with actual transactions, the authors documented that, on average, appraisals are more than 12% above or below the subsequent transaction price (correcting for the time lag between property transactions and valuations). These results are consistent with the findings of Fisher, Miles, and Webb in a 1999 study conducted for the 1978–1998 period. They documented an average absolute deviation of 9% to 12.5% between appraisals and transaction prices.

Woah, that’s a lot of inefficiency.

Now that you understand the issues with the appraisal industry, you can understand why we sought to correct these wrongs.

By simultaneously aggregating and analyzing the data used by appraisers, brokers and market analysis consultants, and using actual data science to quantify the impact of every variable that influences real estate investment potential, our team has worked hard to create a more objective approach to value.

Seriously, it’s time to ditch pseudo-science in favor of data science products on the market.

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