In the wake of the 2008 financial crisis, home sale activity plunged and foreclosures increased dramatically. As a result, the pool of recent sales appraisers could use as comparable sales shrank. At the same time, REO sales (“Real Estate Owned” by banks) became an increasing percentage of sales. In many cases, appraisers used REO sales in their appraisals – with complaints subsequently levied by brokers and buyers who argued that the use of REO sales resulted in appraisals that understated market value. So what exactly is an appraiser supposed to do in such a situation and is the use of foreclosure or REO sales acceptable practice?
First, it is important to understand that the appraiser is usually hired to provide an opinion of “market value.” Market value is defined as the most probable price that a property will sell for as of a particular date assuming that a sale is consummated between a willing buyer and a willing seller, neither of whom are under undue pressure to complete a transaction. The definition of market value also assumes that the property is sold for cash or financed at market rates (in other words, no unusual seller financing) and is exposed to the market for a specific period of time.
It is not sufficient for an appraiser to merely develop an opinion of market value for a property. He or she must also put the value conclusion in context. For example, an appraiser may opine that the market value of a house is $300,000 assuming it is marketed for sale and listed in the local multiple-listing service for about 90 days. In another example, a bank may hire an appraiser to value a property assuming a short marketing time of only 30 days, or assuming that the property will be sold at auction. The values developed in these scenarios may be very different depending on local market conditions.
Next, it is important to understand what is meant by the terms “foreclosure” and “REO.” A foreclosure occurs when the lender takes possession of a property after the borrower has defaulted on the mortgage. This type of transfer occurs under duress and is not reflective of a market transaction that can be used to develop an opinion of market value. In some cases, the sale price that is recorded is simply the amount of the outstanding mortgage.
An REO sale, on the other hand, refers to the sale of a property by the bank after it has foreclosed. REO properties can be sold at auction or through a broker, but they do represent sales between a “willing seller” and a “willing buyer.” Therefore, just because a property is sold by a bank that has foreclosed on it doesn’t mean that it can’t be an indicator of market value. To use the sale correctly, however, the appraiser needs to consider some additional factors.
The appraiser needs to consider the “marketing time” of the comparable sale – both how long the property was exposed to the market before the sale was completed and also how it was marketed. In some cases, a bank may want to unload a property quickly and will be willing to accept a low price in exchange for a quick sale. Usually, the quickest way to sell a property is via auction. If an appraiser chooses to use such a sale, the sale price may require adjustment.
In some cases, however, the bank will expose the property to the market for a typical period of time, often through a broker. In this case, a discount for short marketing time would not be expected and the sale might be a good indicator of market value without any adjustment.
Of course, bank-owned properties are frequently sold “as-is” and may be in poor condition, although this is not always the case. The appraiser should take into account any difference in condition between the comparable sale and property that is being appraised. But this holds true for any comparable sale, not just REO properties.
Another factor to consider when determining if REO sales are appropriate comparables is the level of foreclosure activity in the neighborhood. When a house is listed for sale, it will have to compete with other listings in the neighborhood. In some neighborhoods, REO sales accounted for over half of sales during the housing bust. If a house is listed for sale in a neighborhood with a substantial number of foreclosures and bank-owned properties, the price it will achieve will likely be negatively impacted by the supply of these competing homes on the market. In this case, an appraiser would be incorrect to ignore these sales altogether. Conversely, in a neighborhood where there is very little foreclosure activity, an REO sale with a short marketing time may simply represent an anomaly and should be given little or no weight by the appraiser.
In short, the use of REO sales by an appraiser depends on the dynamics of the local market as of the specific date of the appraisal. In neighborhoods where there is a significant inventory of REO homes, the market value of a house could very well be negatively impacted and the appraiser should consider the impact of such sales on the market. However, it is critical that the appraiser take into account how any comparable REO sales used in the appraisal were marketed and their physical condition at the time of sale.
As long as detailed commentary is included in the report for the end user that explains the necessity of using an REO comparable and the appraiser has provided sufficient information then REO’s are an acceptable comparable when the market calls for it. Appraisers should be prepared to provide additional information.
As an AMC we always look for the detailed commentary in cases like this. This is one distinction that makes SAMCO stand out from other AMC’s that use only automated quality checks. Sometimes the story is in the details. This is a perfect example of why appraisers tell their story in the addendum notes and why it is important to understand the whole story.