Why Property Valuation Methods Must Be More Robust

The most significant cause of continued instability in the real estate market is the ongoing struggle to determine accurate housing valuations. The lack of an objective risk management system makes it difficult for the government sponsored enterprises and others to establish appropriate fees and generates uncertainty for the mortgage backed securities market. Without the ability to measure risk in real estate valuation, policymakers and business leaders have been severely handicapped in their ability to apply effective remedies.

During the boom in the U.S. residential real estate market from 2001 to 2006, sound valuation practices became the exception rather than the rule. By focusing exclusively on rising real estate sales prices, financial institutions largely failed to question the reported value of the real estate-linked assets in which they had a massive investment.

One of the major problems in the collapse was the lack of transparency in MBS with regards to the quality of their underlying assets. As a result, investors were stuck with assets worth much less than they thought they were worth. The uncertainty about asset quality decreased the willingness of investors to buy MBS and thus helped cause a major paralysis in the marketplace. Since the collapse of the housing bubble, the Federal Reserve has amassed $1.71 trillion dollars of MBS with questionable quality, and the United States Treasury has allocated billions more to help stabilize hard-hit neighborhoods.

The housing market still remains fragile due to a number of factors. The Federal Reserve is contemplating a rise in interest rates to prevent an overheated economy. Financial institutions have struggled to find a balance between mortgage modification vs. foreclosure, while implementing more stringent reporting and capital reserve requirements established by the federal government. Further, the housing market recovery has stalled in a number of states while other states might be starting a housing bubble. This creates challenges for regulators and raises the potential for infusion of another round of bailout funds for Fannie Mae and Freddie Mac, which would fall back again to the taxpayers within the United States.

Technology currently exists in the marketplace that can appropriately assess the risk of real estate investments for both financial institutions and homeowners. In addition to the sales comparison approach, cost and income approaches are also recognized by Uniform Standards of Professional Appraisal Practice.

Using all three valuation methods is similar to the three legs of a stool that help provides stability. This multiple valuation approach is a far more robust method of risk assessment and could help detect bubbles that are starting in certain parts of the country. Having this protection in place will help build a true housing recovery along with the protection of the American homeowner and taxpayer.

Hogan Copeland II is chairman of Smithfield & Wainwright.
Dr. David Macpherson is the chief economist at Smithfield & Wainwright.