The Mother of All Bubbles! Danger Ahead

Tick – Tock – Tick – Tock…

The mother of all bubbles has yet to appear. The national real estate market has already been turned upside down and inside out, but the worst is yet to come. There are many influences on the real estate market that, when combined, will once again send property values spiraling downward. It’s not a question of if, only when. The writing is already on the wall. In areas where the market has already been hardest hit, batten down the hatches; crisis “part two” is looming ahead. For those areas where prices have only slightly dipped or held their own, they will continue to remain stable. The economy will always provide a healthy real estate balance. Look back at the last 50 years and real estate has provided one of the most reliable investments in our society. It’s only when that balance was manipulated by greed, that the valuation bubble grew to unrealistic highs, leaving no other options than a dramatic decline and inevitable burst.

So, what is fueling this second crisis path? First, a growing reliance on automated valuation products or AVM’s. These computer generated services have been around for a very long time, playing a small role in the overall lending market. For many users of AVM services, there is an unspoken “acceptable margin of error” that is taken into consideration. Even back in the late 1980s, if a borrower had a $300,000 home (with an existing $75,000 first mortgage) and was only trying to get a $10,000 line of credit, an AVM offers the perfect valuation product. Even if the AVM incorrectly values the home (with up to a 20% variance either way), the lender is still safe. It gets a little more complicated though, when AVM’s are used for 80% or 90% loans, because a 20% variance in value can mean the difference between a safe loan and one that is under-collateralized. Another problem is that no one tells the homeowner anything about this “margin of error.” Homeowners are left to assume the value on their property is current and accurate. After all, the bank wouldn’t be lending money if the “valuation” was not accurate; right? So, the borrower plans on having “X” amount of money when they do decide to sell their home. When they finally decide to contact an agent about listing their home, they discover it’s not worth what they had been led to believe and they will only get “Y” if they sell now, which may totally change their plans. Just imagine a $50,000 to $100,000 difference in equity. Would that affect your plans to buy another house? This unspoken “margin of error” is just one more factor in creating a sluggish real estate market.

Most people familiar with the lending industry understand the limited role of automated valuation products. The problem today, is that the nation’s largest mortgage lenders are busy convincing government officials that these “valuation” products offer a viable replacement for traditional appraisals. Not only are they working hard to persuade big business about the improving quality of AVMs, they are pushing even harder to get the public accustomed to hearing words like AVM, BPO, automated valuation, technology based, electronic pricing, etc.. And, used to hearing the word “appraisal” used interchangeably. These products are NOT the same as an appraisal, and never will be. However, they can make the lending process much easier (and more profitable) for lenders, who would be happy to eliminate appraisers from their mortgage lending process. These computer generated products are created using the information (available for free) in public records, repackaging and selling the information provided by your local tax dollars.

A free information source is like many things in life: you get what you pay for. The information contained in the local assessor’s office was never designed or intended to be used in the professional home valuation process. That job belongs exclusively to the real estate industry and the MLS. That’s why the MLS was created: professionals sharing quality information. These “public records” are created through a mass appraisal process as an estimate for tax purposes only. Assessors never enter the property and have to make judgments on a home’s size, quality, and condition from an “exterior only” view. While the values provided by the local tax office are often all over the place, they can still be more accurate than many AVMs. Based on our study over the last eight years, the total tax values listed in public records have been equal to, if not more reliable, than those so-called “valuation products,” where the same information is placed in fancy packages and sold to consumers, and required by many lenders. Even though the local tax values may be just as reliable as any computerized valuation service, and they are provided by someone who has actually seen the house, they do have one major flaw – there’s no profit for the lenders in using free information. At the end of all the conversations about appraisal and mortgage reform, it all comes back to money and profits. Refer to the Golden Rule…

There is also no nationally mandated system for assessors to report square footage information. Across the country, there are hundreds of different methods for counting and listing this critical information. Different states use different methods of counting and naming square footage data, so how does any national computer program search for “total” square footage when it may be listed by any of a hundred different names (e.g. finished, heated, totalheated, EstLivAr, living area, gross living area, gross space, heated living area, square footage, estimated living area, apxsqft, finished/heated living space, building area, etc… Do the numbers all mean the same thing? In a word: NO.

There can be above and below “grade” living area included in many of these numbers; some areas considered “finished” and some just considered as ‘under roof.” Some numbers are broken down by floor level (i.e. 1200/2000 – meaning 1,200 on the first floor and 800 on the 2nd floor; or they may be listed as1200/900, in this case meaning a total of 2,100 sqft). How does anyone know the difference? Any “national search” for property details is impossible to do accurately or consistently. Remember, real estate is always “local” in nature and this is just one of the reasons why local knowledge is a requirement for accurate home appraisals. Computer valuations often compare apples to oranges and property values and subject to a host of variables; none of which helps to provide consistent home values. Makes you feel all warm and fuzzy about property values, doesn’t it???

And, to add to the economy woes, our state governments are at risk of shutting down at any time. One wrong event and we could be in total economic chaos. How’s that going to help the real estate market? Tax breakdowns, inaccurate computer valuations, and the fundamental problem of someone being responsible for measuring each house listed in MLS. In a poll of 1,000 home-sellers, 97% assumed measuring the square footage and being responsible for its accuracy was part of their listing agent’s duties.

Why haven’t we heard about this square footage issue before? Because, there are no easy answers to this problem and the powers that be, think it’s easier to leave a little mystery surrounding this subject so they don’t have to explain it. They like the public perception that measuring square footage is so complicated that they just can’t explain it to anyone outside the real estate industry. Without national standardization, this could be a liability nightmare for the real estate industry. There has been no agreement between agents and appraisers on measuring residential square footage in over a century, and no one has ever really studied the topic and tried to work out a solution.

After our eight years of research, we have found a solution and it is not as complicated as many would have us believe. However, the experts will have to agree on one method of measuring a single-family house. Imagine, real estate “professionals” all measuring houses the same way… Why consumers haven’t demanded this before now is a mystery. Size or square footage is the currency of real estate, yet the industry cannot agree on this topic that is imperative for consistent home values. Try to think of any other industry without measurement “standards” in this day and time. Real estate is the ONLY industry without national and/or international mandated measurement standards. It’s time for real estate to join the rest of the standardized world.

So, what’s the big deal about size or square footage in pricing homes? The big deal is, these seemingly unimportant numbers are used to value every home in the country. In residential real estate, size equals money. The vast majority of home valuations are based on a very simple formula that only uses two numbers. We all know the formula; price-per-square-foot. Even those not familiar with the real estate industry recognize and understand this simple calculation. Buyers, sellers, agents, assessors, insurance adjustors, appraisers, and many others base their valuation opinions by taking the home’s sales price and dividing it by the square footage. Considered by most to be a quick and easy method of determining a home’s fair price. Look at any Realtor’s CMA (competitive market analysis). Under all the color pictures, graphs and charts, you’ll find this simple, yet very powerful formula. It is just a fact of the real estate business.

The largest majority of home pricing decisions are made, totally dependent on the accuracy of the square footage details, often taken from public records. If you change the size, you change the value. Errors in square footage can cause errors in home valuations, from a few thousand to a few hundred thousand. Especially in areas where lower level living areas or upper level living areas are prevalent, mistakes are common. Measurements listed in tax records are created without ever entering the home and any square footage count is a guestimate. Computer generated valuation products, using the information listed in public records, creates inaccurate home values. Using these automated valuations, big banks can often end up owning property and paying much less than it’s really worth. They are the masters of the valuation game (seen the bank’s quarterly profits lately – even in a down market?).

Sure, the market is down. But, like most things in the real estate business, “it depends” applies to locations and specific situations. But, the errors in value that computer generated valuation services are providing, along with the increased acceptance of these so-called “valuation products,” is creating a new, rapidly expanding real estate bubble that is destined to explode. There’s no way to stop this steamroller without some huge changes, and fast; changes to the very heart of the real estate industry. The appraisal industry and their level of quality, will always be dependent (at least in part) on the level of quality information available through MLS records (better info in, better info out). At the end of all the discussions, the MLS must be accountable for accurate property details or our home appraisal system does not work.

The MLS is the key source of all property information used by the appraisal industry; not local tax departments. Appraisal “quality” starts with Realtors® and the MLS. However, for most automated valuation products, the local tax department is their main information source. The way the system works right now, neither appraisals or computerized valuations can provide consistently accurate home valuations. While appraisals are far ahead of the computerized programs, they still are totally dependent on the real estate industry to provide accurate property details, so the appraisal industry can properly compare homes. When you break it all down, the credibility of every mortgage loan is at the mercy of the real estate industry and the MLS. Any reform has to include the MLS.

For right now, big banking is calling all the shots in any appraisal/mortgage reform discussions, influencing government officials and agencies. When all the dust settles, big banking will have grown even bigger. At a time when the national real estate market is the worst it’s been in half a century, big banking is making more profits than ever. And, you better believe they have a master plan and strategy to control the mortgage loan process in the future. Plain old fashioned greed; nothing less and nothing more. American consumers don’t stand a chance. The lending “giants,” who convinced consumers to get loans they could not afford, is now convincing them that walking away from their home and losing any investment they made in the property is their best option. And, sometimes it’s actually true. However, the same lenders that made huge profits from all the easy-money loans, now own those homes; and often got them far below market value. In five years from now, what will banking profits look like? When they do decide they own enough real estate inventory, then they may open the lending gates and help property values climb once again. But, this time, they will be double-dipping in profits. Well actually triple-dipping. Profits from new loans; profits from foreclosed homes (and red tape fees); and a new profit center, taking a slice of the appraisal fee on every new home loan. They are very good at what they do; a pure profit-making machine.

The HVCC opened the door into the tightly regulated appraisal industry. It allowed lenders to reduce appraiser’s influence over the home buying process, giving lenders more control over how, when, and where they loan money. And, on top of that huge step to make lending easier (without anyone watching over their shoulder), now they also get a cut of the appraisal profits without doing any more work than they did prior to the HVCC. What a great deal for big banks! Appraisers now have appraisal management companies (AMCs) ordering appraisals, that have to be paid for their services. Well, who do you think ordered appraisals prior to the HVCC? Not only did banks order their own appraisals, they were making plenty of profits for their efforts. So, now lenders have to do less work, but get paid more; only in America! The “Golden Rule” is alive and well in mortgage lending.

The “mother of all bubbles” is a real estate path we cannot avoid. Another sharp downturn for the overall economy and real estate prices is coming in the near future. There are lawsuits flooding the court system right now trying to get someone to take the blame for the problems of the last crisis. While our attention is focused on playing the blame game and looking backwards, the future may sneak up and bite us once again.

The HVCC was an over-reaction by one government official that should have never been allowed to happen, in any industry. It put a Band-Aid on the dyke and diverted everyone’s attention away from the bigger problems at hand. The HVCC was followed by Dodd-Frank, which did not address the fundamental flaws of the HVCC. All the talk of “reform” since then has been focused on trying to fix an appraisal industry, which isn’t really broken. We’re trying to fix a broken hip by operating on the ankle. The appraisal industry is just one spoke in this real estate and mortgage lending wheel. Any “reform” needs to start at the beginning and fix the root of the problem. Until we fix the foundation of our valuation problem, any and all other attempts at a cure will be meaningless and only delay the inevitable. The question ahead may be how long this new bubble lasts, how bad it gets, and how we keep it from bursting again. Hold on, it’s going to be a bumpy ride…