Editor’s Note: This fascinating interaction between an appraiser and builder sheds light on the role of both in a declining market.
How Builders Think (in a Down Market)
By Thomas J. Inserra, MAI, SRA
I had a very interesting conversation with a builder recently on the issue of cost versus value.
The Executive Vice President of sales for a very large and well-known builder called to beat us up because the appraised value of a proposed jumbo luxury home came in well below the contract sales price. When I sensed the call was nothing more than an attempt to intimidate me into changing the value, I asked if he had read the appraisal report and he stated he was looking at it now but no, he had not fully read it. I said, “Why don’t you read the appraisal report, as I believe most answers to your questions are likely already addressed.” He then says, “My boss would like to speak with you.” The next guy introduces himself as the CEO and I about fell out of my chair.
I spoke with the CEO about the confidentiality provision of USPAP and indicated I would be happy to speak with him in more detail but that I first needed to obtain the permission of my client, and explained the confidentiality provision of USPAP and agreed to call him back.
A short time later I called the CEO, since the lender authorized me to do so.
The builder CEO started our discussion by saying: “Look, my Executive VP of Sales is of course focused primarily on selling more homes. However, as the CEO, I am focused on the bigger picture and the economy concerns me. Right now, I think it might be more about survival than selling homes.” He said, “I honestly and truly want to understand why you are appraising this for below the contract price, and in fact, you are actually appraising it below our cost to build it. If your appraisal is accurate, it will have strategic implications for how I guide our company through this economic crisis, so I really want to better understand your appraisal.”
This guy was dead serious in that he really wanted to understand and was not trying to get me to change the value. I asked him what specifically he wanted to know. He said he had taken the time to read the appraisal and was amazed at how much information about the market was in the report. He indicated he had never seen an appraisal with so much information. He did however want to know two things about the appraisal: 1) How could I value the land at an amount that was lower than what he paid for the land; and 2) How could a brand new home that was not even built yet have depreciation?
Appraising Dirt
I explained that if he were to look on page __ in my report, he would note that I provided several land sales and land listings. One of the listings was a vacant lot adjacent to his lot (owned by a competitive builder). He was quite surprised to learn it was listed for sale with an asking price almost $150,000 less than he had paid for his lot. We then discussed all the other land sales and listings. I asked him, given all that information, what would he be willing to pay to buy a lot today, and he agreed that the land value I arrived at was reasonable. It was as though he finally realized for the first time, that land prices had actually declined.
External Obsolescence and Cost Approach
We then discussed the external obsolescence. I had him agree that his development competed with other million-dollar homes in about a 10 square mile radius. We spoke about several specific custom home subdivisions by name and their selling points. He agreed they were in fact in competition with his project and that it would be acceptable to use comps from those developments. I asked him if he knew how many listings of homes in the same price range were available for sale in that competitive area, but he did not. I asked him to look at page __ of my report where I had listed all types of statistics, including the observation that at the current rate of sales, there was a 10 year supply of homes in that price range in the competitive area.
I further explained that not all luxury home builders list in MLS, so that 10 year supply only represents data in MLS and that the true supply is actually larger. I asked him that if he was a buyer, with such a huge supply of homes that he could select from, what type of a discount or lower price would he want to motivate him to select one home over another. He said at least a 25 percent discount. I said, great, whether you know it or not but that discount you just agreed with is what appraisers define as external obsolescence and it reflects the large oversupply that exists in the market, and if you look in my cost approach you will find I measured a similar amount of external obsolescence in the market and the depreciation is about 30 percent.
He then agreed that given those explanations, the appraisal was well documented and contained reasonable value conclusions. He agreed that all 12 comps (sales and listings) used in the report were in fact from competitive areas. He then said all the appraisals he sees only have three comps, why did I use 12? I said that if you were buying a luxury home, how many homes would you look at? He said quite a few. I replied, “An appraiser’s job is to reflect the actions of a typical buyer and I think a typical buyer would have checked out many or all those competitive subdivisions we spoke about, that you agreed are your competitors. Besides, if I had omitted that data, it would have appeared that I omitted relevant information or perhaps that I was not fully informed about the market.”
When lenders and regulators review appraisals, one of the things they look for is omitted information since that increases the risk of fraud and abuse. By including so much information in the report, I gain the confidence of you and my client that I have really done my homework: that I have not overlooked any relevant information and that my report can survive even the toughest of reviews by lenders and regulators. I asked if he was aware of any comps or data I may have missed and he said no.
Even if he secretly did call me in an attempt to change the value, I think he realized there was no factual basis or any relevant data to support a higher value, and I had the sense he now fully agreed with the appraised value. He then said, “This means our homes will likely sell at price that is lower than it currently costs us to build them.” And I did not disagree. We then talked about the cyclical nature of the market and how just a few years ago, builders enjoyed some rather lucrative profits when the market was willing to pay attractive prices, above costs, and that regrettably during tough times, the reverse is also true. I said, price is a function of supply and demand and the appraisal accurately represents what people are currently willing to pay given the economy and the oversupply.
He asked me, “Given this terrible economy, what advice do you have for me considering market prices where we compete are below our costs?” I said I had never been a builder but I did have a few observations: 1) If you lose money on every home, then sell fewer homes. Selling more homes is only going to increase rather than decrease your loss; and 2) Sell as many non-producing assets like land as possible in order to raise cash to help whether the storm. If you can raise debt or equity in the markets do that as well, and we talked about the importance of liquidity and cash in today’s market. We also discussed the idea of focusing on buyers who do not require financing and who could afford to pay cash, and the difficulty many buyers were having in obtaining jumbo loans.
He was very appreciative and thanked me for taking the time to explain the appraisal, and the market information. The explanation about external obsolescence appeared to help him better understand what was happening in the market so he could devise an appropriate strategy for his firm to survive.
Overall, I found him to be reasonable, inquisitive, and that he was truly trying to understand the market. I had the impression he had never heard of external obsolescence prior to our call and he was surprised that land prices had dropped, and was stunned at the 10 year supply. I suspect others he interacts with, like agents and his sales team, are not quite as candid or factual about current market conditions. He hinted his team was presenting a much rosier picture of the market and he was now starting to doubt those rosy forecasts they had been supplying.
I’d encourage others to engage in conversations with builders as there does appear to be a need to share our knowledge of the market and to educate them about issues that seem quite simple and logical to appraisers but perhaps not fully understood by others. It is also a good opportunity for paid consulting work.
(Thanks to the Appraisal Institute Forum.)
About the Author
Tom Inserra and his wife Nancy own Pinnacle Peak Appraisal in Scottsdale Arizona. He served as National Chief Appraiser for the FDIC/RTC during the banking crisis in the 1990s, National Chief Appraiser for HFC, Chief Appraiser for Citibank Arizona, and CEO of a publicly traded appraisal company. Tom also leads a national financial services consulting practice at a CPA firm that currently manages 11 failed banks with $7 billion in assets on behalf of the FDIC. The views expressed by the author are his personal views and observations and have not been approved by any organization.