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Weekly UpdatesLast month an appraiser was complaining to me about the additional work required to complete Fannie Mae's new "Market Conditions Addendum," Form 1004MC (Freddie Mac Form 71). The appraiser said she thought it was unfair to add so much to the scope of work of a residential appraisal. Is this new requirement an increase in the scope of work, is it an increase in the reporting requirements, or both? Is this a new area of focus or is this a new area of appraisal? Should residential appraisers have been doing this type analysis all along, or is it a reaction to the new market paradigm?
Market Analysis in Real Estate Literature
Analysis of market trends in residential appraisal is not new. The first real estate textbook I ever read was published in 1960, and I used it in college-level real estate classes in the 1970s. In this textbook, there were chapters on economic trends and another chapter on real estate market analysis. These chapters discussed supply and demand, economic base analysis, and trade areas for shopping centers.
Similarly, professional appraisal classes in the 1970s used a textbook published by the Society of Real Estate Appraisers that also included a chapter focused on economic base analysis, location quotients, and market analysis. These topics were emphasized in the course of study because it was thought to be important to know when trends are changing and why.
In 1981, the American Institute of Real Estate Appraisers published the 9th edition of The Appraisal of Real Estate. This reference book referred to the economic characteristics of a neighborhood and districts, and discussed occupancy and income levels, percent of owner occupancy, rental levels, and the amount of new construction and development. It also discussed situs relationships, and even the supply and demand reported on the residential forms.
The Appraisal of Real Estate, 12th edition, included a chapter titled "Market Areas, Neighborhoods, and Districts" This edition discussed economic influences that affect real estate, per capita income, and the extent of homeownership. It also included discussions about national and regional economic trends and other relevant demographics.
More recently, the Appraisal Institute has published Appraising Residential Properties, fourth edition. This book includes chapters on "Principles of Real Estate Economics" and "Neighborhood and Market Area Analysis." The former discusses economic base analysis, while the latter addresses market and marketability studies. Also, a textbook published by the Appraisal Institute, Market Analysis for Real Estate: Concepts and Applications in Valuation and Highest and Best Use by Stephen F. Fanning, MAI, (1) focuses on nothing but market analysis.
Finally, in the 13th edition of The Appraisal of Real Estate there is a full chapter dedicated to the analysis of real estate markets, and another chapter focused on market and marketability analysis. These chapters are quite detailed in regards to market segmentation and delineation, real estate cycles, and the six-step market analysis process.
Clearly, much has been written about market analysis in the appraisal literature, so this topic is not a new area for appraisal practice; however, it is an area of new emphasis in residential appraisal. Although Form 1004MC represents an increase in the reporting requirements, some form of market analysis should have been part of the appraisal process all along.
Despite decades of discussion on market analysis in textbooks, there still appears to be a gap in many appraisers' training on this topic, as illustrated by the often-expressed difficulty in completing a "Market Conditions" form. In fact, some appraisers are having so much difficulty that third-party companies are now offering programs to complete the form for the appraisers. If this service is indeed filling a void and there is demand for such a service, is it because some appraisers do not know how to do it themselves? Apparently so!
The lack of understanding of market analysis is not necessarily the fault of the appraiser, but is probably more a function of the curriculum requirements for appraisers. Some appraisers were not well trained on this issue, and therefore may be strangers to the process. Recently this situation has been corrected within the Appraisal Qualifications Board's new requirement that all newly licensed residential and certified residential appraisers must attend a two-day course on "Residential Market Analysis and Highest and Best Use" and pass the course exam; nonresidential appraisers must attend a four-day class. This means all new trainees have been exposed to the concepts and procedures of market analysis, but appraisers who received their training prior to 2008 are more likely to be lacking market analysis training.
Market analysis has been an area of primary focus for commercial appraisers. Now, however, focus on market analysis is expanding to residential markets, as seen with the new requirement for residential appraisers to complete the Market Conditions Addendum form from Fannie Mae and Freddie Mac. As appraisers look forward, it is likely that they will need to perform more market analyses, not less.
The Market Analysis Process
Needless to say, in tumultuous times like these, the focus has increased on market analysis. This is obviously needed since "yesterday's market actions may or may not be indicative of current or future market behavior" Although this line sounds like a caveat from an investment advertisement, it really applies to appraisals today. Using comparable sales, capitalization rates, or even lease rates from a prior market is always dangerous when the market is moving up and down fast. Appraisers should be asking, does this data show what the subject is worth or does it show what the subject would have been worth when the comparable sale closed? Does the market conditions adjustment in the appraisal reflect the real change in the market? Without market analysis, an appraiser cannot be sure if the market conditions adjustments should be negative or positive, and how much the adjustments should be.
Form 1004MC is a modest attempt to require appraisers to show support for their market analysis conclusions. (A copy of Form 1004MC is included in the Appendix.) Although this new form specifies certain minimum requirements for analysis, this does not preclude an appraiser doing more than the minimum and supplementing the form with more analysis. With the focus on market analysis today, many appraisers are asking, what else can an appraiser do to supplement the market conditions form? In practice, supplemental analyses may end up being the primary method in some markets where the median sale and list prices do not produce convincing results.
Categories and Levels of Market Analysis
First, it should be stated that most market analyses can be categorized as either inferred or fundamental. An inferred analysis relies on historical data and tries to estimate future changes based on the past trends. This category of analysis is based on the assumption that what has happened in the past gives clues to what will happen in the future. Inferred analysis is based on evidence of change, not on the cause of change. Fannie Mae's Form 1004MC is an inferred analysis.
A fundamental analysis interprets demographic and economic data to forecast market changes in the future. For example, if the population increases in a city, how will that affect demand for homes priced from $X to $Y? Fundamental analysis is much more appropriate in tumultuous times like now; however, it is much more complicated and sometimes more subjective.
Market analysis can be broken down further into four levels of analysis, which are labeled simply A, B, C, and D. The level of detail in the analysis increases with the letter; for example, a Level A study would be the least detailed and simplest to do.
Level A studies rely primarily on macro data found in many market studies. Level A studies focus on a broader market, and use general data and published reports as a basis for conclusions. This is the minimum analysis that should be included in every appraisal analysis. For example, a Level A study could state "the appraisal assumes property values are declining by 5% per year as reported by the National Association of Realtors' median price analysis for the Bigville metropolitan area." A Level A study is always an inferred analysis.
Level B studies are more detailed than Level A studies and rely on the appraiser's analysis. A Level B analysis includes much of the analysis included in Level A, and supplements it with research on supply and demand factors for the subject's specific market. This level of analysis is similar to what is done on Form 1004MC for residential appraisals. A Level B analysis is usually adequate for stable (not volatile) markets, but may be inadequate for the rapidly changing markets seen in many states today. Because a Level B study is based on historical data and develops trends from that historical data, it is an inferred analysis.
Level C studies measure demand with fundamental tools, including employment and population trends, and average household size. This level of analysis includes ranking the subject within a specific market and measuring both supply and demand for the product type in the market. A Level C market analysis does not read the signs of change, but it measures the causes of change and therefore is a fundamental analysis. This level market study always includes analysis with comparisons of the subject property measured against a market standard or ideal improvement. The subject and all competing properties are compared to the standard to determine where the subject property falls within the scheme of things.
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