Flawed property valuations and how you can check the real market value!

As a reputable property sourcing company the single most important 'number' to get right is the property valuation. Unless a fair market value can be established the investor faces two big problems:

Firstly, any discount offered is not 'real', as is isn't based on a realistic market value, and

Secondly, at the time the mortgage valuation is carried out the deal can collapse

In the last couple of years making a fair judgement of market value has got immesurably more difficult and we believe its important for investors to understand the issues so that they can make sensible judgements about the value of the deal and the real equity delivered in the property they are considering.

Let's look at the various ways that valuations can be obtained, the problems that arise and how investors (and us!) can get to a sensible result where there is a good level of confidence that the property is correctly priced.

Price variation

Valuation is not an exact science and never has been. There are simply too many variables which mean that two different valuers on two different days may come to different answers. Of course they all ought to know all the factors to consider, but they often don't. Also some place more weight on (say) location, whilst another may give more weight to size of the property.

Traditionally, valuers would expect to be within 5% of a median price. What this means is that if, for example, the median valuation of a property was £100,000, all valuers should estimate a price between £95,000 and £105,000.

At the end of the day that's as good as it got. By the way, the ultimate value will be what a buyer in the open market will pay for it, which could be more or less than the valuation achieved. This creates a responsibility for the investor, who should take any valuation given and then make they own view of the value.

Right now, with continued uncertainty in the market, this 'spread' of values has increased. Instead of a 5% spread from the median we are now seeing 10% spreads, sometimes even more.

What this could mean is that a property worth £100,000 could get valuations between £90,000 and £110,000.

Two types of valuation

In our view there have always been two types of valuation. An 'open book' market valuation that is based on a sale between a willing seller and a willing buyer allowing enough time for marketing.

Then there is a 'forced sale' valuation that is between an unwilling seller and a willing buyer, with a very short time for sale.

Not surprisingly, these two criteria for valuation create different results. At Axis, we operated in the forced sale market, which is why we can negotiate and then offer highly discounted deals to our clients. We aren't trying to 'fake' the open market valuation, we are negotiating a reduced price from distressed sellers based on very quick sale.

Surveyor valuations

The current problem about 'in-person' valuations arises because of worries on the part of the surveyors and the lenders.

The surveyors worry because they are afraid of getting it wrong. They won't be penalised for underpricing a property, but they could be liable if they overprice a property. In an uncertain market it is natural for them to be extremely conservative.

Secondly, the lenders are being extremely cautious and want to make sure that their approved loan-to-value ratios are not exceeded. So they sometimes instruct valuers to take a more conservative line.

Take these two things together and a live valuation can turn out to be a disaster. In some cases the surveyor gets a sniff of a discount being given away, and although their valuation instructions are 'open market value', they can still knock £10,000, £20,000 or more off their assessment!

In fact in a difficult market our experience is that the surveyors make it even more difficult by regularly underpricing with absolutely no justification and no form of appeal to get it changed.

Investors buying should not be surprised that some deals will fall apart at valuation purely because of a nonsense result!

Having said all of this, a RICS (Royal Institute of Chartered Surveyors) remains the best options for a current and valid valuation that is likely to stand up when it comes to obtaining a loan.

Automated valuations

There are a handful of automated valuation systems that use complex systems to come up with values on properties. At Axis we use just such a system and in general they are extremely good and very accurate.

The systems typically take electronic feeds from:

• Land registry sale data
• Lender's valuation data
• Comparables for sale
• Ordnance survey data

This massive amount of data is analysed by the system to produce a valuation for every property in the UK, together with a 'confidence level' of how accurate the answer is.

In our experience, automated valuation systems (AVS) are extremely good when there is good evidence of value in other local property of a very similar nature. So, for example, a two bedroom house in a street in Manchester where there are 100 other identical units is a wonderful example.

It's less accurate with a detached house in the country which was built 300 years ago as a Manor House and there is no comparable property within 50 miles, if at all.

Some of the challenges that can throw an AVN system off track are:

• A property that is substantially in better or worse condition than average 
• A property that has had a large extension built on
• A property that is untypical for the area
• A flat where there is a great variation of size and outlook in one block. Eg sizes from 1 bed to 4 beds, some on lower floors and some as penthouse
• A property that is much bigger or smaller than others in the neighbourhood
• A new build property where none have sold so far

All these possibilities mean that we are very careful with automated valuations. In some cases they are extremely reliable and good enough to be confident by themselves. In other cases we may use the AVS as a starting point for further investigation.

Comparables

Our AVS gives us a wonderful spread of comparables very quickly, also enabling us to choose those which are most relevant in terms of location, similar property and so on. We can also eliminate those we know are not really comparables.

There is a lot of value in looking at comparables to assist with valuations but some pointers need to be borne in mind:

• The condition of the property can't be judged by comparables on a website. It could be great or it could need substantial work at considerable cost
• You don't know if the seller is in a hurry and selling very low, or holding out for a higher than realistic price
• The Agent may be underpricing the property in order to gain interest
• The Seller may be testing the market and have no intention of selling
• In general properties sell below their asking price. The actual sale price is typically 5%-8% lower so this amount needs to be taken off comparables to arrive at a genuine market value

It's possible that the comparables will contain repossessed property and/or distressed sales, which could be a lot cheaper than standard market prices and can distort your assessment of valuation.

However, if you are aware of these issues that can distort the value, then comparables can be a very useful indicator of value.

Valuation based on yield

In the commercial market (e.g. shops, offices and warehouses and, more recently, hotel developments), valuation has frequently been based on a calculation that starts with the rental yield. Let's illustrate:

Suppose a commercial property is achieving a rent of £20,000 pa and the anticipated rental yield for this kind of property is 6% pa. Then on a yield basis the theoretical capital value is £20,000/6% = £333,333. If the buyer thinks the yield should be higher, say 7%, then the capital value they will attribute to the property will be lower.

In recent years some specialist residential property has started to be valued on a yield basis. For example, hotel rooms, HMOs, student property and social housing with guaranteed rentals. These properties often have more secure income and far fewer comparables to use for a valuation. In fact they are very similar in many ways to commercial valuations.

For now, buy to let lenders do not use the yield basis for formal valuations, but we encourage the use of this tool as a quick 'sanity check' on the price that is being asked.

Market distortion through distressed sales

In all the valuation systems we have discussed, investors should beware of market distortion because of the inclusion of distressed sales. In Florida some areas have 45% of listed property at a forced sale price way below market value.

That massive weight of unsold property at a low price is now affecting valuations of 'normal' property. Valuers are reducing valuations of standard property to an average price that takes into account the forced sale property that is available.

To use a simple example, if the open market value is £80,000 and there is a repossession on sale at £40,000, a valuer may now come up with a market price of £60,000!

This is disastrous for the owners who now can't sell at a sensible price because its forcing down their property values.

In the UK the situation currently is not as bad as this, but in some areas it's starting to be noticed. The Land Registry actually classifies sales into two segments: open market sales and "Power of Sale" sales which are effectively repossessions. Only the open market sales values are currently made available to our AVS. Most people think this is sensible, including us. A few think that all sales should be considered when calculating valuation.

The point to make is that distressed sellers can be offering property on the internet and if you don't know this then any valuation you reach through comparables can actually be distorted by these low prices.

It can also happen with property from some time ago. I bought a house in 2004 that was valued at £279,000 for £230,000. The sale was recorded at £230,000 at the land registry but as an 'open market sale'. So all AVS systems include the £230,000 value in working out the current value and come up with the wrong figure. They simply don't know the deal I got.

I'm firing warning guns to show you that in yet another way values are not always what they seem and can distort current market prices quite considerably.

What does this mean for investors?

So where does all this take us? I've shown you there are considerable problems and issues with valuations whether they are done by:

• A surveyor in person
• An automated valuation system
• Comparables

If a valuation comes up with a high confidence on our Automated Valuation System then almost always this will be more accurate than a surveyor, provided that the property is in 'average' condition.

Otherwise a valuation by a surveyor is Axis 'gold standard', and of course is always required if you are getting a mortgage on the property.

Before Axis finalises a deal we complete anything from one to three of the valuation methods above. It will depend on the pricing, comparables and our assessment of the property itself. In some instances we instruct a surveyor as well as using every other method.

Ultimately, even allowing for our knowledge of the obstacles and taking great care, the final valuation can end up significantly different from our estimated market value. The truth is that almost always our valuation will be pretty spot on, and the valuer will be wrong.

That's tough to say and a real criticism of the valuation process but we are convinced, having seem enough deal screwed up because of silly valuations, that our statement is true.

What should an investor do to reach a real market value?

The first thing is to understand the issues involved with all kinds of valuation and that a market price is a best judgement which is sometimes easy, sometimes difficult.

Some valuations from a valuer will be plain wrong. There is no sensible appeal process and it doesn't make the sourcing company incorrect in it's assessment.

If this happens you will need to come to your own decision about market value, with a level head and by doing the homework. By all means ask us for a copy of the AVN and our comparables if the surveyor has come up with a low number.

At the end of the day, if the valuation for mortgage purposes falls a bit below what you expect, then you may sensibly decide to go ahead and buy anyway, just putting a little more cash in the deal.

If the valuation for mortgage purposes is way out, then probably the deal is going to fail.

The benefit of buying at net price

Let's take a property valued at £120,000 which you agree to purchase for £84,000, a discount of 30% from open market value.

If you are doing some kind of 'creative finance' and borrowing based on the gross market value of £120,000, even the slightest downvaluation is likely to upset the deal. Why? Because you are most likely going for a no money down or low money down deal and typically you will be an investor with very limited cash resources.

Apart from the questionable legality of this sort of funding, at Axis we believe that deals like this are inherently risky for the client. This is because...

• The slightest undervaluation will upset the deal
• The extremely high level of gearing means a higher interest rate and a higher borrowed amount, leading to poor cash flow. 
• Any increase in mortgage rates, which will certainly happen, means that even the small cashflow will probably disappear and could cause real financial troubl

On the other hand, if you borrow against the net purchase price, then you will ensure...

• Virtually no likelihood of a downvaluation because you are buying at the distressed price which is disclosed to the lender
• Often lower stamp duty
• Lower fees because no bridging required
• Lower mortgage at lower interest rate
• Far greater positive cashflow
• Increase in mortgage rates can be accommodated without any problem, which ensures a stress free and secure future

I hope that this article helps you understand the different valuation mechanisms, the challenges that can be encountered, the reasons that a valuation can vary and be plain wrong, and the best way to purchase for security and peace of mind.

Happy Investing

Live with Abundance

Rod Thomas FCA   

 

Posted in Property Prices

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