Rental parity analysis in appraisals would prevent another housing bubble
Evaluating rental parity would provide a check and balance preventing comparable sales from getting overvalued.
I have long contended that rental parity is the fundamental value of houses. Whenever values differ significantly from rental parity, up or down, reversion to the mean is inevitable. Buyers should be aware of rental parity because paying more than rental parity significantly limits a buyers options.
First, such a buyer cannot rent the property to cover the bills, so if they had to move, they either must sell the property or endure an indefinite period of negative cashflow. Since paying more than rental parity also means overpaying, there is significant risk to the buyer that they may not be able to sell in the future for enough to break even thus forcing them into a negative cashflow situation or a credit-crushing short sale.
Lenders should be concerned with rental parity most of all. In the wake of the housing bust, it should be apparent to lenders that borrowers will walk away from their mortgage debts and leave lenders holding the bag.
When lenders loan out money with payments greater than the potential rental cashflow, they also severely limit their options because the potential income from the property cannot service the debt. If lenders stayed within the confines of cashflow, in a worst-case scenario, they could take back the property in a foreclosure sale and rent it out to sustain their income stream.
As the housing bust has proven, this worst case scenario can easily come to pass. Of course, lenders are loathe to accept any limitations on the size of the loans they underwrite. Smaller loans mean smaller profits. However, when the go beyond the cashflow-backed loan amount, they rely on the borrower to make up the difference based totally on the borrower’s promise to repay. We have all seen how good the borrower’s promises are.
The easiest way to alert lenders and borrowers to the rental parity value of any home is through the appraisal process. We at the OC Housing News feel so strongly about this, we make this analysis part of our fundamental value reports we provide every client of the brokerage. It would be easy for appraisers to do the same — if lenders and borrowers wanted them to. I wrote about the correcting problems with appraisals in the Great Housing Bubble back in 2008 in the final chapter, Preventing the Next Housing Bubble:
… When the fallout from the Great Housing Bubble is evaluated, it is clear that the comparative-sales approach simply enables irrational exuberance because the past foolish behavior of buyers becomes the basis for future valuations allowing other buyers to continue bidding up prices with lender and investor money. Prices collapsed in the Great Housing Bubble because prices became greatly detached from their fundamental valuation of income and rent. This occurred because the comparative-sales approach enables prices to rise based on the irrational exuberance of buyers. If lenders would have limited their lending based on the income approach, and if they would not have loaned money beyond what the rental cashflow from the property could have produced, any price bubble would have to have been built with buyer equity, and lender and investor funds would not have been put at risk. There is no way to prevent future bubbles, and the commensurate imperilment of our financial system, as long as the comparative-sales approach is the exclusive basis of appraisals for residential real estate.
It has taken six years for others to warm up to the idea, but income-based appraisals is gaining interest among those who don’t want to see inflated house prices leading to another catastrophic crash.
The danger of using comparable sales approach becomes obvious when the market is gripped with irrational exuberance. Sheeple are stupid. Once prices start going up, the perception of value becomes nearly infinite. No price is too high if prices are guaranteed always to go up.
The best thing that happened to real estate during the crash was when appraisers became truly independent. Once appraisals became assigned on a round-robin basis, there was no way for realtors and fraudsters to hand select and appraiser who would “hit the number,” any number needed to make the deal go through.
Right now, appraisers are under pressure by homebuilders and sellers who have hooked a fool into over-offering on real estate. Appraisers are ensuring people don’t overpay by providing honest opinions of value because they no longer fear being blackballed if they didn’t tell sellers what they wanted to hear. Appraisers will keep the spring rally engineered by banks from getting out of hand. Many deals will fall out of escrow this spring and summer, and the complaints against appraisers will intensify. I hope they hold their ground. They will stop irrational exuberance from taking over the market.