If you’re using a traditional valuation product that relies on a subjective selection of three comparables, developing a quality control process that can help you better navigate the risk is worth the investment.
Managing risk is a critical part of private lending. In this vein, it’s important to remember that compliant does not mean good. This is especially true in the world of property valuations.
Many institutions and professionals simply look to “check the boxes” of compliance to show they’ve managed risk. In reality, however, they could be ignoring the true underlying risk of the loans they are financing. Developing the right quality control processes and finding the best valuation providers can help you better navigate this risk and protect your capital from a variety of problems that might just fall outside the “checkboxes” of compliance.
This article focuses on a central topic for property valuation: comp selection. This topic is acutely important if you find yourself ordering old-school appraisals, whose values are generated by the manual selection of three comparable properties, followed by applying any set of quantitative adjustments deemed fit by the appraiser performing the work.
According to USPAP rules and common practices, there are basic parameters for selecting comps. There are also situations where appraisers may go outside of these parameters to select their comps. The truth remains that it’s possible to meet all USPAP guidelines when selecting comps yet still provide a set of conclusions that are, shall we say, less than accurate.
Here are four common areas where we frequently uncover valuation risk concerning the comp selection and subsequent conclusion of value:
- Distance from subject
- Condition versus budget (for ARV) or versus inspection (for current AIV)
- Property size and “under” adjustments
- Vintage and architectural style/quality
Let’s take a closer look at each one.
Distance From Subject
As the old adage goes, real estate is about location, location, location. It’s understood that proximity to the subject should be an important factor when evaluating recently sold comparables to determine property value. Proximity isn’t the only factor, however. Location can be affected by neighborhood, subdivision, school district, and more.
The best question to research first is what other sold comparables were “overlooked” or not selected when the valuation professional(s) selected the comps in the report. For example, a standalone report showing three comps from 0.78 – 1.02 miles away might look great on its own, but if there were 53 comps within 0.5 miles away, then a natural skepticism should arise. What was wrong with the 53 comps that were closer in proximity to the subject that caused the valuation professional(s) to go with the comps that were further away? Was there a valid reason for selecting outside of this closer geography?
To answer these questions, you can use simple solutions such as free sites (e.g., Zillow) to view recent, nearby sold comparables, or you can use more in-depth analysis tools like RicherValues and others.
Selecting comps further away does not automatically mean the conclusions of value are incorrect. Nevertheless, it certainly should raise a flag for a deeper review. Although it does not necessarily mean the report is wrong or risky, we do find that valuation conclusions can be questionable in more than 60% of instances (not a statistical study, just loose observations).
The first item to investigate is whether the comps further away were more representative of the subject property than the sold comps that were closer in proximity. Were they chosen due to size, vintage, lot size, style, quality, or other factors? If yes, there could be a great justification for selecting these comps further away. However, if you’re able to identify comps equally (or more) similar to the subject property, yet at closer distances to the subject, that should be a red flag.
The second item to investigate is whether there appears to be a qualitative difference in the subject neighborhood versus the neighborhoods of the selected comps and whether other/closer sold comparables appear to be in a more comparable neighborhood to the subject property.
One easy way to evaluate this is to use Google Maps, particularly its Street View feature. Although it’s true that in some secondary/tertiary/rural locations, the street views are not always current, the Google Maps platform can provide a great qualitative view into each neighborhood. Simply look up the subject property on Google Maps and use the Google Street View to drive up and down the block for as far as you’d like to go, including neighboring streets. Then do the same thing for the selected comps, and again for other sold comps you may have found that are closer in proximity to the subject property. Friendly tip: Opening multiple browser tabs can provide an easy way to keep things straight!
Finally, if the comps appear justified or OK but the neighborhoods do appear to be different in quality, then were adequate adjustments (up or down) applied to the analysis to reflect these differences?
The main question is simple: Do you feel the selected comps are truly representative and comparable to the subject property for valuation purposes?
Condition Versus Budget (or Inspection)
Another critical factor at play when evaluating comp selection is property condition. Unfortunately, with traditional appraisals, you will probably only be provided with a single, exterior photo for each comparable, making it difficult to truly evaluate. Therefore, it helps to look up each comparable on a different online source in order to view more photos.
Once you have access to a complete set of photos for each comparable, you’re now in a position to ask the question: Does the condition of these selected comps reflect the “correct” condition, either as “target” condition for a post-renovation budget (when evaluating ARV) or the current as-is condition when evaluating AIV? For more on this, take a look at the Q4 Edition of the AAPL’s Private Lender magazine, where you’ll find an entire article about identifying the correct condition/quality level when evaluating comps for ARV.
Property Size and “Under” Adjustments
This one is interesting and, unfortunately, we encounter it more often than you might think. The issue is simple. Property size is typically a major value driver for residential real estate; the larger the property, the higher the value (usually). Therefore, when comps are selected that are smaller or larger than the subject property, an appraisal would typically apply an adjustment for the difference in size to help arrive at a comparable sales price for the subject.
Interestingly, for compliance watchdogs and common quality control practices, setting large adjustments to comp sales prices can raise red flags; however, setting small adjustments will typically go unnoticed. Why? There’s typically no easy way to flag adjustments that are too small. This is exactly the scenario where you can uncover real risk hidden within deals and outside reports.
If you notice the comps selected are larger than the subject property, then ask whether the adjustments applied to these comps appear reasonable and adequate to account for the difference in size. For example, if you have a subject property that is 2,600 square feet and a comp was used in the analysis at 4,200 square feet, and only a negative $10,000 adjustment was applied in a market of properties worth $200 to $400 a square foot, then doesn’t this measly $10,000 downtick seem strange?
It should! Whether intentional or unintentional, this should be a red flag because it’s an indication the property’s value is being overestimated by comparing it to superior/larger properties, without making the proper downward adjustments to value to account for these material differences.
Whether you have access to some great analytical tools or use some good old-fashioned common sense, going through this quality control check will help mitigate your risk by making sure the value conclusions are not being disproportionately skewed due to the selection of comps and the adjustments applied (or not applied) to these comps.
Vintage and Architectural Style/Quality
Property vintage and/or architectural style/quality is another factor that typically drives value in most markets. Like property size, it’s important to spend some time investigating it.
To truly evaluate this, it’s best to find access to a full photo set for each comparable in the analysis. Once you have that, scan through the exterior and interior photos of each comparable property. Also investigate landscaping and curb appeal. Then compare those to the inspection photos (For more on that, please read our article in the Q1 2024 edition of Private Lender).
Once you have a good visual on each of the comps and the subject property, you should be in a position to determine whether you think these are strong, adequate reflections of potential value for the subject property or whether they represent a different value proposition to prospective homebuyers in that market.
Selecting properties of different vintage or architectural style/quality is not necessarily a bad thing, but if the difference is material, then you need to make sure the proper adjustments are applied to the sales price(s) of the comps.
These are just a few common examples of risk. Many more exist. If you’re using a traditional valuation product that relies on a subjective selection of three comparables, take note! It’s important to put in the effort to obtain better information. You will greatly benefit from developing the right quality control processes and finding the best valuation providers who can help you better navigate this risk and protect your capital from a variety of problems that might just fall outside the “checkboxes” of compliance.
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