Valuation: market value
A red flag over market value
6 November 2012
As valuers bear the consequences of the property market crash, Chris Rispin considers the latest interpretation of market value in the Red Book
The release of the latest RICS Valuation Standards (the Red Book) had me rushing to see what had changed, as if it were the next in the series of Harry Potter books. The inclusion of the International Valuation Standards (IVS) gave me immediate food for thought - especially the commentary on market value in the light of the trauma experienced in the property market over the past decade. Since then, I’ve been reflecting on what ‘market value’ really means.
The definition of market value, and the commentary around it, are found in sections 30 and 31 of the IVS Framework and have changed little over the years. But there are some areas that bear examination in the context of the residential market as valuers experienced it in the boom years. The question is: was this interpretation of market value reasonable then, and would it be reasonable and sustainable if we experienced the same buoyant conditions all over again?
The first point to make is that market value is applied in accordance with a ‘conceptual framework’. Alternatives for ‘conceptual’ in Roget’s Thesaurus are ‘theoretical’, ‘abstract’ or ‘intangible’. I wonder if clients appreciate the intangibility of market value? This is underlined by the description of the willing seller as ‘a hypothetical owner’ ('The factual circumstances of the actual owner are not a part of this consideration because the willing seller is a hypothetical owner'), whereas ‘the willing buyer’ is operating 'in accordance with the realities of the current market and current expectations, rather than in relation to an imaginary or hypothetical market that cannot be demonstrated or anticipated to exist'.
On the face of it, this appears to contain a contradiction, but it is important to appreciate that there is a considerable amount of imperfect information in the marketplace and it is this that has resulted in priority being given to the real circumstances affecting the buyer.
There can be little doubt that availability of Land Registry data has significantly improved the level of residential market information in the public domain. However, it has also revealed a degree of inaccuracy in the recorded figures. The value is recorded after completion, which is assumed to take place 90 days after the sale is agreed. Yet I personally know of several occasions when completion has not taken place for more than six months and clients have not asked for a valuation update. If the time lag extended from, for example, July 2007 to January 2008 - or even if it only meant a change of season, from autumn to winter - the value differential could be significant. Is the client aware of the significance of the valuation date?
This leads to the next point: that the conceptual framework hinges on the parties acting ‘knowledgeably’ and ‘prudently’. In many respects, this is where the gap between theory and reality becomes apparent.
Buyers are expected to have a reasonable knowledge of pricing, based on the assumption that they have looked at a number of properties. However, this is likely to be limited to such matters as design, appearance and internal fittings, rather than more complex factors such as design failure and legal deficiencies. It is often said that 80% of buyers rely on nothing more than a mortgage valuation report (assuming they have a mortgage; a significant percentage of buyers now pay cash), which should cover all factors that materially affect value, but in reality is so limited that numerous assumptions have to be made. This devalues it as a report on which buyers can rely for all the information that might affect their decision to purchase.
Importantly, even this limited valuation report is not usually available when the original offer is made and therefore cannot be reflected in the ‘most probable price reasonably obtainable’, which is so critical to the definition of market value.
The commentary goes on to say that ‘this estimate excludes an estimated price inflated or deflated by special terms such as ... atypical financing ... ’. It is not clear what the term ‘atypical financing’ actually means, and it is not defined. However, it certainly brings into play another significant party, the lender, who makes most transactions possible yet features very little in the definition or commentary.
Should the lender be ‘knowledgeable’ and ‘prudent’ to the same level as the buyer, since the lender is usually the client for whom the report is intended? Lenders have a range of advisers to help them make underwriting decisions, and without their long-term finance, many transactions could not take place - certainly not at the level seen in recent years. Figure 1 shows the relationship between house prices and earnings - in particular how prices are a multiple of earnings.
Figure 1: This graph shows the rise in average house prices between 1974 and 2011 and the multiples of the median income required to achieve those prices over the same period
Average house prices (the red line) are shown relative to median incomes (the broken line) and their potential multiples between 1974 and 2011. The other lines show the multiples of earnings necessary to achieve the level of house prices. It can be seen that there appears to be a correlation between earnings and house prices, although it has become more distorted in recent years, indicating that something else has intervened. Current prices indicate that house prices are above four times median earnings, whereas the trend until the late 1980s was three times median earnings.
The graph clearly shows the period during the late 1980s when lending criteria were relaxed to allow lending to be increased to four times median earnings in order to support the boom in house prices. However, this can be regarded as a minor blip compared to the volcano (the double peak with a crater) that formed through the first decade of this century. Some statisticians have used average earnings, which show similar trends, but as averages are lower than medians, the multiple has to be eight times to achieve the peak. Three times median appears to be the sustainable level based on history, but is it? Have circumstances changed, or is this level merely a new norm generated by a period of atypical financing?
We now know that numerous forms of lending vehicles were used during the boom, such as ‘self-certification’, loans in excess of 100% loan to value (LTV), increased income multiples, extended terms, interest only, and so on, all of which reduced repayments and boosted affordability. This was helped by a period of low interest rates. However, over the period in the graph, interest rates fluctuated quite significantly (for many years in the 1970s they were more than 10%, as they were at times in the 1980s and 1990s) and that does not appear to have affected the overall trend in house prices.
The case of Paratus AMC v Countrywide  turned the spotlight on underwriting issues that suggest that ‘prudence’ could have become a devalued concept. The High Court judge was not prepared to say that the use of the lending product itself had been imprudent, but the judgment did deal with the contributory negligence of the lender. The court indicated that if the valuer had been negligent (he was not, based on the facts) and damages had been awarded as a result, the lender’s conduct would have justified a 60% reduction in those damages because of contributory negligence during the mortgage application and approval process.
The negligence related to a lack of proper assessment of loan affordability and failure to investigate discrepancies in the information provided in the loan application. Given that the loan was made available at 90% LTV on a self-certified basis and it was acknowledged that only a minority of lenders would have considered such a loan at the time, surely this is an example of ‘atypical financing’?
Has the scale and variety of this kind of lending distorted the lending norms so that they themselves have become atypical? And how aware were the lenders of the influence their practices were having on the marketplace? More importantly, were buyers aware of it? Clearly, four times median earnings had not been the norm, so when did buyers become reconciled to a higher proportion of their disposable income being required to support the repayment of a home loan?
Now, have lenders resolved the issue by reinstating higher deposits, reduced terms and repayment mortgages, all of which appear to have dampened demand? The website Money Marketing reported on 23 May 2012 that Linda Blackwell, manager of mortgage policy at the Financial Services Authority, had told the Mortgage Business Expo in Manchester that some lenders were calling for interest-only loans to be banned. If this happens, it will be another limitation on mortgage finance that might prevent the volcano erupting again in future, leaving significant amounts of negative equity.
A matter of interpretation
Chris Thorne, Technical Director of the International Valuation Services Council, responds
The IVS definition and supporting conceptual framework for market value has remained almost unchanged since 1992, and has appeared in every edition of the Red Book since 1995, so it has been well and truly ‘road tested’ by numerous practitioners in many different markets. Chris Rispin correctly points out that it is a hypothesis, and perhaps too often people assume that prices in the market always reflect the terms of that hypothesis. The reality is that actual prices will not all be settled on market value terms, and the skill of the valuer is in identifying and understanding the impact of any transaction-specific terms on the price that was agreed.
On the question of ‘atypical financing’, this is one of a list of examples of matters that could affect the price in an actual transaction, but that are excluded from the hypothesis. ‘Atypical’ is used in its normal dictionary meaning and no special or restricted meaning should be inferred. Whether or not financing is typical is, like all other matters in the hypothesis, to be considered as at the valuation date. If a particular mortgage deal is available in the market on the valuation date, it is not ‘atypical’, regardless of whether it might differ significantly from those available historically, or with benefit of hindsight at a later date. What should be excluded is the impact on price caused by a financing arrangement that is available only to a specific party.
What is typical?
So, is the lending regime we have now typical or atypical? If typical, valuers should have been made aware during the boom years that residential property was being purchased subject to atypical finance arrangements or other ‘elements of special value’ that should (in terms of the current definition and commentary) have been excluded from the calculation of the estimated price.
If valuers really were unaware that the lending then was atypical, the implications are enormous. How do we protect ourselves in future? Do valuers have the resources to recognise and deal with this sort of lending when the tide begins to turn? And should we be responsible for monitoring the behaviour of lenders? Considering the paltry fees received by valuers for mortgage valuations, it seems a tall order, but that begs the question of whether it is fair and reasonable to include the reference to ‘atypical lending’ in the commentary on market value?
In many respects, this is a macro event and interpreting it on a micro scale is difficult with current technologies. Now, when new-build schemes offer financial subsidies, it is straightforward enough to detect inflated prices with the help of the CML disclosure form, but the intensely competitive nature of lending during the first decade of this century made even this kind of atypical financing hard to root out.
On the basis of the commentary, if lenders want valuations to comply with the Red Book, they need to address all the manifestation of atypical lending. Are they prepared to do that?
The knock-on effect
If valuers were unaware of the true impact on the market place of such lending, how could buyers have been expected to act ‘knowledgeably’? They operated on the basis that they would pay the price asked by the seller as long as they could get the finance. If they needed to take into account that inflated prices might not be sustainable - in fact that the whole market might not be sustainable - should sustainability be part of the definition?
On the back of this lending frenzy, the market kept rising ... a vicious circle, since the increased capital values justified even more lending, usually by way of re-mortgaging. The comparables to support these re-mortgages were always available thanks to the sheer volume of other transactions taking place, which in turn were supported by the endless variety of financial incentives that made them affordable. When more rigorous lending criteria were applied at last, the market all but collapsed, hence the crater shown in Figure 1 as prices dipped. The low volume of transactions, together with continued low interest rates, seems to have provided some stability.
In the light of all this, is the current definition fit for purpose? It provides a conceptual framework, but is it too far-removed from reality, especially when the market becomes overheated? Or was what happened in the financial services industry a freak event that will never be repeated? There is an argument for referring specifically to the role of lenders in the commentary on market value. It is hard to believe that regulation alone will prevent a repeat of the kind of contributory negligence that justified a reduction of 60% in the hypothetical award in the Paratus case. It should not be the valuer’s job to determine the existence and impact of atypical lending.
It is also clear that, at the time of making the offer, most buyers do not have all the information that could affect their decision and contribute to the ‘most probable price’ - hence, the conceptual nature of the definition.
And it is equally clear that not all lenders are fully aware of the commentary relating to market value. Perhaps they should be, if they expect their underwriting policies to comply with the guidance.
Chris Rispin FRICS is a Director of BlueBox Partners and a member of the Residential Survey & Valuation Group
- Image source: CML Regulated Mortgage Survey
- Related competencies include: T083