Reconsidering Foreclosures, Short Sales and Listings in an Upside Down Market

When sales activity has diminished, as is the case in today’s market, appraisers have a much smaller pool of comparable transactions available to them. Such times require that appraisers give greater scrutiny to transactions that have traditionally been discarded. 

Here’s why and how appraisers are reconsidering foreclosures, short sales and listings in an upside down market.

A sales transaction that complies with the definition of market value is often referred to as an “arm’s length” transaction. In this regard, an “arm’s length” transaction refers to a conveyance in which the parties are typically motivated, well informed, acting in their own best interest, have time to market the property and are not deploying unusual financing incentives.

Perhaps the most frequently cited example for a “non-arm’s-length transaction” is the sale of a foreclosed property. This is because, in a normal market, the mortgage balance is most often below market value. When the mortgage balance is below market value, the foreclosing lender has the option to cut the price of the real estate in order to achieve a quick sale.  This allows the foreclosing lender to terminate his investment in the loan quickly and favorably, without the risk of an extended marketing period.  Similarly, an owner who is selling in a normal market, under the duress of foreclosure, can cut his price for the purpose of quickly getting out from under a mortgage to salvage his credit. 

However, the relationship between the mortgage balance and market value is overturned under the recessionary market conditions we are presently experiencing. We all watched while the real estate bubble inflated larger and larger, rising to its fattest somewhere around the end of 2005 or early in 2006.  During this inflating period, credit was easily available and lenders were competing to make loans to buyers who were competing with other buyers in bidding up prices, often even higher than the original asking prices.  When the bubble eventually burst and values began to decline, many owners were left with huge mortgage balances. As the market declined precipitously, market values dipped below the principal balance on many mortgages, leaving owners “upside down.”  This situation was exacerbated as the supply of listings and foreclosures accelerated, while prices continued to plummet. 

These new market conditions created a new and abnormal relationship between the mortgage principal and market value. We now see that mortgage balances are often much more than market value. Foreclosing lenders are finding themselves with collateral that is worth considerably less than the mortgage amount. In many ways, this “upside down” posture makes a sale by a lender of foreclosed property much more similar to any other market transaction where a seller is simply trying to get as much as he can out of his real estate. No longer does the foreclosing lender have the ability of creating a “non-arm’s-length” transaction by simply choosing to liquidate the investment at below market value.  Instead, the foreclosing lender is now on equal footing with any other seller in the marketplace (typically motivated), simply trying to get the most money possible out of the real estate. Doesn’t this new set of circumstances equate the lender to any other seller?  Doesn’t this new set of circumstances qualify a sale of foreclosed property as an “arm’s length” transaction? 

Short Sales
One particular form of evidence that these transactions represent “arm’s length” arrangements is the emergence of the “short sale.”  A “short sale” is the modern label for a transaction in which the lender has simply agreed to accept a loan payoff that is less than the mortgage balance. In the circumstance of a “short sale,” there is no actual foreclosure because the owner and the lender (as well informed and well advised sellers) know that the value of their real estate and collateral has diminished and wish to take advantage of a present opportunity to get cash out of the property, just as would any other active seller.  There is no special or creative financing, only a mutual agreement by owner and lender to sell, just as any other seller might agree to sell. This often qualifies these transactions as “arm’s length” under current market conditions.

Nonetheless, many appraisers remain intent on avoiding the use of foreclosed and “short sale” transactions, claiming these transactions are representative of duress because of the depressed state of the recessionary market.  But the fact that these transactions are representative of the current state of the market is the very reason they are more worthy of our consideration. When the market is oversupplied and prices are low, we have an obligation to seek a value in our appraisals that realistically represents what a seller can obtain in the open market. The fact that a seller in the open market must compete with a plethora of other sellers, many of whom are lenders, cannot be ignored in any legitimate quest for market value. 


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