Real estate appraisers almost uniformly defend the practice of including foreclosure sales in their list of "comparables" when reporting a property's fair market value.
They argue that a public bidding process, which can occur in foreclosures, is a measure of value in the marketplace.
Such comparisons, however, amount to using the selling price of rotten apples to reflect the value of fresh ones.
The notion that foreclosure sale auctions reflect fair market value is a fallacy. In my TKstate, "fair market value" has long been defined by the courts as the amount of money a purchaser, willing but not obligated to buy, would pay an owner that is willing – but not obligated – to sell.
A foreclosure does not, therefore, reflect fair market value as defined by law. However, there is no law prohibiting appraisals from referring to foreclosure sales as indicators of the voluntarily sold property's value.
That needs to change.
The law should address the issue of practical differences between foreclosed properties and those sold in ordinary transactions. In cases where the foreclosed-upon owner is still in possession of the property, a buyer must generally wait a period of time to evict his new tenant – a time-consuming and sometimes expensive process often reflected in the purchase price.
Then there is the issue of deferred maintenance on abandoned properties, an effort sometimes requiring repair of vandalism or waste left behind by a disgruntled former owner. Again, the foreclosure sale bidder will discount the value for such conditions.
Another significant difference between voluntary property sales and foreclosures is the number of buyers competing for the property. The pool of eligible buyers at foreclosure sales is smaller than the pool of buyers for a private, conventional sale. That's because almost all free and voluntary real estate sales are financed, while foreclosure sales require cash payment. Since there are far fewer buyers with ready cash, the smaller pool of buyers at foreclosure sales decreases the competition compared to voluntary sales.
So why would appraisers use distressed property sales in their appraisals of nondistressed property? Some appraisers are perhaps reacting to criticism that their profession over-inflated appraised values in recent years and seek to project conservative values by factoring in foreclosures.
Another reason could be that there aren't enough voluntary sales to generate sufficient numbers of comparable properties for an appraisal report. Lender criteria for appraisals can sometimes limit "comps" to sales of like properties within a half-mile radius of the subject property. In times when the majority of sales are foreclosures, what is the appraiser to do?
However, allowing, encouraging or requiring rotten fruit to be the standard on which fresh fruit is valued contributes to the stagnation of the market because when an appraisal reflects an artificially low value, financing is unattainable and the voluntary transaction fails.
In order to reinstate fairness to property owners and get the market back on track, the law should prohibit the use of distressed property sales in appraisals of nondistressed properties.