We are honored to have Chip Wagner, an icon in the appraisal industry and our good friend, as a guest blogger yesterday and today. Yesterday, Chip defined the role of the appraiser in today’s real estate market.  – The KCM Crew

Today, Chip will discuss the impact distressed properties have on housing values.

Contrary to the alarming nature being used in reporting that appraisers are killing deals, I would bet that most of my peer appraisers are not seeking the lowest possible sales to use in their appraisals. They are searching the data available in the real estate market for the best comparables out there. But the reality is that good comparables are hard to find.

Just last week, I was finishing up an appraisal in a condominium in a Chicago suburb.  It is a 246-unit development that has 24 listings available. In the past 12 months, there were 5 sales, of which 4 were distressed (short sales and foreclosures). The one arm’s-length transaction sold pretty low too, and when confirming with the listing agent, we found that the owner needed to sell (but not under duress) and understood the oversupply in their marketplace and didn’t want to sit on the market for a year or more competing with the overpriced competition. In this same condo development, in the previous year (13 to 24 months ago), there were 15 sales of which 6 were distressed (still 40%, but not 80% of the market). As a result, the average sales price has dropped over 15% in the past year.

First of all, with 24 competing on the market and only 5 sales in the past year, which is a 2.5 year supply of inventory. A balanced market is 4 to 6 months, so a 2.5 year supply of inventory is going to place significant downward pressure on prices.

What does this mean to overall values?

According to RealtyTrac.com, foreclosures, on average, sell for a 35% discount and short sales sell for a 10% discount. These distressed properties might not be in the same physical condition as the non-distressed properties. However, at sizable discounts, many purchasers are more than willing to absorb the risk of purchasing a property “as-is” and doing the necessary repairs as well as playing the waiting game with lenders in purchasing short sales.

There comes a point where distressed market competition becomes the marketplace. The appraiser may consider making an adjustment for the “terms of sale.” For example, if using a short sale or a bank-owned foreclosure comparable in an appraisal, an adjustment could be made to reflect the discounted value of that comparable. I have done this in many of my appraisals, without underwriter or appraisal reviewer concerns. The appraiser must support this adjustment and thoroughly explain why it was made.

There are other scenarios where distressed competition is a very small portion of the market, and these sub-markets appear to be doing better.  But even if there are not distressed sales flooding the marketplace, we are still often challenged with finding decent comparables – and that is the volume of sales taking place.

In the entire Chicago area, according to local MLS data, in January 2006 we had over 83,000 detached homes to sell in the previous 12-month period. In July 2011 it has fallen to 38,300 detached homes to have sold in the past year. What this tells us is that on average, neighborhoods that once had 20 comps to select from for consideration in our appraisal reports, now have 8 comps to select from. And you can bet with the typical market having 30% distressed competition, this is down to 4 or 5 arm’s-length transactions. This is making the appraiser’s job more difficult than ever. Comparables are limited, and the motivations and terms of the sale are complicated.