Secondary Marketing Executive, March 2004.
In the real estate capital markets, there has been much discussion lately on the viability and usefulness of a relatively new tool – the automated valuation model (AVM), touted as being both faster and more cost effective than traditional appraisal methodology.
While it is generally accepted that AVMs live up to their promise on speed and affordability, could this new paradigm be more risky than traditional appraisals? Until recently, many lenders thought so. However, as lenders have gained experience with AVM performance – vis-Ã -vis loss ratios in their portfolios – many in the industry are concluding that AVMs are far better and far more reliable than originally thought.
As a simple alternative to traditional appraisals, AVMs truly are more cost effective and faster, and if the story ends there, the lending community has a significant win through their introduction.
However, there have been major structural changes in the appraisal industry that virtually no one thought possible, even as recently as one year ago. Federal regulators, and more particularly, the residential real estate lending community, have become extremely concerned about numerous problems in the valuation sector of our economy. Topping the list are appraisal fraud and overvaluations in certain markets.
How might these problems be detected and mitigated? In the past, the traditional appraisal was the main tool for estimating the value of a property, but it is becoming painfully apparent that this methodology is sometimes inadequate.
A slice in time
Due to data limitations, a traditional appraiser is relegated to looking at a very narrow slice in time. For example, a traditional appraisal has as its theoretical foundation the notion that comparable sales, cost data, etc. should use only the most recent information available.
The final report only proffers "point" estimates of value with no measure of confidence in that value rendered. No historical trend of the subject's value, or of the value of properties in the general area is stated. Data is selected by reference to current data only.
In the case of fraud, such as flipping, the appraiser might be unaware of multiple sales transactions of either the subject or comparables used in the analysis. In the case of a possible price bubble, myopic reliance on current data only, might not reveal an unsustainable inflated market. These issues worry lenders.
It has been said that "necessity is the mother of invention." Such has proven to be the case in the AVM world. Through no fault of the appraiser, appraisals are conducted using a relatively thin set of current data. Many AVMs, on the other hand, have very deep historical and current data sets maintained in robust data warehouses. Additionally, AVMs usually contain complex mathematical algorithms run on very powerful computers that are capable of analyzing this expanded data.
Recognizing not only the need but also the inherent ability now in place, AVM providers first developed a tool to measure confidence. This, for the first time, gave lenders not only a value estimate, but also a measure of how confident or comfortable they should feel about that estimate. Not previously available to lenders, this was an important improvement in the appraisal process.
But this represents only the first step. AVM developers have now developed algorithms that can detect potential fraud. AVMs can also detect possible price bubbles that could crash, sending property values precipitously downward. The importance of this innovation for lenders simply cannot be overemphasized. As a result, this represents the first true innovation in the appraisal industry in more than 20 years.
The ability of the AVM to not only be unbiased, but also address confidence, as well as indicate red flags for possible abuse and potential problems, is quite remarkable. This is absolutely no indictment of current traditional appraisal methodology.
AVMs have been able to rely on hardware technology, software technology and, because of the large volume of usage, are able to enjoy low prices per unit to justify the huge and expensive databases. Because of their significant investments in equipment, software, application system development and data acquisition, the AVM providers can address these new and troublesome issues.
In addition, multiple proprietary empirical studies, coordinated on a regular basis for validation purposes, have demonstrated that AVMs generally give results similar to traditional appraisals, but in many cases with less bias, at much lower cost, and much faster.
The bottom line is this: the "inexpensive little replacement for the traditional appraisal" is all grown up. No longer an inferior substitute, the AVM brings far more information to the table than has ever been available in the past.
New technological innovations and particularly significant advancements in valuation modeling, coupled with the recent expansion of national databases, have made possible sophisticated analysis of real estate markets that were not previously available. The future for AVMs now promises to be a bright one.
Dr. H. Stan Banton, MAI, is founder and chairman of Banton Technologies and an expert in the real estate and appraisal industries.