The Limits of an Appraisal or CMA
The Efficient Market Hypothesis (EMH) holds that the market is complete – that all participants have access to the same information about an asset (perfect information), and that transactions occur such that assets realize a fair price.
The residential real estate market rejects EMH. Homes, home sellers, and home buyers are heterogeneous, and every single real estate decision is based on asymmetric information.
Here are some simple examples illustrating some of the basics of these concepts:
- Real estate is immobile (immobilier in French) – a home in one location cannot be moved to another location.
- No two locations are the same.
- Homes on the same block, in the same building, even in the same line vary tremendously, especially as they age.
Property owners are heterogeneous:
- Every home seller searches for buyers differently.
- Property owners have different purchase prices, holding costs, motivations, and varied perspectives on how much their home is worth.
- Property owners have unique maintenance and upgrade standards influenced by personal goals and economic circumstances.
- Property owners know more about the hidden problems and risks of their homes (seller information asymmetry).
Property buyers are heterogeneous:
- Every buyer searches for homes differently.
- Every buyer has a unique perspective on how much each home feature is worth to them.
- Different Buyers have different budgets, risk tolerance, and opportunity costs – some have to buy quickly and may be willing to pay more even if a home’s features are not ideal, and some may believe waiting is better.
- Buyers know more about the deals offered by different sellers in different locations (buyer information asymmetry).
Under these circumstances, it becomes obvious that predicting when a home seller will meet a ready, willing, and able home buyer is impossible, because it’s a random event.
Home Price Dispersion & Property Valuation
Price dispersion is an asset market characteristic which describes the tendency for identical (homogeneous) goods often sell for different prices. Price dispersion exists because of asymmetric (incomplete) information, and buyer/seller heterogeneity.
The most common (and in fact accurate) type of property valuation is the sales comparison approach used by appraisers (and real estate agents). This method compares the differences between a subject property and a series of similar sold properties, then employs subjective adjustment – an “expert opinion” of the value of the differences – to predict the value of the subject property.
The statistical probability of a spot on appraisal is by definition zero, due to the following factors:
- Homes are not identical goods (heterogeneous).
- Previous sales are not necessarily accurate predictors of the future due to seasonality and other factors (homes generally sell for less in winter than spring, etc.).
- Price dispersion.
- Data can be wrong and opinions vary, making adjustments inherently inconsistent (sampling error).
Conclusion
In reality, the value of a home is best expressed as a distribution of prices and probabilities rather than any discreet value. Furthermore, to quote econometrists: average values, mean values, and price distributions are something one never encounters in real life. All just approximations.
I discuss property value distributions and their impact on pricing and selling in Part 2 – Property Value Distribution.
