Lenders Must Focus On Spread Between Market Value And Replacement Cost

In the current real estate market, home buyers can purchase homes beyond their wildest dreams in terms of size and amenities. This sounds good at first – however, some of these loans will turn out to be very risky, in part because some of these homeowners will have a difficult time maintaining these large properties.

The problem is that more loans than ever have a large spread between the market value and the replacement cost. If the spread is significant, the homeowner probably lacks sufficient income to remedy any deficiencies and will defer maintenance. As such, they will be unable to properly maintain the property at a level that will protect its value for the lender and insurer.

The condition of the systems in most homes – such as heating, plumbing, electrical, roofing, foundation and major appliances – often does not significantly impact the value, even if the systems have been recently replaced or repaired. At the same time, these systems can significantly increase exposure to loss – especially in larger homes where the replacement costs are much higher.

These systems have a cost that is directly proportional to the replacement cost of the structure. In the current housing market, the difference between replacement cost and market value can vary greatly, and the spread between these two numbers is greater and more important than ever.

The more replacement cost exceeds market value, the greater the chance that a failed system component will affect the lenders' equity, as the homeowners' desire to maintain such a home will be dampened. Even if the home is in average to good condition at the time of origination, further on down the road as the loan and the home age, these systems will also age and depreciate.

Most home buyers purchase homes relative to their income; however, beyond the purchase price, they are also responsible for the insurance, taxes, maintenance and utilities, as well as other costs. Lenders and insurers will often approve loans regardless of the additional risk in these cases.

Should home prices start to fall, it will only compound the problem, robbing the homeowner of equity that could provide for maintenance and upkeep, as well as the desire to maintain what may turn out to be a bad investment. A single large repair – such as a roof repair – can be a relatively large percentage of a home's value when the home has a large spread. As mentioned, when system components are expensive in relation to market value, it makes it that much more difficult for even the most responsible homeowner to keep the home in good condition. (This, obviously, is not the case for homeowners who avoided buying "too much house" for their budget and/or needs.)

Lenders and insurers can determine if loans meet acceptable risk tolerance with one of two simple solutions: First, a calculation can easily be made using a set of automated valuation models (AVMs). These applications are simple to use and provide relatively accurate results almost instantaneously. Lenders are already widely using AVMs to screen loans for values – and automated replacement cost analysis is readily available from companies like Marshal and Swift, for insurance purposes.

The second solution is also a simple one: using standard appraisals that provide a market value/cost approach. The cost approach could be calculated as a replacement cost in order to complete this calculation. This will be especially useful with the new Uniform Appraisal Dataset format from government-sponsored enterprises Fannie Mae and Freddie Mac, which allows for simple analysis and screening to determine if a loan meets acceptable risk tolerance.

In the current housing market, many see opportunities to buy high replacement cost housing stock at extremely low prices. The market value of such homes – and those purchasers who meet the required income to buy them – makes it possible for buyers to get the most for their money. In some cases, lending on these homes is risky and may even harm neighborhoods, should foreclosure be the end result. What's more, as mentioned, those loans with replacement costs far in excess of market value will negatively impact lenders' and insurers' portfolios.

The costs to restore, maintain and rehab homes in foreclosure have been significant and are often unforeseen to many in the business. Lenders and insurers should proceed with these ‘risky’ loans with a great deal more caution by simply paying attention to the spread between market value and replacement cost. This will result in a great deal of savings to the mortgage and insurance industries – as well as undue stress on already vulnerable neighborhoods.

Steve Wiese is a real estate appraiser based in Farmington, Mich. He developed Appraisal Map, a thematic mapping tool for residential real estate values, and Enviro Check, a tool that reports on potential environmental dangers near residential properties.


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