Bubble; not a bubble? - Arlington, Texas

You might be interested in a widely cited report by the Center for Economic Policy and Research. Please visit the following link:

http://www.cepr.net/index.php/publications/reports/the-changing-prospects-for-building-home-equity

An interesting aspect of this report is the Rule of 15. This rule-of-thumb defines a normal (non-bubble) residential housing market as home prices that are approximately equal, or less, than 15 times the annual gross rent. For example, the average rental rate in Arlington is roughly $850 per month or $10,200 per year. $10,200 times 15 would indicate an average residential property value of about $150,000, which corresponds to the actual average residential transaction price in Arlington, Texas --> Not a bubble.

However, in some other areas of the country, we have witnessed a great divergence between the residential rental market and transaction prices (these are the "Bubble" markets). This report defines a bubble as locations where the average transaction price is 18 or more times greater than the average annual gross rent. Most of these bubble markets are located on the West Coast and the Northeast. Check out the report for more details.

Student Question: Mortgage Markets

I have a question for you about this real estate mess that is going on with the market right now. What is going to happen to the people who are signed up for these ARM loans and the rates will be adjusting soon? They're not going to be able to refi because more than likely the value of the house is much lower than the loan they are stuck with. Are they going to be forced into foreclosure? It seems that is the only option for these people in this situation. I know on the Indymac Federal Bank website, they will consider re-writing your existing mortgage if you are in default and going to face foreclosure, but nothing is being done to prevent the problem from reoccurring in a year from now. So, if you have a loan that you know will be a problem in the future, I guess you have to default before you can get help? These loans were still being written two years ago and if you were signed up for a 3 yr ARM, the fun hasn't even started yet. I'm just curious on how you think the future is going to look for these people who are stuck.

REPLY
Yes, what you describe is at the core of this current financial crisis. Way too many people, borrowed way too much money, to buy way too expensive homes. This process was encourage by the Federal government (for several decades, Democrats and Republicans were in a competition to report the highest levels of home ownership during their terms in power) and by government sponsored enterprises, such as Fannie Mae. Federal tax deductible mortgage interest paid on first, and second, mortgages on homes also helps to encourage housing consumption.

The fact that many of these mortgages are adjustable rate is just the icing on the mess. As interest rates increase, you will see a sharp increase in default rates in adjustable rate mortgages. Now the Federal Reserve has to be very concerned about keeping interest rates fairly low which could cause problems with the value of the US dollar and inflation expectations.

These poorly underwritten and often adjustable rate mortgages are clogging-up the financial system because of the expectation that many more will default in the future, making these mortgage bad investments. Financial institutions, and all other owners, holding these mortgages or mortgage-backed securities cannot get them off their books (sell them) because no one wants to buy this junk. One of the few large scale sales of mortgage-backed securities from a while back realized an 80% discount (the purchase paid about 22 cents on the dollar).

My grandfather, who had a lot of old fashioned commonsense and was very conservative with his finances, had an old rule-of-thumb that you should not borrow more than 2 times your gross annual income to buy a house. Although this might be a little too conservative, especially in some of the higher cost of living areas, I would say a maximum of 3 times would be prudent. However, due to the run up in housing prices and lax lending standards, many people have borrowed 4 to 5 times, or more, their annual gross income.

I am afraid that we will continue to see and hear more about foreclosures. However, you don't need to fear that everyone will be out on the streets (this should not be a major concern as long as employment markets holdup). Many of the foreclosures will result in people downsizing to houses and mortgages that are more affordable (from 4 or 5 times gross income to around 2 or 3 times). The average house price in Arlington is around $150,000 so a family earning $50,000 could own a comfortable house under the 3x gross income rule-of-thumb. Finding affordable housing in other areas of the country will be a lot more difficult. If the old school rule-of-thumb of 2 to 3 will in-fact apply, then housing prices in high housing cost markets may have to adjust substantially.

If anyone out there is having difficulty with making mortgage payments, you should contact your mortgage company immediately. Foreclosure is a very expensive process for the mortgagee. It is usually a much better deal for the mortgagee to work something out with the mortgagor (the borrower), if possible. The Indymac website is a good example of a mortgagee willing to work with mortgagors to prevent foreclosures.

Some timely student questions...

A student e-mailed some interesting questions last week. You do not need to agree, but I thought I would share the thoughts on our blog.

1.) How important is finance to the U.S./the world?

Very important. With the decline of defined benefit pension plans and the increase in defined contribution retirement plans, most people are relying on the financial markets for their retirement and general financial security. For most of us, how we manage our retirement investments and the return on these investment will dictate the quality of life we will have during retirement (or even if we can afford to retire).


2.) Has financed changed much over the years? How have events like the Iraq war and Sept. 11 changed finance?

Regarding your question about Sept 11 and the Iraq war, I am amazed at how well the financial markets stood up and bounced back from the September 11, 2001 terrorist attaches, especially considering the physical damage to Wall Street itself. I believe this is a sign of the strength and level of sophistication of the US financial markets. However, there are serious challenges today. Maybe even more challenging than the recovery from 911.

Finance has evolved and change tremendously over the decades. Take for example, residential real estate finance. The old model of residential real estate finance was depicted in the movie, It's a Wonderful Life, the Christmas classic starting James Stewart as George Bailey. George Bailey's job was managing a Savings and Loan (S & L). The original S & L financial institutions simply collected deposits from a local community and made residential mortgage loans to that same community. These old time S & L held the mortgages in-house and therefore needed to make 'good' loans or live with 'bad' loans.

Today we have a sophisticated secondary mortgage market that has its advantages, but also some disadvantages. Very quickly, the new model of real estate finance provides tremendous liquidity to the mortgage markets. Primary lenders, such as the remaining Savings and Loans and many other types now, can sell their mortgages to secondary market, most likely to Fannie Mae (FNMA). FNMA creates large mortgage 'pools' from primary lenders from across the country. FNMA then securitizes these mortgages making nice diversified mortgage investments for investors from around the world. Quiet different from the simple Bailey S & L model.

However, we are currently realizing some problems with this modern system. Because primary lenders are most often selling mortgages to the secondary mortgage market, and not holding these mortgage long term, primary lenders now have a big incentive to generate fees from mortgage originations and shift the risk of mortgage default (bad loans) to secondary mortgage market investors. We have originated a lot of bad loan over the last 10 to 20 years and we are paying the price. With changes and innovations comes new challenges.

I am concerned with the financial responsibilities that the US tax payers are taking on by bailing-out some of these companies, such as Bear Sterns, Fannie Mae, and Freddie Mac [now AIG too]. These bailouts will be a tremendous financial burden, present and future. Also, I am worried about the signals these decisions send. If we keep bailing out people who make bad investments or companies that make bad choices, there is no incentive to stop making bad investments and decisions. Do a deal, makes some money off fees, and if the deal goes well, everyone is happy. If the deal goes bad, not a problem-you get bailed out.

The Iraq War is also a financial strain on our economy but there could be future benefits, including economic, if there are improvements in this region. If chaos breakout in Iraq, we will loose the investment that we have already made and might be forced to reinvest here again in the future. Unfortunately, this issue is such a political hot button it is difficulty for most people to think about this objectively. From a financial perspective, I think we need to do the best that we can here. Especially considering the economic burdens we are taking on at home, I don't think we have a choice.

As opposed to Iraq, there are no foreseeable benefits to these bad loans and mortgage market bailouts, except for some managers, debt holders, and even some stockholders of these bailed-out companies (for example, FNMA preferred stockholders have not been bailed out yet but some are speculating that they will be in the future).

It is a shame. Despite the transparency, sophistication, and strength (especially in times of crisis like 911) of the US financial markets, it seems like we cannot avoid a major self-inflicted financial crisis about every 10-years or so. I attribute this perpetual problem to moral hazards and a little bit of human nature.

Will my ______ (insert property type here) property value increase?

This is a common question and a question relevant to anyone who owns property.  Unfortunately, this is not an easy question to answer. 

There are so many variable and factors to focus on in any real estate market.  We could looks that the relationship between property values and interest rates, vacancy rates, inflation rates, rental rates, regional output, etc…  All of these factors are relevant.

If forced to narrow our answer to this question down to one factor, the key variable is most likely basic employment.  If local basic employment is strong in the future, this is good for local real estate markets and property values.  If prospects for local basic employment are weak or deteriorating, this is bad for local real estate markets and property values.

This is also why appraisers, market analysts, investors, developer, and lenders perform or commission market analyses before making decisions.  A primary focus of an appraisal or market analysis should be basic employment that leads to economic forecasts for that local economic basis.

Although many other factors come in to play for any specific location, the easiest answer to the tough question above is as follows. If basic employment in your local economy and growing, yes, your property value is likely to increase.  If basic employment in your local economy is declining, sorry, your property value is likely to decrease.

Competitive Advantages of Cities

Why do some cities seem to grow and thrive and other cities seem to decline in population and importance?  This is a complicated question, but the answer should be related to a city’s competitive advantage.  A competitive advantage is a feature of an urban area that is attractive to residents and businesses. 

The US is a mobile society.  Citizens have great freedom and flexibility to move to a neighboring city or state.  This is a important benefit to our economy as workers and employers can relocate to find each other.

This mobility is not as apparent in other parts of the world.  In Western Europe, for example, citizens have political freedom to move but nationalism, employment permits, and language barriers usually prevent an unemployed German worker from relocating to France to fill a job opportunity, and vice versa.

With the US population mobility, cities need a reason to attract and keep residents and businesses.  The reason people and businesses migrate to and remain in a particular city is the city’s competitive advantage.  Competitive advantages fall into a wide range of categories.  We will review several typical competitive advantages.

Skilled and educated workforce  A good labor force can certainly attract potential employers to an area.  In the 1990s, Mack Truck moved some production operations from its headquarters in Pennsylvania to South Carolina.  South Carolina offered a skilled and non-unionized labor force, and also relatively cheap land prices for its new facilities.

In today’s information-based economy, an educated labor force is important to many service and technology driven companies.  These companies might choose to locate near universities for the access to prospective knowledge workers and academic research.  This was certainly a factor in Michael Dell’s decision to locate Dell Computer in Austin, Texas, home to the University of Texas.  Bill Gates selected Seattle, Washington as Microsoft’s headquarters in part because of the concentration of knowledge and technology workers in this region.

Natural resources  Proximity to natural resources was an important competitive advantage when the US was primarily an industrial based economy.  Cities like Pittsburgh, Pennsylvania were very important because of their proximity to coal.  Coal fueled the blast furnaces used in steal production.  As our economy transitioned from a manufacturing to an information-based economy, Pittsburgh had a difficult transition.  Pittsburgh’s competitive advantage in steal production was no longer important and the city lost many factories and citizens.  However, Pittsburgh was able to eventually transform its competitive advantage to education, medical, cultural, and entertainment activities, and Pittsburgh is doing well today.

Climate  A warm, snow-less climate can be very appealing.  Particularly with so many Americans, specifically the Baby Boomers, currently retiring, climate can be an important competitive advantage.  In fact, there has been a general population trend for several decades of people moving from the northeast and the Rust Belt region to the south and the southwest, called the Sunbelt region.  States like North and South Carolina, Georgia, Florida, Texas, Arizona, Nevada, and California have experienced population growth due to net migration.

Let’s also give some credit to a technological innovation for this trend too.  This southern migration would not be possible without the invention and economical, widespread use of air conditioning.  The Sunbelt cities definitely owe a thank-you to air conditioning.  Imagine how popular Las Vegas and Phoenix would be without A/C.

Transportation  Some cities have important transportation advantages.  Our earliest colonial villages were settled because of their ports.  On the East Coast, New York City, Baltimore, and Charleston still enjoy competitive advantages in shipping.  The West Coast has important port cities San Diego, San Francisco, and Seattle.

Atlanta and Chicago are important terminuses for rail distribution.  Today, these cities also have advantages in air transportations.  (In fact, Florida retirees say you can’t go to heaven without passing through Atlanta’s Hartsfield International Airport.)  Although Chicago or Atlanta airports usually hold the record for the busiest airports in terms of passengers, airports of Denver and Dallas Fort-Worth are close rivals in terms of traffic. 

Denver and Dallas airports are located near the geographic center (good hub locations for National carriers) of the US and have plenty of room for expansion.  These are the two largest airports in the country in terms of land area.  Both of these airports will be become airport cities, cities within the airport itself, over the next 15-years.  

Attitude and leadership  Some cities encourage development and business growth where other cities are not aggressive in attracting new residents and may even put up barriers, such as high property taxes, to new residential and business relocation.  Municipal leadership and a good chamber of commerce can be an important factor in attracting new residents and businesses in a competitive and mobile environment.

Once the competitive advantage of an area is identified, it is important to understand the future competitiveness of this current advantage.  Will the competitive advantage persist?  Will the nature of the general economy change?  Some cities that thrived during the decades of the manufacturing-based economy have had difficult transitions into our newer information and service-based economy.  To help address these questions, we need to define and discuss the concept of an economic base.

Profile - Johann Heinrich von Thünen

Von Thünen was born 1783 and died 1850.  He was a German landowner and is credited with the first serious treatment of spatial economics, The Isolated State.  The Von Thünen model of agricultural land use (the Thünen rings) and the concept of highest and best use are relevant today and important fundamental concepts in spatial, regional, and urban economics.

History of the World Over the Last 13,000 Years, in a Blog Post

This post was developed from the 1997 book titled Guns, Germs, and Steel by Jared Diamond.  Subsequently, videos were produced based on this volume by the National Geographic Society and broadcasted by PBS in 2005.  

Jared Diamond, professor of geography and physiology at University of California Los Angeles, won a Pulitzer Prize and the Aventis Prize for Best Science Book for his theory of societal evolution described in Guns, Germs, and Steel.  We find from his book, which is summarized crudely in this post, that geography maybe the single most important factor in human history.

After studying the history of the world over the last 13,000 years, Dr. Diamond concluded that the roots of inequality and the fates of societies could be traced back ultimately to environmental and geographic factors.  The reason that some societies have progressed and others remain as hunter/gather or agrarian is not due to differences in genetics, culture, or morality, but geography.  See figure below (arrows in figure not visible but diagram flows from top to bottom with most important factor at the top).

 

Ultimate Factors

                                          East-West Axis

                                           (Geography)

                                                              

    Various Suitable Wild Animals            Easy Movement of Animals

 

                                Numerous Domesticated Plants and Animals

 

                                 Food Surplus and Storage

 

                                 Large Complex Societies

 

   Horses    Technology   Politics & writing   Epidemics

                     Guns

                     Steel

                     Ships

Proximate Factors

           

From this diagram developed in the text, we can see that the ultimate factor in determining which societies developed proximate factors of horses, technology, politics and writing, and antibodies to major epidemics was geography.  Let’s look briefly at each of these individual factors.

East-west Axis

East-west axis refers to the migration of humans, animals and vegetation.  Climate, temperature and soil conditions are more similar when moving from east to west rather than north to south.  Most domesticated animals and crops originated in the Fertile Crescent (Middle East) and migrated to the east (Asia) and to the west (Europe).

Farming developed in relatively few places independently and migrated on the same line of latitude.  Wheat, barely, sheep, and goats spread from the Fertile Crescent to Europe and Asia.

 

Various Suitable Wild Animals

Plant and animal domestication provided food surpluses, a prerequisite for civilization development.  For example, the inhabitants of the Fertile Crescent were the first to stored large quantities of wheat and barely in humidity controlled granaries.  Many of history’s greatest empires have their roots in or near this area. 

Domesticated animals provided meat, milk, fertilizers, and strength to pull plows.  Diamond counted 148 wild plant eating terrestrial mammals over 100 pounds. These animals are the best candidates for domestication.  However, only 14 of these animals have been domesticated for any length of time.  13 of the 14 domesticated animals originated in Asia, North Africa, or Europe.  Only 1 0f 14 originated elsewhere, as the Llama is indigenous to South America.

 

Large Complex Societies

Food surpluses allowed for development of societies and specializations.  Mesopotamia, Egypt, and China emerged in roughly the fourth millennium.  Large complex societies also created epidemics, politics and writing, and technology.

 

Epidemics

Large sedentary populations created the conditions for wide spread epidemics, called crowd diseases.  These diseases need large concentrated populations to sustain themselves and all major diseases have originated from animal genes.  Animal microbes are passed on to humans all the time and some of these germs can cause serious diseases to humans. 

Societies with domesticated animals have suffered from these epidemics but these populations have acquired defenses from these diseases due to the exposures.  People in societies with no or few domesticated animals have not acquired any immunizations and have been devastated, and some wiped-out, when exposed to these germs.

Major epidemics in history:   

Egypt 1150 BC Smallpox

Greece 400 BC Malaria & Mumps

Origin unclear 200 BC Leprosy

Europe 1350 Bubonic Plague

Vermont, USA 1894 Epidemic Polio

Africa 1959 AIDS

Politics and Writing

Writing developed relatively late in human history and developed separately in the Fertile Crescent, China, and Mexico.  These societies already had complex political systems, but writing allowed for record keeping and propaganda dissemination.  All societies that subsequently developed writing were influenced by these early systems.

 

Technology

Population growth fostered the development of specializations and technologies.  Freed from burdens of hunting, gathering, and farming, some members of societies could focus on creating and inventing items that could improve their lives (we referred to this as ‘engineering’ today) and could barter for food.  As an example, early homebuilders constructed sophisticated housing over 9,000 years ago.

 

Ships, Horses, Steel Swords, and Guns

Geographic advantages that resulted in productive farming and ranching led to the development of ships, steel swords, and guns.  Horses and ships led to superior mobility and colonization.  Steel swords and guns provided lethal firepower and led to decisive military victories by Europeans over Native Americans (Incas and Aztecs) and the conquerors’ germs decimated these indigenous populations.

Now most of us in real estate do not have the luxury of thinking strategically over thousands of years in terms of our investment, lending, and development decisions.  Typical investment holding periods assumptions range from one to twenty years.  Furthermore, most real estate investors and portfolio managers probably can't think too far past the next mortgage payment or fiscal quarter, let alone the next century or millennium.  However, the histories of civilizations highlight the importance of geography and demonstrate how seemingly small, small at a particular moment in time, location advantages resulted in the fall or rise of an entire society.  This of course is a very macro perspective, but any time period you evaluate (could be a single battle in a war or the effective life of a strip shopping center), you will find the importance of location, location, location.

Dr. Diamond studied history over the last 13,000 years to explain the state of current society.  What if Dr. Diamond was around to write a sequel to Guns, Germs, and Steel 13,000 years from today?  What would be the title of part II?  

I am afraid that germs would be the one constant proximate factor as the earth’s population grows and we continue to battle epidemics today (AIDS for example).  Technology would likely be included in the title but probably represented by a more contemporary form than guns or steel.  A future title might include references to ‘information’ and 'energy,' but I bet geography would still be an ultimate factor.  Just a little something to think about.

Appraisal District as an Employment Opportunity

Working for the county assessor can be a good way to get to know an area and property value in the county. Although sometime the pay is not competitive with some other areas in the real estate industry, the work is steady because property taxes are collected in good an bad economic times. Also, the job might also include employer-sponsored benefits like medical insurance and retirement plans.

Many students have started out their real estate careers in the assessment offices. Some have stayed to make tax assessing their career, others have moved into other areas such as development, appraisal, investing, or lending.

Concept review: property tax calculation

A property has an ad valorem value of $475,0000 in a state that requires a 50% assessment ratio (Texas's assessment ratio is 100% but let's use 50% to make it interesting).  The property owner qualifies for two exemptions.  First, the owner qualifies for a homestead exemption of $25,000.  Second, the owner also qualifies for an additional $12,000 exemption because she is over the age of 60.  The property tax rates for the jurisdiction are as follows:

County tax            4 mills

School district      11 mills

Hospital                2 mills

Fire department     1 mill

Total tax rate        18 mills or .018 (18/1000)

STEP 1: Calculate the assessed value.

      Ad valorem value  x  assessment ratio = assessed value

          $475,000         x         .50              = $237,500

STEP 2: Calculate the taxable value.

      Assessed value  -  exemptions   =  taxable value

          $237,500      -   ($25,000 + $12,000)  =  $200,500

STEP 3: Calculate the property tax due.

     Taxable value  x  millage rate  =  property tax due

       $200,500      x  .018  =  $3,609.00

In addition the property tax due, it would also be useful to know the tax savings from the exemptions and also the effective tax rate.

STEP 4: Calculate the tax savings from exemptions.

     Exemptions  x  millage rate  =  tax savings from exemptions

       $37,000    x  .018  =  $666.00

STEP 5: Calculate the effective tax rate.  The effective tax rate is the ratio of the property tax to the ad valorem value.

                                     Property tax due          $3,609.00

Effective tax rate =   Ad valorem value  =    $475,000  =  0.0076 or .76%

Concept review: tax rate calculation and mills

With a budget and the tax digest calculated, the tax rate is calculated based on the ratio of the fiscal budget less anticipated fee collection, and the tax digest less exemption.

               Budget amount for fiscal year less anticipated fee collection

Tax rate =                         Tax digest less total exemptions

For example, a county has a funding need of $5,000,000 for the up coming year and 20% of this amount is expected to be met with fees.  The tax digest in the county is $250,000,000 with a total amount of exemptions of $50,000,000.  What is the tax rate?

                             $5,000,000 - $1,000,000

Tax rate =     $250,000,000 - $50,000,0000  = 0.020

The tax rate for the county in the example above is .02 or 2.0%.  However, property tax rates are commonly quoted in mills rather than as a percent.  A millage rate or mill means 1 per 1,000 or 1/1000.  Don’t let this confuse you.  A millage rate is very similar to a percent meaning 1 per 100 or 1/100.  A mill just has an extra decimal place (.001 versus .01 with percentages). 

To convert a decimal format to a percent, move the decimal place over two spaces to the right and add a % sign at the end.  Above, .02 was written as 2.0% and this did not upset you. 

How would a tax rate of .02 be expressed in mills? 

Move the decimal place over three spaces to the right and add ‘mills.’  The answer is 20 mills!  20 mills are synonymous with 2% and .02. 

Although we might prefer percentages, many tax assessors prefer to use mills.  Since we need to know the language of tax assessors, we need to understand the millage rate system.

Concept Review: property tax exemptions

Taxing jurisdiction can allow some exemptions that will reduce a property’s assessed value by a specified amount and lower the subsequent property tax bill.  The property’s taxable value is the assessed value less all applicable exemptions. 

Please note that the property tax bill is not reduced by the exemption amount.  The exemption reduces the assessed value that results in a tax saving based on the exemption amount times the tax rate.

Property tax savings from exemption = exemption amount x tax rate

For example, a county has an exemption of $15,000 for qualifying property owners.  The total tax rate in the county is 1.5%.  What is the tax savings for property owners qualifying for this exemption?

Property tax saving from exemption = $15,000 x .015 = $225

All property owners qualifying for an exemption in the example above will receive a tax savings for $225.  Note that the tax savings is not $15,000!

Exemptions can be granted for a variety of reasons, sometime for political purposes.  Examples of exemptions include assessed value reductions for blind, disabled, military veterans, and older property owners. 

A common exemption is the homestead exemption.  The homestead exemption may be available to state residents who use their property as their primary residence or homestead.  This exemption is used to give homeowners, a large group of people who often vote in local elections, a property tax break and to encourage homeownership (or, looking at it from another perspective, to place a greater tax burden on investors, business property, and second home owners). 

In addition to exemptions, some properties are granted tax-exempt status.  Tax-exempt property owners are not responsible for paying any property taxes and tax-exempt properties do not add any value to the tax digest.  Examples of typical tax-exempt properties include government owned building, churches, and some properties owned by non-profit organizations.

Property tax administration

Property tax administration starts with a general budget for the upcoming fiscal year.  All departments and services using property tax revenue submit a budget to determine the total funding to run the local governments.  However, fees collected for certain services may offset this total budget amount.  Trends by many local governments have been to raise revenue through fees to manage the general budget and lessen property tax burdens.  Direct fees maybe charged for services such as garbage collection, water and sewer, fire and ambulance calls, certain police actions, and many other services.

With a projected budget less anticipated fee collections estimated the next step, in determining the tax rate, is to establish the tax digest.  The tax digest is the total amount of taxable assessment value of all the real estate within the county.  The county tax assessment office or tax appraisal district is staffed with tax assessors who are responsible for calculating and maintaining the tax digest.  This is not an easy undertaking because it requires an individual ad valorem estimate by the assessment office for each property in the county.  To value every property, the assessment office must keep an accurate inventory of all property.

The assessment office identifies every parcel of land with a numbering system giving each parcel a unique identification number, called the assessor’s parcel number.  In addition, the assessment office maintains a file and records for every parcel of land, improvements to the parcel, property ownership history, and historic assessed values.

With information on each property, the assessment office now makes ad valorem estimates.  We will discuss property valuation in a future chapter.  However, assessors use a variety of techniques and different techniques for different property types.  Let’s not get bogged down in assessment valuation techniques at this point, but it is important to remember that an assessor cannot spend too much time on any one-property valuation because they office have to make and keep current thousands of ad valorem values.  Assessors rarely have the time or resources to do valuations utilizing all three traditional approaches to value that will be covered.

Therefore, assessment offices often use mass valuation techniques.  One example of a mass valuation technique is a statistical model estimated from comparable sales data.  Such a model can be used to value a large number of properties very quickly once a model is developed.

Because of the nature of the assessor’s task, ad valorem estimate are not necessarily very accurate estimates of current market values.  Sometimes the assessor is too high, sometimes too low, and sometimes just about right. 

Usually, when property owners think that their ad valorem estimate is too low, resulting is a low property tax bill, or just right there is no incentive to take the time and effort to ask the assessor for a change.  However, if a property owner thinks that their ad valorem estimate is too high, assessment offices offer times during the year in which the property owner can an assessment appeal. 

With an assessment appeal, the property owner needs to build a case for an adjustment in the ad valorem value for his or her property and present this case before an assessor or an assessment board of appeals.  An assessment board of appeals is a group of officials given the authority to change ad valorem values if convinced that an adjustment is warranted.  The property owner’s basis of the ad valorem assessment appeal might be accomplished by hiring an appraiser, providing comparable sales data, presenting a recent sale contract, showing ad valorem values on similar properties, reviewing economic data in the area, or providing pictures of the property.

The assessor now takes the ad valorem estimate for each property and multiplies by an assessment ratio yielding the assessed values.  Assessment ratios generally range from 40% to 100% of the ad valorem estimate and are set by the taxing jurisdiction. For simplicity, some states, like Texas, just use 100% of the ad valorem estimate as the assessed value.  This makes sense to me!

Does assessed value influence valuation judgments?

This was the research question and title of a paper by Mathew L. Cypher and J. Andrew Hansz that was published in the Journal of Property Research (Volume 20 Issue 4, December 2003, pp. 305-318).  In a prior post, we discussed the anchoring and adjustment heuristic and we learned that certain reference points influence human judgment.

This study was setup to observe if an assessor’s ad valorem value estimate influenced the market value opinions of others, both novices and expert real estate decision makers.  Novices were defined as undergraduate students taking an introductory real estate course.  Experts were operationalized as experienced real estate appraisers.  The 53 novices volunteering were randomly assigned to a control (or no assessed value), a low assessed value treatment group, and a high-assessed value treatment group.  The 44 experts volunteering were also randomly assigned to three groups: control, low treatment, and high treatment.

A valuation problem, based on an actual property and market, was designed and provided to all study participants, in the form of a written case, all the information necessary to make a valuation judgment: subject property information, neighborhood and area descriptions, maps, comparable sale information, and photographs of the subject property and comparable sales.  The subject property was a vacant piece of land, which is typically valued based on comparable sales data exclusively.

The novice and expert control groups received the valuation case exclusively and were asked to make individual judgments of market value.  The four treatment groups received the exact same valuation case as the control groups with one additional piece of information, the property’s current ad valorem and assessed values.  The assessed value was configured at two levels in relation to the comparable sale data: ‘high’ and ‘low.’

Would the assessed value reference points influence the treatment groups?  In other words, would the average property value estimates for control and treatment groups be approximately the same or would the ‘high’ and/or ‘low’ assessed value information cause different results among the groups? 

Because the participants were randomly assigned to groups, we should not expect any large differences between control and treatment groups if the assessed value information had no influence on valuation judgments.  However, if assessed value treatment did influence valuation judgment then differences in the groups would be observed.  What do you think was found?  Would the assessed value of a property effect your valuation judgment?  Prospective buyers often check the property’s assessed value.

Below is a summary of the study results.  Each cell is the average appraised value per acre.

	‘low’ assessed	Control	‘high’ assessed
novice groups	$82,242  (a)	$85,338  (b)	$93,261  (c )
expert groups	$91,054  (d)	$90,464  (e)	$89,753  (f)

Now, there are different average values in all cells, however, the only statistical (or significant) differences between these group means was between cells labeled a and c ($11,019) and b and c ($7,923).  Note that the significant differences are only in the novice groups.  Statistically speaking, there were no significant differences among the three expert groups.

These results appear to indicate that assessed value influence novice judgment and not expert judgment.  Novices (students), probably not very confident in their valuation abilities, look toward assessed value as a valid indicator of a property’s worth.  Using assessed value as an initial reference point (anchor), the assessment value did appear to influence their judgments.

Experts (experience appraisers) know about the limited content validity of assessed values and could very well be a flawed market value indicator.  Experts appeared to disregard this unsanctioned reference point and rely more on the comparable sales data.

Although we often use assessed value as indications of market values we should be careful in doing this.  As you can see, experts who make a living selling their own valuation opinions give very little credence in assessed values as an indication of market values.  Should you?