The market sets the price an informed buyer is willing to pay

The real estate market never rests. Related, the market allows for no pricing equilibrium from month to month, much less from year to year. Property pricing, though not its value, is either headed up or headed down. By virtue of the constantly shifting market, there is never a solstice moment to observe pricing.

Inevitably as in business cycles, California home prices peaked one evening in May 2022, reversing course after skyrocketing in 2020-2021. This compels the astute reader to question: was it gravity, magnetic pull of a mean-pricing trendline, sobriety of buyers, the bond market?

Read on for some insight.

The 2022 peak in prices was preceded by a peak in home sales volume three months earlier in March, a span normally of nine months between peaks. By August 2022, failing home sales volume reached a grim 29% below a year prior and has not yet decelerated.

The financial result of sellers losing perceived wealth is already well known: home prices are in freefall destroying family balance sheets, and buyer demand further weakens. Expect California’s housing market to continue to experience declining sales volume and prices, not to find a stable bottom until around 2025. Thus, a real estate recession has unequivocally put down roots.

In recessions, sellers’ agents will encounter owners who tell them they intend to sell but claim their property has greater value than its present — and declining — market price.  Based on their convictions (or pride), they will only agree to an asking price for their property greater than prices buyers are currently paying for comparable property.

The illusion of greater wealth

Conceptually, most sellers erroneously believe the price they paid to acquire and improve their property only rises from year to year. This is an industry-wide myth, mischief orchestrated to disregard interest rate cycles and resulting pricing cycles.

This money illusion held by sellers of property is about the relevance of past dollar pricing. This hang-up on yesterday pricing seriously inhibits their listing agent’s ability to successfully market the property in, well, today’s market — or even market the property for a sale within the next five plus years when yesterday’s prices might then fully return.

When mortgage rates rise, buyers quickly learn yesterday’s prices — pre-2022 — were set based on ever lower mortgage rates which gave buyers ever larger amounts of purchase-assist mortgage funds to pay ever greater asking prices. A virtuous cycle for those who sold at the time.

Unlike buyers, sellers do not talk to mortgage lenders. Consequently, sellers are unaware, or simply refuse to grasp that the dynamic of rising mortgage rates and the fixed debt-to-income (DTI) payment ratio works to reduce the amount of mortgage funds available to buyers.

The initiating force driving prices down today is the calculus of rising mortgage rates and the amount of mortgage payment the buyer is allowed to pay. The monthly payment permissible is determine by applying the qualified-mortgage DTI ratio to the buyer’s income to set the maximum amount of mortgage money available to the buyer.

Since the maximum amount of purchase-assist funding a buyer is able to borrow is the amount that classically funds 97% of the purchase price of a home, it is mortgage rates and the income of the prototype buyer of a particular home that sets a property’s price — not the mathematical abstraction of a seller’s asking price.

More attenuated but fundamental, are the underpinnings which hourly set the FRM rates:

  • the 10-year treasury note rate;
  • plus a mortgage-default risk premium; and
  • the Mortgage Backed Bond (MBB) market controls both, not the seller, the buyer or the lender.

Specifically, home prices are mostly equivalent to the maximum amount of purchase-assist funds a typical buyer of a comparable home can borrow.

Further, personal income among likely buyers competing for a property does not vary much, rarely declining short of a loss of employment. Alternatively, mortgage rates vary hourly; often a lot monthly. The income of buyers is tied to a running average of annual inflation rates — the cost-of-living adjustment (COLA), averaging 2%.

As for sellers, they need to know what buyers are able to pay for the seller’s property before setting an asking price or reviewing a purchase offer for acceptance or rejection. For a listing agent, the best method for informing their seller what buyers are now paying for property comparable to the seller’s property requires a search into what buyers have very recently paid for like-type property.  This data is known, thus discoverable by a little due diligence application.

Important also is a discussion with the seller about the effect of the current pricing trend, whether up or down.

Related FARM letter:

FARM: Will Zillow give you an accurate home value?

Sticky prices and the recalcitrant seller dilemma

The resistance sellers have to set or adjust their asking price at declining market prices is a phenomenon called the sticky price syndrome.

Sticky pricing always occurs in recessionary times. The seller understands all property prices have peaked, that prices paid by buyers are lower every month — net equity today, gone tomorrow. Yet that seller is unwilling to lower their asking price or the sales price they will accept on an offer.

For wide-eyed listing agents, a recalcitrant seller fast becomes a waste of their energy, time, and talent: a black hole. The marketplace of real estate sales with inventories growing and sales volume shrinking indicates the necessity of an asking price to be reasonably close to what today’s buyers are paying.

Before an agent marketing a property for sale can attract a qualified buyer who will close a purchase escrow on the seller’s property, the seller needs to hold reasonable pricing expectations. When they do not — or will not — the seller’s agent needs to back away from this prospective client for their lack of rational behavior.

Sellers who follow this illusion — and their agents who enable it to persist — will see the property sit on the market and the listing expire with the property unsold. No chance of a fee despite the agent’s efforts.

Longer days on market shopworn listings — convince prospective buyers something is wrong, either with the property, the owner or their agent. The market has had a look at the listing and rejected it, only to leave it orphaned. It has not sold while others have. As a consequence, the seller now receives offers at lower prices than had their agent been authorized to market the property at a realistically competitive price from the first posting of the property for sale — a listing consistent with current market conditions for optimal fast closings.

To assure — educate — the seller they are listing the property at an asking price which appears reasonable and will attract buyers quickly before prices slip further, a seller’s agent prepares a comparative market analysis (CMA) and reviews it with the seller.

The CMA is a critical tool an agent uses to inform themselves, and the seller, about realistic pricing buyers are paying to acquire similar properties at the time of the listing.

When the seller accepts the agent’s price analysis — known in the industry as a broker price opinion (BPO) — the agent achieves the objective of an asking price that is at or sufficiently close to prices buyers are currently paying which will attract buyers and offers. With pricing no longer an issue and a property staged with “curb appeal,” the agent can effectively concentrate on locating a buyer qualified and ready to purchase the property. Escrow, we are on our way. [See RPI Form 318 and 318-1]

Related FARM letter:

FARM: Competitively pricing your home

Comparative Market Analysis and the BPO

A CMA is a form filled out by an agent to work up an opinion about the market price of a property — the BPO. Using the worksheet, the agent compares attributes and amenities of a seller’s property to similar properties in the area that recently sold, called comps.

The agent analyzes the information gathered and entered on the itemized CMA checklist. The agent then reviews it with the seller to come up with an informed listing price for the property — i.e., the seller’s asking price. The agent will use the seller’s asking price to market the property for sale.

To attract potential buyers, the asking price in the agent’s marketing adverts need to be:

  • reasonably close to recent sales prices and asking prices of comparable properties;
  • an amount likely to encourage buyers to make offers; and
  • likely to result in a closed sales transaction. [See RPI Form 318]

An agent gathers information for use in a CMA by downloading a property profile on the property to confirm:

  • the vesting;
  • any liens on the property;
  • property tax status;
  • any foreclosure notices; and
  • use restrictions other than zoning.

The agent also prints out a report on recent sales in the surrounding area from a title company website.

From the recent sales report, the agent pulls data on comps recently sold in the area and enters them on the CMA form.

A seller’s agent uses a CMA worksheet for:

  • establishing the price of the seller’s property for the seller [See RPI Form 318]; and
  • setting rents for a seller’s single family residence (SFR) held out for rent. [See RPI Form 318-1]

CMA for setting the market price

Both a seller’s agent and a buyer’s agent use a Comparative Market Analysis for Setting Values form to determine prices buyers recently paid for comparable properties. On an analysis, the agent develops their opinion about a property’s market price, which is communicated to the seller. [See RPI Form 318]

The comparable properties always have some features distinguishable from the seller’s property. The agents make dollar adjustment on the CMA worksheet to reflect the lesser or greater value of the comps based on the agent’s observations. [See RPI Form 318]

The Comparative Market Analysis for Setting Values confirms price adjustments for:

  • zoning [See RPI Form 318 §2.1];
  • easements [See RPI Form 318 §2.2];
  • use restrictions governed by covenants, conditions and restrictions (CC&Rs) [See RPI Form 318 §2.3];
  • retrofitting or water conservation improvements [See RPI Form 318 §2.4];
  • location factors, including:
    • neighborhood trends;
    • street amenities;
    • lot size and shape;
    • vehicle access;
    • schools/churches/institutions;
    • utilities available; and
    • environmental hazards and nuisances [See RPI Form 318 §3];
  • landscaping features, such as:
    • the quality;
    • maintenance costs;
    • the condition of the soil; and
    • topography [See RPI Form 318 §4];
  • improvements, including their:
    • age;
    • type;
    • highest and best use;
    • design/style;
    • energy efficiency;
    • maintenance and obsolescence;
    • exterior conditions; and
    • interior conditions [See RPI Form 318 §5];
  • livable space, documenting the:
    • gross livable square feet;
    • number of bedrooms;
    • number of bathrooms;
    • kitchen/appliances;
    • existence of a:
      • living room;
      • dining room;
      • family room;
      • basement/storage; and
      • attic [See RPI Form 318 §6]; and
  • amenities, including a:

A completed CMA confirms the market price of the seller’s property based on what buyers of comparable properties have been recently willing to pay. Thus, the agent sets their BPO for the property. [See RPI Form 318 §10]

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CMA for setting rents

The pricing of any income property begins with a study of the income the property produces or will produce. A property’s income is exclusively rents paid by tenants for space they do or will occupy, called rental income.

The property’s annual income and expenses are disclosed to prospective buyers on an operating spreadsheet, called a profit and loss (P&L) statement.  The rental income is the first item on the statement; the most significant and the most important. Simply, no income = no value as an income property.

All operating expenses and ownership obligations (mortgage debt/income taxes) are analyzed and judged as percentages of the rental income.

When the amount of income is erroneously presented, the expenses and ownership obligations stated as percentages are distorted. Worse, the bottom line end result of a property’s operating statement is the amount of Net Operating Income (NOI) the property produces annually for ownership.

As always, the NOI together with the capitalization (cap) rate a buyer determines is applicable to their investment in the property sets the market price the buyer of an investment property will offer to pay to acquire the property.

When the rental income is overstated, say, just 5%, the NOI will be overstated at around 15% greater than it actually is. On applying the buyer’s cap rate to this distorted NOI, the result is an excessive price at around 15% over market for the property.

Building the case for setting rental income

To determine the amount of rent tenants are currently willing to pay for units in a property — space — the listing agent needs to know what tenants are presently paying for units/space in comparable properties.

For gathering and analyzing rents in comparable properties, the listing agent may use a Comparative Market Analysis to Set Rent — Single Family Residence form. It is a worksheet used repeatedly for each type of unit or space in the income property. The agent notes the distinguishable features of comparable rental units/spaces from the listed property and enters a dollar adjustment needed to correct for the comparable property’s greater or lesser rental value than the listed property. [See RPI Form 318-1]

The Comparative Market Analysis to Set Rent sets forth the following aspects on the subject property and three comparable properties:

With adjustments entered and totaled, the agent arrives at an adjusted monthly rent for the comps, a BPO for rental amount. [See RPI Form 318-1 §§8 and 9]

Informed by a review of the comps, the seller and the agent set the monthly rent a buyer may reasonably expect the property to generate. The operating statement the agent makes available to interested investors and their agents will set the annual rental income as justified by comparable properties, not scheduled income expectations. The CMA is the supporting documentation. [See RPI Form 318-1 §10]

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A “BPO” for DRE licensees, an “appraisal” for CalBREA

A BPO is an evaluation of a property setting its market price as developed by a DRE-licensed broker or agent. It expresses their opinion of the property’s current market price stated as a dollar figure.

An appraisal on the other hand, is an opinion of value about a property’s pricing that requires the individual expressing the opinion to hold a certified appraiser license issued by the California Bureau of Real Estate Appraisers (CalBREA).

The appraised fair market value (FMV) submitted by an appraiser is relied on by a mortgage lender as the value of the property for applying loan-to-value ratios. The ratio applied to the appraised value sets the maximum mortgage amount for financing secured by the property. While the BPO determines the current market price for a particular property, the appraiser determines the market price submitted as the property’s fair market value.

In practice, both opinions rely on the same comparable sales approach to evaluate the property. Thus, the dollar amount of value and market price will be nearly the same. Both clearly are opinions based on the same concrete data and rational approach to evaluation.

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