Real Estate Appraisal and Transaction Price: An Empirical Evaluation of Alternative Theories
Gwin, Carl R., Ong, Seow E., Spieler, Andrew C., Journal of Housing Research
Mortgage appraisals are often required before a loan is approved. If information on the transaction price is available and lenders compensate appraisers, a principal-agent problem may arise. As a result, appraisers tend to overstate the value of a property because of their incentive to set the appraised value to be equal to (or greater than) the transaction price (Gwin and Maxam, 2002). This paper offers an alternative theory that generates a different empirical prediction. The theory is predicated on the updating appraisal process ala Quan and Quigley (1991) and a signaling modification to Gwin and Maxam (2002). Empirical tests to the theoretical moral hazard model postulated by Gwin and Maxam and the alternative theory herein is conducted using appraisal and transaction data from a lending institution in Singapore. The results support the alternative specification.
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Daly (2001) finds that the main priority of valuers in the United Kingdom, Ireland and Australia is to confirm the transaction price. As one anonymous valuer puts it, "The mortgagee valuation is a confirmation of transaction price." If true, this practice undermines the independent valuation of the subject property.
Do appraisers acting on behalf of lenders exercise independent judgment in ascertaining the appraised value, or are they influenced by the lenders? This question is important since lenders require appraisals before mortgages are approved. The primary purpose of mortgage appraisal1 is to ensure the value of the real estate meets or exceeds a minimum loan-to-value ratio. The appraiser is cognizant of this practice and a moral hazard problem can arise if the lender rewards the appraiser with future business for successful appraisals (i.e., those that result in mortgage financing).
This principal-agent problem has been highlighted in Lentz and Wang (1998). If a representative of the lender is compensated based on loans generated, then the lender may pressure an appraiser to value the real estate at the transaction price agreed upon by the seller and buyer. On the other hand, a lender concerned about the number of defaults may be more likely to pressure an appraiser to undervalue real estate. Smolen and Hambleton (1997) report that nearly 80% of appraisers in the study had been pressured by lenders to alter their appraisals. The authors argue for regulations to protect appraisers from aggressive lenders. Worzala, Lenk and Kinnard (1998) find in a survey of appraisers that most of the respondents had experienced lender pressure to overestimate real estate value. However, they find no evidence that lender size or change in the value of the appraisal significantly influences appraisers. Cole, Guikey and Miles (1986) examine deviations in appraised values from sale prices arising from buyer and seller motivations, but do not examine lender motivations.
The sale or transaction price is the product of negotiation between sellers, real estate brokers and buyers who may have interests that do not perfectly coincide with those of the lender. For example, home buyers/borrowers have a strong incentive to see appraisals at their maximum value in order to qualify for as large a loan as possible and as independent verification of a fair price. Sellers and brokers would happily accept high appraisals to close the sale and avoid the costs of further marketing the property. These incentives contribute to the possibility that the transaction price can be significantly greater than true value. However, a lender may face losses if the borrower defaults on the mortgage and there is insufficient collateral to recover the face value of the loan. In this regard, LaCour-Little and Malpezzi (2003) find that the quality of appraisals has a significant influence on the probability of default. Consequently, lenders rely on independent appraisers to verify the true value of the real estate, but should they? …