Driving home from the grocery store last week, I noticed a car slowly driving around my neighborhood, with a sign on the door that clearly read "real estate appraiser." I knew these people existed, and one had certainly signed off on the price of my house when I bought it, but I'd never actually seen one in person. I felt like I had spotted a unicorn.

I think I can say that housing is a mess without sparking any arguments. However, when it comes to what caused the problem, or how to fix it, there seems little that people can agree on. Some homeowners may have recently hit the lottery -- even though I didn't agree with it -- but I don't think anyone is deluded enough to think that measure will squelch the housing market's ongoing inferno.

Given all that, I had to chase down this appraiser and get some answers.

People just don't do it that way!
After introducing myself to the nattily dressed, Cadillac-driving appraiser, I began my asking what method he used when determining the value of residential real estate. Not at all surprisingly, he replied that it was based on comparable home sales in the area -- "comps," in appraiser and realtor speak.

Why don't appraisers use some sort of approach such as multiples of local rents, or even a discounted cash flow of assumed rental income, which would put a more solid value on the home? "Because people just don't buy houses that way."

A light bulb flashed on above my head: That's exactly the problem! I tried to argue the point with him, suggesting that the current massive slump in housing prices suggested that maybe there was something wrong with the way things had been done. No use. All I got was a few more repetitions of "people just don't buy houses that way."

The value of a house
To talk to my appraiser friend, you'd think that the primary value of a home was something ephemeral, something you could measure based on how much people paid elsewhere, but not something you could touch, feel, or stomp your foot on. It makes a home seem like a work of art. Somebody paid $2 million for a Picasso last week? Well, we'll price this Picasso, which is very similar in size and but slightly higher-quality, at $2.1 million.

But take it from somebody who has toured quite a number of KB Home (NYSE:KBH) and Toll Brothers (NYSE:TOL) homes -- there's nothing artistic about most homes built today. They have four walls, a front door, and a roof up top. Depending on where you live, some new communities offer little more than that. Don't get me wrong; personal preference certainly comes into the picture when choosing a home. But if people had a better sense of what the asset value of the home was when they bought it, I think it might temper their enthusiasm for paying $100,000 or more beyond that asset value.

The role of the appraiser
Appraisers get paid for assessing the value of houses. They need to be the sober third party who comes in to provide a realistic picture of the situation. If an appraiser says that the value of a house is $200,000, even though the seller is asking $215,000, it's up to buyers to decide whether they're willing to pay that extra $15,000. Even so, at least those buyers have a solid value to start from.

We've seen all too many times what can happen when the supposedly sober third party in a financial transaction gets drunk along with the rest of the partygoers. In fact, we had a perfect example just a few years before the real estate bubble -- the Internet bubble. Financial advisors who should have been giving their clients an accurate assessment of the nuttiness in the stock market instead got caught up in the hype. Stocks like Cisco (NASDAQ:CSCO) and Amazon.com (NASDAQ:AMZN) got bid up to truly insane multiples. When Mr. Market's massive dose of happy pills wore off, the Nasdaq collapsed by some 75%.

And hey, if the appraisers are primarily worried about how people buy houses when they're doing their valuations, why do we need appraisers at all? If they're trying so hard to put themselves in the shoes of buyers, why not just let the buyers sign off?

Why it's better for everyone
Comps seem to be a way of life in residential real estate, so why change things now? Well, for one thing, a huge national slump in housing prices just might suggest that this particular method isn't working.

I'm guessing that homebuilders won't like this argument. DR Horton (NYSE:DHI), for example, saw profit margins far exceeding its historical norms from 2003 to 2006. Rather than some miraculous leap in efficiency, I suspect that increase owed to sky-high sale prices for their homes. Take a hammer and nails to the valuation process, instead of a paintbrush, and you're likely to keep those margins from ever inflating so dramatically again.

A realistic valuation of homes would be a great benefit to banks, though. Whether we're talking about big ol' Wells Fargo (NYSE:WFC) or the somewhat smaller Regions Financial (NYSE:RF), banks are suffering major losses a people foreclose on their homes, and bank discover that they can only resell those homes at a heady discount to what they lent out. When a mortgage loan is made, it's made against a house -- an asset -- not an emotionally valued home. Realistic valuations from appraisers would provide a lot of downside protection to banks when they make their loans.

And of course, it would help consumers, too. We'd be less likely to run into an out-of-control housing market in the future -- at least, not one as bad as we have now. At the same time, it wouldn't hinder buyers from paying up for a house that truly was unique or in a great location. They'd just have to face up to the difference between the asset and intangible values of their purchase.

This change could also help put a floor under today's falling housing market. If all you know is comps-based valuations, housing prices can spiral downward just as dramatically as they rose. Realistic valuations will give both investors and homebuyers confidence that they're paying a fair price for a house.

The comps stop here
Just like valuing a stock, looking at comparable homes can be a good place to start when valuing a house -- but that shouldn't be where the process stops. While arresting the pain of the current economic disaster is of primary importance, we also need to seek ways to prevent a similar situation in the future. Tightening the screws on how real estate is valued seems like a great step in that direction.

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