Australian’s are known for their love affair with bricks and mortar. This may be largely due to familiarity combined with an almost constant supply of lifestyle media attention to the subject. It's also because a significant contribution to Australia’s wealth has been from property investment.
But how much useful factual information is really available and understood by the man and women on the street?
To illustrate this point, consider two common statements made about property. Many people inaccurately refer to their own home as ‘the best investment they have’ and many people declare, ‘our home is our superannuation fund’.
Both statements are inaccurate at best, naive at worst.
In reality, a person’s home is not an investment as it doesn't generate income and most probably can't be sold without its proceeds needing to be used to buy or rent elsewhere.
Who does the property valuation?
An important part of the purchase of an investment property is its valuation.
- This is because the valuation figure usually directly affects the amount of funds that can be borrowed to invest in that property — because funders lend against the percentage of the total valuation or the contract price - whichever is lower.
If an investor is going to borrow, (gear) to invest, then part of their overall strategy may include to borrow as much money as possible for tax-deductible debt. Some lenders use an independent qualified Property Valuer while many banks simply use a member of their staff.
Currently, the qualified property valuer needs to hold an Advanced Diploma in property valuation through TAFE whilst many also complete an undergraduate degree through a university. The staff at a bank are not required to have any specific qualifications but they work under the rules and instructions as set down by the bank management.
- The qualified property valuer needs to hold an Advanced Diploma in property valuation through TAFE whilst many also complete an undergraduate degree through a university. The staff at a bank are not required to have any specific qualifications but they work under the rules and instructions as set down by the bank management.
- The staff at a bank are not required to have any specific qualifications but they work under the rules and instructions as set down by the bank management.
How much is the property really worth?
Price v Value
Traditionally a property’s value is said to be 'the price at which a willing, informed seller would freely sell the property and the price at which a willing, informed buyer would freely pay' for the property.
Another way to assess this value is to
- quantify what part will the property play in your overall wealth management plan
- consider how long do you intend to hold it,
- know what are the risks associated in having to hold it longer than anticipated or sell it sooner than expected?
In practical terms, if you intend to hold the property for the long term as part of an overall wealth and risk management plan, whether you pay $10,000 more or less than the perceived market value, may be less important than the overall value the property will play in your plan - its annual compounding capital growth and the opportunity costs of your doing nothing. (Opportunity cost is the effective cost to an investor in not taking up an opportunity when available).
Real estate valuing
There are various methods of valuing real estate, the three most common are below.
The comparison with recent sales in the area. The problem with this method is that it may take up to six months for the sales data to become available. Property values can change dramatically in just six months and for a range of reasons that are not reflected in the sales data too.
The second way of valuing is the summation method. This is the calculation of the replacement cost of a building plus the estimated value of the land.
The third is the assessment of the capitalisation of rental which is mainly used for commercial property. All of these methods are dependent on the attitude of the valuer and the commercial pressures they work under.
“The banks pay them (valuer’s) very little per valuation so the time they can spend on each is limited which sometimes leads to them cutting corners and producing inaccurate or irrelevant valuations. The valuers can also be held personally responsible if a property is ‘overvalued’ and the bank cannot retrieve their funds in a foreclosure.” (Bank spokesman)
What have the courts said about the issue?
In 2008 the NSW Supreme Court held that “a valuer may owe a duty of care to a person on whose account or for whose benefit and use it prepares the valuation.” The court held that the valuer company “owed a duty of care to the bank ... the bank relied on the valuation.” In this case experts were called in relation to a fair market value of properties. “the expert accepted that established valuation practice recognises that two valuers, acting reasonably and carefully, can differ in their valuations by around 10%.”
The Court also found in this particular case that there was negligence on behalf of the valuer company. The valuer failed to make allowance for the negative features of the property, overstating the size of living areas, relying on comparable sales that were not comparable.” (Adelaide Bank Ltd V DTS Property Services Pty Ltd (2008) NSWSC 1328)
As in this case, an incorrect valuation by a valuer could result in the bank lending to the borrower more than the expected loan to valuation ratio which can mean that if the loan defaults and the property is sold the bank may be unable to recover the debt.
On the other hand, if a valuation for the bank is carried out with the valuer acting under instructions from the bank it can disadvantage the borrower as an understated value will mean they can borrow less. The majority of bank valuations now are endorsed ‘Bank Valuation’ and that it is prepared for the banks use only, in accordance with their instructions. In the author's opinion, a bank valuation is not a true independent valuation and to suggest otherwise would be to ignore the evidence.
How do we know if a real estate valuation is accurate (or reasonable)?
When investing in property, as with investing in share’s, the price being asked is not always the indicator of the true value being received. Its in being able to recognise this value is the true worth to an investor.
So how much should an investor pay for a property?
On one hand, the valuer might deliberately reduce the valuation amount on the property to minimise their risk of personal liability.
- A typical real estate salesperson who is working on behalf of the vendor has a vested interest in selling the property at the ‘best’ price to increase their commission (their commission is often a percentage of the final sale price.)
- If the investor relies upon a bank valuation the investor should always remember to expect a conservative result as bank valuations are regularly below purchase prices for reasons that may have little or nothing to do with the value of the property.
How does bank policy affect the valuation process?
- The formal bank policy may be to restrict a bank’s exposure to no more than 15% of a particular development or class of development.
“I have never seen a valuation ever returned stating that the bank has reached their exposure and do not wish to provide a loan for that reason. The valuation is always returned significantly lower in the hope that the applicant will be forced not to purchase that property but will stay with the bank anyway because of the frustration of completing a fresh application with a different funder.” (Investment Mortgage Broker)
This policy is often referred to as bank over exposure and is rarely ever made public by a funder. Commercially this may make sense, but rather than simply tell you they do not wish to use the property as security, they instruct the valuer accordingly.
This lack of disclosure by the funder is another reason why investors use professional advisers to help them navigate through the lending maize. [By way of comparison, the bank’s mortgage insurers openly publish their maximum exposure level cap to a single individual investor.]
What should a property investor do?
- Remember to make your own assessment of the role of the property to your overall financial plan.
- Do not rely solely on either a pushy market salesperson, a seminar sale pitch, a real estate agent or just a bank valuer.
- Examine what your overall investment goals are against the value that the property will provide and consider using the ASIC Risk and Return Calculator as an initial guide to investing.
To invest wisely in a property the investor needs to: use a suitably qualified financial planner, a licensed real estate agent and a professional skilled in investment methodology.
An investment property purchased should takes into account the investor needs, personal circumstances, expectations and ongoing ability to have an investment property as part of their financial future.
The following 3 case studies highlight some of the common pitfalls of bank valuations.
Refinance from a Bank
John, a home owner was seeking to have his property refinanced. The bank made all the right noises about being able to assist but when John hadn't heard from the Bank he rang to ask ‘when someone was coming to value the property?’. The loans clerk indicated that he had personally valued the property at $300,000. John felt the actual value was closer to $500,000 and asked how he valued the property.
The loans clerk indicated he was working in the loans area with the bank for the past three years and that he had ‘stopped out the front of the house in his car’ and did not get out but it appeared to be a ‘normal’ three bedroom house without a garage. He said he used the ‘local average price’ that had been set by the bank to determine the valuation. John insisted on another valuation to be completed by a qualified valuer. The new property value was found to be $490,000 for the five bedroom, single garage and two living room property on 1,000 square metres of land.
Buying an Investment property
A mortgage broker was arranging finance for a recently constructed strata property development. The first valuer returned the valuation at $360,000. This was surprising as the purchase price was $399,000 and other funders had valued in the same complex higher.
- As the loan was not required for another 6 weeks, the mortgage broker simply resubmitted the online application for a fresh valuation 6 weeks later - when the original valuer was on holidays.
- The same property was then valued by different staff from the same office at $399,000.
Did the property fall in price and then grow in value by $39,000 in the course of 6 weeks?
Constructing an investment property
A new house near the water was valued by Funder A at $73,000 under the purchase price. Similar properties had already been purchased at a higher price but the sales data had not yet become publically available. A week later, the identical property was then valued by Funder B at $73,000 more than Funder A.
If this investor was not using a professional adviser who understood these different funders, their valuation policy and processes, the investor may have been unable to enter the investment market at that particular time. The result would have been a missed strong opportunity and sustained significant ‘opportunity cost’ for not being able to proceed with her plans.