There are three methods of appraising the resale value of residential real estate: the comparative-sales approach, the cost approach, and the income approach. The comparative-sales approach uses recent sales of similar properties in the market because comparable sales reflect the behavior of typical buyers in the marketplace. The cost approach determines market value by calculating the replacement cost of an identical structure plus the cost of the land or lot upon which the house would sit. The income approach determines market value by analyzing market rents of comparable properties and applies the gross rent multiplier of expected rents. Most lenders give the greatest weight to the comparable sales approach when establishing market value before applying any loan-to-value limitations to the loan amount. The income approach is generally only considered for non-owner occupied homes. The three-test approach to appraising market value as used during the Great Housing Bubble is fraught with risk and is seriously flawed.

The comparative-sales approach reinforces the delusive behavior and irrational exuberance of a financial mania. If everyone is overpaying for real estate, the comparative-sales approach simply enables greater fools to continue overpaying for real estate. Since market prices for houses which serve as loan collateral fall to fundamental valuations based on income after the financial mania runs its course, mortgages originated based on the comparative-sales approach have a great deal of market risk not reflected in the pricing of collateralized debt obligations based on the underlying mortgage loans.

The cost approach has an even greater level of market risk. The cost of a structure may represent a relatively small percentage of the market value of real estate in high-value markets. In some of the most overvalued markets during the bubble, the replacement cost of the structure may have been $250,000 while the value of the underling land was $450,000; however, since the market value of land is a residual calculation based on the market value of the property, the value of the land cannot be determined independently of the house situated on it. Either the comparative-sales approach or the income approach must first be applied to establish the market value of the property before any calculation of the market value of the land can be determined. In short, since the cost approach is dependent upon another valuation method, it is not useful as an independent method of property valuation. Also, since the valuation of land is extremely sensitive to small changes in the valuation of the property, the cost approach is misleading with respect to the valuation of residential real estate.

The only reliable method for the valuation of residential real estate is the income approach, and it is the only approach that is widely ignored by the lending community. It has been demonstrated in previous residential market bubbles in California and in major metropolitan areas in other states that once a price decline begins, prices fall to fundamental valuations based on income and rent. The reason for this is that once the speculative investment incentive is removed from the market, buyers do not support prices until there is a new reason for them to buy: they can save money versus renting.

Comparative rents are the fundamental valuation of residential real estate. Mortgage default loss risk is low only when market prices are in line with comparative rents or when market prices are increasing. Default loss risk is low when prices are in line with rents because a property can be converted from owner-occupied to a rental unit and the payment can still be covered. Default loss risk is low when prices are rising because a borrower experiencing financial difficulty can always sell the property to repay the loan. Unfortunately, once market prices increase above the level of comparative rents, they endure a period of decline back to comparative rent levels; therefore, if lenders continue to use the comparative-sales approach, they will enjoy a temporary period of low market risk while prices increase and another painful period of losses when prices decrease.

As was demonstrated in the aftermath of the Great Housing Bubble, these periods of lender losses can imperil the entire banking and financial system. The only way to prevent the pain of loss is to recognize the end-game risks when prices are increasing and choose not to participate in that lending environment. Many lenders did not participate in the crazy lending of the Great Housing Bubble, and they were not significantly damaged in the aftermath; however, the hunger for mortgage loans from the CDO market compelled many lenders to participate or get buried by their competitors. The only real market-based solution to the problem of originating bad loans must come from the CDO market.Lawrence Roberts is the author of The Great Housing Bubble: Why Did House Prices Fall? Learn more and get FREE eBooks at: http://www.thegreathousingbubble.com/ Read the author's daily dispatches at The Irvine Housing Blog: http://www.irvinehousingblog.com/ Visit Residential Appraisals and Collateralized Debt Obligations.