How to measure market reaction has been the subject of debate and confusion among residential lending appraisal users and appraisers. The purpose of this article Is to offer methods and examples of how to measure market reaction to energy-efficient features, especially as market reaction pertains to government agency requirements.
Measuring market reaction is an important skill in valuing property features. In an appraisal, a market study is "an analysis of the market conditions of supply, demand, and pricing for a specific property type in a specific area." (1) Appraisers analyze data, review studies, and survey market participants to understand the market's acceptance of certain property features and how much they are willing to pay for the features, i.e., market reaction. Measuring market reaction is most difficult for new property features and especially green or energy-efficient features. When a feature is new to a market, sales of properties with these features are not present. Therefore, measuring market reaction requires the use of methods other than paired sales to address how buyers in the market may react regarding demand and the price they are willing to pay. The lack of sales with the feature(s) may simply be a result of databases that have limited searchable fields, and it does not necessarily support a conclusion that the feature has no value and no demand. While the market reaction discussion in this article centers around green and energy features, similar issues may arise for any new home feature. Appraisers must avoid making an unsupported assumption or premise about market area trends. The purpose of this article is to offer methods and examples of how to measure and support findings of market reaction to energy features.
Supporting Findings of Market Reaction
The lack of understanding of how to support market reaction exists in the underwriting/ lender world as well as in the valuation profession. Market reaction is treated in distinctively different ways by Fannie Mae, Freddie Mac, and FHA. The disagreement of how to address market reaction mainly centers around the Fannie Mae Selling Guide's wording quoted in Exhibit 1. (2) As shown, this section of the Selling Guide calls for adjustments for market reaction to energy efficient improvements, but it does not provide guidance on how market reaction is to be identified, measured, or supported. The Selling Guide also specifically states that it is an "unacceptable appraisal practice" to use "adjustments to comparable sales that do not reflect market reaction to the differences between the subject property and the comparable sales." (3)
Exhibit 1 Fannie Mae Selling Guide: Energy Efficient Improvements Energy Efficient Improvements An energy-efficient property is one that uses resource-effective design, materials, building systems, and site orientation to conserve nonrenewable fuels. Special energy-saving items must be recognized in the appraisal process and noted on the appraisal report form. For example, when completing the appraisal report (Form 1004), special energy-efficient items are to be addressed in the Improvements section in the Additional features field. The nature of these items and their contribution to value will vary throughout the country because of climactic [s/c] conditions, differences in utility costs, and overall market reaction to the cost of the feature [Emphasis added] Some examples of special energy-efficient features may include, but are not limited to, energy efficient ratings or certifications, programmable thermostats, solar photovoltaic systems, low-e windows, insulated ducts, and tank-less water heaters. Appraisers must compare energy-efficient features of the subject property to those of comparable properties in the Sales Comparison Approach adjustment grid. If the appraiser's analysis determines that an adjustment is warranted based on the market reaction to such item(s), the adjustment must be Included in the adjustment grid. [Emphasis added.] Source: Fannie Mae, Sec. B4-1.3-05 "Improvements Section of the Appraisal Report," Selling Guide: Fannie Mae Single Family (Washington, DC: Fannie Mae, March 6, 2019), 566. Confusion arises when the Selling Guide's statement regarding "comparable properties in the Sales Comparison Approach adjustment grid" is emphasized and the text related to consideration of "market reaction to the cost of the feature" is ignored. Appraisers have reported that some underwriters have interpreted the Selling Guide sections shown in Exhibit 1 as implying that market reaction support means only comparable sales evidence or at least a paired-data set analysis. They have been told that if they do not have a comparable sale with the same energy or green feature, they cannot attribute value to the feature.
Freddie Mac's Single-Family Seller/Servicer Guide (4) also calls for the contributory value of energy-efficient features to be measured based on market reaction, but it goes a step further than Fannie Mae by clearly identifying methods beyond paired-data analysis to support a conclusion. In comparison, the FHA Single Family Housing Policy Handbook does not use the term market reaction, but like Freddie Mac's Seller/Servicer Guide it discusses alternate methods of analysis to measure the contributory value of features. A review of the residential selling guides from Fannie Mae, Freddie Mac, and FHA, and some examples of how each addresses market reaction, are most revealing.
It is instructive to first look at what Fannie Mae has accepted in the past regarding market reaction analysis. Previous forms made it clear that the cost and income approaches could be used to discern market reaction when comparable sales were not available. In 1989, Fannie Mae Form 1004A (Freddie Mac Form 70A) gave an example of how to value energy efficiency if no comparable sales were available. Exhibit 2 shows this form's example of how to calculate the value of energy-efficient items.
While use of this form was discontinued in 2009, it offers an example of how to estimate the value of energy-efficient or green features when sales are not yet available in the market (or not identifiable due to limitations of databases). The calculations in the form make it clear that the value of the features may be estimated using the lesser of the present worth of the estimated savings or the installed cost of the energy-efficient item less any depreciation. These two methods, cost and income, were only to be used if comparable data were not available according to the Fannie Mae Energy Addendum.
Exhibit 2 Fannie Mae Form 1004A Estimate of Value of Energy-Efficient Items Part 2--Estimate of value of energy-efficient items This section can be used to help estimate the value or energy-efficient items only when adequate comparable market data are not available. In such cases, the value of the energy-efficient items should be the lesser of (a) the present worth of the estimated savings in utility costs, as determined by capitalizing the savings at an interest rate that is not less than the current interest rate for home mortgages for a period that does not exceed the lesser of the item's expected physical life or seven years, or (b) the installed cost of the energy-efficient item or construction technique, less any physical, functional, and external depreciation. For example, if the subject property is an existing house with inadequate insulation and infiltration barriers--such as one without storm windows, caulking and weather-stripping- and the estimated savings per month is $35 for upgrading the property (based on an energy audit/rating), the appraiser could use the following calculations as a guide. Installed cost (less depreciation) $2,500 Expected life 7 + years $420 x 4.789 Expected monthly savings $35 per month = $2,011.38 Expected annual savings $420 per year Present value factor $4,789 (annual compound interest at 10,5% for 7 years) For this example, it would appear reasonable (only if adequate comparable data were not available) that a typical purchaser might pay a premium of $2,000 for the property as improved with the suggested energy-related items. Market Reaction to Cost New. If a product is priced too high, how will the market react? While there may be "early adopters" willing to purchase at a price considered too high, they may not reflect the majority of the market. If a high percentage of the market refuses to pay the price, it must be lowered to gain market share, or incentives must be applied to offset the cost new and kick-start the market. Once the market accepts the pricing the incentive is removed. If a builder or seller prices their house over the market level, it will experience a longer marketing time and/or an eventual lower sale price. The example in Fannie Mae Form 1004A alludes to cost as one indicator of the market reaction. Estimating the possible depreciation from obsolescence for a new product is the weakness in this method.
A good example of the market reacting to cost new can be seen in the history of residential solar photovoltaic (PV) systems, which shows installations have increased as the costs have decreased. Ten years ago, the solar PV cost exceeded $6.50 per watt and the number of installations was few. When the price fell to +/-$3 per watt, the number of installations increased. It could be argued that part of the increase in installations may be attributed to an improving economy and/or increased buyer knowledge; however, the lower cost cannot be ignored as a probable reason as well. As costs decreased, the property owners' period to recoup the initial investment also decreased, making the buying decision more favorable. The residential solar market has reacted to the lower costs by demonstrating an increased willingness to pay; this trend is illustrated in Exhibit 3.
It would be inappropriate to address each feature of a home based on cost new...