By Steve Waters
Despite a risk of being shunned by some elements of our property investor community, I’m about to state a controversial position that will shake many to their core.
Are you ready?
I believe a ‘too-high’ valuation is more dangerous than a ‘too-low’ valuation.
I’m not referring to a result which truly reflects market value but surprised an owner who had preconceived low expectations.
I mean instances where an error in the process meant the valuer’s assessed figure was well and truly above the definition of market value and would allow the financier to loan a sum beyond the borrower’s wildest dreams.
I realise I’m being counter-intuitive. It sounds like a ridiculous ‘problem’ to anyone struggling for finance – but bear with me. I believe there are extraordinary dangers that can lead to an unravelling of a lot of good work when you get a result that exceeds your expectations.
How does it happen?
The first thing to understand is there are different types of valuation reports commissioned by financiers.
These include automatic valuation models (AVM), desktops, drive-bys and full inspections.
You’ll rarely get an overvaluation from a full inspection. If a qualified property valuer has full access to your property and a strong knowledge of local comparable sales, your result will probably fall within the bounds of market value.
You are most likely to get an over-valuation from a drive-by, desktop or AVM.
Drive-bys come in high because the valuer won’t be aware of a property’s features that can’t be seen from the road front. An assumption that a home is of ‘average fitout and finish’ could be completely false.
The outcome can be even more extreme when talking about a desktop assessment. In these instances, the valuer doesn’t leave their office. They must derive a figure based on information about the property provided by the financier (supplied by the client), and any additional they unearth themselves.
You can image how this can skew an outcome. The results can be compounded further when overworked valuers are asked to assess property that’s out of their locations of expertise.
However, all these pale in comparison to the overvaluation errors generated by AVMs.
AVMs use algorithms that rely on ‘averages’ for each suburb. These figures can be easily skewed by statistical anomalies – such as a new housing estate with high priced homes, or a few top-end sales within a short time frame. AVMs also don’t identify the individual characteristics of the property – both good and bad – because they’re computer generated.
Thus, their margin of error is fairly substantial.
Have you heard those stories of ordinary people who, due to an administrative error by a bank, ended up with hundreds-of-thousands of dollars in their account? Some of them head off on a Christmas-like shopping spree that drains the funds immediately. Unfortunately, when the bank comes knocking asking for their erroneous dollars back, the big spender is in a world trouble.
This is because the money wasn’t theirs – in a sense, it wasn’t ‘real’.
Getting a higher valuation is similar. It sounds like a dream, doesn’t it? You end up receiving tens of thousands of dollars in extra ‘equity’ placed at your disposal by the slip of a pen rather than a rise in the market.
And this why you are now at risk – because this added equity isn’t real.
The market value assigned to the holding would be unachievable at sale which means it shouldn’t be securing a loan.
If you decide to draw a higher LVR against the top end value you’ve just received, it could leave you in a negative-equity situation which is fraught with risk.
Undisciplined investors who don’t understand property price cycles and are unsophisticated in managing their personal finances are on a fast track to failure if they knowingly take advantage of a valuation outcome that’s too high.
At the moment, I feel particularly for Sydney and Melbourne buyers who may have purchased at the top of the peak. They’re already back 15 to 20 per cent in some locations.
I’d hate to be sitting in negative equity in their markets right now, and drawing against an overvaluation just compounds the danger.
What to do
I’m not suggesting as an investor that you should argue down a valuation assessment. Apart from the wasted time and effort, there’s no upside for you in talking down the figure.
Having a higher figure on the books is advantageous if you take the correct steps. For example, under the current system where valuations are ordered and audited by third parties for the banks, your historic valuation figures are recorded, reported and filed away.
These numbers are often referenced by new valuers at a later date. This means arguing down your figure could have an unexpected long-term implication for your future finance plans.
My solution is to take the borrowing you originally intended to draw, but at a lower loan-to-value ratio (LVR).
Say you’re borrowing $330,000 for a new purchase. You ask for a valuation on your current investment property knowing it’s realistically worth $350,000 – that’s a 94 % LVR.
The valuation comes back at a staggering $415,000 under the AVM process.
What do you do?
The foolish investor will cry, “Happy days! 95 % of $415,000 is around $395,000. I can buy my investment property and still have $65,000 left over for that new ‘work’ car I’ve had my eye on!”
This is just outright stupidity. It’s a house of cards ready to fall – not the least because you’ve bought a depreciating asset with the extra dough.
The smart investors will say, “Happy Days! $330,000 in borrowing against a $415,000 valuation is an LVR of 80 %. I’m going to make all sorts of savings on mortgage insurance, fees and costs. I’ll also have the backup of being considered a solid, low-risk borrower by my bank.”
This is a sensible approach. You’ve kept your costs down, buffers up and will be safe until your property’s value actually rises to be in line with the high assessment.
Don’t destroy years of hard work by being selfish with an over-valuation. Make good decisions and remain liquid so you can sleep well at night, and jump on new opportunities when they arise.