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There are basically two ways that short-sales and REOs are given consideration in an appraisal.  The first way is by straight-out using them as comparable sales.  The scenario I described in a previous blog demonstrates  that at times it's all but impossible not to use them.  In that case distressed sales made up 50% of the comparable sales and 50% of the competitive active listings.  The distressed properties had a clear advantage in terms of lower prices.  When I say "distressed" properties, I don't mean properties in poor condition, either.  I mean properties that are in as good a shape as the subject.  In some cases they are in even better condition because they've never even been occupied.  We hear a lot about bank-owned properties being stripped down to the walls by the former owners.  I would not use those sales in my analysis since they are not comparable to the subject.  They are not comparable because of their poor condition, not necessarily because of their status as a short-sale or a bank-owned property.

Some people feel that you shouldn't ever use short-sales or REOs as comparables.  Their logic is that they are not arm's-length transactions and therefore do not represent "market value."  An inherent assumption in the definition of market value is that neither buyer nor seller is under any duress, i.e., pressure to buy or sell.  It is true that a person who is short selling their home is under some pressure to sell or they wouldn't be short-selling.  They most likely can no longer afford to make their mortgage payment and would like to avoid foreclosure if possible.  However, in this market, isn't it also true that just about everybody who is selling their home is under some kind of pressure to sell? 

What about bank-owned properties?  Are banks under terrible pressure to sell?  Not really.  They simply do not want to be in the business of owning real estate, especially in a declining market.

Let's not forget a basic principal of appraising: the principal of substitution.  Why should you pay my price for my home when you can walk across the street and get one that is virtually identical to mine for 20% less?  If it can be bought for less, it will be.  The appraiser's main concern is the market value of the subject.

The second way that short-sales and REOs are given consideration in the appraisal is in the market/time adjustments.  I will not use short sales or REOs as comparable sales when it is possible and/or appropriate not to use them.  But that does not mean that we escape their influence altogether.  If you ascertain that the market for properties comparable to your subject is declining, you must address that in your report.  It may be that your comparable properties sold recently and the rate of decline is low enough so that any adjustment be unwarranted.  On the other hand, if you determine the market has declined by, say, 12% over the past year and your most recent sale went under contract three months ago, you may have to make a market/time adjustment. 

At this point in time, there are so many short-sales and REOs it would be almost impossible not to be affected by them.  So, even if you do not use short-sales and REOs as comparables, they are probably a factor in your declining market, and their influence shows up in the market/time adjustments.  At the very least, they have probably affected the value of the comparable sales that were used in the analysis.  In any case, short-sales and REO's make up a large percentage of many markets today.  Trying to ignore them altogether could result in a misleading appraisal report.