Imagine a vacant, boarded-up shell of a house at auction. The local community development corporation is bidding, though it has calculated that even if the price were zero, substantial subsidies would still be needed to fund an adequate rehab job. Imagine another bidder, this one a speculator, willing to pay $20,000 for the house, intending to slap on some siding, install new windows and paint and resell it for many times that amount without any subsidies at all.
The CDC can either pay $21,000 and try to get even more subsidies or drop out of the bidding. Either way, the amount of affordable housing built per subsidy dollar shrinks. Meanwhile, the foreclosures pile up on the speculators’ lots, draining the stability CDCs have worked so hard to build up.
These things sometimes seem inevitable – the result of market forces or isolated examples of fraud – but they are not. The alleged “magic” of the market – that invisible hand that is supposed to automatically set the “right” prices – is sometimes wrong. Or more specifically, the market needs certain protections and conditions in place before it works properly – protections and conditions that are often missing in older and lower-income neighborhoods.
How it’s supposed to work
Our economic life can sometimes seem a lot like the game show, “The Price Is Right.” All kinds of stuff are rolled in front of us, one item at a time, and we have to figure out how much to pay for each. For standardized items sold through standardized outlets, the process is straightforward: If we want to buy a compact disc player, we can look through the Sunday supplements, check out a few web sites, and swing by the local Wal-Mart before deciding where to buy and what is a fair price.
When I recently contemplated buying a new car, a librarian directed me to a car comparison guide, and, for $12, a staffer at Consumer Reports faxed me a report indicating how much the dealer had probably paid and suggesting a negotiation range over that price. I paid in the bottom of that range and drove away confident the price had been right. If only figuring out how much to pay for houses were as straightforward.
But houses are not standardized products sold through standardized outlets. Housing markets are local and each property is different, so figuring out the right price for a house involves finding out how much other people have paid recently for similar houses in the same neighborhood. And determining what is “similar” isn’t so simple.
Conventional wisdom says that schools and safety dictate housing prices. That roughly, though not perfectly, parallels wealth. In wealthy places, prices are higher because people are willing to pay more to live there. But that isn’t all there is to it. In poorer places, there are still attributes of a property or a location that can make one home worth more, and therefore legitimately priced higher, than another. Two attributes predominate: condition and community.
When a block of brand-new, identical homes is built and sold for the first time, they are nearly equivalent and should be similarly priced. Much, however, can change over the next hundred years. One property might be blessed with attentive and financially able homeowners who rapidly repair any problems as soon as they appear and who make the significant investments in new systems and structural soundness that keep a property in top condition. By contrast, another home might be cursed with owners who consume its shelter without having the willingness or ability to put anything back into it. After a number of years, the best-maintained property should be worth considerably more than the worst-maintained property.
Community may have a greater impact on value in lower-income neighborhoods than in higher-income ones. In some cities, it is common for properties to be listed by parish, a practice that acknowledges that some parish communities are selling points – something people will pay extra to be a part of. Neighborhood associations or block clubs, when they have reputations as significant presences and successful advocates, will attract more buyers than a place without those groups. Well-kept parks create more demand and higher prices; poorly-maintained and dangerous parks erode demand and should legitimately result in lower prices.
In order to figure all this out, buyers might check the real estate pages of the Sunday newspaper, plumb home sale databases on the web and perhaps talk to realtors or other homebuyers active in the area. But these tasks are not easy, and few people ever buy enough homes in their lives to get good at them.
Instead, in upper-income markets, the vast majority of homes are sold by brokers whose stock in trade is everything they know about home sales in the area. Brokers compete for listings and closely monitor each other’s sales. Almost all homes are advertised on the open market, usually in the newspaper. A lot of people are watching. Further, because prices and commissions are high, everyone has an incentive to preserve the value in the area, and nix any shenanigans, to keep things that way. The best housing markets are highly transparent, meaning buyers, sellers, and lenders know a lot about what is being bought and sold and under what conditions.
When the higher-valued homes in higher-valued neighborhoods are rewarded with higher prices, a benefit accrues not only to the homeowner who has spent time and money fixing up the home or organizing a good block club, but also to the neighborhood, because such pricing creates a good “investment climate” that encourages other homeowners to do the same.
It’s not working
It doesn’t work that way in the neighborhoods most CDCs work in, however. There, often, homes in better locations or in better condition don’t get higher prices, or conversely, similar homes are not priced similarly. A few years ago, on a single street in a Boston neighborhood, four three-family houses sold over an eight-month period for between $128,000 and $205,000. No trend was evident: The lowest-priced sale was not the earliest nor of the house in poorest condition. In fact, the most expensive house appeared to need the most work.
In low-income neighborhoods, where prices are lower to begin with, fewer homes are represented by brokers, and those brokers present not only have less information about other sales, but have less incentive to get more, because the higher-price sale (with the higher commission) may be the less legitimate one. Fewer sales are advertised in the newspaper, since the cost to do so will make a sizable dent in an already modest commission. And fudging the numbers to qualify a buyer who would not otherwise have qualified is considered unavoidable by some sellers in places where buyers with downpayments are in short supply. Under these conditions it is difficult even for a professional to track market developments. For an amateur, however, the situation is worse: Even defining the boundaries of a neighborhood and whether one house is “similar” to another can get complicated. So housing markets in these areas are often extremely opaque: No one has a clue about what is going on or why.
When prices are virtually random, anything goes. The land flipper can take advantage of pricing inefficiencies to buy low and sell high without adding any value. Like the slumlord who maximizes profit on a rental by putting as little as possible back into the house, the speculator maximizes profits on sales by spending as little as possible to create the illusion the house is in better condition than it is. Usually that means siding, windows, perhaps new paint and maybe new front stairs. The big ticket items – the furnace, the wiring, the roof – might be on their last legs but the speculator hopes no one – buyer, appraiser, lender – will notice. All too often, the speculator guesses right.
Leona Thompson bought her three-family house at 44 Speedwell Street in Dorchester, Massachusetts, in December 1995 for $160,000. The seller had bought it, empty and boarded, at auction several months earlier for a fraction of that price and installed vinyl siding and windows, which created the illusion that the home was in better condition and more valuable than it really was. To justify the sales price, the appraiser used three not-very-comparable “comparable sales” – one a top-to-bottom rehabilitation, a second across the street from the police station, and the third another “flip” done by an associate of the seller. All the properties were marked as “similar.” The subject property was recorded as having furnaces and systems with 10 to 20 years remaining life. It noted that after rehabilitation there would be “no functional inadequacies.” In fact, within months of purchase, the ancient kitchen wiring in one rental unit shorted out and the furnace in another unit died. Rents were withheld by Section 8, and Thompson had to sell the house to avoid foreclosure.
In the neighborhoods where most CDCs work, in other words, the market fails to distinguish between illusions of value and the real thing.
Why does this happen?
Lenders bear special responsibility for allowing inefficient housing markets to thrive in lower-income, older areas. Until recently buyers weren’t entirely on their own in protecting themselves from paying too much for a house. As long as mortgage lenders held mortgages in their own portfolio, they had at least as much interest as the homeowner in forcing down the price of homes that needed new roofs or furnaces. They also used to inspect, to ensure that home improvement loans were actually used to improve the homes. Like brokers, they worked in very local areas and built up expertise in local market conditions.
Of course, mortgage applicants rarely appreciated the pressure savings banks applied to make prices reflect the condition of properties. No one likes to be told no. But fundamentally, the interests of the borrower and the lender were aligned. If a buyer bid too much for a property, the lender would say no. Now, with the secondary mortgage market, they can say yes and sell the loan, leaving buyers on their own.
Appraisers deserve a lot of the blame, too. Appraisal forms allow for adjustments for condition and location, but appraisers, often under pressure from lenders to value the home at or above the sale price, have little incentive to look for reasons why a property might not be worth that much.
Not everyone thinks it is the lenders’ or appraisers’ responsibility to prevent overfinancing of excessively priced homes. “This is her fault,” raved a Boston city official when I told him about Thompson last fall. “She should have hired a building inspector.” True, she should have. But as long as mortgage financing was available for a price that high, someone would have bought the property at that price. And the market would have continued to rise, pushed up by high rental levels and unsupported by value in the house.
Folks like the Boston city official believe that homebuyer education is the correct approach to preparing people to negotiate in their own best interest when they buy a home. But sometimes successful negotiation is not possible for even the best educated homebuyer.
First, the necessary information is hard to find. In most places, complete information about the condition of properties and the health of communities is difficult or impossible to get, even in print, let alone free and online as it would have to be to be routinely used by homebuyers, appraisers, and auditors. Although it is easy to point a finger at those appraisers and lenders who couldn’t care less whether a property is overpriced, the trouble is compounded when even those who do care can’t figure out accurate pricing.
In Boston, at the very center of one of the country’s high-tech capitals, to get specific information about a property’s condition, one must go in person to an office, stand in line, fill out a form and wait for a staff member to bring out a file folder stuffed with little pieces of paper describing building permits issued over the years. No appraiser could routinely check these building jackets and break even. Although many cities are considering creating centralized repositories of information about the attributes of various neighborhoods, very few have collected data, and even fewer have made that data available for free and online.
So lenders ignore the question. If demand for low-cost housing is greater than supply, then the prices for all low-end housing rise to the capitalized cost of rent regardless of condition, community or remaining useful life. The market then becomes high and undifferentiated. Prices routinely are too high and just plain wrong.
If the correct information about the properties and the sales had been used by the appraiser of Thompson’s house, he or she would not have been able to justify the sales price of $160,000, and her mortgage application would have been denied. The seller would then have been forced to renegotiate the sales price at a lower level, leaving the buyer the option of using the difference between the value of the completely rehabilitated building and the one she was buying to replace the antiquated systems. Unfortunately, that didn’t happen.
An Action Agenda
No entity is better positioned to directly address this problem than local government. Unlike virtually all other major policy areas affecting low-income areas, which are usually thoroughly tangled up in national politics, this problem is best handled at home. If local governments thought about themselves as versions of the New York Stock Exchange with real estate, rather than stock, changing hands, they would get some idea of the role they could play.
What stock exchanges do is rationalize the stock markets. They keep track of who is buying and who is selling and for how much. They make good information available to the public on a timely basis. The Securities and Exchange Commission sets rules and regulations for how the exchanges should operate, which adds clarity to what happens, and it enforces rules to make sure no one manipulates prices.
Housing markets also can be structured to maximize the chance that everyone will be able to differentiate higher-value from lower-value properties. That means making local housing markets as transparent as possible. Such a practice would do as much or more than a ton of housing subsidies to rationalize prices and increase the quantity, availability and affordability of housing.
First, local government could track “asks” and “bids” for properties for sale to encourage owners to sell through brokers and to encourage brokers to list all their properties – not just the high-priced ones. The immediate goal would be to increase the percentage of houses listed and sold publicly.
Equally important, local governments could act aggressively to make complete and accurate information about the condition of homes available free and online to anyone interested. The bonus of this system would be this: If appraisers and auditors for secondary mortgage market buyers could easily and cheaply get this information, they would also readily see which properties were hidden gems in above-average condition and deserving prices higher than superficially similar houses. This transparency is a foundation upon which real reinvestment could be built.