Written by Bill Waltenbaugh, as originally published in The Reverse Review.

Should an appraisal include or exclude bank-owned sales comps? This is a great question and one that has become more relevant over the past several years. Not long ago, foreclosures and short sales were few and far between and the need to consider these transactions in the market approach was unnecessary. Most “distressed” properties were rough around the edges and the typical buyer didn’t consider them reasonable alternatives. These properties were typically purchased by investors with the intent of cleaning them up, making a few renovations, then listing and selling the property at a higher price for entrepreneurial profit. However, today’s market is much different. In some neighborhoods,  "distressed” inventory and sales can make up a significant portion of the market. When this happens, these properties can’t be ignored.

The Uniform Standards of Professional Appraisal Practice (USPAP ) is the standard appraisers must adhere to when completing an appraisal for a federally related mortgage transaction. This standard requires appraisers to consider all relevant transfers and determine which sales should be used in the analysis to arrive at a credible opinion of value for the subject property. To do this, the appraiser investigates the circumstances of each transfer to determine if atypical motivations or sales concessions were involved in the transaction. However, just because a property is bank-owned doesn’t mean the transaction is atypical. These days, many bank-owned properties are in similar, if not better, condition than non-distressed competing properties. As such, given adequate market exposure, the typical buyer in the neighborhood will also consider these properties when in the market for a home.

One of the main tenets of appraisal theory is the principle of substitution.

This principle dictates that a buyer will not pay more for a property than the price of an equivalent substitute property. As such, the value of a property (or any other goods or services, for that matter) is limited by its competition. When enough “distressed” properties are available, the subject will need to compete with those properties.

I like to explain it this way: A good comparable property is one the typical buyer of the subject would also consider when in the market for a home. Essentially, these properties are considered “reasonable alternatives.” They are similar with respect to location, condition, utility and appeal. For the most part, the owner of the property doesn’t matter; a similar turnkey conditioned property from a lender is just as appealing as a similar turnkey conditioned property from the Average Joe homeowner. At the end of the day, it comes down to availability and competition. If there are enough “reasonable alternative” properties available at a lower price, the price of the competing properties will need to be lower in order to compete.

As a general rule, appraisers should avoid using bank-owned comparable sales in the market approach. However, when the abundance of these properties begins to define the market, it is irresponsible for an appraiser to exclude or ignore the consideration of these transactions in their analysis.