The Dangers Of Overvaluing Real Estate

By: Luigi Frascati
Submitted: 2007-01-17 16:25:36
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We all have done it at one time or another.

When short of listings, the Realtor goes out and ‘buys' one. The process of buying a listing is as old as Real Estate itself. The agent shows up at someone's doorsteps and inflates the value of the property by more than $30,000, $40,000 or even $50,000 over and above the actual market value. I know of agents who have actually listed properties for $200,000 more than what those properties were in fact worth. The owner happily signs the listing agreement with those dollar signs sparking right in the eyes, and the Realtor happily sticks up a sign right in the front lawn. Of course the house subsequently does not sell because it is overpriced, but it doesn't really matter.

Or does it?

All the way back in 1988, in a legal case entitled Basic Inc. v. Levinson, the United States Supreme Court endorsed a theory known as ‘fraud on the market', which in turn relies on another theory known in Economics as the Efficient Market Hypothesis. The Efficient Market Hypothesis postulates that prices of traded assets like stocks, bonds, or real property, already reflect all known information and therefore are unbiased in the sense that they reflect the collective beliefs of all investors about the value of the underlying asset and enable investors, therefore, to assess future prospects.

In essence the Efficient Market Hypothesis, which was developed in the 1950's and 1960's, states that subject to certain conditions the market price of a traded asset fully and accurately reflects all the available information relevant to its value. Under this Hypothesis, in an efficient market the only reason as to why a price changes is that new information comes to light.

Because market prices reflect all available information about an asset, reasoned the Supreme Court, misleading statements as to the integrity of price will affect and negatively impact the decision-making process of investors, who rely on those statements as the primary guide to finalize a purchase. Which is tantamount to ‘intentional deceit', more vulgarly known as ... fraud.

That ruling has proven a goldmine for American trial lawyers, who have won fortunes by suing firms for damages when new financial information, often in practice a restatement of their balance sheets, is followed by a sharp fall in stock prices of the same firms. The fall is treated as proof of overvaluation due to the initial, wrong statements.

This decision of America's highest Court has now crossed the border with Canada and has spilled into Real Estate. A case involving a Seller, a Buyer and a Real Estate Agent acting in a position of dual agency is now pending in front of the Supreme Court of Ontario. The Agent first grossly overvalued the subject property at the time he took the listing, then actually found a Purchaser ready, willing and able to buy at a price close the grossly inflated asking price. As the transaction was being financed through an institutional lender, the underlying case initially also involved an appraisal firm, which subsequently has settled out of Court with the disgruntled Purchaser.

The decision of the Supreme Court will have an enormous impact on how real estate is practiced in Ontario and possibly throughout the whole country, and it will be interesting to see what the outcome will be. The Buyer bases his case on the Efficient Market Hypothesis arguing that he reached the decision to purchase on the integrity of the asking price and claims, furthermore, that the dual Agent knew or should have know that the asking price was grossly over and above the market value of the subject property. The Buyer is claiming damages both as against the Agent and the Seller.

The line of defence is that the true meaningful value of an interest in land is given by its ‘objective value', defined as the price that the property will fetch in an open and fair market, given sufficient time to find a Purchaser, the amount of advertising involved in the marketing of the property, the relationship between the parties and the terms of financing. The additional argument of the defence is that the truthfulness of the Efficient Market Hypothesis is actually being disputed by Economists even in its original field of application: the Stock Market. More specifically, the defence argues that even highly developed financial markets such as the New York Stock Exchange are not efficient enough to allow Courts to calculate the financial damages caused by fraud, and that estimates of damages based on the Hypothesis will be necessarily overstated.

The Realtor in particular contends, furthermore, that at no time the thought of earning a double commission ever crossed his innocent mind (he was walking the dog one day and ...).

All of which goes to prove once again the point I have been making for years - that is sellers, buyers, realtors, lawyers and judges invariably make an explosive mix.

Luigi Frascati

Article source: Expert Articles