Defining the Valuation Problem: The First Step Toward Fair Value

Definition of the Valuation Problem: The First Step Towards Fair Value

Introduction:

The real estate valuation process is an integrated journey towards estimating the fair value of the property, based on systematic and well-studied steps. The first and most important step in this process is “defining the valuation problem.” This step is like laying the proper foundation upon which the entire valuation is based. A precise understanding of the valuation problem guides the appraiser’s efforts and ensures focus on the aspects relevant to the value to be estimated.

Importance of Defining the Valuation Problem:

1. Defining the scope of the valuation: Helps in defining the boundaries of the task, what the valuation includes and what it does not.
2. Directing the appraiser’s efforts: Ensures that the appraiser focuses on collecting and analyzing data that serves the specific purpose of the valuation.
3. Avoiding errors: Reduces the likelihood of collecting unnecessary data or analyzing aspects that do not affect value.
4. Achieving accuracy and reliability: Increases the chances of reaching an accurate and reliable estimate of value.
5. Meeting the client’s needs: Ensures that the valuation fully meets the client’s needs and requirements.

Elements of Defining the Valuation Problem:

1. Identifying the property being valued:

   • Legal Description: The property must be precisely identified through the legal description found in the real estate registry, specifying the geographic location, boundaries, and dimensions.
   • Actual Location: The actual location of the property must be identified on the map and its address clearly identified.
   • Physical Characteristics: The physical characteristics of the property must be described in detail, including land area, building area, number of rooms, number of bathrooms, finishes, property condition, and other relevant features.
   • Improvements and Additions: Identify any improvements or additions to the property, such as swimming pools, gardens, parking spaces, etc.
   • Personal Property: Specify whether the valuation includes any personal property located on the property (such as furniture or appliances) or not.

2. Identifying the real estate rights to be valued:

   • Fee Simple: The highest form of ownership, where the owner owns all rights related to the property without restrictions (except for general legal restrictions).
   • Leasehold: The right to use the property for a specified period under a lease agreement.
   • Easement: A limited right that allows another person to use part of the property for a specific purpose (such as passage or extension of service lines).
   • Mortgage: A right for the creditor (bank or financial institution) on the property as collateral for the debt.
   • Partial Interests: Such as mineral rights or water rights.
   • The type of real estate right to be valued must be accurately determined, as the value of different rights varies significantly.

3. Determining the purpose of the valuation:

   • Real Estate Finance: To obtain a mortgage loan.
   • Buying and Selling: To determine a fair price for the property.
   • Real Estate Taxes: To estimate the value of the property for tax purposes.
   • Insurance: To estimate the value of the property for insurance purposes.
   • Litigation: To estimate the value of the property in the event of legal disputes.
   • Real Estate Planning: To estimate the value of the property for development planning purposes.
   • The purpose of the valuation affects the choice of appropriate valuation methods and the data required.

4. Determining the definition of the value to be estimated:

   • Market Value: The most probable price for which a property should sell in a competitive market, assuming that the seller and buyer are acting freely and with full knowledge of the surrounding circumstances. This is the most common definition of value in real estate valuation.
   • Insurable Value: The value of the property on the basis of which the amount of insurance necessary to cover fire losses or other disasters is determined.
   • Liquidation Value: The value that can be obtained from selling the property quickly under less than ideal conditions.
   • Investment Value: The value that a particular investor sees for the property based on their own expectations of return and risk.
   • Fair Value: A term used in accounting to estimate the value of assets and liabilities.
   • The choice of the definition of value depends on the purpose of the valuation and the beneficiary.

5. Determining the Valuation Date:

   • The valuation date must be accurately determined, as it is the date on which the estimated value reflects market conditions.
   • The valuation date may be the date of the property inspection, or it may be a date prior to or subsequent to it, depending on the purpose of the valuation.
   • The prevailing economic and market conditions on the valuation date significantly affect the estimated value.

6. Defining the Scope of Work:

   • The scope of work determines the extent of data collection, analysis, verification, and reporting.
   • The scope of work may include a detailed inspection of the property, collection of data on comparable sales, market analysis, use of multiple valuation methods, and preparation of a detailed valuation report.
   • The scope of work must be commensurate with the purpose of the valuation and the complexity of the property.

7. Identifying Specific Assumptions and Limiting Conditions:

   • The appraiser must identify any assumptions on which the valuation is based, such as assuming that the property is free of hidden defects or that the market will remain stable.
   • The appraiser must also identify any limiting conditions that limit their liability, such as not conducting a detailed engineering inspection of the property.
   • Assumptions and limiting conditions help clarify the appraiser’s limits of liability and improve users’ understanding of the report.

Applied Example of Defining the Valuation Problem:

Suppose we are valuing a residential home for the purpose of obtaining a mortgage loan. Here’s how to define the valuation problem:

• Property Identification: An independent residential house located on Street (A) No. (10) in District (B) in City (C). The legal description of the property is in the real estate register under number (S). The land area is 500 square meters, and the building area is 250 square meters. The house consists of three bedrooms, a hall, a kitchen, two bathrooms, and a small garden.
• Identification of Real Estate Rights: Fee Simple.
• Determining the Purpose of the Valuation: Obtaining a mortgage loan from Bank (D).
• Definition of Value: Market Value.
• Valuation Date: 2024/01/15.
• Scope of Work: Conduct a comprehensive inspection of the property, collect data on comparable sales in the same area, analyze the market, use the direct comparison approach, and prepare a detailed valuation report.
• Assumptions and Limiting Conditions: Assuming that the property is free of hidden defects, that the information provided by the client is correct, and that no detailed engineering inspection is conducted.

Theories and Scientific Principles

1. Highest and Best Use Principle: The value of the property depends on its most profitable, legal, and possible use. The appraiser must determine the highest and best use of the property before starting the valuation process.
2. Supply and Demand Theory: The relationship between supply and demand affects real estate prices. The appraiser must analyze supply and demand conditions in the market to determine the fair value of the property.
3. Substitution Principle: A buyer will not pay more for a property than they would pay for a similar substitute property. This principle is used in the direct comparison approach.
4. Contribution Principle: The value of any element of the property depends on its contribution to the total value of the property.

Mathematical Formulas and Equations:

• Area Calculation: The appraiser must be able to accurately calculate the land area and building area using basic geometric equations.
  • Rectangle Area (A) = Length (L) × Width (W)
  • Triangle Area (A) = 0.5 × Base (b) × Height (h)
• Statistical Data Analysis: The appraiser may need to use some statistical tools to analyze market data and identify trends.
  • Mean: The sum of the values divided by their number.
  • Median: The middle value in an ordered set of values.
  • Standard Deviation: A measure of the dispersion of data around the mean.

Conclusion:

Defining the valuation problem is the crucial step that determines the course of the entire valuation process. By identifying the property, real estate rights, purpose of the valuation, definition of value, valuation date, scope of work, and assumptions and limiting conditions, the appraiser can focus on collecting and analyzing data effectively to achieve an accurate and reliable estimate of fair value.