The Appraisal Process: A Step-by-Step Guide

Chapter 3: The Appraisal Process: A Step-by-Step Guide

This chapter provides a detailed examination of the appraisal process, breaking it down into its constituent steps. Understanding each step is crucial for developing a comprehensive and defensible appraisal. The appraisal process, at its core, is a systematic application of valuation principles to estimate the market value❓❓ of a property. It’s not merely a collection of data but a structured analysis that considers various market forces, property characteristics, and legal constraints.

I. The Eight Steps of the Appraisal Process

The appraisal process typically consists of eight key steps. These steps are iterative, meaning that the appraiser may need to revisit earlier steps as new information becomes available or as the analysis progresses.

1. Defining the Appraisal Problem: This initial step is crucial as it sets the scope and direction of the entire appraisal. It involves identifying the client and intended users, the intended use of the appraisal, the type of value to be estimated, the property to be appraised, and the effective date of the appraisal.

2. Preliminary Analysis: This step involves a preliminary investigation of the market and the subject property to determine the scope of work required and the data needed to perform a credible appraisal. It includes identifying data sources and formulating a plan for data collection and analysis.

3. Collecting, Verifying, and Analyzing the Data: This step focuses on gathering relevant data from various sources, ensuring its accuracy, and analyzing it to understand market trends, neighborhood characteristics, and property-specific factors.

4. Highest and Best Use Analysis: Determining the highest and best use (HBU) of the property is a critical step. HBU is defined as the reasonably probable and legal use of vacant land or an improved property, which is physically possible, appropriately supported, financially feasible, and that results in the highest value.

5. Valuing the Site: The site, or land, is valued separately from any improvements. This is important for various reasons, including cost approach❓ calculations and understanding the land’s contribution to the overall property value.

6. Applying the Three Approaches to Value: This step involves applying the three traditional approaches to value: the cost approach, the sales comparison approach, and the income capitalization approach (when applicable). Each approach provides a different perspective on value, and the appraiser must carefully consider the strengths and weaknesses of each approach in the context of the specific appraisal assignment.

7. Reconciling the Value Indicators: After applying the three approaches to value, the appraiser must reconcile the resulting value indications into a single, final value opinion. This involves weighing the reliability and relevance of each approach and considering the specific characteristics of the subject property and the market.

8. Reporting the Value Estimate: The final step is to communicate the value estimate and the reasoning behind it in a clear, concise, and well-supported appraisal report. The report must comply with the Uniform Standards of Professional Appraisal Practice (USPAP) and any other applicable regulations.

II. Step 1: Defining the Appraisal Problem

Defining the appraisal problem is arguably the most important step in the appraisal process. A clear and concise problem definition provides a framework for the entire appraisal and ensures that the appraiser addresses the client’s needs and expectations. This process is deeply intertwined with Scope of Work decision.

A. What is to Be Appraised? (Identification of the Property)

• Legal Description: The legal description provides a precise and unambiguous identification of the property. This can be a metes and bounds description, a rectangular survey system description, or a lot, block, and tract description. (Refer to Chapter 4 for details on these systems).
• Physical Characteristics: A thorough description of the property’s physical characteristics is essential. This includes the size and shape of the site, the dimensions and layout of the improvements, the materials used in construction, and the overall condition of the property.
• Property Rights to be Appraised: The appraiser must clearly identify the specific property rights being appraised, such as fee simple, leasehold, or easement. This is crucial because different property rights have different values.

B. When is It to Be Appraised? (Effective Date of the Appraisal)

• Market Conditions and Temporal Influence: The effective date of the appraisal is the date as of which the value estimate applies. Market conditions can change significantly over time, so the effective date is critical.
• Retrospective, Current, and Prospective Appraisals: Appraisals can be retrospective (valuing the property as of a past date), current (valuing the property as of the present date), or prospective (valuing the property as of a future date). The type of appraisal will influence the data and analysis required.
• Example: An appraisal for estate tax purposes would be retrospective, using the date of death as the effective date. A current appraisal might be used for a mortgage loan, while a prospective appraisal could be used for a proposed development project.

C. Why is It to Be Appraised? (Intended Use of the Appraisal)

• Influence on Scope of Work: The intended use of the appraisal significantly influences the scope of work required. For example, an appraisal for a mortgage loan may require a different level of detail than an appraisal for estate planning purposes.
• Examples of Intended Uses: Common intended uses include mortgage lending, estate planning, divorce settlements, tax assessments, and investment decisions.
• USPAP Requirements: USPAP requires the appraiser to identify the intended use of the appraisal.

D. How is It Being Valued? (Type of Value)

• Market Value: The most common type of value sought in appraisals is market value, which is defined as the most probable price that a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus.

• Other Types of Value: Other types of value include:

  • Insurable Value: The cost of replacing or repairing a property after a loss, used for insurance purposes.
  • Liquidation Value: The price that could be obtained in a forced sale, typically lower than market value.
  • Investment Value: The value of a property to a specific investor, based on their individual investment criteria.
  • Going Concern Value: The value of a business as an operating entity, including both tangible and intangible assets.

  (See PDF, page xi)

• Defining Market Value Mathematically: While a precise mathematical definition of market value is difficult, we can express it conceptually using expected value principles.

  Let:

  • P_i = Potential sale price i for the property
  • Pr(P_i) = Probability of achieving sale price P_i

  Then, the expected market value (EMV) can be approximated as:

  EMV ≈ Σ [ P_i * Pr(P_i) ] for all i

  This equation represents the sum of all potential sale prices, each weighted by its probability of occurrence. In practice, appraisers don’t calculate this literally, but rather, the process of appraisal attempts to arrive at a value that approximates this expected market value. The more stable and predictable the market, the closer the final opinion will align with the “true” EMV.

E. Defining the Appraisal Problem in the Appraisal Report

• Clarity and Transparency: The appraisal report must clearly and concisely define the appraisal problem, including all of the elements discussed above.
• USPAP Compliance: Failing to adequately define the appraisal problem can result in a violation of USPAP.

III. Step 2: Preliminary Analysis

Preliminary analysis sets the stage for effective data gathering and accurate valuation.

A. Identifying the Necessary Data

• Market Data: This includes data on comparable sales, market trends, supply and demand, and economic conditions. (Refer to Chapter 5 for detailed information on data collection.)
• Property Data: Detailed information about the subject property, including its physical characteristics, legal description, and zoning regulations.
• Cost Data: Information on construction costs, depreciation rates, and replacement costs.
• Income and Expense Data: (If applicable) Information on rental rates, Operating Expenses❓❓, and vacancy rates.

B. Identifying the Sources of Data

• Public Records: County recorder’s office, assessor’s office, planning department.
• Multiple Listing Services (MLS): A database of properties listed for sale.
• Commercial Data Providers: Companies that provide real estate data and analytics.
• Real Estate Professionals: Brokers, agents, and other appraisers.
• Subject Property Inspection: A physical inspection of the subject property is crucial for gathering accurate data.

C. Preliminary Analysis

• Market Trends: Preliminary assessment of relevant market trends, such as price appreciation or depreciation, inventory levels, and interest rates.
• Property Characteristics: Preliminary evaluation of the key features and attributes of the subject property.
• Scope of Work Determination: Based on the preliminary analysis, the appraiser determines the scope of work required to perform a credible appraisal. This includes the level of detail required, the data to be collected, and the approaches to value to be applied.

D. Creating a Plan

• Data Collection Strategy: A detailed plan for gathering the necessary data, including identifying specific sources and timelines.
• Analysis Methodology: Outline of the analytical techniques to be used, such as statistical analysis, regression analysis, or discounted cash flow analysis.
• Timeline and Budget: Establishment of a realistic timeline and budget for completing the appraisal assignment.

E. Fee Proposal and Contract

• Scope of Services: The fee proposal and contract should clearly define the scope of services to be provided, including the type of appraisal, the property to be appraised, and the intended use of the appraisal.
• Fees and Payment Terms: The fee proposal should clearly state the appraisal fee and the payment terms.
• USPAP Compliance: The contract should state that the appraisal will be performed in compliance with USPAP.

IV. Step 3: Collecting, Verifying, and Analyzing the Data

This stage moves from planning to execution, solidifying the appraisal’s informational foundation. This is expanded upon in Chapter 5.

• Comprehensive Data Gathering: Collect all data identified in the preliminary analysis plan. Sources include public records (deeds, plats, tax assessments), MLS data, comparable sales information, property inspection reports, environmental reports, and economic data.
• Data Verification: Critically verify all data for accuracy and reliability. Check public records for inconsistencies or errors. Contact parties involved in comparable sales (buyers, sellers, agents) to confirm sale terms. Inspect the subject property to verify physical characteristics.

• Data Analysis: Employ various analytical techniques to extract meaningful insights from the collected data. This involves statistical analysis (mean, median, standard deviation), trend analysis, and comparative analysis.

  For example, you might analyze comparable sales data to determine the market value of a specific feature:

  Sale Price = Base Price + (Feature Value * Feature Quantity)

  By comparing multiple sales with varying quantities of the feature, one can statistically derive an approximate Feature Value. Paired sales analysis (discussed in Chapter 9) is a specific method used for this purpose.

V. Step 4: Highest and Best Use Analysis

Highest and Best Use (HBU) is the bedrock upon which value is determined. HBU dictates what a rational buyer would pay for a property, considering its potential. (See Chapter 6).

• Four Tests of HBU: The HBU must meet four criteria:
  1. Legally Permissible: The use must comply with zoning regulations, deed restrictions, and other legal constraints.
  2. Physically Possible: The site must be suitable for the proposed use, considering its size, shape, topography, and soil conditions.
  3. Financially Feasible: The use must generate sufficient income or value to justify the cost of development or renovation.
  4. Maximally Productive: Of all the legally permissible, physically possible, and financially feasible uses, the HBU is the one that results in the highest value.
• HBU as Vacant vs. Improved: Analyze the HBU both “as if vacant” and “as improved.” If the existing improvements do not represent the HBU, consider the cost of demolition or renovation in the analysis.
• Example: A property currently used as a single-family home might have a higher HBU as a commercial office building if zoning permits and market demand exists.

VI. Step 5: Valuing the Site

Separate site valuation is essential, particularly for the Cost Approach, but also for gaining a more granular understanding of the property’s total value. (See Chapter 6).

A. Reasons for Separate Site Valuation

• Cost Approach: The cost approach requires a separate estimate of the site value.
• Land Residual Technique: Some income capitalization methods rely on separate site valuation.
• Highest and Best Use Analysis: Comparing the site value under different potential uses is a key part of the HBU analysis.
• Market Analysis: Separate site valuation provides insights into the market for land, which can be useful for understanding overall market trends.

VII. Step 6: Applying the Three Approaches to Value

This step brings together all the preceding analyses to form distinct value indicators.

A. Cost Approach (See Chapter 8)

• Principle of Substitution: The cost approach is based on the principle of substitution, which states that a buyer will pay no more for a property than the cost to acquire an equivalent substitute.
• Steps:
  1. Estimate the replacement or reproduction cost of the improvements.
  2. Estimate accrued depreciation (physical deterioration, functional obsolescence, and external obsolescence).
  3. Subtract accrued depreciation from the replacement or reproduction cost.
  4. Add the site value to the depreciated cost of the improvements.

• Formula:

  Value = Site Value + Replacement Cost - Depreciation

B. Sales Comparison Approach (See Chapter 9)

• Direct Market Evidence: This approach relies on direct market evidence of comparable sales to estimate the value of the subject property.
• Steps:
  1. Identify comparable sales.
  2. Adjust the sale prices of the comparables to account for differences between the comparables and the subject property (e.g., location, size, condition, features).
  3. Reconcile the adjusted sale prices to arrive at a value indication for the subject property.
• Adjustments: Adjustments can be made using various techniques, such as percentage adjustments or dollar adjustments. The goal is to isolate the effect of each difference on the sale price.

C. Income Approach (See Chapter 10)

• Investment Perspective: This approach focuses on the income-producing potential of the property.

• Steps:

  1. Estimate the potential gross income (PGI) of the property.
  2. Estimate vacancy and collection losses.
  3. Subtract vacancy and collection losses from PGI to arrive at effective gross income (EGI).
  4. Estimate operating expenses.
  5. Subtract operating expenses from EGI to arrive at net operating income (NOI).
  6. Capitalize NOI into value.

• Direct Capitalization Formula:

  Value = NOI / Capitalization Rate

  Where the Capitalization Rate (Cap Rate) is derived from market data of comparable income-producing properties:

  Cap Rate = NOI / Sale Price

VIII. Step 7: Reconciling the Value Indicators

Reconciliation isn’t simply averaging. It is a weighted analysis of the reliability and applicability of each approach to the subject property. (See Chapter 11).

• Analyzing Strengths and Weaknesses: Critically evaluate the strengths and weaknesses of each approach in the context of the specific appraisal assignment. Consider the availability and reliability of data, the complexity of the calculations, and the relevance of each approach to the subject property type.
• Weighting the Value Indicators: Assign weights to each value indicator based on its reliability and relevance. The approach with the most reliable data and the strongest theoretical support should receive the highest weight.

• Final Value Opinion: Arrive at a single, final value opinion based on the weighted average of the value indicators.

  Value = (Weight_Cost * Value_Cost) + (Weight_Sales * Value_Sales) + (Weight_Income * Value_Income)

  Where Weight_Cost + Weight_Sales + Weight_Income = 1

IX. Step 8: Reporting the Value Estimate

Communication is paramount. The appraisal report is the formal document that conveys the appraiser’s findings and conclusions to the client and intended users. (See Chapter 12).

A. The Two Basic Appraisal Reports

• Self-Contained Appraisal Report: Provides a complete summary of all data, analyses, and conclusions. It includes detailed descriptions of the property, the market, and the approaches to value. This report type requires the most comprehensive documentation and is suitable for complex appraisal assignments.
• Summary Appraisal Report: Summarizes the data and analyses used in the appraisal but does not include all the supporting documentation. This report type is suitable for less complex assignments where the client does not require a detailed explanation of every step in the appraisal process.

B. Essential Elements of the Appraisal Report

• Identification of the Client and Intended Users: Clearly identify the client and any other intended users of the appraisal.
• Intended Use of the Appraisal: State the intended use of the appraisal.
• Type of Value: Specify the type of value being estimated (e.g., market value).
• Property Description: Provide a detailed description of the property, including its legal description, physical characteristics, and location.
• Scope of Work: Describe the scope of work performed, including the data collected, the analyses conducted, and the approaches to value applied.
• Assumptions and Limiting Conditions: List any assumptions or limiting conditions that affected the appraisal.
• Effective Date of the Appraisal: State the effective date of the appraisal.
• Value Opinion: Clearly state the appraiser’s opinion of value.
• Certification: Include a signed certification stating that the appraisal was performed in compliance with USPAP.
• Supporting Documentation: Include supporting documentation, such as maps, photographs, and comparable sales data.

This chapter has provided a thorough overview of the appraisal process. By understanding each step and applying the appropriate techniques, you can develop credible and defensible appraisals that meet the needs of your clients and comply with professional standards. The following chapters will delve deeper into specific aspects of the appraisal process, such as property description, data collection, site valuation, and the three approaches to value.