The Appraisal Process: Foundations

Chapter 2: The Appraisal Process: Foundations

I. Introduction to the Appraisal Process

The appraisal process is a systematic, logical, and well-defined procedure that appraisers follow to develop and communicate credible opinions of value❓. It is not simply a matter of intuition or guesswork but relies on established economic principles, market data analysis, and standardized methodologies. This chapter will delve into the foundational elements of the appraisal process, focusing on the critical first steps that set the stage for a reliable and defensible valuation.

II. The Interdisciplinary Nature of Appraisal

Real estate valuation is inherently interdisciplinary, drawing from various fields of study. Understanding these underlying disciplines is crucial for a comprehensive grasp of the appraisal process:

• Economics: Principles of supply and demand, utility, scarcity, and transferability directly influence property values. Microeconomic concepts like marginal utility and opportunity cost are integral to understanding market behavior.
• Finance: Concepts such as present value, discounted cash flow analysis, and risk assessment are essential for income capitalization and investment analysis. The time value of money is a cornerstone principle.
• Statistics: Statistical methods are used to analyze market data, identify trends, and quantify adjustments in the sales comparison approach. Regression analysis, measures of central tendency (mean, median, mode), and measures of dispersion (standard deviation, variance) are frequently employed.
• Law: Real estate law, including property rights, easements, zoning regulations, and environmental laws, significantly impacts property value and its permissible uses.
• Geography: Location attributes, site characteristics, accessibility, and proximity to amenities all influence value. Geographic Information Systems (GIS) are increasingly used to analyze spatial data.

III. Fundamental Economic Principles Underlying Value

Several economic principles form the basis for understanding real estate value. These principles guide the appraiser’s analysis and reasoning:

• Supply and Demand: The interaction of supply and demand in the real estate market directly affects prices. When demand exceeds supply, prices tend to rise, and vice versa. This is mathematically represented in its simplest form as:

  • Price (P) = f(Demand, Supply), where f is some function (often complex) relating the variables.

• substitution❓❓: The principle of substitution states that a rational buyer will pay no more for a property than the cost of acquiring an equally desirable substitute. This principle underlies the sales comparison approach.

• Anticipation: Value is influenced by the expectation of future benefits, such as income, appreciation, or tax advantages. Discounted cash flow (DCF) analysis is a practical application of this principle. The present value (PV) of a future income stream is calculated as:

  • PV = CF / (1 + r)^n, where CF is the cash flow, r is the discount rate, and n is the number of periods.

• Change: Real estate markets are dynamic, constantly evolving due to changes in economic conditions, demographics, technology, and other factors. Appraisers must consider these changes in their analysis.

• Contribution: The value of a component of a property is measured by how much it contributes to the overall value of the whole. This is also known as marginal productivity.

• Increasing and Decreasing Returns: This principle states that incremental increases in the investment of an agent of production (capital, Land❓❓, labor, and coordination) in a property will first cause the rate of return to increase, but will eventually reach a point (the point of diminishing returns) where the return begins to decrease.

  • Let R be the return on investment, and I the investment in an agent of production.
  • Initially, dR/dI > 0 (increasing returns).
  • At the point of diminishing returns, dR/dI decreases, eventually reaching 0.
  • Beyond that point, dR/dI < 0 (decreasing returns).

• Highest and Best Use: The highest and best use is the reasonably probable and legal use of a property that is physically possible, appropriately supported, financially feasible, and that results in the highest value. This is a critical consideration in valuation.

• Balance: Value of a particular property, or of all properties in a particular market, is optimized when the agents of production are in balance. The point where the agents of production are in balance is the point of diminishing returns.

IV. Agents of Production and Surplus Productivity

Wealth is created by the four agents of production: capital, land, labor, and coordination (entrepreneurship). The optimal combination of these agents maximizes productivity and, consequently, value.

• Capital: Investment in improvements, equipment, and other resources.
• Land: The natural resource providing location and physical space.
• Labor: Human effort and skills applied to the property.
• Coordination: The entrepreneurial function of organizing and managing the other factors of production.

Surplus productivity is attributed to the land. It is what is left of the property’s net income after deducting the costs of capital, labor and coordination.

V. Types of Value

Appraisal reports must define the Standard of Value that is being appraised. Different types of value exist, each with its own specific definition and application:

• Market Value: The most probable price which 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.

  • Buyer and seller are typically motivated.
  • Both parties are well informed and acting in their best interest.
  • A reasonable time is allowed for exposure to the market.
  • Payment is made in terms of cash or its equivalent.
  • Financing, if any, is typical for the market.

• Value in Use: The value of a property for a specific purpose or use, which may or may not be its highest and best use.

• Investment Value: The value of a property to a specific investor, based on their individual investment criteria and risk tolerance.

• Liquidation Value: The estimated price that a property would bring in a forced sale or liquidation, with a limited exposure time to the market.

• Assessed Value: The value assigned to a property by a taxing authority for property tax purposes. Typically a market value multiplied by the applicable assessment ratio.

• Insurable Value: The value of a property for insurance purposes, representing the cost to replace or rebuild the improvements in the event of a loss.

• Going Concern Value: The value of an operating business, including its real property, tangible assets, and intangible assets (e.g., goodwill, brand recognition).

VI. Factors Affecting Value (PEGS)

Real estate value is influenced by a complex interplay of external factors, often categorized as:

• Physical: Site characteristics, location, size, shape, topography, environmental conditions, and improvements.
• Economic: Income levels, employment rates, interest rates, inflation, construction costs, and market cycles.
• Governmental: Zoning regulations, building codes, property taxes, environmental regulations, and government policies.
• Social: Demographic trends, population growth, lifestyle preferences, community values, and crime rates.

VII. The Appraisal Process: An Overview

The appraisal process is a series of steps that provides a framework for developing a credible opinion of value. These steps are generally accepted and followed by appraisers worldwide.
Note: The following steps are from Chapter 3 of the PDF file and included here for completeness

1. Defining the Appraisal Problem:

   • Identify the property to be appraised (legal description, address).
   • Specify the property rights being appraised (fee simple, leasehold).
   • Define the purpose and intended use of the appraisal.
   • Determine the effective date of the appraisal (valuation date).
   • Establish the type of value being sought (market value, investment value).
   • Define the scope of work.
   • Identify Assumptions and Limiting Conditions.

2. Preliminary Analysis:

   • Identify data necessary for the appraisal.
   • Identify data sources.
   • Perform a preliminary analysis of the subject property and the market.
   • Develop a plan for completing the appraisal.
   • Prepare a fee proposal and contract.

3. Data Collection, Verification, and Analysis:

   • Gather general data on the region, city, and neighborhood.
   • Collect specific data on the subject property and comparable properties.
   • Verify the accuracy of the data.
   • Analyze the data to identify trends and patterns.

4. Highest and Best Use Analysis:

   • Determine the highest and best use of the land as though vacant.
   • Determine the highest and best use of the property as improved.

5. Site Valuation:

   • Value the site separately from the improvements, even if they are not being sold separately.

6. Application of the Three Approaches to Value:

   • Cost Approach: Estimate the cost to reproduce or replace the improvements, deduct for depreciation, and add the value of the land.
   • Sales Comparison Approach: Compare the subject property to similar properties that have recently sold, adjusting for differences.
   • Income Approach: Estimate the income-producing potential of the property and capitalize it into a value.

7. Reconciliation of Value Indicators:

   • Analyze the results of the three approaches and reconcile them into a single value estimate.
   • Determine the appropriate weight to give each approach.

8. Reporting the Value Estimate:

   • Prepare a written appraisal report that clearly and accurately communicates the appraiser’s opinions and conclusions.
   • The appraisal report can be a narrative report, a form report, or an oral report.

VIII. Conclusion

This chapter has laid the groundwork for understanding the appraisal process by exploring the fundamental economic principles, types of value, and external factors that influence real estate value. A solid grasp of these concepts is essential for comprehending the subsequent steps in the appraisal process and for developing credible and defensible opinions of value.