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Defining the Appraisal: Assumptions, Scope, and Use
Chapter 3: Defining the Appraisal: Assumptions, Scope, and Use
A. Introduction
Defining the appraisal is a critical first step in the appraisal process. It involves clearly establishing the parameters within which the appraiser will operate. This ensures that the appraisal is relevant, reliable, and legally defensible. The key elements of defining an appraisal are: specifying the assumptions made, defining the scope of the appraisal work, and clearly stating the intended use of the appraisal. A well-defined appraisal problem minimizes ambiguity and the risk of misinterpretation by the client or other users of the appraisal report.
B. Assumptions: The Foundation of Valuation
Assumptions are fundamental to any appraisal. They are statements that the appraiser accepts as true for the purpose of the valuation, even though they may not have been independently verified. They simplify the valuation process and allow the appraiser to focus on the core aspects of the assignment. There are several types of assumptions that may need to be considered when performing an appraisal:
- Ordinary Assumptions:
These are common assumptions made in most appraisals, relating to factors like the integrity of provided data or the continuity of market conditions. They represent a baseline level of acceptance of prevailing conditions.
Example: Assuming provided building plans accurately represent the existing structure.
- Extraordinary Assumptions:
An extraordinary assumption is an assumption that is directly related to a specific assignment. If this assumption is found to be false, it could alter the appraiserโs opinion of value. These assumptions must be clearly documented in the appraisal report.
Example: Assuming that a planned road improvement project will be completed on schedule, which would significantly increase the propertyโs accessibility and value. If the project is delayed or cancelled, the appraisal value would be affected.
Mathematical Representation:
Let V be the appraised value, and A be the factor associated with the extraordinary assumption. If the assumption holds true (A = 1), the value is V1. If the assumption is false (A = 0), the value is V0. The difference |V1 โ V0| represents the potential impact of the extraordinary assumption.
- Hypothetical Conditions:
A hypothetical condition is something that is contrary to what actually exists but is supposed for the purpose of the assignment. It allows the appraiser to analyze the property under different circumstances than those that currently exist. Hypothetical conditions must also be clearly documented.
Example: Valuing a vacant lot as if it already had a completed building on it, based on submitted architectural plans. The hypothetical condition is the existence of the building.
Application of Decision Theory:
The decision to use a hypothetical condition can be informed by decision theory. If the potential benefit of analyzing the property under a hypothetical condition outweighs the risk of misrepresentation, then it may be appropriate to include such conditions. This can be framed as an expected value calculation, weighing the potential outcomes and their probabilities.
Let EB be the Expected Benefit of using a hypothetical condition
RB be the Revenue associated with the hypothetical condition
CB be the Cost associated with the hypothetical condition
P(RB) be the probability of the Revenue occurring
P(CB) be the probability of the Cost occurring
Then EB = P(RB) * RB - P(CB) * CB
If EB > 0, then the hypothetical condition can be used, otherwise, it should not.
C. Scope of the Appraisal: Defining the Breadth and Depth
The scope of the appraisal defines the extent of the research and analysis required to develop a credible opinion of value. It is determined by the Standard of Value required, the intended use of the appraisal, and the intended users. A well-defined scope ensures that the appraisal is appropriate for its intended purpose and that the appraiser conducts sufficient due diligence.
- Factors Influencing Scope:
a. Standard of Value: Different standards of value (e.g., market value, investment value, liquidation value) require different approaches and levels of analysis.
b. Intended Use: The intended use of the appraisal dictates the level of detail required. For example, an appraisal for a mortgage loan may require less detail than an appraisal for litigation purposes.
c. Intended Users: The sophistication and understanding of the intended users will influence the level of detail and explanation included in the appraisal report. An appraisal for a sophisticated investor may use complex financialโ models, while an appraisal for a homeowner may require a more straightforward approach.
- Elements of Scope Definition:
a. Property Identification: A clear and accurate description of the property being appraised, including its location, physical characteristics, and legal attributes.
b. Data Collection: Specifying the types and sources of data that will be gathered, such as market data, property records, and comparable sales.
c. Analysis Techniques: Identifying the valuation methods that will be employed (e.g., sales comparison approach, cost approach, income capitalization approach) and the specific techniques used within each approach.
d. Reporting: Defining the format and content of the appraisal report, including the level of detail and the supporting documentation that will be provided.
D. Intended Use: Why the Appraisal Matters
The intended use of the appraisal is the specific purpose for which the appraisal is being performed. It is a critical element in defining the appraisal problem because it directly influences the scope of work, the valuation methods used, and the level of detail required in the appraisal report.
- Importance of Defining Intended Use:
a. Determines Relevance: The intended use ensures that the appraisal is relevant to the clientโs needs and decision-making process.
b. Guides Scope of Work: The intended use dictates the appropriate scope of work, including the data collection and analysis methods.
c. Limits Liability: By clearly specifying the intended use, the appraiser limits their liability to the specific purpose for which the appraisal was commissioned.
- Common Intended Uses:
a. Mortgage Lending: To determine the value of a property for loan underwriting purposes.
b. Purchase/Sale Decisions: To assist buyers and sellers in negotiating a fair price.
c. Estate Planning: To determine the value of assets for estate tax purposes.
d. Property Tax Assessment: To determine the assessed value of a property for tax purposes.
e. Litigation: To provide expert testimony in legal proceedings.
- Limiting Conditions and Intended Use:
The appraisal report should clearly state the limiting conditions that apply to the appraisal and emphasize that the value opinionโ is only valid for the stated intended use. This helps to prevent the appraisal from being misused or misinterpreted by unintended users.
Example: An appraisal performed for mortgage lending purposes should state that the value opinion is only valid for determining the loan-to-value ratio and is not suitable for use in a divorce settlement.
E. Date of Appraisal Report & Valuation
- Valuation Date: This is the specific date as of which the value is estimated. This is commonly the date that the appraiser inspects the subject property.
- Report Date: This is the date the appraiser completes and signs the report. This may or may not be the same date as the valuation date.
The appraisal report date, as opposed to the valuation date, does not directly affect the value estimate. It is simply the date on which the appraisal report is issued.
F. Practical Applications and Experiments
To illustrate the concepts discussed, consider the following examples:
- Impact of Extraordinary Assumptions:
Experiment: Conduct two appraisals of a property. In the first appraisal (A1), assume that a new transit station will be built nearby within one year (Extraordinary Assumption). In the second appraisal (A2), assume that the transit station will not be built (or will be delayed indefinitely). Compare the resulting value opinions. The difference in value quantifies the impact of the extraordinary assumption. - Scope of Work Variation:
Experiment: Prepare two appraisal reports for the same property, but with different scopes of work. The first report (S1) is a limited scope “drive-by” appraisal, while the second report (S2) is a full appraisal with detailed market research and analysis. Compare the time required to complete each report, the level of detail provided, and the confidence level in the resulting value opinions.
G. Conclusion
Defining the appraisal through clear assumptions, a well-defined scope, and a specific intended use is essential for producing a reliable and relevant valuation. This foundational step ensures that the appraisal process is focused, transparent, and defensible, ultimately providing valuable insights for informed decision-making.
Chapter Summary
This chapter, “Defining the Appraisal: Assumptions, Scope, and Use,” emphasizes the critical importance of clearly defining the appraisal problem before undertaking an appraisal assignment. This involves understanding the purpose of the appraisal, the intended useโrs, and the various factors that influence the valuation process. The chapter highlights several key aspects:
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Extraordinary Assumptions and Hypothetical Conditions: These are specific conditions that, if proven false, would alter the appraiser’s opinion of value and are contrary to what actually exists, respectively. They must be clearly documented.
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Date of appraisal reportโ: The report date signifies when the appraisal is issued and its timeliness for the client’s decision-making. It differs from the valuation date, which represents the date the value estimate is basedโ upon, often when the property is inspected. The difference reflects the time needed for data analysis and report preparation.
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Intended Use: The appraiser must understand the specific purpose for which the appraisal is being conducted (e.g., loan application, investment decision, property tax assessment). Specifying the intended use limits the appraiser’s potential liability by restricting the validity of the value estimate to that specific purpose and client. Appraisals for different uses may emphasize different valuation approaches (e.g., sales comparison for resale value vs. income approach for investment decisions).
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Scope of the Appraisal: This refers to the extent of research and report development needed for a reliable and understandable appraisal result. It is determined by the standard of value, the intended use, and the number and sophistication of intended users. The appraiser determines the scope, adhering to USPAP and relevant laws, ensuring the client receives what they need, not just what they want.
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Assumptions: These are facts the appraiser assumes to be true without independent verification (e.g., good title, zoning compliance). The report should state these assumptions and identify any exceptions.
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Limiting Conditions: These are statements that restrict the application or assumptions underlying the appraisal conclusions. They define the boundaries of the appraisal’s validity. Examples include specifying that the appraisal is solely for estimating value, not for surveys or legal opinions.
The chapter concludes that clearly defined assumptions and limiting conditions are critical for ensuring the appraisal report is properly understood, preventing unwarranted conclusions, and mitigating potential liability for the appraiser.
