Appraisal Foundations: Assumptions, Scope, and Intended Use

Chapter 3: Appraisal Parameters: Assumptions, Scope, and Use

This chapter delves into the critical parameters that define and constrain the appraisal process: assumptions, scope, and intended use. Understanding these parameters is fundamental to producing a reliable and defensible appraisal. These parameters are intertwined and directly influence the credibility and utility of the final valuation.

A. The Importance of Defining Appraisal Parameters

An appraisal is not conducted in a vacuum. It’s a complex process influenced by various factors, which must be explicitly stated and considered. Failing to do so can lead to inaccurate valuations, flawed❓ decision-making based on the appraisal, and potential legal liabilities for the appraiser. This chapter provides a comprehensive understanding of these essential appraisal parameters and their implications.

B. Assumptions in Appraisal: The Bedrock of Valuation

Assumptions are foundational elements within the appraisal process. They are beliefs or premises accepted as true for the purpose of the appraisal, even without direct verification. Assumptions simplify the analysis and provide a framework for drawing conclusions about value. There are different kinds of assumptions; these are explained below.

1. Types of Assumptions:

   • Ordinary Assumptions: These are common, everyday assumptions routinely made in appraisals, such as assuming the accuracy of public records related to property ownership or zoning.

   • Extraordinary Assumptions: These are assumptions related to a specific assignment, and their validity can significantly impact the value opinion. These should be clearly documented within the appraisal report. Per definition from the document, If any extraordinary assumption is found to be false after the appraisal has been completed, the appraiser’s opinion of value will change.

   • Example: Assuming the completion of planned infrastructure improvements that are critical to the property’s accessibility and value. If the infrastructure isn’t constructed as planned, the appraisal result would likely be different.

2. The Role of Verification:

While assumptions are accepted as true, it’s crucial to acknowledge the limits of their validity. The appraiser has a responsibility to investigate the reasonableness of assumptions and document the extent of their verification efforts. If significant doubt exists about an assumption’s validity, it should be treated as a hypothetical condition instead.

3. Mathematical Representation of Assumption Impact:
   The relationship between assumption validity and appraisal accuracy can be conceptualized as follows:

   Let:

   • V = Appraisal value
   • A_i = Assumption i
   • w_i = Weight or significance of assumption i in the valuation process
   • v(A_i) = Validity score of assumption i (e.g., 0 to 1, where 1 is completely valid)

   Then:

   • V = f(A₁, A₂, …, A_n)

   This simply states that the appraisal value is a function of all the assumptions. A more detailed, albeit simplified, version could be:

   • V ≈ V₀ + Σ [w_i * v(A_i)] (summation from i=1 to n)

   Where V₀ is a base value and the second term represents the adjusted value based on the validity and weight of each assumption. This equation demonstrates the cumulative impact of assumptions on the final value. If v(A_i) is low for a significant w_i, the overall value is affected.

C. Hypothetical Conditions: Exploring “What If” Scenarios

Hypothetical conditions are assumptions contrary to known facts, used for a specific appraisal assignment. They are applied to explore scenarios that do not currently exist but are presumed for the purpose of analysis.

1. Distinction from Assumptions:

   • Assumptions are beliefs about existing conditions, while hypothetical conditions introduce elements that don’t currently exist.

2. Applications of Hypothetical Conditions:

   • Prospective Valuation: Valuing a property as if a planned renovation has been completed.
   • Legal Compliance: Determining value as if a non-conforming use was legally permissible.
   • Development Analysis: Estimating value of a proposed development as if it were already built and stabilized.

3. Transparency and Disclosure:

   • The use of hypothetical conditions must be explicitly stated and justified in the appraisal report. The appraiser must clearly explain the reasons for using the hypothetical condition and its potential impact on the value opinion. The investor needs to understand how the “what if” condition changes the opinion of value.

4. Case Example: An investor owns land, and they plan to build an apartment building, but it does not yet exist. The investor asks the appraiser to determine what the value will be in 5 years once the building is built.
   In this case, the appraiser will use extraordinary assumptions such as market conditions, demographics, and economic trends. The building itself is a hypothetical condition, because it does not currently exist.

D. Scope of Work: Defining the Appraisal’s Boundaries

The scope of work defines the extent of the research and analysis performed by the appraiser. It specifies the procedures undertaken to develop credible assignment results.

1. Elements of Scope of Work:

   • Extent of data collection: Types of data gathered (market data, property-specific information, etc.) and sources consulted.
   • Extent of analysis: Appraisal approaches applied (sales comparison, cost, income), reconciliation of value indications, and depth of market analysis.
   • Reporting requirements: Level of detail in the appraisal report, supporting documentation, and certifications.

2. Factors Influencing Scope of Work:

   • Intended Use: The purpose for which the appraisal is being used (loan, litigation, investment) directly dictates the required scope.
   • Standard of Value: The definition of value being sought (market value, liquidation value, etc.) influences the data and analysis needed.
   • Property Type: The complexity of the property (single-family home vs. a large commercial building) determines the level of effort required.
   • Intended Users: The knowledge and experience level of the intended users influences the level of detail in the appraisal report.

3. Scope Creep and Risk Management:

   • Scope creep occurs when the client requests additional services or analysis beyond the original agreed-upon scope. This can lead to increased costs and potential delays. The appraiser must clearly define the scope in the engagement letter and manage any scope changes through written amendments.
   • Incomplete or inadequate scope of work can result in unreliable appraisals and increased liability.

4. Case example: A lender requests an appraisal for market value on a single-family residence to determine if the borrower’s private mortgage insurance payments can be removed. Because both the lender and the appraiser worked together on the appraisal for the original loan, a less-expensive “drive-by” appraisal may work.

E. Intended Use and Intended Users: Shaping the Appraisal’s Focus

The intended use and intended users are critical parameters that guide the entire appraisal process.

1. Intended Use:

   • The specific purpose for which the appraisal is performed. Examples include:
     • Loan origination
     • Estate planning
     • Divorce settlement
     • Property tax assessment
     • Investment decisions
     • Litigation support

2. Intended Users:

   • The parties who will rely on the appraisal’s conclusions. This includes the client, but may also extend to other parties, such as lenders, investors, or legal counsel.

3. Impact on Appraisal Process:

   • Value Definition: The intended use dictates the most appropriate definition of value. For example, loan origination typically requires market value, while estate planning may require fair market value.
   • Scope of Work: The intended use influences the level of detail and analysis required. An appraisal for litigation support often requires a more comprehensive scope than one for a routine loan.
   • Reporting Requirements: The intended users’ needs shape the format and content of the appraisal report.

4. Limiting Conditions and Liability:

   • The appraiser must clearly state the intended use and intended users in the appraisal report.
   • The appraisal’s conclusions are only valid for the stated intended use and for the benefit of the identified intended users.
   • This limitation helps protect the appraiser from liability if the appraisal is used for unintended purposes or relied upon by unauthorized parties.
   • Case Example: The value estimate is only valid for the intended use by the client, and is not valid for any other use or any other user.

F. Date of Appraisal Report

The appraisal report date does not directly effect the value estimate. It is simply the date on which the appraisal report is issued. The client needs to know that the appraisal will be issued in time to be of use in the client’s decision making process. This shows if the property is being valued as of the past, present, or future.

The valuation date and report date will NOT necessarily be identical, even in the case of an appraisal for current value. The VALUATION DATE is the date as of which value is estimated, commonly the date that the appraiser inspects the subject property. The REPORT DATE is the date the appraiser completes and signs the report.

G. Conclusion

Understanding and carefully defining the appraisal parameters – assumptions, scope, and intended use – are essential for producing credible and reliable appraisal results. These parameters guide the appraisal process, influence the appraiser’s decisions, and ultimately determine the usefulness and defensibility of the value opinion. By adhering to sound appraisal principles and clearly articulating these parameters, appraisers can provide valuable insights to their clients and contribute to informed decision-making in the real estate market.