Defining the Appraisal Problem and Process

Chapter 2: Defining the Appraisal Problem and Process

This chapter details the critical initial steps of the appraisal process, focusing on defining the appraisal problem comprehensively. A well-defined problem is crucial for ensuring the relevance, reliability, and credibility of the appraisal.

I. The Eight Steps of the Appraisal Process

The appraisal process is a structured sequence of steps undertaken by appraisers to arrive at a credible opinion of value. This process is dynamic and iterative, not strictly linear. The generally accepted steps include:

1. Define the Appraisal Problem: Clearly identify the appraisal’s purpose, the property’s characteristics, the date of valuation, and the specific value definition required.
2. Preliminary Analysis: Determine the scope of work, including the data needed, its sources, and the resources❓ required to complete the appraisal.
3. Data Collection, Verification, and Analysis: Gather relevant market data, property-specific information, and economic trends, ensuring data accuracy and reliability.
4. Highest and Best Use Analysis: Determine the most probable and legal use of the property, considering its physical, legal, and financial feasibility.
5. Valuing the Site: Estimate the value of the land or site as if vacant and available for its highest and best use.
6. Applying the Three Approaches to Value: Develop value indications using the cost approach, sales comparison approach, and income capitalization approach.
7. Reconciling the Value Indicators: Analyze the results of the different approaches and weigh their relevance to arrive at a final value estimate.
8. Reporting the Value Estimate: Communicate the appraisal findings in a clear, concise, and accurate report.

II. Step 1: Defining the Appraisal Problem

This initial step is foundational to the entire appraisal process. Failure to adequately define the appraisal problem can lead to an inaccurate or misleading value conclusion. The key elements in defining the appraisal problem are:

A. What is to Be Appraised?

1.  **Identification of the Real Estate:** This involves a precise description of the property, including:

    *   Legal description (e.g., metes and bounds, lot and block).
    *   Street address.
    *   Parcel identification number (PIN).
    *   Physical characteristics (e.g., size, shape, topography).
    *   Improvements (e.g., building size, construction quality, amenities).

    *Example:* A property located at 123 Main Street, Anytown, USA, legally described as Lot 1, Block A of the Anytown Subdivision, PIN 123-456-789, consisting of a 0.5-acre rectangular lot with a two-story residential dwelling of 2,500 square feet.

    a.  **Personal Property (Sometimes Included):** Identify any personal property included in the appraisal (e.g., appliances, furniture). The inclusion of personal property can influence value and must be clearly stated.

    b.  **Repairs and New Construction:**  If the appraisal is for a property with planned or ongoing repairs or construction, the scope must clearly define whether the valuation is "as is," "as complete," or "prospective upon completion."

2.  **Identification of Real Property Interest:** Specify the exact rights being appraised, such as:

    a.  **Ownership Rights:**

        *   **Fee Simple:** The most complete form of ownership, granting the owner full rights to the property.
        *   **Leasehold:** The right to use and occupy property for a specified period under a lease agreement.
        *   **Life Estate:** Ownership for the duration of someone's life.

    b.  **Restrictions:** Identify any easements, covenants, zoning regulations, or other restrictions that may affect the property's value.

        *Example:* An easement granting a utility company the right to run power lines across the property.

    c.  **Property Taxes:** Understanding the current property tax assessment and rates is critical as it impacts the operating expenses of the property and therefore its value.

3.  **The Standard of Value:** Define the specific type of value being estimated. Common standards of value include:

    *   **Market Value:** The most probable price 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. *Market Value = f(Supply, Demand, Utility, Scarcity).*
    *   **Value in Use:** The value of a property for a specific use, which may differ from its highest and best use.
    *   **Investment Value:** The value of a property to a particular investor, based on their specific investment criteria.
    *   **Liquidation Value:** The price that could be obtained in a forced sale or quick disposition.
    *   **Assessed Value:** The value assigned to a property for property tax purposes.
    *   **Insurable Value:** The value of a property for insurance purposes, typically representing the cost to replace the improvements.
    *   **Going Concern Value:** The value of an operating business, including real property and intangible assets. *Going Concern Value = Real Property Value + Business Value (Intangibles, Goodwill, etc.)*.

B. When is It to Be Appraised?

1.  **Effective Date of the Appraisal (Valuation Date):** The specific date to which the value opinion applies. This is not necessarily the date the appraisal report is written.

    a.  **Value as of the Current Date:** The most common scenario, where the appraisal reflects current market conditions.

    b.  **Appraisal of Past Values (Retrospective Appraisal):** Used for estate settlements, tax disputes, or historical analysis. Requires careful consideration of past market conditions.

    c.  **Appraisal of Future Value (Prospective Appraisal):** Used for proposed construction, renovations, or developments. Requires forecasting future market conditions and project feasibility.

    *Formula for Future Value (FV): FV = PV (1 + r)^n, where PV is present value, r is the interest rate or growth rate, and n is the number of periods.*

2.  **Date of Appraisal Report:** The date the appraisal report is completed and delivered to the client.

C. Why is It to Be Appraised?

1.  **The Intended Use of the Appraisal:** The purpose for which the appraisal is being conducted. This could be for mortgage lending, sale, purchase, estate planning, tax assessment, or litigation. The intended use influences the scope of work and the level of detail required.

D. How is It Being Valued?

1.  **Scope of the Appraisal (Scope of Work):** The extent of research and analysis performed in the appraisal. This includes:

    *   The extent to which the property is inspected.
    *   The type and extent of data researched.
    *   The approaches to value applied.

2.  **Assumptions:** Statements assumed to be true for the purpose of the appraisal, such as the property being free of environmental contamination, or the validity of supplied documents.

3.  **Limiting Conditions:** Factors that limit the appraiser's analysis or liability, such as reliance on information provided by third parties, or exclusion of specific property features.

E. Defining the Appraisal Problem in the Appraisal Report:

The appraisal report must clearly and concisely state all elements of the defined appraisal problem, ensuring transparency and clarity for the intended users.

III. Step 2: Preliminary Analysis

Following the definition of the appraisal problem, preliminary analysis sets the stage for the remainder of the appraisal process.

A. Identifying the Necessary Data: Determine the specific data required to complete the appraisal, based on the defined appraisal problem and scope of work. Examples include:

*   Market data (comparable sales, rental rates, vacancy rates).
*   Property-specific data (site characteristics, building details, operating expenses).
*   Economic data (interest rates, inflation rates, employment trends).

B. Identifying the Sources of Data: Determine the reliable sources from which the necessary data can be obtained. These sources may include:

*   Public records (county assessor, recorder's office).
*   Multiple Listing Services (MLS).
*   Real estate databases (e.g., CoStar, Real Capital Analytics).
*   Property owners and managers.
*   Appraisal industry data providers.

C. Preliminary Analysis: Conduct a preliminary review of available data to identify potential challenges or opportunities. This may involve:

*   Analyzing market trends.
*   Identifying potential comparable properties.
*   Assessing the overall feasibility of the appraisal.

D. Creating a Plan: Develop a detailed plan outlining the specific steps to be taken in the appraisal process, including timelines and resource allocation.

E. Fee Proposal and Contract: Provide the client with a fee proposal outlining the cost of the appraisal services and a contract specifying the terms of the engagement.

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

This step involves gathering the data identified in the preliminary analysis, verifying its accuracy and reliability, and analyzing it to identify relevant trends and patterns. This is typically divided into:

General Data: Data about the market area including demographics, economic trends, governmental regulations and environmental factors.
Specific Data: Details about the subject property and comparable properties.

V. Step 4: Highest and Best Use Analysis

Highest and best use analysis is a critical step in determining the most profitable and likely use for a property. It considers physical possibility, legal permissibility, financial feasibility, and maximal productivity.

VI. Step 5: Valuing the Site

Site valuation involves estimating the value of the land or site as if vacant and available for its highest and best use.

A. Reasons for Separate Site Valuation:

*   Land value is a key component of overall property value.
*   Separate site valuation is required in the cost approach.
*   Land value trends can differ from overall property value trends.

VII. Step 6: Applying the Three Approaches to Value

This step involves developing value indications using the cost approach, sales comparison approach, and income capitalization approach.

A. Cost Approach: Estimates value by summing the estimated land value and the depreciated cost of the improvements. Value = Land Value + Replacement Cost New - Depreciation.

B. Sales Comparison Approach: Estimates value by comparing the subject property to similar properties that have recently sold, making adjustments for differences.

C. Income Approach: Estimates value based on the property’s potential to generate income.
* Direct Capitalization: Value = Net Operating Income (NOI) / Capitalization Rate (Cap Rate).
* Discounted Cash Flow (DCF): Value = Σ (CFt / (1 + r)^t), where CFt is the cash flow in period t, r is the discount rate, and t is the time period.

VIII. Step 7: Reconciling the Value Indicators

Reconciliation involves analyzing the results of the different approaches to value and weighing their relevance to arrive at a final value estimate. It is not a simple averaging of the values, but rather a reasoned judgment based on the reliability and applicability of each approach.

IX. Step 8: Reporting the Value Estimate

The final step is to communicate the appraisal findings in a clear, concise, and accurate report.

A. The Two Basic Appraisal Reports:

1.  **Narrative Report:** A comprehensive report that provides a detailed description of the appraisal process, analysis, and conclusions.
2.  **Form Report:** A standardized report format used primarily for residential appraisals.

3.  **Oral Report:** Used in court settings or informal reports.

B. Essential Elements of the Appraisal Report:

*   Identification of the property.
*   Definition of the appraisal problem.
*   Description of the appraisal process.
*   Analysis of relevant data.
*   Explanation of the approaches to value.
*   Reconciliation of the value indicators.
*   Final value estimate.
*   Assumptions and limiting conditions.
*   Appraiser's certification and signature.