Foundations of Real Estate Appraisal: Concepts and Standards

Chapter: Foundations of Real Estate Appraisal: Concepts and Standards

Introduction

This chapter lays the groundwork for understanding real estate appraisal by exploring its core concepts and the standards that govern its practice. Real estate appraisal is not merely guesswork; it is a systematic process that relies on economic principles, market analysis, and standardized procedures to arrive at a credible opinion of value. We will delve into the definition of value, the forces that influence it, and the ethical and professional obligations of appraisers. This chapter will primarily refer to The Appraisal Foundation’s Uniform Standards of Professional Appraisal Practice (USPAP) and will include excerpts from USPAP’s 2016-2017 edition.

1. Defining Real Estate Appraisal

• 1.1. What is an Appraisal?

  • An appraisal is defined as an opinion of value. However, this opinion must be supported by thorough research, analysis, and a systematic approach. An appraisal must be numerically expressed.
  • USPAP Definition: “APPRAISAL: (noun) the act or process of developing an opinion of value; an opinion of value. (Adjective) Of or pertaining to appraising and related functions such as appraisal practice or appraisal services.”
  • Essential Elements of an Appraisal:
    • Opinion of Value: The appraiser’s professional judgment regarding the worth of a property.
    • Orderly Process: A structured approach involving data collection, market analysis, and application of appraisal techniques.
    • Data Analysis: Gathering and interpreting relevant information to support the value opinion.

• 1.2. Appraisal vs. Valuation Services

  • Appraisal Practice: Valuation services performed only by appraisers, for example appraisal, appraisal review, or appraisal consulting.
  • Valuation Services: Services performed by a variety of professionals and others.
    • The terms appraisal, appraisal review, and appraisal consulting are not mutually exclusive and could be required as a component of the analysis.

• 1.3. Consulting, Appraisal Review, and Appraisal Practice

  • Appraisal Consulting: the act or process of developing an analysis, recommendation, or opinion to solve a problem, where an opinion of value is a component of the analysis leading to the assignment results.
  • Appraisal Review: the act or process of developing and communicating an opinion about the quality of another appraiser’s work that was performed as part of an appraisal, appraisal review, or appraisal consulting assignment.
  • Appraisal Practice: valuation services performed by an individual acting as an appraiser, including but not limited to appraisal, appraisal review, or appraisal consulting.

• 1.4. The Role of the Appraiser

  • Appraisers are independent professionals who provide objective and unbiased opinions of value.
  • They must adhere to ethical guidelines and professional standards.
  • Their expertise is essential for informed decision-making in real estate transactions, lending, investment, and legal matters.

2. Understanding Value

• 2.1. Defining Value

  • Value is the present worth of future benefits arising from the ownership of real property. It is an economic concept, not a fact.
  • USPAP Definition: “VALUE: the monetary relationship between properties and those who buy, sell, or use those properties.”
  • Key Considerations:
    • Monetary Relationship: Value is expressed in monetary terms.
    • Economic Concept: It reflects the principles of supply and demand, utility, and scarcity.
    • Opinion: Value is an appraiser’s informed judgment, not an absolute measurement.
    • Specific Definition: The type of value being estimated (e.g., market value, investment value) must be clearly defined.

• 2.2. Types of Value

  • 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.
    • This is the most common type of value sought in appraisals.
  • Investment Value: The value of a property to a particular investor based on their individual investment criteria and objectives.
  • Liquidation Value: The value of a property when it must be sold quickly, often under duress.
  • Insurable Value: The value of a property for insurance purposes, typically representing the cost to replace the physical structure.

• 2.3. Forces Affecting Value

  • Real estate value is dynamic and influenced by a variety of factors:
    • Economic Forces:
      • Interest rates
      • Inflation
      • Employment levels
      • Economic growth
    • Social Forces:
      • Population trends
      • Lifestyle preferences
      • Demographic shifts
    • Political Forces:
      • Government regulations
      • Zoning laws
      • Tax policies
    • Environmental Forces:
      • Location
      • Accessibility
      • Environmental hazards
      • Natural disasters

• 2.4. Principles of Value

  • Several economic principles underpin real estate valuation:
    • Principle of Supply and Demand: Value is determined by the interaction of the availability of properties (supply) and the desire and ability of buyers to purchase them (demand).
      • Formula: Value ∝ Demand / Supply
    • Principle of Substitution: A buyer will pay no more for a property than the cost of acquiring an equally desirable substitute. This principle underlies the sales comparison approach.
    • Principle of Anticipation: Value is based on the expectation of future benefits. For example, a property with development potential may be valued higher than its current use warrants.
    • Principle of Change: Real estate values are constantly changing due to market fluctuations, economic conditions, and other factors.
    • Principle of Conformity: Properties tend to achieve their highest value when they are similar to surrounding properties in terms of style, size, and quality.
    • Principle of Contribution: The value of a component of a property is measured by how much it contributes to the overall value of the property.
    • Principle of Highest and Best Use: The use of a property that results in the highest possible value, legally permissible, physically possible, financially feasible, and maximally productive.

3. The Appraisal Process

• 3.1. Overview of the Appraisal Process

  • The appraisal process is a systematic series of steps designed to arrive at a credible opinion of value.
  • The Eight Steps of the Appraisal Process:
    1. Defining the Appraisal Problem: Identifying the client, intended use, type of value, and property characteristics.
    2. Preliminary Analysis: Developing a plan for data collection and analysis.
    3. Collecting, Verifying, and Analyzing Data: Gathering relevant market data, property information, and comparable sales data.
    4. Highest and Best Use Analysis: Determining the most profitable and legally permissible use of the property.
    5. Valuing the Site: Estimating the value of the land separately.
    6. Applying the Three Approaches to Value: Using the cost approach, sales comparison approach, and income capitalization approach (when applicable).
    7. Reconciling the Value Indicators: Weighing the results of the different approaches to arrive at a final value opinion.
    8. Reporting the Value Estimate: Communicating the appraisal findings in a clear, concise, and accurate report.

• 3.2. Defining the Appraisal Problem

  • The first step is crucial for setting the scope and direction of the appraisal.
  • Key Elements:
    • Client and Intended Users: Identifying the party or parties who will rely on the appraisal.
    • Intended Use: Specifying the purpose for which the appraisal is being conducted (e.g., mortgage lending, estate planning).
    • Type of Value: Defining the specific type of value to be estimated (e.g., market value, liquidation value).
    • Property Characteristics: Identifying the legal, physical, and economic attributes of the property.
    • Effective Date of the Appraisal: Specifying the date for which the value opinion is relevant.

• 3.3. Preliminary Analysis and Data Collection

  • This stage involves planning the appraisal and gathering necessary data.
  • Tasks:
    • Developing a Plan: Outlining the scope of work, data sources, and appraisal techniques to be used.
    • Identifying Data Sources: Locating reliable sources of information, such as public records, market reports, and real estate databases.
    • Collecting Data: Gathering information on the subject property, comparable sales, and market conditions.
    • Types of Data:
      • General Data: Information about the economy, demographics, and real estate market in the area.
      • Specific Data: Information about the subject property and comparable properties.
      • Competitive Supply and Demand Data: Number of homes on the market, etc.

4. Appraisal Standards and Ethics

• 4.1. The Uniform Standards of Professional Appraisal Practice (USPAP)

  • USPAP is the ethical and performance standard for appraisers in the United States.
  • The Appraisal Foundation: Chartered by Congress to develop education and ethical standards for appraisers. It oversees the activities of the ASB, AQB, and APB.
  • It is developed, interpreted, and amended by the Appraisal Standards Board (ASB).
  • Compliance with USPAP is required for federally related transactions and is widely adopted by state appraiser regulatory agencies.
  • ASB Definition: “The ASB promotes acceptance of the USPAP, and updates standards to reflect new developments in appraisal practice. The Appraisal Standards Board is responsible for developing USPAP.”

• 4.2. Key Components of USPAP

  • Ethics Rule: Requires appraisers to conduct themselves with integrity, impartiality, and objectivity.
  • Competency Rule: Mandates that appraisers have the knowledge and experience necessary to perform an assignment competently.
  • Scope of Work Rule: Requires appraisers to identify the problem to be solved, determine the scope of work necessary to develop credible assignment results, and disclose the scope of work in the report.
  • Record Keeping Rule: Requires appraisers to maintain work files that document the data, analyses, and conclusions of an appraisal.
  • Reporting Standards: Set forth the requirements for communicating appraisal results in a clear, accurate, and understandable manner.

• 4.3. Appraisal Qualifications Board (AQB)

  • The AQB establishes the minimum education, experience, and examination requirements for appraiser licensing and certification.
  • AQB Definition: “The AQB is concerned with education, testing, and experience requirements for appraiser certification and licensing.”
  • Appraiser Regulatory Boards (States): Individual state boards regulate appraisers and adhere to the national criteria.
    • General Certification: An appraiser certification for all types of property.
    • Residential Certification: An appraiser certification for residential property only.

• 4.4. Ethics and Professional Conduct

  • Appraisers have a responsibility to maintain public trust and confidence.
  • Ethical Considerations:
    • Independence and Objectivity: Avoiding conflicts of interest and biases.
    • Confidentiality: Protecting client information.
    • Competency: Accepting only assignments that can be performed competently.
    • Disclosure: Clearly communicating all relevant information in the appraisal report.
  • Appraisal Management Company (AMC): Oversees a network of appraisers.

5. Property Rights and Interests

• 5.1. Real vs. Personal Property

  • Real Property: Land and anything permanently attached to it (e.g., buildings, fixtures).
  • Personal Property: Movable items that are not permanently attached to the land (e.g., furniture, appliances).
    • Fixture: A former item of personal property which has become part of the realty.
  • Distinguishing between real and personal property is important for determining what is included in a real estate transaction.

• 5.2. Estates in Real Property

  • An estate is the degree, quantity, nature, and extent of interest that a person has in real property.
  • Types of Estates:
    • Freehold Estates: Ownership interests that have an indefinite duration.
      • Fee Simple: The highest form of ownership, granting the owner full rights to the property.
      • Life Estate: Ownership for the duration of someone’s life.
    • Leasehold Estates: Right to possess and use property for a specific period of time.
      • Tenancy at Will: An agreement which may be terminated at any time.
      • Tenancy for Years: A lease for a fixed period of time.
      • Periodic Tenancy: A lease that renews automatically.
    • Non-Possessory Interests: Encumbrances.

• 5.3. Encumbrances

  • An encumbrance is a claim or liability that is attached to real property and may lessen its value or affect its use.
  • Types of Encumbrances:
    • Liens: Financial claims against the property (e.g., mortgages, tax liens).
      • General Lien: Lien which covers all property of debtor.
      • Specific Lien: Lien that applies only to designated property.
    • Easements: Rights to use another person’s property for a specific purpose.
      • Easement Appurtenant: An easement benefitting a property.
      • Easement in Gross: An easement benefitting a person rather than a property.
    • Restrictions: Limitations on the use of property (e.g., covenants, conditions, and restrictions -CC&Rs).
  • Encumbrances can affect the marketability and value of real property.

6. Property Description and Site Valuation

• 6.1. Legal Descriptions

  • A legal description is a precise way of identifying a parcel of land that is acceptable in a court of law.
  • Methods of Legal Description:
    • Metes and Bounds: Uses distances and directions to define the boundaries of the property.
    • Lot and Block: Identifies property by reference to a recorded subdivision plat.
    • Rectangular Survey System: Divides land into townships, sections, and smaller units using a grid system.

• 6.2. Site Valuation

  • Site valuation is the process of estimating the value of the land separately from any improvements on it.
  • Importance of Site Valuation:
    • Required in the cost approach to value.
    • Helps to determine the highest and best use of the property.
    • Provides a basis for property tax assessments.
  • Methods of Site Valuation:
    • Sales Comparison: Comparing the subject site to similar vacant sites that have recently sold.
    • Allocation: Estimating the land value as a percentage of the total property value.
    • Extraction: Deducting the value of the improvements from the total property value to arrive at the land value.
    • Development Method: Estimating the value of the land based on its potential for development.
    • Ground Rent Capitalization: Capitalizing the income generated by a ground lease to estimate land value.

Conclusion

This chapter has provided a foundational understanding of real estate appraisal, including its core concepts, the forces that influence value, and the standards that govern its practice. By grasping these fundamental principles, you are well-equipped to delve into the more advanced techniques and applications of real estate appraisal in the following chapters.