Appraisal Foundations: Principles & Procedures

Chapter: Appraisal Foundations: Principles & Procedures

Introduction

Real estate appraisal is a complex process grounded in economic principles, legal frameworks, and statistical analysis. This chapter will lay the foundation for understanding appraisal theory and practice, focusing on the underlying principles and standard procedures. We will explore core concepts, including the definition of value, the forces❓ influencing value, and the three traditional approaches to valuation. The content will emphasize the scientific underpinnings of appraisal, integrating economic theory, statistical methods, and practical application.

1. Defining Value in Real Estate Appraisal

The term “value” is central to appraisal but requires careful definition. In appraisal, value is not simply the price paid but rather an estimate of 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. Several types of value are relevant to real estate appraisal.

• Market Value: The most probable price, as defined above, expressed in terms of money. It assumes a willing buyer and a willing seller, reasonable exposure time in the market, and no undue duress.
• Investment Value: The value of a property to a specific investor based on their individual investment criteria and requirements. This may differ from market value.
• Use Value: The value of a property based on its specific use, which may or may not be its highest and best use.
• Assessed Value: The value assigned to a property by a taxing authority for property tax purposes.
• Insurable Value: The value of a property for insurance purposes, typically representing the cost to replace the physical structure.

The mathematical expression of value, while not a direct calculation, relies on understanding the factors that contribute to it. We can express value conceptually as:

V = f(L, I, U, M)

Where:
V = Value
L = Location (and all its associated attributes)
I = Improvements (to the land)
U = Utility (functional aspects of the property)
M = Market Conditions (Supply and demand)

This highlights the multi-faceted nature of appraisal, necessitating a comprehensive understanding of various market and property-specific factors.

2. Fundamental Economic Principles Influencing Value

Several fundamental economic principles underpin the appraisal process. These principles influence supply, demand, and ultimately, property values.

• Supply and Demand: The interaction of supply and demand is a primary driver of property values. If demand increases while supply remains constant, prices tend to rise. Conversely, if supply increases and demand remains constant, prices tend to fall.

  We can express a simplified model as:

  P = f(D/S)

  Where:
  P = Price
  D = Demand
  S = Supply

  This represents the general relationship, although the specific function, f, is complex and influenced by numerous other factors.

  Experiment/Example: Examine historical housing data in a specific neighborhood. Correlate changes in the number of properties listed for sale (supply) and changes in the number of closed sales (demand) with changes in average sale prices. Use regression analysis to quantify the relationship between these variables.

• substitution❓❓: The principle of substitution states that a rational buyer will pay no more for a property than they would pay for a reasonably equivalent substitute. This principle is the basis for the sales comparison approach.

• Contribution: The value of a component of a property is measured by its contribution to the overall value, not by its individual cost. For example, adding a swimming pool may not increase the property value by the full cost of the pool’s installation if the market does not highly value swimming pools in that area.
• Anticipation: Value is influenced by the expectation of future benefits. For example, a property located near a planned future transportation hub might increase in value based on the anticipated improved accessibility.
• Conformity: Properties achieve maximum value when they are in reasonable conformity with surrounding properties. Over-improvement or under-improvement relative to the neighborhood can negatively impact value.

3. Forces Influencing Real Estate Values (PEGS)

These are the broad categories of forces that appraisers❓ must consider when analyzing a market:

• Physical Forces: Natural or man-made characteristics that define a specific location that affect property value, such as the size and shape of the lot, topography, soil, and climate. Topography can be viewed as a complex variable. Properties on level ground are easier to develop than those on steep slopes.
• Economic Forces: Economic factors such as income levels, employment rates, interest rates, inflation, and availability of financing can significantly impact property values.
• Governmental Forces: Government regulations, zoning ordinances, building codes, property taxes, and government-sponsored programs (e.g., tax credits, infrastructure projects) can affect property values. Zoning regulations dictate how land can be used, thereby directly influencing its value.
• Social Forces: Social trends, demographic shifts, population growth, lifestyle preferences, and crime rates can all influence property values. An increase in the elderly population of a particular area may mean that the demand for single-story, accessible housing will increase.

Appraisers analyze these forces to understand the dynamics of the market and how they affect a specific property.

4. The Appraisal Process: A Systematic Approach

The appraisal process is a systematic and standardized procedure designed to arrive at a credible opinion of value. The typical steps include:

1. Problem Definition: Clearly identify the purpose of the appraisal, the type of value to be estimated (e.g., market value, investment value), the property being appraised, and the date of valuation.
2. Scope of Work Determination: Determine the extent of research and analysis required to produce a credible appraisal. This includes identifying data sources, appraisal methods to be used, and the level of detail required in the analysis.
3. Data Collection and Analysis: Gather relevant data, including general market data (economic trends, demographics), specific property data (site characteristics, improvements), and comparable sales data.
   • General Market Analysis: Analyze economic, social, governmental, and environmental forces affecting the area.
   • Specific Property Analysis: Investigate the property’s legal characteristics, physical characteristics, and economic characteristics.
   • Comparable Sales Analysis: Gather data on recent sales of similar properties in the area, including sales prices, dates of sale, locations, and physical characteristics.
4. Highest and Best Use Analysis: Determine the most probable and legal use of the property, which is physically possible, appropriately supported, financially feasible, and results in the highest value. This considers the property as if vacant (land) and as improved.
5. Application of the Three Approaches to Value: Develop an opinion of value using one or more of the following approaches:
   • Sales Comparison Approach: Based on the principle of substitution. Value is estimated by comparing the subject property to similar properties that have recently sold. Adjustments are made for differences in characteristics.
   • Cost Approach: Based on the principle of substitution. Value is estimated by calculating the cost to reproduce or replace the improvements, subtracting accrued depreciation, and adding the land value.
   • Income Capitalization Approach: Based on the principle of anticipation. Value is estimated by capitalizing the income stream that the property is expected to generate.
6. Reconciliation of Value Indications: Analyze the results of the different approaches and reconcile them into a single opinion of value. Weigh the strengths and weaknesses of each approach based on the specific characteristics of the property and the market.
7. Report of Defined Value: Communicate the appraisal opinion to the client in a clear, concise, and understandable report. The report must comply with the Uniform Standards of Professional Appraisal Practice (USPAP).

5. The Three Approaches to Value: Detailed Examination

Each of the three approaches to value provides a different perspective on value. The applicability of each approach depends on the property type and the availability of data.

• Sales Comparison Approach:

  This approach relies heavily on comparable sales data. The process involves:

  1. Identifying comparable sales.
  2. Verifying the data with a party involved in the transaction.
  3. Selecting relevant elements of comparison (e.g., location, size, condition, amenities).
  4. Adjusting the sales prices of the comparables to account for differences between them and the subject property.

  The adjustments can be expressed as percentages or dollar amounts. For example, if a comparable sale is superior to the subject property in terms of lot size, a negative adjustment is made to the comparable sale price to reflect this. If the comparable is inferior, a positive adjustment is made.

  Adjusted Sale Price = Sale Price ± Adjustments

  Statistical analysis, such as paired data analysis, can be used to quantify the market’s reaction to particular features or characteristics. For example, to determine the value of a garage, one can compare sales of similar properties with and without garages.

• Cost Approach:

  This approach is based on the principle that a buyer will not pay more for a property than the cost to build a new one. The process involves:

  1. Estimating the land value.
  2. Estimating the cost to reproduce or replace the improvements.
  3. Estimating accrued depreciation (physical deterioration, functional obsolescence, and external obsolescence).
  4. Subtracting the accrued depreciation from the cost to reproduce or replace the improvements.
  5. Adding the land value to the depreciated cost of the improvements.

  Value = Land Value + (Cost to Reproduce/Replace - Accrued Depreciation)

  Accrued depreciation is often the most subjective part of the cost approach. The straight-line method, for example, assumes a constant rate of depreciation over the economic life of the asset.

  Annual Depreciation = (Cost - Salvage Value) / Economic Life

• Income Capitalization Approach:

  This approach is used to value income-producing properties. The process involves:

  1. Estimating the potential gross income (PGI) of the property.
  2. Estimating vacancy and collection losses.
  3. Subtracting vacancy and collection losses from the PGI to arrive at effective gross income (EGI).
  4. Estimating operating expenses.
  5. Subtracting operating expenses from the EGI to arrive at net operating income (NOI).
  6. Selecting an appropriate capitalization rate (cap rate).
  7. Dividing the NOI by the cap rate to arrive at an estimate of value.

  Value = NOI / Cap Rate

  The cap rate is the rate of return an investor expects to receive on their investment. It can be derived from comparable sales data.

  Cap Rate = NOI / Sale Price (of Comparable Properties)

  The accuracy of the income capitalization approach depends heavily on the accuracy of the income and expense projections and the appropriateness of the cap rate.

6. Reconciliation and Final Value Opinion

Reconciliation is not simply averaging the values indicated by the three approaches. It involves critically evaluating the strengths and weaknesses of each approach and assigning weights to each approach based on their reliability and relevance to the specific property being appraised. Factors considered during reconciliation include:

• Data Reliability: Is the data used in each approach accurate and reliable?
• Market Relevance: Which approach is most reflective of the market’s perception of value for this type of property?
• Property Type: Which approach is most appropriate for the property type being appraised? (e.g., the income capitalization approach is most suitable for income-producing properties).

The final value opinion should be supported by the data and analysis presented in the appraisal report and should reflect a well-reasoned and credible conclusion.

Conclusion

Understanding the foundational principles and procedures of real estate appraisal is crucial for conducting accurate and reliable valuations. This chapter has provided an overview of the key concepts, including the definition of value, the forces influencing value, and the three traditional approaches to value. By applying these principles and procedures in a systematic and rigorous manner, appraisers can provide credible opinions of value that are essential for informed decision-making in the real estate market. Subsequent chapters will build upon this foundation, focusing on specific aspects of neighborhood analysis and their impact on property values.