The Valuation Process

Chapter 4: The Valuation Process

4.1 Introduction

The valuation process is a systematic, iterative series of procedures an appraiser follows to provide credible opinions of value. It’s a framework that ensures consistency, objectivity, and defensibility in real estate valuation. This chapter outlines the key steps involved, grounding them in established appraisal principles and relevant scientific theories.

4.2 Overview of the Valuation Process

The valuation process typically involves the following steps:

1. Problem Identification: Clearly defining the purpose and scope of the appraisal.
2. Scope of Work Determination: Determining the extent of research and analysis required.
3. Data Collection and Property Description: Gathering relevant market data and detailed information about the subject property.
4. Data Analysis: Analyzing the collected data to identify market trends and support value conclusions.
5. Highest and Best Use Analysis: Determining the most probable and legal use of the property that is physically possible, appropriately supported, financially feasible, and that results in the highest value.
6. Land Value Opinion: Estimating the value of the land as if vacant and available for its highest and best use.
7. Application of the Approaches to Value: Applying one or more of the three traditional approaches to value: the sales comparison approach, the cost approach, and the income capitalization approach.
8. Reconciliation of Value Indications and Final Opinion of Value: Analyzing the results of the different approaches and arriving at a single, supportable value opinion.
9. Report of Defined Value: Communicating the value opinion and supporting information in a clear and concise appraisal report.

4.3 Problem Identification

This initial step is crucial for setting the foundation for the entire valuation. It involves:

• Identifying the Client and Intended Users: Understanding who will rely on the appraisal.
• Identifying the Intended Use of the Appraisal: Knowing the purpose for which the valuation is being performed (e.g., mortgage lending, sale, taxation).
• Identifying the Property to Be Appraised: Clearly defining the property’s legal description, address, and any relevant characteristics.
• Identifying the Property Rights to Be Valued: Specifying the estate or interest being appraised (e.g., fee simple, leasehold). This requires an understanding of real property law and how different rights impact value.
• Defining the Value Being Estimated: Selecting the appropriate definition of value (e.g., market value, investment value, assessed value). Market value, often used, is typically defined as the most probable price which 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.
• Specifying the Effective Date of the Valuation: Establishing the date as of which the value opinion is relevant.

Example: A bank (client) needs an appraisal to determine the market value of a commercial building (property) with fee simple ownership for mortgage lending purposes, effective as of today’s date.

4.4 Scope of Work Determination

The scope of work defines the extent and depth of the appraisal process. It includes:

• Identifying the Extent to Which the Property Is Inspected: Describing the level of physical inspection performed.
• Identifying the Extent of Data Research: Outlining the types of data sources to be consulted and the depth of the data search.
• Identifying the Extent of Analyses Applied: Specifying which valuation approaches will be used and the level of detail in the analysis.
• Defining Reporting Requirements: Determining the type of appraisal report to be prepared (e.g., self-contained, summary, or restricted).

The scope of work should be appropriate for the complexity of the assignment and the needs of the client. It should also comply with relevant appraisal standards and regulations (e.g., USPAP in the United States).

4.5 Data Collection and Property Description

This phase involves gathering comprehensive data related to the property and its market.

• General Data: This includes macroeconomic data (e.g., interest rates, inflation), regional economic data (e.g., employment rates, industry growth), and local market data (e.g., vacancy rates, sales prices). This information is often analyzed using time series analysis to identify trends. For example, one can analyze historical sales data to identify trends in prices, using statistical methods such as regression analysis.
• Specific Data: This includes detailed information about the subject property, such as its physical characteristics, legal description, zoning, and any encumbrances.
• Comparable Data: This includes information on comparable properties that have recently sold or are currently listed for sale.

4.6 Data Analysis

Data analysis involves processing the collected information to identify relevant market trends and support value conclusions. This includes:

• Market Analysis: Examining supply and demand factors affecting the property’s market. This may involve analyzing absorption rates, vacancy rates, and construction trends. Concepts of supply and demand elasticity are relevant here.
• Highest and Best Use Analysis: Determining the most probable and legal use of the property that is physically possible, appropriately supported, financially feasible, and that results in the highest value.
• Financial Analysis: Evaluating the income and expenses associated with the property.

Statistical techniques like regression analysis, scatter plots, and descriptive statistics are frequently employed in data analysis.

Example: Using regression analysis to determine the relationship between property size and sales price in a specific market area. The model could be expressed as:

Price = β0 + β1 * Size + ε

Where:

• Price is the sales price of the property.
• Size is the size of the property (e.g., square footage).
• β0 is the intercept (the price when size is zero).
• β1 is the coefficient representing the change in price for each unit change in size.
• ε is the error term.

4.7 Highest and Best Use Analysis

Highest and best use analysis is a cornerstone of appraisal theory. It determines the most profitable use of a property, considering legal permissibility, physical possibility, financial feasibility, and maximum productivity.

• Highest and Best Use as Vacant: Analyzing the most profitable use of the land if it were vacant.
• Highest and Best Use as Improved: Analyzing whether the existing improvements contribute to the overall value or whether redevelopment would be more profitable.

This analysis often involves discounted cash flow (DCF) modeling to compare the present value of different development scenarios.

4.8 Land Value Opinion

Estimating the value of the land as if vacant and available for its highest and best use. Common methods include:

• Sales Comparison Approach: Comparing the subject land to similar land sales.
• Extraction Method: Subtracting the depreciated cost of the improvements from the overall property value.
• Allocation Method: Allocating a percentage of the overall property value to the land.
• Land Residual Technique: Estimating land value based on the income remaining after deducting the costs of development.

4.9 Application of the Approaches to Value

The three traditional approaches to value are:

1. Sales Comparison Approach: This approach relies on the principle of substitution, comparing the subject property to similar properties that have recently sold. Adjustments are made for differences in characteristics.

   • Adjusted Sale Price = Sale Price ± Adjustments
     2. Cost Approach: This approach is based on the principle of substitution, estimating the cost to reproduce or replace the improvements, deducting depreciation, and adding the land value.

   • Value = Reproduction/Replacement Cost - Depreciation + Land Value

   • Depreciation can be calculated using various methods, including straight-line depreciation:

     • Annual Depreciation = (Cost - Salvage Value) / Useful Life
       3. Income Capitalization Approach: This approach converts future income into present value. Common methods include direct capitalization and discounted cash flow (DCF) analysis.

   • Direct Capitalization:

     • Value = Net Operating Income (NOI) / Capitalization Rate (R)
   • Discounted Cash Flow (DCF): This approach involves projecting future cash flows and discounting them back to present value using a discount rate.
     • PV = ∑ (CFt / (1 + r)^t) where PV is present value, CFt is cash flow in period t, r is the discount rate, and t is the time period.

4.10 Reconciliation of Value Indications and Final Opinion of Value

After applying the different approaches, the appraiser reconciles the value indications to arrive at a final opinion of value. This involves:

• Analyzing the Strengths and Weaknesses of Each Approach: Considering the reliability of the data and the applicability of each approach to the specific property.
• Weighing the Value Indications: Assigning weights to the different value indications based on their reliability and relevance. This is not simply averaging. The appraiser uses professional judgment to determine which approach(es) provide the most credible indication of value.
• Arriving at a Single, Supportable Value Opinion: Providing a clear and concise statement of the final value opinion.

4.11 Report of Defined Value

The final step is to communicate the value opinion and supporting information in a clear, concise, and understandable appraisal report. The report should:

• Clearly State the Purpose and Scope of the Appraisal: Defining the intended use and the extent of the analysis.
• Describe the Property and Its Market: Providing detailed information about the subject property and the relevant market conditions.
• Explain the Valuation Process: Describing the steps taken in the valuation process and the rationale for the conclusions reached.
• Support the Value Opinion: Providing sufficient data and analysis to support the final value opinion.
• Comply with Relevant Appraisal Standards: Ensuring compliance with USPAP or other applicable standards.

4.12 Practical Applications and Related Experiments

• DCF Sensitivity Analysis: Create a DCF model for a commercial property and perform sensitivity analysis by changing key variables such as rental growth, vacancy rates, and discount rates to observe the impact on the property’s value. This demonstrates how different assumptions can affect the final value conclusion. Use tornado diagrams (as mentioned in the index) to visually represent the impact of each variable.
• Sales Comparison Grid Development: Collect data on comparable sales and develop a sales comparison grid to adjust for differences between the comparable properties and the subject property. Experiment with different adjustment techniques (e.g., percentage adjustments, dollar adjustments) and observe the impact on the adjusted sales prices.
• Market Analysis Simulation: Simulate changes in market conditions (e.g., an increase in interest rates, a decrease in employment) and analyze the potential impact on property values in a specific market area.
• Highest and Best Use Case Study: Analyze a property with potential alternative uses (e.g., a vacant lot that could be developed into residential, commercial, or industrial use) and determine the highest and best use based on legal, physical, financial, and maximum productivity criteria.

4.13 Conclusion

The valuation process is a dynamic and evolving framework. By understanding the key steps involved and grounding them in established appraisal principles and relevant scientific theories, real estate professionals can develop credible and supportable value opinions that are essential for informed decision-making. The use of statistical and financial modeling techniques enhances the objectivity and reliability of the valuation process.