The Valuation Process: Problem to Value

Chapter: The Valuation Process: Problem to Value

This chapter focuses on the crucial initial stage of the property valuation process: defining the appraisal problem. Accurately identifying the problem is paramount as it dictates the scope of work, data collection, analysis techniques, and ultimately, the credibility and reliability of the valuation opinion.

1. Identification of the Appraisal Problem: Laying the Foundation

The first step in any valuation exercise is a thorough understanding and precise definition of the appraisal problem. This involves identifying all the key parameters that will govern the entire valuation process. Just as a physician cannot prescribe effective treatment without a proper diagnosis, an appraiser cannot arrive at a sound valuation without a clear understanding of the problem to be solved. Problem identification logically precedes scope of work determination.

2. Key Components of Problem Identification

The identification of the appraisal problem requires meticulously defining the following elements:

• Client: Identifying the party or parties who have engaged the appraiser. This is crucial for establishing confidentiality and ethical responsibilities.

• Intended Use: Clearly stating the purpose for which the valuation is being conducted. Examples include:

  • Mortgage lending
  • Estate settlement
  • Tax assessment
  • Litigation support
  • Purchase/Sale decision

  The intended use significantly influences the type of value sought and the depth of analysis required.

• Intended Users: Defining all parties (beyond the client) who will rely on the appraisal report. This clarifies the appraiser’s responsibilities and liability. Common intended users include lenders, investors, courts, and government agencies.

• Type of Value and its Definition: Specifying the precise type of value being sought and its authoritative definition. Common types 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. Its definition is often derived from regulatory agencies (e.g., USPAP, FIRREA).

    • Mathematical Representation (Simplified):
      • MV = E[P | Competitive & Open Market]
      • Where:
        • MV = Market Value
        • E[P] = Expected Price
        • Competitive & Open Market = Conditions of a fair sale.

  • Investment Value: The value of a property to a particular investor based on their specific investment criteria, risk tolerance, and tax situation.

  • Use Value: The value of a property for a specific use, regardless of its potential highest and best use.
  • Liquidation Value: The net amount that can be realized from the sale of an asset if it is disposed of quickly, such as in a foreclosure or bankruptcy sale.
  • Insurable Value: The cost of replacing or reproducing a property’s improvements, used to determine the appropriate amount of insurance coverage.

  The selected value type directly affects the appraisal methodology and data emphasis.

• Effective Date of the Opinion: Establishing the specific date for which the value opinion is relevant. Market conditions and property characteristics can change over time, making the effective date a critical reference point.

• Relevant Property Characteristics: Identifying the physical, legal, economic, and locational attributes of the subject property that are pertinent to the type of value sought and the intended use of the appraisal. This includes:

  • Location: Neighborhood characteristics, accessibility, proximity to amenities, environmental factors (e.g., flood zones, pollution).

  • Property Rights: Fee simple, leasehold, easement, etc. Understanding the property rights being valued is essential.

    • Example: Valuing a leasehold interest requires analyzing the terms of the lease, including rent payments, lease duration, and renewal options. This impacts the cash flows and therefore the valuation.

  • Physical Characteristics: Size, shape, topography, improvements (buildings, landscaping), condition, age, and construction quality.

  • Legal Characteristics: Zoning regulations, easements, deed restrictions, and other legal encumbrances.

• Assignment Conditions: Explicitly stating any extraordinary assumptions, hypothetical conditions, laws, regulations, jurisdictional exceptions, and other conditions that affect the scope of work or the valuation outcome. These conditions must be clearly disclosed and justified.

  • Extraordinary Assumption: An assumption, directly related to a specific assignment, which, if found to be false, could alter the appraiser’s opinions or conclusions.

  • Hypothetical Condition: A condition assumed for the purpose of analysis that is contrary to what is known by the appraiser to exist on the effective date of the assignment results.

  • Example: A hypothetical condition might involve assuming the completion of a planned renovation that has not yet occurred. This requires careful analysis and disclosure of the potential impact on value.

3. The Interdependence of Problem Identification Components

The components of problem identification are not isolated elements; they are interconnected and influence each other. The appraiser must carefully consider how each element affects the overall valuation process. For example, the intended use of the appraisal (e.g., mortgage lending) may dictate the type of value required (e.g., market value) and specific regulatory guidelines that must be followed. Before an appraiser identifies the initial characteristics of the property and any assignment conditions that are relevant to the purpose of the assignment, an appraiser must identify the client, intended users, intended use, the type and definition of value, and the effective date of the opinion of value.

4. Scope of Work Determination: Defining the Path to Value

Once the appraisal problem is clearly defined, the appraiser must determine the scope of work necessary to solve the problem. This involves defining the extent of research, data collection, analysis, and reporting required to develop a credible valuation opinion.

• The scope of work decision is acceptable when it allows the appraiser to arrive at credible assignment results and is consistent with the expectations of intended users of similar assignments and the work that would be performed by the appraiser’s peers in a similar assignment.

• Scope of work encompasses all development aspects of the valuation process, including:

  • Which approaches to value will be used.
  • How much data is to be gathered, from what sources, from which geographic area, and over what time period.
  • The extent of the data verification process.
  • The extent of property inspection, if any.

5. Planning the Appraisal: Ensuring Efficiency and Accuracy

Effective planning is essential for completing the valuation assignment efficiently and accurately. This involves creating a timeline, allocating resources, and delegating tasks as needed. A well-defined work plan typically includes an outline of the proposed appraisal report, which helps organize data and allocate appropriate time to each step in the valuation process.

6. Data Collection and Property Description: Gathering the Evidence

After defining the problem and scope of work, the appraiser begins collecting data on the market area, the subject property, and comparable properties. This data can be categorized as:

• General Data: Information about the social, economic, governmental, and environmental forces that influence property values in the market area. This includes demographic trends, employment rates, interest rates, zoning regulations, and environmental regulations.

• Specific Data: Information directly related to the subject property and comparable properties, including legal descriptions, physical characteristics, sales prices, income and expenses, and financing terms.

  • Irrelevant data should be excluded because the inclusion of that data may detract from the credibility of the appraiser’s analyses and conclusions.

7. Data Analysis: Unveiling Market Insights

Once the data has been collected, the appraiser analyzes it to understand market conditions, identify trends, and determine the highest and best use of the property. Data Analysis has two components:

• Market Analysis: A study of market conditions for a specific type of property, including supply and demand factors, vacancy rates, rental rates, and sales prices.

• Highest and Best Use Analysis: An analysis to determine the most probable and legal use of the property that is physically possible, appropriately supported, financially feasible, and results in the highest value.

  • The determination of highest and best use is crucial because it forms the basis for the valuation opinion. Appraisers must address the question of the highest and best use for whatever is being valued. In valuing an improved property, the appraiser must address the question of the highest and best use as currently improved. In valuing a vacant site, the appraiser must address highest and best use as though vacant.

8. Land Value Opinion: Isolating the Ground Value

In many appraisal assignments, it is necessary to develop a separate opinion of land value. This is important because land and improvements can change in value at different rates. Techniques for estimating land value include:

• Sales Comparison: Comparing the subject land to similar vacant land parcels that have recently sold.

• Extraction: Estimating land value by subtracting the depreciated cost of improvements from the overall property value.

• Allocation: Estimating land value based on its typical proportion of the overall property value in a given market.

• Subdivision Development: Analyzing the potential value of a subdivided property.

• Land Residual: Estimating land value by capitalizing the residual income remaining after deducting expenses and return on improvements.

• Ground Rent Capitalization: Capitalizing the ground rent income generated by the land.

9. Application of the Approaches to Value: Converting Data to Value

The final step in the valuation process is to apply one or more of the three traditional approaches to value:

• Sales Comparison Approach: Comparing the subject property to similar properties that have recently sold, adjusting for differences in characteristics.

• Income Capitalization Approach: Estimating the value of the property based on its potential income stream.

• Cost Approach: Estimating the value of the property by adding the value of the land to the depreciated cost of the improvements.

The choice of approach or approaches depends on the type of property, the intended use of the appraisal, and the availability of data. In many cases, multiple approaches are used, and the results are reconciled to arrive at a final opinion of value.

10. Conclusion

The “Problem to Value” stage is the cornerstone of a credible and defensible property valuation. By meticulously defining the appraisal problem, determining the appropriate scope of work, collecting relevant data, and conducting thorough analysis, the appraiser lays the foundation for a reliable and accurate valuation opinion. The effective integration of all the elements in the process depends on the appraiser’s skill, experience, and judgment.