The Valuation Process: Identification to Application

Chapter: The Valuation Process: Identification to Application

This chapter provides a comprehensive exploration of the valuation process, encompassing its stages from initial problem identification to the final application of valuation approaches. The process is scientific, requiring rigorous data collection, analysis, and application of established principles. The appraiser’s skill, experience, and judgment are crucial in effectively integrating these elements.

1. Identification of the Appraisal Problem

The initial step in the valuation process involves a clear and concise definition of the appraisal problem. This is the cornerstone upon which the entire valuation rests. A poorly defined problem will invariably lead to inaccurate or irrelevant results. Problem identification logically precedes the scope of work determination.

Specifically, the identification of the appraisal problem includes determining the following:

• 1.1 Client: Identify the party or entity who has commissioned the appraisal. Understanding the client’s needs and motivations is crucial for tailoring the appraisal to their specific requirements.

• 1.2 Intended Use: Define the purpose for which the appraisal will be used. Examples include mortgage lending, estate settlement, litigation support, and investment analysis. The intended use dictates the type of value to be estimated and the level of detail required.

• 1.3 Intended Users: Identify all parties who will rely on the appraisal report, in addition to the client. This may include lenders, investors, or regulatory agencies. Knowing the intended users ensures that the report is clear, concise, and meets their expectations.

• 1.4 Type of Value and Definition: Specify the type of value to be estimated (e.g., market value, investment value, insurable value, liquidation value) and provide a clear definition of that value. Market value, for instance, is commonly 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.”

  • The definition of value chosen must be appropriate for the intended use and reflect relevant legal and regulatory requirements.

• 1.5 Effective Date of Valuation: Establish the specific date for which the value opinion is applicable. The real estate market is dynamic, and value changes over time. The effective date ensures that the valuation reflects market conditions at a specific point in time.

• 1.6 Relevant Property Characteristics: Identify the characteristics of the property that are relevant to the defined type of value and intended use. This includes:

  • 1.6.1 Location: Geographic location and its influence on value (accessibility, amenities, neighborhood characteristics).
  • 1.6.2 Property Rights: The specific rights being valued (fee simple, leasehold, easement).
  • 1.6.3 Physical Characteristics: Size, shape, topography, improvements, and condition.
  • 1.6.4 Legal Considerations: Zoning regulations, easements, restrictions, and other legal encumbrances.

• 1.7 Assignment Conditions: Define any extraordinary assumptions, hypothetical conditions, laws, regulations, jurisdictional exceptions, and other conditions that affect the scope of work.

  • 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 contrary to what is known by the appraiser to exist on the effective date of the assignment results, but used for the purpose of analysis.

2. Scope of Work Determination

Defining the Scope of Work is one of the most critical decisions an appraiser will make in performing an assignment.

• 2.1 Identify the appraisal problem.
• 2.2 Determine the scope of work necessary to solve the client’s problem.
• 2.3 Apply the scope of work necessary to solve the problem.

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

• Approaches to Value: Which valuation approaches (sales comparison, cost, income capitalization) will be employed.
• Data Requirements: The quantity and types of data needed, sources of information, geographic area of data collection, and relevant time period.
• Data Verification: The extent to which data will be verified and validated.
• Property Inspection: The level of property inspection required, if any.

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.

3. Data Collection and Property Description

After defining the appraisal problem and scope of work, the next step is to gather pertinent data. Data is broadly categorized as:

• 3.1 General Data: Information about the broader market area, including:

  • 3.1.1 Social Trends: Population demographics, household income, education levels, and lifestyle preferences.
  • 3.1.2 Economic Trends: Employment rates, economic growth, inflation, interest rates, and industry trends.
  • 3.1.3 Governmental Factors: Zoning regulations, property taxes, building codes, and environmental regulations.
  • 3.1.4 Environmental Factors: Climate, topography, soil conditions, and environmental hazards.
  • These trends significantly influence supply and demand for real estate.

• 3.2 Specific Data: Information directly related to the subject property and comparable properties:

  • 3.2.1 Subject Property Data: Legal description, physical characteristics, site improvements, building construction details, zoning compliance, and operating expenses (if applicable).
  • 3.2.2 Comparable Property Data: Sales prices, property characteristics, locations, dates of sale, financing terms, and any other factors that may influence value.
  • This specific data is analyzed to identify similarities and differences between the subject property and comparable properties.

The amount and type of data collected for an appraisal depends on the approaches used to develop an opinion of value and on the defined scope of work.

4. Data Analysis

Data analysis involves two primary components: market analysis and highest and best use analysis. These analyses are interconnected and critical for developing a credible value opinion.

• 4.1 Market Analysis: A study of market conditions for a specific type of property, which provides a background against which local developments are considered.

  • 4.1.1 Demand Studies: Analysis of factors driving demand for real estate in the market area, such as population growth, employment trends, and income levels.
  • 4.1.2 Supply Studies: Analysis of the existing and planned supply of real estate in the market area, including vacancy rates, construction activity, and land availability.
  • 4.1.3 Marketability Studies: Assessment of the property’s ability to be readily sold or leased in the market, considering its characteristics and competitive position.

• 4.2 Highest and Best Use Analysis: The reasonably probable and legal use of vacant land or an improved property that is physically possible, appropriately supported, financially feasible, and that results in the highest value.

  • 4.2.1 Land as Though Vacant: Analysis of the potential uses of the land if it were vacant and available for development.
  • 4.2.2 Property as Improved: Analysis of the current use of the property and whether it represents the highest and best use given the existing improvements.
  • The appraiser must address the question of the highest and best use for whatever is being valued.

5. Land Value Opinion

Appraisers often develop an opinion of land value separately, even when valuing properties with extensive building improvements. Land value and building value may change at different rates over time. Improvements are almost always subject to depreciation with age, while land value is reported as of the date of valuation without any consideration of depreciation. While land value may fluctuate over time, land itself does not depreciate.

An appraiser can use several techniques to obtain an indication of land value:

• 5.1 Sales Comparison: Directly comparing the subject site to comparable vacant sites that have recently sold.
• 5.2 Extraction: Inferring the land value by subtracting the depreciated cost of the improvements from the overall sale price of a comparable improved property.
• 5.3 Allocation: Allocating a percentage of the total property value to the land, based on market norms or ratios.
• 5.4 Subdivision Development: Estimating the total revenue from the sale of subdivided lots, subtracting development costs and entrepreneurial profit, and discounting the resulting cash flow to present value.
• 5.5 Land Residual: Capitalizing the income attributable to the land after deducting the income required to support the improvements.

6. Application of the Approaches to Value

The valuation process culminates in the application of one or more of the three traditional approaches to value:

• 6.1 Sales Comparison Approach: This approach is based on the principle of substitution, which states that a buyer will pay no more for a property than the cost of acquiring an equally desirable substitute.

  • The appraiser identifies comparable properties that have recently sold in the market area and adjusts their sale prices to account for differences in characteristics compared to the subject property.
  • Formula: Subject Property Value = Comparable Sale Price ± Adjustments

• 6.2 Cost Approach: This approach is based on the principle of contribution, which states that the value of a component is measured by its contribution to the value of the whole property.

  • The appraiser estimates the current cost of constructing a new replica or replacement for the subject property’s improvements, subtracts accrued depreciation, and adds the value of the land.
  • Formula: Property Value = Land Value + Cost of Improvements - Accrued Depreciation
    • Depreciation = Physical Deterioration + Functional Obsolescence + External Obsolescence

• 6.3 Income Capitalization Approach: This approach is based on the principle of anticipation, which states that the value of a property is equal to the present worth of its expected future income stream.

  • The appraiser estimates the potential income stream that the property is expected to generate and converts it into a present value using either direct capitalization or yield capitalization techniques.
  • 6.3.1 Direct Capitalization: This method uses a capitalization rate (R) to convert a single year’s income (NOI - Net Operating Income) into a value estimate.
    • Formula: Value = NOI / R
  • 6.3.2 Yield Capitalization (Discounted Cash Flow Analysis): This method involves projecting future cash flows over a holding period and discounting them back to present value using a discount rate (Y).
    • Formula: Value = Σ [CFt / (1 + Y)^t] + [Reversion Value / (1 + Y)^n]
      • Where:
        • CFt = Cash flow in year t
        • Y = Discount rate
        • t = Year
        • n = Holding period

7. Reconciliation of Value Indications and Final Opinion of Value

After applying the various approaches to value, the appraiser reconciles the resulting value indications into a single, final opinion of value. Reconciliation is not a simple averaging of the different indications. Rather, it involves a careful analysis of the strengths and weaknesses of each approach and assigning appropriate weight to each based on its reliability and relevance to the specific appraisal problem.

The final opinion of value is a well-supported conclusion that reflects the appraiser’s best judgment based on all available data and analysis.

8. Report of Defined Value

The final step is to communicate the appraisal findings in a clear, concise, and credible report. The report should include:

• A clear statement of the appraisal problem, including the type of value, intended use, and intended users.
• A detailed description of the property and its relevant characteristics.
• A summary of the data collected and analyzed.
• A comprehensive explanation of the valuation approaches used and the reasoning behind the final opinion of value.
• All extraordinary assumptions and hypothetical conditions.
• A signed certification by the appraiser affirming compliance with relevant ethical and professional standards.

The appraisal report serves as a record of the valuation process and provides the client and other intended users with the information necessary to make informed decisions.