Appraisal Foundations

Chapter 1: Appraisal Foundations

Introduction

This chapter lays the scientific groundwork for understanding real estate appraisal. Appraisal is more than just a subjective opinion; it’s an objective estimation of value based on economic principles, market analysis, and data-driven methodologies. This chapter will explore these underlying principles, ensuring a solid foundation for subsequent topics.

1. The Concept of Value

• 1.1 Defining Value:

  • Value, in an appraisal context, is typically defined as 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. Implicit in this definition are several crucial assumptions:
    • Market Value: The most common type of value sought in appraisals.
    • Exposure Time: Reasonable time allowed for the property to be exposed in the open market.
    • Arm’s Length Transaction: The transaction occurs between unrelated parties acting independently.
    • Cash Equivalent Terms: The transaction assumes typical market financing or is adjusted to reflect its equivalent.
  • 1.2 Types of Value:
  • Beyond market value, other types of value exist and are used for specific purposes:
    • Insurable Value: The cost of replacing or repairing a property after damage.
    • Assessed Value: The value assigned to a property by a government entity for taxation purposes.
    • Liquidation Value: The value if the property is sold quickly, often under duress.
    • Investment Value: The value of a property to a specific investor, based on their individual requirements and investment criteria.
    • Use Value: The value of a property based on its specific use.
  • 1.3 Value vs. Cost vs. Price:

  • It’s important to differentiate between value, cost, and price:

    • Cost: The total expenditure required to create a property (e.g., materials, labor, and construction).
    • Price: The amount actually paid for a property in a transaction.
    • Value: An estimate of the most probable price.

  • Ideally, in a perfectly efficient market, price should equal value. However, market imperfections and individual circumstances often lead to deviations between the two. Cost may influence value, especially for new properties, but doesn’t directly determine it.

2. Economic Principles Underpinning Appraisal

• 2.1 Supply and Demand:
  • One of the most fundamental economic principles. It governs the relationship between the availability of a good or service (supply) and the desire for it (demand).
  • In real estate, supply refers to the number of properties available for sale or rent. Demand refers to the number of potential buyers or renters in the market.
  • Mathematical representation: Although a direct equation is difficult to formulate for real estate due to its heterogeneity and localized nature, the general principles apply:
    • Increased demand, if supply is constant, will increase prices.
    • Increased supply, if demand is constant, will decrease prices.
• 2.2 Substitution:
  • The principle of substitution states that a prudent purchaser will pay no more for a property than the cost of acquiring an equally desirable substitute in the open market.
  • This principle is the basis for the sales comparison approach to valuation. Appraisers analyze comparable sales to determine the upper limit of value for the subject property.
• 2.3 Anticipation:
  • The principle of anticipation states that value is created by the expectation of future benefits, such as income, appreciation, and use.
  • This principle is especially relevant to income-producing properties. Investors purchase properties based on their anticipated future cash flows.

  • Mathematical representation: The present value (PV) of a future income stream can be calculated using the formula:

    PV = CF1/(1+r)^1 + CF2/(1+r)^2 + … + CFn/(1+r)^n

    • Where:*
      • PV = Present Value
      • CF = Cash Flow for a given period
      • r = Discount rate (reflecting risk and opportunity cost)
      • n = Number of periods
    • 2.4 Change:
      • The principle of change recognizes that real estate markets are dynamic and constantly evolving.
      • Factors such as economic conditions, demographic shifts, and technological advancements can all impact property values.
      • Appraisers must analyze these trends to accurately forecast future market conditions and their impact on value.
    • 2.5 Contribution:
      • The principle of contribution states that the value of a component part of a property is measured by how much it contributes to the overall value of the property. It’s not necessarily measured by the cost of the component.
      • For example, adding a swimming pool might contribute more or less to the overall value than its cost, depending on buyer preferences and market conditions.
    • 2.6 Highest and Best Use:
      • Highest and best use is defined as the reasonably probable and legal use of a property that is physically possible, appropriately supported, financially feasible, and that results in the highest value.
      • Determining highest and best use is a critical step in the appraisal process. It provides the foundation for selecting appropriate comparable properties and valuation methods.
      • Four tests must be applied:
    • Legally Permissible: The use must be allowed under zoning regulations and other legal restrictions.
    • Physically Possible: The site must be suitable for the proposed use, considering factors like size, shape, and topography.
    • Financially Feasible: The use must generate sufficient income or value to justify the costs of development.
    • Maximally Productive: Among the feasible uses, the one that results in the highest value.

3. Forces Influencing Real Estate Value

• 3.1 Economic Forces:
  • These forces relate to the overall health and stability of the economy.
  • Factors include:
    • Interest rates
    • Inflation rates
    • unemployment rates❓
    • Wage growth
    • Consumer confidence
    • Availability of credit
  • Economic growth generally leads to increased demand for real estate, while economic recession can depress property values.
• 3.2 Social Forces:
  • These forces reflect changes in demographics, lifestyle preferences, and social attitudes.
  • Factors include:
    • Population growth or decline
    • Household size and composition
    • Age distribution
    • Education levels
    • Crime rates
    • Lifestyle trends (e.g., preferences for urban or suburban living)
• 3.3 Political Forces:
  • These forces arise from government policies and regulations.
  • Factors include:
    • Zoning regulations
    • Building codes
    • Property taxes
    • Environmental regulations
    • Government spending on infrastructure
  • Changes in these policies can significantly impact property values. For example, rezoning a property from residential to commercial use can dramatically increase its value.
• 3.4 Physical Forces:
  • These forces relate to the characteristics of the property itself and its surrounding environment.
  • Factors include:
    • Location
    • Topography
    • Soil conditions
    • Climate
    • Natural hazards (e.g., flood zones, earthquake risk)
    • Environmental contamination
  • Desirable locations with favorable physical characteristics tend to command higher prices.

4. The Appraisal Process

• 4.1 Overview:
  • The appraisal process is a systematic approach to estimating the value of a property. It involves a series of steps:
    1. Problem Definition: Clearly identifying the purpose of the appraisal, the property being appraised, the type of value sought, and the date of valuation.
    2. Scope of Work Determination: Determining the extent of research and analysis necessary to develop credible assignment results.
    3. Data Collection and Analysis: Gathering relevant information about the property, the market, and comparable sales.
    4. Application of Appraisal Approaches: Applying one or more of the three traditional approaches to value (sales comparison, cost, and income).
    5. Reconciliation of Value Indications and Final Opinion of Value: Analyzing the results of each approach and arriving at a final, supported estimate of value.
    6. Report Definition and Final Report: Communicating the appraisal findings in a clear, concise, and accurate report.
• 4.2 Scope of Work:
  • The scope of work defines the extent to which the appraisal will be developed.
  • It includes:
    • The extent to which the property is identified and inspected
    • The extent of data research
    • The type and extent of analysis applied
• 4.3 Data Collection and Analysis:
  • Appraisers collect two primary types of data:
    • General Data: Information about the region, city, and neighborhood in which the property is located. This includes economic, social, political, and physical factors.
    • Specific Data: Information about the subject property and comparable properties. This includes property characteristics, sales data, and cost data.
  • Data sources can include:
    • Public records
    • Multiple Listing Services (MLS)
    • Real estate professionals
    • Property owners
    • Appraisal data services
    • On-site inspections
• 4.4 Reconciliation:
  • In many appraisal assignments, the application of the three approaches to value (Sales Comparison, Cost, and Income) will generate differing value indications.
  • Reconciliation is the process by which the appraiser weighs the relative reliability of each approach and arrives at a single, final opinion of value.
  • This is not a simple averaging of the results, but rather a reasoned judgment based on the strength of the data and the appropriateness of each approach for the specific property and market.
• 4.5 Reporting:
  • The final step in the appraisal process is communicating the appraisal findings in a written report.
  • The report must clearly and accurately present the appraiser’s opinion of value, the data and analysis used to support that opinion, and any assumptions or limiting conditions.
  • Appraisal reports must comply with the Uniform Standards of Professional Appraisal Practice (USPAP).

5. Practical Applications and Related Experiments

• 5.1 Sales Comparison Approach Experiment:
  • Objective: To understand the practical application of the principle of substitution.
  • Method:
    1. Select a residential property in a specific neighborhood.
    2. Research recent sales of similar properties in the same neighborhood (at least 3-5 comparable sales).
    3. Identify key differences between the subject property and the comparable sales (e.g., size, age, condition, features).
    4. Make adjustments to the sale prices of the comparable properties to account for these differences. Use a consistent method for determining the size and direction of adjustments. For example, paired data analysis could be used to extract market support adjustments.
    5. Arrive at an indicated value range for the subject property based on the adjusted sale prices of the comparables.
  • Analysis: Analyze the adjusted sale prices and consider the strengths and weaknesses of each comparable sale. Which comparable is most similar to the subject property? Which required the fewest adjustments?
• 5.2 Highest and Best Use Analysis Experiment:
  • Objective: To understand the factors considered in determining highest and best use.
  • Method:
    1. Select a vacant parcel of land in a developing area.
    2. Research the zoning regulations for the property and identify potential uses.
    3. Analyze the physical characteristics of the site (size, shape, topography, access).
    4. Research market conditions and identify potential demand for different types of development.
    5. Evaluate the financial feasibility of each potential use. Consider the costs of development and the potential income or value that could be generated.
    6. Determine which use is legally permissible, physically possible, financially feasible, and maximally productive.
  • Analysis: Justify your conclusion by explaining why the selected use represents the highest and best use of the property.
• 5.3 Impact of Economic Forces Study:
  • Objective: To understand how economic forces can influence real estate values.
  • Method:
    1. Choose a specific geographic area (e.g., a city or county).
    2. Collect data on relevant economic indicators for that area over a period of time (e.g., interest rates, unemployment rates, housing prices).
    3. Analyze the relationship between these economic indicators and housing prices.
    4. Consider additional economic forces that may have an impact on real estate values.
  • Analysis: Describe how changes in economic conditions have affected real estate values in the chosen area. What economic factors are most important to watch in the future?

Conclusion

This chapter has laid the foundation for understanding the principles and procedures of real estate appraisal. By grasping the concepts of value, economic principles, and the forces that influence real estate markets, you are well-prepared to delve deeper into the specific methods and techniques used by appraisers. The practical exercises provided can reinforce your understanding and allow you to apply these concepts in real-world scenarios.