Appraisal Principles and Procedures Overview

Real Estate Appraisal: Principles & Procedures - Your Path to Expertise

Chapter: Appraisal Principles and Procedures Overview

Introduction

This chapter provides a foundational overview of the principles and procedures underpinning real estate appraisal. We will delve into the core concepts that dictate how value is determined, exploring the economic, legal, and social forces that influence property valuation. A strong understanding of these fundamentals is crucial for anyone seeking expertise in real estate appraisal, whether for professional practice or informed decision-making in real estate transactions.

1. Defining Value and Appraisal

• Value: In appraisal, value is most often defined as the most probable price which a specified interest in real property is likely to bring under all conditions requisite to a fair sale, assuming the buyer and seller are acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus. This definition contains several key elements:

  • Most Probable Price: This is not necessarily the average or the highest possible price, but the most likely one given the market conditions. It recognizes the inherent uncertainty in valuation.
  • Specified Interest: The specific rights being valued must be clearly defined (e.g., fee simple, leasehold).
  • Fair Sale Conditions: This implies an open and competitive market with adequate exposure time.
  • Prudent and Knowledgeable Parties: Both buyer and seller are acting rationally with full knowledge of relevant facts.
  • No Undue Stimulus: The price isn’t driven by artificial factors (e.g., desperation, speculative bubbles).

• Appraisal: An appraisal is an unbiased written estimate of the value of an adequately described property, as of a specific date. Key aspects of an appraisal:

  • Unbiased: Appraisers must be impartial and independent. Their compensation should not be contingent on the value opinion.
  • Written Estimate: Appraisals are formal reports that document the analysis and conclusions.
  • Adequately Described Property: A precise description of the property is essential for accurate valuation. This includes legal descriptions, physical characteristics, and any relevant encumbrances.
  • Specific Date: Value is time-sensitive. Appraisals are valid only for a specific point in time, as market conditions change.

2. Fundamental Appraisal Principles

Several core principles guide the appraisal process and provide a theoretical framework for value determination.

• A. Principle of Supply and Demand:

  • Theory: This fundamental economic principle states that the price of a good or service is determined by the interaction of supply (the amount available) and demand (the desire and ability to purchase). A surplus of supply relative to demand leads to lower prices, while a scarcity of supply relative to demand leads to higher prices.
  • Application: In real estate, changes in supply (new construction, foreclosures) and demand (population growth, interest rates) significantly impact property values.

  • Mathematical Representation (Simplified): While not a precise equation in real estate, the relationship can be conceptually represented as:

    • P = f(S, D)

    • Where:

      • P = Price
      • S = Supply
      • D = Demand
      • f = Represents a functional relationship (price is a function of supply and demand)

  • Experiment/Example: Consider a hypothetical neighborhood with a sudden influx of new homes (increased supply). If demand remains constant, prices will likely decrease. Conversely, if a new major employer moves into the area (increased demand) with no new construction, prices will likely increase.

• B. Principle of Substitution:

  • Theory: A rational buyer will pay no more for a property than the cost of acquiring an equally desirable substitute. This principle forms the basis for the sales comparison approach.
  • Application: Appraisers analyze recent sales of comparable properties to determine the subject property’s market value.
  • Example: If two similar houses are for sale, a buyer will choose the one with the lower price, assuming all other factors are equal.

• C. Principle of Contribution:

  • Theory: The value of a component part of a property is measured by its contribution to the overall value of the property, not by its individual cost.
  • Application: Appraisers consider how each feature or improvement contributes to the property’s total value. An improvement might not add value equal to its cost if it’s not aligned with market demand.

  • Mathematical Representation (Conceptual):

    • ΔV = V_after - V_before

    • Where:

      • ΔV = Change in Value due to the component
      • V_after = Value of the property after the component is added
      • V_before = Value of the property before the component is added

  • Example: Adding a swimming pool to a property in a cold climate might not add value equal to its cost because it’s not a highly desirable feature in that market.

• D. Principle of Anticipation:

  • Theory: Value is based on the expectation of future benefits to be derived from the property. These benefits can be income, appreciation, or personal satisfaction.
  • Application: Investors in income-producing properties are primarily concerned with the anticipated future income stream. Homebuyers may anticipate future appreciation in value.
  • Example: A property located near a planned new transportation hub may experience an increase in value due to the anticipation of improved accessibility and economic activity.

• E. Principle of Conformity:

  • Theory: Property values are maximized when there is reasonable similarity among properties in a neighborhood. Conformity creates stability and predictability.
  • Application: Appraisers consider the degree of conformity when selecting comparable properties. A non-conforming property may experience diminished value.
  • Example: A large, modern house in a neighborhood of smaller, older homes may not achieve its full potential value because it doesn’t conform to the surrounding properties.

• F. Principle of Increasing and Decreasing Returns:

  • Theory: As successive increments of capital are added to a property, the resulting increase in value will eventually reach a point where additional increments will yield smaller and smaller returns. Beyond that point, additional investment will actually decrease value.
  • Application: This principle guides investment decisions in property improvements.
  • Example: Remodeling a kitchen can significantly increase a property’s value, but over-improving it with luxury finishes that are not typical for the neighborhood may not yield a proportionate return on investment.

• G. Principle of Highest and Best Use:

  • Theory: The highest and best use of a property is the reasonably probable and legal use that is physically possible, appropriately supported, financially feasible, and that results in the highest value.
  • Application: This principle is the cornerstone of appraisal. Appraisers must determine the most profitable use for the property being appraised, even if it’s not the current use. This use must meet the following tests:
    • Legally permissible: Conforms to zoning regulations, building codes, and other legal restrictions.
    • Physically possible: The site must be suitable for the use.
    • Financially feasible: The use must generate sufficient income or return to justify the investment.
    • Maximally productive: Of all the possible and feasible uses, this use yields the highest value.
  • Example: An old house on a commercially zoned lot might have a higher value as a site for a new office building (its highest and best use) than as a single-family residence.

3. The Appraisal Process (Procedures)

The appraisal process is a systematic approach to value estimation, typically involving the following steps:

• 1. Problem Definition: Clearly identify the purpose of the appraisal, the property being appraised, the date of valuation, and the property rights being valued.

• 2. Scope of Work Determination: Define the extent of research and analysis required for the appraisal. This includes identifying the data sources, appraisal approaches, and level of detail needed.

• 3. Data Collection and Analysis: Gather relevant data, including:

  • General Data: Economic trends, demographic information, and market conditions.
  • Specific Data: Property characteristics, sales data on comparable properties, cost data, and income/expense information.

• 4. Application of Appraisal Approaches: Apply one or more of the three traditional approaches to value:

  • A. Sales Comparison Approach:

    • Theory: Value is estimated by comparing the subject property to similar properties that have recently sold. Adjustments are made to the sale prices of the comparables to account for differences in features, location, and market conditions.
    • Procedure:
      • Identify comparable sales.
      • Verify the sales data.
      • Make adjustments to the comparables based on differences from the subject property.
      • Reconcile the adjusted sales prices to arrive at an indicated value for the subject.

    • Formula (Adjustment Process - Additions/Subtractions):

      • Adjusted Sale Price (Comparable) = Sale Price +/- Adjustments
        * Example: If a comparable property has a larger lot than the subject, the sale price is adjusted downward to reflect the difference in lot size.

  • B. Cost Approach:

    • Theory: Value is estimated by determining the cost to reproduce or replace the property, less accrued depreciation, plus land value. This approach is most applicable to new or unique properties.
    • Procedure:
      • Estimate the land value.
      • Estimate the cost of new improvements (reproduction or replacement cost).
      • Estimate accrued depreciation (physical deterioration, functional obsolescence, and external obsolescence).
      • Subtract accrued depreciation from the cost of new improvements.
      • Add the land value to the depreciated cost of the improvements to arrive at an indicated value.

    • Formula:

      • Value = Land Value + (Reproduction/Replacement Cost - Accrued Depreciation)
        * Example: Estimate the cost to build a new house similar to the subject, subtract the estimated depreciation due to its age and condition, and then add the value of the land.

  • C. Income Capitalization Approach:

    • Theory: Value is estimated based on the potential income the property can generate. This approach is most applicable to income-producing properties.

    • Procedure:

      • Estimate potential gross income (PGI).
      • Subtract vacancy and collection losses to arrive at effective gross income (EGI).
      • Subtract operating expenses to arrive at net operating income❓❓ (NOI).
      • Capitalize the NOI by dividing it by an appropriate capitalization rate (Cap Rate).

    • Formula (Direct Capitalization):

      • Value = NOI / Cap Rate
    • Example: A commercial building generates $100,000 in NOI, and the market capitalization rate for similar properties is 10%. The estimated value is $1,000,000 ($100,000 / 0.10).

• 5. Reconciliation and Final Value Opinion: Analyze the results of the different appraisal approaches and reconcile them into a single, final value opinion. This involves weighing the strengths and weaknesses of each approach and considering the reliability of the data.

• 6. Report Writing: Prepare a clear, concise, and well-supported appraisal report that communicates the value opinion and the reasoning behind it. The report must comply with the Uniform Standards of Professional Appraisal Practice (USPAP).

4. Influences on Real Estate Value

Several broad forces influence real estate values:

• Economic Forces: Interest rates, inflation, unemployment, economic growth, and availability of credit.
• Social Forces: Population trends, demographics, lifestyle changes, and community preferences.
• Governmental Forces: Zoning regulations, building codes, property taxes, environmental regulations, and government spending.
• Environmental Forces: Climate, topography, natural resources, and environmental hazards.

5. The Importance of USPAP

The Uniform Standards of Professional Appraisal Practice (USPAP) are the ethical and performance standards for appraisers in the United States. Compliance with USPAP is essential for maintaining credibility and ensuring the accuracy and reliability of appraisal reports.

Conclusion

Understanding the principles and procedures outlined in this chapter is fundamental to mastering real estate appraisal. These concepts provide the foundation for analyzing market data, applying appraisal approaches, and developing credible value opinions. As you progress through this course, you will build upon this knowledge and develop the skills necessary to excel in the field of real estate appraisal.