Appraisal Foundation: Problem Definition and Scope

I. Introduction

The foundation of any credible appraisal lies in clearly defining the problem and establishing a well-defined scope of work. This chapter delves into these crucial initial steps, aligning with the Uniform Standards of Professional Appraisal Practice (USPAP) and providing a scientific understanding of the underlying principles. USPAP Standard 1 mandates that appraisers must “identify the problem to be solved and the scope of work necessary to solve the problem, and correctly complete research and analysis necessary to produce a credible appraisal.” We will explore how these steps are not isolated tasks but integral components of the unified valuation process.

II. The Appraisal Process: A Scientific Approach

The appraisal process can be viewed as a systematic, iterative application of scientific principles to arrive at a well-supported value conclusion. The steps outlined in the process, though presented sequentially, often overlap and interact in practice.

1. Define the Appraisal Problem: Clearly articulate the “what,” “when,” “why,” and “how” of the appraisal assignment.
2. Preliminary Analysis: Determine the resources necessary and available to solve the problem. This involves an initial assessment of data requirements and potential challenges.
3. Collect, Verify, and Analyze the Necessary Data: Gather relevant market information, property-specific data, and other pertinent details. Data verification is crucial to ensuring accuracy and reliability.
4. Determine the Property’s Highest and Best Use: Analyze the potential uses of the property to determine the most profitable, legally permissible, physically possible, and financially feasible use.
5. Estimate the Value of the Site: Isolate and estimate the value of the land or site, independent of any improvements.
6. Apply the Three Approaches to Value: Employ the sales comparison approach, cost approach, and income capitalization approach (when applicable) to derive independent indications of value.
7. Reconcile the Various Value Indicators to Reach a Final Value Estimate: Analyze and weigh the results from each approach to arrive at a single, supportable value conclusion.
8. Prepare and Deliver an Appropriate Appraisal Report: Communicate the findings, analysis, and conclusions in a clear, concise, and USPAP-compliant report.

The relationship between these steps can be represented as a system, where each step influences and is influenced by the others. Furthermore, each step adheres to a certain degree of scientific rigor, where assumptions are clearly stated, data is validated, and the chosen methods of analysis are explained.

III. Step 1: Defining the Appraisal Problem

Defining the appraisal problem is paramount. It involves understanding the client’s needs and the terms and conditions of the appraisal assignment. This step essentially answers the following questions:

1. What is to be Appraised?
2. When is it to be Appraised?
3. Why is it to be Appraised?
4. How is it to be Appraised?

Answering these questions sets the stage for a focused and effective appraisal process.

A. WHAT is to be Appraised?

Identifying “what” is to be appraised necessitates specifying three key elements:

1. The Real Estate: Precisely identify the subject property.
2. The Real Property Interest: Define the specific rights being appraised (e.g., fee simple❓❓, leasehold, easement).
3. The Standard of Value: Specify the type of value being sought (e.g., market value, fair market value, investment value).

Failing to properly identify these three elements would undermine the entire appraisal process.

1. Identification of the Real Estate

Real estate identification must be unambiguous. While a street address provides a common reference, a legal description offers the most accurate and definitive identification.

Legal Descriptions: There are three primary types:

• Metes and Bounds System: A system that describes property boundaries using distances (metes) and directions (bounds) from a known point of beginning (POB). This system is frequently used in areas with irregular land parcels.
  • Example: “Beginning at a point on the north side of Elm Street, 100 feet east of the intersection of Elm Street and Oak Street; thence east along the north side of Elm Street, 50 feet; thence north, 100 feet; thence west, 50 feet; thence south, 100 feet to the point of beginning.”

• Rectangular (Government) Survey System: This system divides land into a grid of townships, ranges, and sections. Townships are six miles square, containing 36 one-mile-square sections. This is prevalent in many parts of the US.

  • Example: “The NW 1/4 of the SE 1/4 of Section 22, Township 3 North, Range 2 East of the Principal Meridian.”

  • Calculation of Acreage: The area in acres❓ represented by a legal description in a rectangular survey system can be determined using the following equation:

    A = (640 acres) / (D1 * D2 * … Dn)

    Where:

    • A = acreage
    • 640 = acres in a section
    • D1, D2, … Dn = denominators of the fractional divisions (e.g., 4 for 1/4, 2 for 1/2)

    Example: NW 1/4 of the SE 1/4 = 640 / (4 * 4) = 40 acres

• Lot, Block, and Tract System: Uses plat maps recorded in county records. Properties are identified by lot and block numbers within a specific subdivision.

  • Example: “Lot 12, Block B, of the Sunny Acres Subdivision, as recorded in Plat Book 42, Page 18, in the records of King County, Washington.”

2. Identification of Real Property Interest

The bundle of rights associated with real property ownership includes the rights to possess, use, enjoy, exclude, and dispose of the property. An appraiser must clearly define which of these rights are being appraised. Common real property interests include:

• Fee Simple: The most complete form of ownership, granting the owner all possible rights.

• Leasehold Interest: The right to possess and use property for a specified period, granted by a lease agreement. The value of a leasehold interest can be calculated using discounted cash flow analysis. If the market rental rate is greater than the contract rental rate, the leasehold interest has value. The formula for calculating the present value of A leasehold advantage❓❓ is:

  PV = Σ [ (R_m - R_c) / (1 + i)^t ]

  Where:

  • PV = Present Value of Leasehold Advantage
  • R_m = Market Rent for the Period
  • R_c = Contract Rent for the Period
  • i = Discount Rate
  • t = Period Number

• Easement: A right granted to one party to use another party’s land for a specific purpose (e.g., access, utilities).

• Life Estate: Ownership for the duration of a person’s life.

3. Identification of the Standard of Value

The standard of value defines the type of value the appraiser is expected to estimate. The most common standard of value is market value, which 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. Other standards of value include:

• Fair Value: Typically used in financial reporting, often defined by accounting standards.
• Liquidation Value: The price that could be obtained in a forced sale, typically lower than market value.
• Investment Value: The value of a property to a specific investor, based on their individual investment criteria.

The choice of standard of value significantly impacts the appraisal methodology and the data considered.

B. WHEN is it to be Appraised?

“When” refers to two critical dates:

1. Effective Date of the Appraisal: The date as of which the value opinion is applicable. This date can be retrospective (past), current, or prospective (future).
2. Date of the Appraisal Report: The date the appraisal report is prepared.

The effective date is crucial because market conditions and property characteristics can change over time, impacting value.

C. WHY is it to be Appraised?

“Why” refers to the intended use of the appraisal and the intended users❓.

1. Intended Use: The purpose for which the appraisal is being performed (e.g., mortgage lending, estate settlement, tax assessment). The intended use dictates the scope of work and the level of detail required.
2. Intended Users: The parties who will rely on the appraisal report (e.g., lender, borrower, court). Identifying The Intended Users❓ helps the appraiser tailor the report to their specific needs and understanding.

D. HOW is it to be Appraised?

“How” encompasses the scope of work, assumptions, and limiting conditions.

1. Scope of Work: The extent of the research and analysis performed. This includes the data collected, the approaches to value applied, and the level of inspection conducted.
2. Assumptions: Statements that are taken to be true for the purpose of the appraisal. Assumptions should be reasonable and clearly disclosed. For example, assuming no environmental contamination.
3. Limiting Conditions: Factors that restrict the appraiser’s analysis or liability. These should be clearly stated in the appraisal report. For example, restricting the appraiser’s liability to the client and intended users only.

IV. Practical Applications and Experiments

A. Case Study: Defining the Appraisal Problem for a Mortgage Loan

Scenario: A homeowner wants to refinance their existing mortgage.

1. What: Single-family residential property; fee simple interest; market value. Legal description and property address are identified.
2. When: Effective date: current (as of the date of inspection); Report date: date of report preparation.
3. Why: Intended use: mortgage lending; Intended user: the lender.
4. How: Scope of work: standard appraisal with interior and exterior inspection, sales comparison approach; Assumptions: no hidden defects; Limiting conditions: liability limited to the lender.

B. Experiment: Impact of Scope of Work on Value

Hypothesis: Increasing the scope of work (e.g., expanding the number of comparable sales analyzed) will improve the accuracy and reliability of the value estimate, but will also increase the cost and time required for the appraisal.

Procedure: Conduct two appraisals of the same property. Appraisal 1 will have a limited scope of work (e.g., 3 comparable sales, limited market research). Appraisal 2 will have an expanded scope of work (e.g., 6 comparable sales, in-depth market analysis, interviews with local experts).

Analysis: Compare the value conclusions from each appraisal. Assess the degree of support for each conclusion and the overall credibility of the reports. Calculate the cost and time required for each appraisal.

Expected Results: Appraisal 2 will likely produce a more reliable value estimate with stronger support, but it will also require more time and resources.

V. Conclusion

Defining the appraisal problem and establishing the scope of work are the cornerstones of a credible valuation. By carefully considering the “what,” “when,” “why,” and “how” of the assignment, appraisers can ensure that their work is relevant, reliable, and compliant with USPAP standards. A thorough understanding of these initial steps is essential for mastering the art and science of appraisal.