Appraisal Problem Definition and Scope

Chapter 3: Appraisal Problem Definition and Scope

I. Introduction

This chapter delves into the critical initial steps of the appraisal process: defining the appraisal problem and determining the resources necessary to solve it. Understanding these foundational elements is crucial for developing credible appraisals that adhere to the Uniform Standards of Professional Appraisal Practice (USPAP). Many older texts have historically combined or omitted the preliminary analysis step, but modern appraisal practice recognizes its importance as a distinct phase. While we will present the steps sequentially, it’s important to note that, in practice, these steps often overlap and inform each other. Data collection, for instance, can begin before the appraisal problem is fully defined, and analysis occurs throughout the process. The appraisal process is a unified whole.

II. Step 1: Defining the Appraisal Problem

The first step in the appraisal process is to define the appraisal problem. This is essentially framing the question that the appraisal seeks to answer. It involves understanding:

• The client’s needs (why they are hiring the appraiser – what information do they seek?)
• The specific terms and conditions of the appraisal assignment (how the appraisal will be conducted)

Defining the appraisal problem requires answering four fundamental 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?

A. WHAT is to be Appraised?

Determining “what” is to be appraised involves identifying three key elements:

1. The Real Estate: The physical land and any improvements attached to it.
2. The real property interest❓❓: The bundle of rights associated with the real estate (e.g., fee simple, leasehold, life estate).
3. The Standard of Value: The type of value being sought (e.g., market value, investment value, assessed value).

The appraisal report❓ must unambiguously identify these elements.

1. Identification of the Real Estate

While a common address or building name can be used, the legal description❓❓ is paramount for accuracy and to avoid ambiguity.

• Importance of Legal Descriptions: Legal descriptions precisely delineate the boundaries of the property, eliminating potential confusion.

Example:

Building Name: The Smith Tower, an office building
Common Address: 1024 Western Avenue, Seattle, Washington
Legal Description: Lot 17, Division 3, Pierce Addition, City of Seattle, County of King, as recorded in King County, Washington

An appraisal may include all of the above, but must include the legal description.

• Obtaining Legal Descriptions: The appraiser can obtain the legal description from the client, property owner/manager, real estate broker, or county records office. Unless otherwise agreed, the appraiser is generally not responsible for verifying the accuracy of the legal description.
• Types of Legal Descriptions: There are three primary systems:
  1. Metes and Bounds System
  2. Rectangular (Government) Survey System
  3. Lot, Block, and Tract System

These systems will be discussed in detail in Chapter 4.

2. Identification of the Real Property Interest

The real property interest defines the scope of ownership rights being appraised. This is crucial because different property rights have different values.

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

• Leasehold Interest: The right to use and occupy a property for a specified period under the terms of a lease agreement. The value of the leasehold is dependent on the contract rent versus the market rent.

  • Let CR represent the contract rent (rent specified in the lease).
  • Let MR represent the market rent (rent the property could command in the open market).
  • Let PV represent the present value.
  • Let n represent the lease term.

  The value of the leasehold interest (LHI) can be approximated using the present value of the difference between the market rent and the contract rent over the lease term:

  LHI = PV of Σ (MR - CR) for periods 1 to n.

  (This assumes rents are paid annually for simplicity, can be adjusted for other payment frequencies.)
  If MR > CR, the lessee has a positive leasehold interest. If MR < CR, the lessee has a negative leasehold interest (burden).

• Life Estate: Ownership rights that exist only for the duration of someone’s life (the “life tenant”).

  • The value of a life estate is mathematically related to the expected lifespan of the life tenant, often derived from actuarial tables.

  Let V represent the total property value.
  Let LE represent the life estate value.
  Let R represent the appropriate discount rate (reflecting risk and opportunity cost).
  Let n represent the expected remaining lifespan of the life tenant.

  The life estate value is roughly: LE = V * (1 – (1 + R)^-n )
  (This is a simplified approximation. Actuarial tables and more complex calculations are typically used in practice.)

3. Identification of the Standard of Value

The standard of value dictates the type of value the appraiser must estimate. This must be clearly defined and appropriate for the intended use of the appraisal.

• 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.

• Investment Value: The value of a property to a specific investor, based on their individual investment criteria (e.g., required rate of return, tax situation). Investment value may differ significantly from market value.

  • Let CF_t be the expected cash flow in period t.
  • Let r be the investor’s required rate of return.
  • Let n be the number of periods in the investment horizon.

  The investment value (IV) is:

  IV = Σ [CF_t / (1 + r)^t ] for periods 1 to n.

  This is a present value calculation reflecting the investor’s specific requirements.

• Assessed Value: The value assigned to a property by a taxing authority for the purpose of levying property taxes.

• Other Standards: Other standards include liquidation value, insurance value, and use value.

B. WHEN is it to be Appraised?

Determining “when” involves specifying two critical dates:

1. Effective Date of Appraisal: The date as of which the value opinion applies. This is not necessarily the date the appraisal is performed. It’s the specific point in time to which the analysis and opinion relate. Retrospective or prospective dates can be used.
2. Date of Appraisal Report: The date the appraisal report is completed and transmitted to the client.

These dates are crucial because market conditions can change significantly over time, impacting property values.

C. WHY is it to be Appraised?

Determining “why” requires identifying:

1. Intended Use: How the client intends to use the appraisal report (e.g., mortgage lending, estate planning, litigation support).
2. Intended Users: Who will be relying on the appraisal report besides the client? (e.g., lenders, investors, courts).

Understanding the intended use and users helps the appraiser tailor the scope of work, level of detail, and reporting format to meet their specific needs. For example, an appraisal for mortgage lending may require a higher level of due diligence than one for internal decision-making.

D. HOW is it to be Appraised?

Determining “how” encompasses:

1. Scope of Work: The extent of research, data collection, and analysis required to develop a credible appraisal. This includes the appraisal approaches used (sales comparison, cost, income), the extent of the market area analysis, and the depth of property inspection.
2. assumptions❓❓: Conditions or facts that are taken to be true for the purposes of the appraisal. These can include assumptions about market conditions, property usage, or future development plans. Extraordinary assumptions are those that, if found to be false, could alter the appraiser’s opinions or conclusions.
3. Limiting Conditions: Restrictions or limitations placed on the appraisal assignment that may affect the reliability or accuracy of the value opinion. Examples include limited property access, reliance on information provided by others, or exclusion of certain property components from the valuation.

Documenting the scope of work, assumptions, and limiting conditions is essential for transparency and to inform the intended users of any potential limitations on the appraisal’s conclusions.

III. Step 2: Preliminary Analysis

Preliminary analysis involves determining the necessary and available resources required to solve the appraisal problem. This includes:

• Identifying data sources: public records, MLS databases, market reports, etc.
• Assessing data availability and reliability.
• Determining the time and cost required to complete the assignment.
• Evaluating the appraiser’s competency to perform the appraisal.

This step helps the appraiser determine if the assignment is feasible and whether any additional expertise or resources are needed.

IV. Conclusion

Defining the appraisal problem and scoping the work are foundational to the entire appraisal process. A clear understanding of these elements is essential for developing credible, reliable, and USPAP-compliant appraisals. These initial steps guide all subsequent research, analysis, and reporting, ensuring that the appraisal effectively addresses the client’s needs and the intended use of the appraisal.