Appraisal Fundamentals: Definitions, Standards, and Principles

Chapter: Appraisal Fundamentals: Definitions, Standards, and Principles

Introduction

This chapter lays the groundwork for understanding modern appraisal practices by defining core concepts, exploring relevant standards, and discussing fundamental appraisal principles. A solid grasp of these fundamentals is crucial for navigating the complexities of valuation in today’s dynamic market. We will delve into the theoretical underpinnings of appraisal and demonstrate how these concepts translate into practical application.

1. Core Definitions in Appraisal

• 1.1. Appraisal:

  • Defined as an opinion of value. It’s important to recognize that an appraisal is not a determination of fact, but rather a professional’s reasoned judgment, based on analysis and evidence.
  • USPAP defines Appraisal as: “(noun) the act or process of developing an opinion of value; an opinion of value. (Adjective) Of or pertaining to appraising and related functions such as appraisal practice or appraisal services.”
  • The opinion can be presented as a single point estimate, a range (e.g., \$250,000 - \$275,000), or as a relational statement (e.g., “not less than” or “not more than” a specified benchmark).
  • Example: An appraiser might conclude that the Market Value of a residential property is \$300,000, based on comparable sales, cost analysis, and income potential (if applicable).

• 1.2. Appraisal Practice:

  • Encompasses the various services provided by an appraiser, including appraisals, appraisal review, and appraisal consulting. It is distinct from valuation services, which can be provided by a broader range of professionals.
  • USPAP defines Appraisal Practice as: “valuation services performed by an individual acting as an appraiser, including but not limited to appraisal, appraisal review, or appraisal consulting.”

• 1.3. Value:

  • Represents the monetary relationship between properties and the individuals who interact with them as buyers, sellers, or users. Value is an economic concept and is always an opinion, never a fact.
  • USPAP defines Value as: “the monetary relationship between properties and those who buy, sell, or use those properties.”
  • The type of value being considered (e.g., market value, investment value, liquidation value) must be clearly defined in the appraisal.
  • Example: Market Value is often defined as the most probable price a property should bring in a competitive and open market, given specific conditions related to willing buyer/seller, reasonable exposure time, etc. Liquidation Value is the value that could be obtained in a forced sale.

• 1.4. Price:

  • The amount actually paid for a property in a specific transaction. Price can differ from value due to factors such as negotiation skills, urgency, or lack of information.

• 1.5. Cost:

  • The expenditure required to create or acquire a property. Cost does not always equate to value, particularly if the property is poorly designed, overbuilt, or located in an undesirable area.

2. Appraisal Standards and Regulations

• 2.1. The Appraisal Foundation:

  • A non-profit organization authorized by Congress to establish and maintain appraisal standards and appraiser qualifications. It oversees the Appraisal Standards Board (ASB), the Appraisal Qualifications Board (AQB), and the Appraisal Practices Board (APB).

• 2.2. Uniform Standards of Professional Appraisal Practice (USPAP):

  • Sets forth the ethical and performance standards for appraisers. Compliance with USPAP is mandatory for appraisers in the United States.
  • Key components of USPAP include:
    • Ethics Rule: Emphasizes integrity, impartiality, and objectivity.
    • Competency Rule: Requires appraisers to be competent to perform the assignment or to take necessary steps (e.g., partnering with a competent appraiser) to achieve competency.
    • Scope of Work Rule: Requires appraisers to properly define the scope of work necessary to produce credible assignment results.
    • Record Keeping Rule: Maintain workfiles for a specified period.
    • Reporting Standards: Define the content and format requirements for appraisal reports.

• 2.3. Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA):

  • Enacted in 1989, FIRREA requires state licensing or certification for appraisers involved in federally related transactions.
  • Federally related transactions typically involve loans insured or guaranteed by federal agencies (e.g., FHA, VA) or loans made by federally regulated financial institutions.

• 2.4. Appraisal Qualifications Board (AQB):

  • Establishes the minimum education, experience, and examination requirements for appraiser licensing and certification.
  • Different levels of licensure/certification exist (e.g., Licensed Residential Appraiser, Certified Residential Appraiser, Certified General Appraiser), depending on the types of properties that can be appraised.

• 2.5. Appraisal Standards Board (ASB):

  • Develops, interprets, and amends USPAP. The ASB publishes advisory opinions and FAQs to provide guidance on appraisal practice.

3. Fundamental Appraisal Principles

• 3.1. Principle of Supply and Demand:

  • Value is determined by the interaction of supply and demand in the market. When demand exceeds supply, prices tend to rise. Conversely, when supply exceeds demand, prices tend to fall.

  • Mathematical Illustration:

    • Let P = Price, D = Demand, and S = Supply.
    • A simplified model: P = f(D, S), where ‘f’ represents a function. An increase in D, holding S constant, generally leads to an increase in P.
    • Example: If new housing construction (supply) significantly lags population growth (demand) in a city, housing prices will likely increase.

• 3.2. Principle of Substitution:

  • A buyer will pay no more for a property than the cost of acquiring an equally desirable substitute property. This principle forms the basis of the sales comparison approach.
  • Example: A buyer seeking a 3-bedroom house in a specific neighborhood will compare the prices of similar 3-bedroom houses that have recently sold in the area.

• 3.3. Principle of Anticipation:

  • Value is influenced by the anticipated future benefits of ownership. Potential income streams, appreciation, and other factors can impact present value.
  • Present Value (PV) Calculation: PV = CF / (1 + r)^n
    • Where:
      • CF = Future Cash Flow
      • r = Discount Rate (reflecting risk and opportunity cost)
      • n = Number of Years
  • Example: A property located near a planned new transit station may experience an increase in value due to the anticipated benefits of improved accessibility.

• 3.4. Principle of Change:

  • Real estate values are not static; they are constantly changing in response to market forces and other influences. Appraisers must consider market trends and economic conditions.
  • Real Estate Cycle: The real estate market is cyclical, moving through phases of expansion, peak, contraction, and trough.
  • Example: A neighborhood that was once highly desirable may decline in value due to factors such as aging infrastructure or changes in demographics.

• 3.5. Principle of Conformity:

  • Value is maximized when properties conform to their surrounding environment. Similarity in architectural style, size, and quality enhances property values.
  • Example: A house that is significantly larger or more modern than the other houses in a neighborhood may not sell for as much as it would in a neighborhood with similar properties.

• 3.6. Principle of Contribution:

  • The value of an improvement is equal to the amount it contributes to the overall value of the property, not necessarily its cost.
  • Example: Adding a swimming pool to a property may cost \$50,000, but it may only increase the property’s value by \$30,000, depending on market conditions and buyer preferences.

• 3.7. Principle of Highest and Best Use:

  • The most probable and legal use of a property that is physically possible, appropriately supported, financially feasible, and results in the highest value. Highest and best use can be different for vacant land versus improved land.

4. Practical Applications and Examples

• 4.1. Determining Market Value:

  • Appraisers use the sales comparison approach, cost approach, and income approach to estimate market value. The sales comparison approach is often given the most weight for residential properties.

• 4.2. Appraising a Commercial Property:

  • The income approach is typically the primary method for valuing income-producing properties such as office buildings or shopping centers. Direct capitalization and discounted cash flow analysis are used.

• 4.3. Land Valuation:

  • Various methods can be used to value land, including the sales comparison approach, allocation method, and development method.

• 4.4. Addressing Non-Conforming Uses:

  • Appraisers must recognize and analyze the impact of legal non-conforming uses (uses that were legal when established but no longer comply with current zoning regulations).

5. Conclusion

This chapter provided an overview of essential definitions, standards, and principles underpinning appraisal practice. A firm understanding of these elements is foundational for conducting credible appraisals and navigating the complexities of the real estate market. Subsequent chapters will build on this foundation, exploring advanced appraisal techniques and the application of technology in modern valuation.