Foundations of Appraisal: History and Principles

Chapter: Foundations of Appraisal: History and Principles

Introduction

This chapter lays the scientific groundwork for understanding appraisal by exploring its history and core principles. Appraisal is not merely an art; it is a discipline rooted in economic theory, statistical analysis, and real estate principles. We will delve into the historical evolution of appraisal practices, tracing the development of standardized methods and ethical guidelines. Furthermore, we will examine the fundamental economic principles that underpin value, providing a framework for analyzing real estate markets and property characteristics.

1. A Historical Perspective on Appraisal

1.1 Early Practices and the Rise of Real Estate

Early forms of property valuation were often informal and subjective, relying on local knowledge and bartering systems. As real estate markets developed, the need for more objective assessments emerged. The role of appraisers grew in prominence during the 20th century, particularly with the expansion of mortgage lending and the increasing complexity of real estate transactions.

1.2 The Impact of Legislation and Standardization

The need for standardized appraisal practices became evident following financial crises and inconsistencies in valuation. Landmark legislation, such as the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989, played a pivotal role in establishing minimum standards for appraisals, creating the Appraisal Foundation, and requiring state licensing and certification for appraisers in federally related transactions.

1.3 The Appraisal Foundation and its Components

The Appraisal Foundation is a non-profit organization chartered by Congress to promote professionalism in appraisal. It comprises three independent boards:
1. Appraisal Standards Board (ASB): Develops, interprets, and amends the Uniform Standards of Professional Appraisal Practice (USPAP).
2. Appraisal Qualifications Board (AQB): Establishes minimum education, experience, and examination requirements for appraiser licensing and certification.
3. Appraisal Practices Board (APB): Issues voluntary guidance on recognized valuation methods and techniques.

2. Core Principles of Value

Appraisal is based on a set of fundamental economic principles that influence value. Understanding these principles is crucial for developing well-supported value opinions.

2.1 Supply and Demand

The principle of supply and demand states that market value is determined by the interaction of the availability of goods or services (supply) and the desire and ability of buyers to acquire them (demand).
* Equation: While there isn’t a direct mathematical formula, the relationship can be represented conceptually as:
* Value ∝ Demand / Supply
* This indicates that as demand increases, value tends to increase, and as supply increases, value tends to decrease.
* Practical Application: When analyzing a real estate market, appraisers assess factors affecting supply (e.g., new construction, zoning regulations) and demand (e.g., population growth, employment rates).
* Experiment: Conducting a market analysis to examine the relationship between housing starts (supply) and sale prices (demand) in a specific area can demonstrate the principle in action. Track data over time to observe trends.

2.2 Substitution

The principle of substitution states that a rational buyer will pay no more for a property than the cost of acquiring an equally desirable substitute. This principle forms the basis of the sales comparison approach to valuation.
* Practical Application: Appraisers identify comparable properties that offer similar utility and desirability to the subject property. Adjustments are made to the sale prices of the comparables to account for differences.

2.3 Anticipation

The principle of anticipation states that value is based on the expectation of future benefits to be derived from the property. These benefits may include income, appreciation, or personal enjoyment.
* Equation: The present value (PV) of an asset, reflecting anticipation of future income, is calculated using the following formula:
* PV = CF1 / (1 + r)^1 + CF2 / (1 + r)^2 + ... + CFn / (1 + r)^n
* Where:
* CF = Cash flow in a given period
* r = Discount rate (reflecting risk and opportunity cost)
* n = Number of periods
* Practical Application: When valuing income-producing properties, appraisers project future cash flows❓❓ and discount them to present value to estimate value.
* Experiment: Conduct a discounted cash flow analysis for a hypothetical investment property, varying the discount rate and projected cash flows to demonstrate the impact on present value.

2.4 contribution❓❓

The principle of contribution states that the value of a component of a property is measured by its contribution to the overall value of the property, not by its cost.
* Practical Application: An appraiser might analyze the impact of adding a swimming pool to a residential property. Even though the pool may cost $50,000 to install, it may only contribute $30,000 to the overall value of the property.
* Experiment: Conduct a paired data analysis by comparing sales prices of similar properties with and without a specific feature (e.g., a renovated kitchen) to isolate the contribution of that feature to value.

2.5 Conformity

The principle of conformity states that value is maximized when properties in an area are similar in style, size, and use.
* Practical Application: A property that is significantly different from its surroundings may experience a drag on value due to non-conformity.

2.6 Highest and Best Use

The principle of highest and best use states that the value of a property is based on its most profitable, legal, and physically possible use. The highest and best use analysis is a critical step in the appraisal process.
* Practical Application: An appraiser must determine the most appropriate use of a property, considering zoning regulations, market demand, and physical characteristics. For example, a vacant lot might be best suited for a single-family home, a retail store, or a parking lot.
* Experiment: Conduct a hypothetical highest and best use analysis for a vacant parcel of land, evaluating different potential uses and their associated values to determine the optimal use.

2.7 Change

The principle of change states that real estate values are dynamic and subject to constant change due to economic, social, political, and environmental forces.
* Practical Application: Appraisers must consider current market conditions and trends when developing value opinions. This includes analyzing factors such as interest rates, inflation, and demographic shifts.

2.8 Balance

The principle of balance states that value is created and maintained when there is equilibrium among the various factors of production (land, labor, capital, and entrepreneurship).
* Practical Application: An oversupply of labor or an undersupply of capital can negatively impact real estate values.

2.9 Increasing and Decreasing Returns

The principle of increasing and decreasing returns states that as additional increments of one agent of production are added to fixed amounts of other agents, net income will increase up to a certain point (increasing returns), after which net income will decrease (decreasing returns). This relates to the concept of marginal utility.
* Practical Application: Renovating a property can increase its value up to a certain point. Excessive renovations may not result in a commensurate increase in value.

2.10 Externalities

Externalities are factors outside of the property itself that can influence value, such as neighborhood amenities, environmental conditions, and zoning regulations.
* Practical Application: Proximity to a desirable school district or a major transportation hub can positively impact property values. Conversely, proximity to a landfill or a noisy highway can negatively impact values.

3. Real Property and Personal Property

Understanding the distinction between real property and personal property is essential for appraisers.
* Real Property: Land and anything permanently affixed to it. This includes buildings, fences, and other improvements. Real property rights constitute a “bundle of rights,” encompassing the right to possess, use, enjoy, and dispose of the property.
* Personal Property: Movable items that are not permanently affixed to the land. This includes furniture, appliances, and other portable items.
* Determining the difference relies on: Adaptability, Agreement of the parties, Intention, Method of Attachment and Relationship of the parties.

4. Estates in Real Property

An estate represents the degree, nature, and extent of interest one has in real property.
* Freehold Estates: Confer ownership rights for an indefinite period. The most common type is fee simple, representing the highest form of ownership. Another type is life estate.
* Leasehold Estates: Grant rights of possession and use for a specified period under a lease agreement. Types of leasehold estates include periodic tenancy, tenancy at sufferance, tenancy at will, tenancy for years.

5. Encumbrances

An encumbrance is a right or interest held by someone other than the property owner that affects the title or use of the property.
* Financial Encumbrances: Liens, which are claims against the property to secure payment of a debt.
* Non-Financial Encumbrances: Easements and restrictions that affect the use of the property. Examples include Easement, Emblement, Private Restrictions, and Profit a Prendre.

6. Legal Descriptions

A legal description precisely identifies a property’s location and boundaries. Common methods include:
1. Metes and Bounds: Describes the property by specifying its boundaries using distances (metes) and directions (bounds) from a designated starting point.
2. Lot and Block: Refers to a recorded subdivision plat that shows the property’s location within a specific lot and block.
3. Rectangular (U.S. Government) Survey: Divides land into a grid system using base lines, principal meridians, townships, and sections.

7. Types of Value

Appraisal assignments specify the type of value to be estimated. Common types of value include:

• Market Value: The most probable price a property should bring in a competitive and open market under all conditions requisite to a fair sale, with 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 particular investor based on their specific investment criteria.
• Insurable Value: The value of a property for insurance purposes.

8. Conclusion

Understanding the history and principles of appraisal is foundational for navigating the complexities of real estate valuation. By grounding appraisal practices in economic theory and standardized methods, appraisers can provide credible and reliable value opinions that support informed decision-making in real estate markets.