Reconciliation and Critical Appraisal Review

Chapter 11: Reconciliation and Critical Appraisal Review

I. Introduction

Reconciliation and critical appraisal review are essential components of the cost approach to value in real estate valuation. Reconciliation is the process of analyzing the various value indicators❓ to arrive at a single, supportable opinion of value. Critical appraisal review involves a thorough examination of the appraisal process and report to ensure accuracy, consistency, and compliance with relevant standards. This chapter will delve into the scientific principles underpinning these processes, provide practical examples, and highlight their critical role in ensuring credible real estate valuations.

II. Reconciliation: Integrating Value Indicators

A. Definition and Purpose

Reconciliation is the systematic process of analyzing and weighing the value indications derived from multiple approaches (e.g., cost, sales comparison, income capitalization) or different data sets within the same approach, to arrive at a final, single opinion of value.
* It acknowledges that no single value indicator is perfect and aims to synthesize the most reliable information to achieve a supportable conclusion.

B. Underlying Scientific Principles

1. Statistical Inference:

   • Reconciliation relies on the principle that a combined estimate, weighted according to the reliability and relevance of its components, provides a more accurate reflection of the true value.
   • Formula: V = Σ(wᵢ Vᵢ), where V is the reconciled value, wᵢ is the weight assigned to value indicator Vᵢ, and Σwᵢ = 1.

2. Decision Theory:

   • Decision theory offers frameworks for making rational choices under uncertainty. Appraisers use decision-making principles to weigh the strengths and weaknesses of each value indicator, considering factors such as data quality, market relevance, and the appropriateness of the valuation technique.

3. Information Theory:

   • Information theory suggests that the value of information is related to its ability to reduce uncertainty. Appraisers assess the incremental value of each data point and valuation technique in reducing the uncertainty surrounding the final value opinion.

C. Process of Reconciliation

1. Data Review and Verification:

   • Ensure the accuracy of all data, calculations, and reasoning. Correct any errors and inconsistencies.
     • Example: Double-check all cost estimates, depreciation calculations, and sales adjustments.

2. Consistency of Application:

   • Apply all appraisal techniques consistently to the subject property and all comparables. Ensure uniform standards are used throughout the valuation process.
     • Example: If using the cost approach, apply the same depreciation methods to the subject and all relevant improvements.

3. Reliability Assessment:

   • Evaluate the reliability of each value indicator based on the amount of data, the level of accuracy, and the relevance to the appraisal problem.
     • Example: A value indicator based on a large, verified dataset is generally more reliable than one derived from limited or unverified information.

4. Inclusion and Analysis of Pertinent Data:

   • Ensure all pertinent data is included and analyzed. Avoid selective inclusion of data that supports a predetermined conclusion.
     • Example: Do not ignore comparable sales that suggest a lower value simply because they do not align with an initial estimate.

5. Compliance with Assignment Terms:

   • Confirm that value indicators are derived in accordance with the terms of the appraisal assignment.
     • Example: If the assignment requires a market value opinion, ensure all data and analysis are relevant to market participants.

D. Factors Influencing Reliability

1. Amount of Data:

   • Value indicators are more reliable when based on a larger statistical sampling of data.
   • Larger datasets reduce the impact of outliers and increase the stability of the estimate.
     • Example: Using 20 comparable sales is typically more reliable than using only 3.

2. Accuracy of Supporting Data:

   • accuracy depends❓ on how well the data has been verified.
     • Verification involves confirming the information with independent sources.
     • Example: Verify sales data with both the buyer and seller.

3. Relevance to the Appraisal Problem:

   • The relevance of a value indicator to the particular appraisal problem significantly influences its weighting.
   • Consistency with Assignment Terms: The indicator must align with the terms of the appraisal assignment.
   • Appropriateness of Technique: The appraisal technique used must be appropriate for the property type and market conditions.
     • Example: The income capitalization approach is most relevant for income-producing properties.

E. Practical Application: Weighting Value Indicators

Suppose an appraiser uses the sales comparison approach, cost approach, and income capitalization approach to value a commercial property. The initial value indications are:

• Sales Comparison: $1,050,000
• Cost Approach: $980,000
• Income Capitalization: $1,100,000

Based on the reliability and relevance of each approach, the appraiser assigns the following weights:

• Sales Comparison: 40%
• Cost Approach: 25%
• Income Capitalization: 35%

The reconciled value is calculated as:

V = (0.40 * $1,050,000) + (0.25 * $980,000) + (0.35 * $1,100,000) = $420,000 + $245,000 + $385,000 = $1,050,000

The reconciled value is $1,050,000.

III. Critical Appraisal Review: Ensuring Credibility

A. Definition and Purpose

Critical appraisal review is a systematic examination of an appraisal report and the underlying appraisal process to assess its completeness, accuracy, and compliance with relevant standards and guidelines.
* The goal is to ensure that the appraisal is credible, supportable, and free from bias or material errors.

B. Scientific Foundations of Appraisal Review

1. Audit Theory:

   • Similar to financial auditing, appraisal review applies structured methodologies to verify the integrity and reliability of the appraisal process and report.

2. Risk Assessment:

   • Appraisal review involves identifying and evaluating potential risks and uncertainties that could affect the validity of the appraisal’s conclusions.
     • Example: Evaluating the sensitivity of the value opinion to changes in key assumptions.

3. Compliance Theory:

   • Compliance theory emphasizes adherence to established standards, regulations, and ethical guidelines. Appraisal review assesses whether the appraisal complies with USPAP and other relevant requirements.

C. Process of Critical Appraisal Review

1. Scope of Work Assessment:

   • Verify that the scope of work is clearly defined and appropriate for the appraisal assignment.
     • Examine the appraisal problem, intended use, definition of value, and effective date.

2. Data Adequacy and Reliability:

   • Assess whether the data used in the appraisal is sufficient, accurate, and reliable.
     • Check data sources, verification methods, and any potential biases in data collection.

3. Methodology Evaluation:

   • Evaluate the appropriateness and correct application of the appraisal methodology.
     • Confirm that the valuation techniques are suitable for the property type, market conditions, and assignment requirements.

4. Reasoning and Analysis:

   • Examine the reasoning and analysis presented in the appraisal report to ensure it is logical, consistent, and well-supported.
     • Look for clear explanations, logical flow, and adequate support for all conclusions.

5. Compliance with Standards:

   • Verify that the appraisal complies with relevant standards and guidelines, including USPAP, regulatory requirements, and client-specific instructions.
     • Check for required certifications, disclosures, and adherence to ethical principles.

6. Report Clarity and Completeness:

   • Assess the clarity and completeness of the appraisal report to ensure it is easily understandable and provides all necessary information.
     • Check for clear writing, well-organized presentation, and inclusion of all required exhibits and documentation.

D. Practical Application: Identifying Deficiencies

During a critical appraisal review, the reviewer identifies the following deficiencies in a cost approach analysis:

1. Inadequate Depreciation Support:

   • The appraiser provides a depreciation estimate but fails to adequately support it with market data or relevant analysis.
     • Corrective Action: Require the appraiser to provide additional evidence supporting the depreciation estimate, such as age-life tables, market extraction data, or cost-to-cure analyses.

2. Inconsistent Cost Estimates:

   • The cost estimates used in the cost approach are inconsistent with industry standards and local construction costs.
     • Corrective Action: Request the appraiser to provide verifiable cost data from recognized sources (e.g., Marshall & Swift) or local contractors.

3. Omission of Relevant Data:

   • The appraisal omits relevant data that could affect the valuation, such as environmental reports or zoning restrictions.
     • Corrective Action: Instruct the appraiser to include and analyze the missing data to ensure a complete and accurate assessment.

IV. Practical Examples and Experiments

A. Experiment: Impact of Weighting on Reconciled Value

• Objective: To demonstrate how different weighting schemes in reconciliation can affect the final value opinion.
• Method:
  1. Gather three independent value indicators for a property (e.g., sales comparison, cost, income).
  2. Apply different weighting schemes to these indicators (e.g., equal weights, heavily weighted towards one approach).
  3. Calculate the reconciled value for each weighting scheme.
  4. Analyze how the final value opinion changes with different weighting schemes.

B. Case Study: Critical Appraisal Review and Error Identification

• Objective: To identify common errors and deficiencies in appraisal reports through critical review.
• Method:
  1. Obtain several appraisal reports for similar properties.
  2. Conduct a critical appraisal review of each report using a standardized checklist.
  3. Document all identified deficiencies, errors, and inconsistencies.
  4. Analyze the frequency and impact of each type of deficiency.

V. Mathematical Formulas and Equations

A. Reconciled Value:

V = Σ(wᵢ Vᵢ)

Where:

• V = Reconciled value
• wᵢ = Weight assigned to value indicator i
• Vᵢ = Value indicator i
• Σwᵢ = 1 (Sum of all weights equals 1)

B. Simple Percentage Adjustment Calculation:

Adjustment Amount = (Comparable Price) * (Percentage Difference)

VI. Conclusion

Reconciliation and critical appraisal review are vital to the cost approach in real estate valuation, ensuring that the final value opinion is well-supported, accurate, and credible. By applying sound scientific principles, conducting thorough analysis, and adhering to relevant standards, appraisers can provide reliable valuations that serve the needs of their clients and the integrity of the real estate market.