Principles and Procedures of Real Estate Appraisal

Mastering Real Estate Appraisal: Standards & Practices

Chapter Title: Principles and Procedures of Real Estate Appraisal

Introduction:

This chapter lays the foundational groundwork for mastering real estate appraisal. It delves into the fundamental principles and standardized procedures that underpin the appraisal process, ensuring accurate and defensible property valuations. Understanding these core concepts is crucial for complying with industry standards, particularly those mandated by secondary market participants like Fannie Mae and Freddie Mac, and for minimizing the risk of appraisal deficiencies. We will explore the theoretical underpinnings of value, the specific steps involved in the appraisal process, and how these elements contribute to a reliable and credible appraisal report.

1. Principles of Value:

The concept of “value” in real estate appraisal is nuanced and context-dependent. It is not simply the price paid but rather an opinion of the most probable price. Several key economic and appraisal principles influence value.

• 1.1. Principle of Supply and Demand:

  • Theory: This fundamental economic principle states that the price of a good or service (in this case, real estate) is determined by the interaction of supply and demand. High demand with limited supply leads to increased prices, while high supply with limited demand results in decreased prices.
  • Application: Appraisers must analyze local market conditions to assess the relative supply of comparable properties and the demand from potential buyers. This includes vacancy rates, days on market, and absorption rates.

  • Mathematical Representation: A basic representation, though vastly simplified, could be expressed as:

    • P = f(S, D)

      Where:
      * P = Price
      * S = Supply
      * D = Demand
      * f = indicates the price (P) is a function of supply (S) and demand (D)
      * Experiment: An appraiser analyzes two similar neighborhoods. Neighborhood A has a low vacancy rate (2%) and short average days on market (30 days), while Neighborhood B has a high vacancy rate (10%) and long average days on market (120 days). Holding all other factors constant, properties in Neighborhood A will likely have a higher market value due to the increased demand and limited supply.

• 1.2. Principle of Substitution:

  • Theory: A prudent buyer will pay no more for a property than the cost of acquiring an equally desirable substitute property. This principle is the foundation for the sales comparison approach.
  • Application: Appraisers identify comparable properties (comps) that offer similar utility and amenities to the subject property. Adjustments are made to the sales prices of the comps to account for any differences in features, location, or market conditions.

  • Mathematical Application: The adjusted sale price of a comparable property is calculated using:

    • ASP = SP ± A

      Where:
      * ASP = Adjusted Sales Price
      * SP = Sales Price of Comparable
      * A = Dollar Adjustment (positive or negative) reflecting differences between the subject and the comparable
      * Experiment: An appraiser finds two similar houses; one is 100 sq. ft. larger than the subject. Market analysis indicates a $50 per sq. ft. adjustment for size. Therefore, the comparable property will be adjusted downwards by $5,000 to reflect this difference.

• 1.3. Principle of Contribution:

  • Theory: The value of a component of a property (e.g., a swimming pool, an upgraded kitchen) is determined by the amount it contributes to the overall value of the property, not simply its cost.
  • Application: Appraisers assess the market reaction to specific property features. A $20,000 kitchen renovation may not necessarily add $20,000 to the property’s value. The appraiser must determine how much buyers are willing to pay for that upgrade.
  • Example: Adding a sunroom. Even if it cost $25,000 to build, it only adds $15,000 to the market value based on how buyers perceive the amenity.

• 1.4. Principle of Anticipation:

  • Theory: Property value is influenced by expectations of future benefits, such as future income potential or appreciation.
  • Application: Appraisers consider factors like zoning changes, planned infrastructure improvements, or economic development projects that may impact future property values.
  • Example: Property near a future subway station line.

• 1.5. Principle of Conformity:

  • Theory: Property values are maximized when properties in a neighborhood are similar in style, size, and quality. Properties that deviate significantly from the norm may experience a negative impact on value.
  • Application: Appraisers analyze the neighborhood’s homogeneity and identify any properties that are non-conforming.
  • Example: A large, modern house built among smaller, older homes.

• 1.6. Principle of Increasing and Decreasing Returns:

  • Theory: Investing additional capital into property improvements will increase property value up to a certain point (increasing returns). Beyond that point, additional investment will yield diminishing returns, and eventually, further investment may not increase the property value at all (decreasing returns).
  • Application: Appraisers must consider the cost-benefit ratio of property improvements and determine whether the investment is justified by the resulting increase in value.
  • Example: Remodeling a kitchen: A basic remodel may significantly increase value. A high-end remodel in a moderate neighborhood might not yield a comparable return.

• 1.7. Principle of Competition:

  • Theory: Profits tend to breed competition. Excessive profits in a particular real estate market will attract new entrants, increasing supply and potentially driving down prices.
  • Application: Appraisers monitor market trends and identify areas where increased competition may affect property values.

2. The Appraisal Process:

The appraisal process is a systematic series of steps designed to arrive at a credible opinion of value. Adherence to this process is critical for ensuring compliance with industry standards (e.g., USPAP – Uniform Standards of Professional Appraisal Practice) and satisfying the requirements of secondary market participants like Fannie Mae and Freddie Mac.

1. Problem Identification:

   • Clearly define the appraisal assignment, including the client, intended users, intended use, type of value (e.g., market value, insurable value), property rights to be valued (e.g., fee simple, leasehold), and the effective date of the appraisal.
   • Identify relevant characteristics of the property.
   • Application to Course Description: This step directly relates to “legal descriptions and acceptable practices.” Ensuring the correct property rights are valued is crucial for compliance.
   • Example: Appraisal to determine the market value of a single-family residence held in fee simple, for mortgage lending❓ purposes, with an effective date of [Date].

2. Scope of Work Determination:

   • Determine the extent of the data collection, analysis, and reporting required to develop a credible appraisal. This includes identifying the appropriate approaches to value (sales comparison, cost, and income), the level of detail needed in the data analysis, and the type of report to be prepared.
   • Document any limitations or extraordinary assumptions.
   • Application to Course Description: This addresses “data analysis” and “acceptable practices.”

3. Data Collection and Analysis:

   • General Data: Gather information on regional, national, and local economic conditions, demographic trends, and government regulations that may affect property values.
   • Specific Data: Collect data on the subject property (e.g., site characteristics, building characteristics, improvements), comparable properties, and market conditions. This includes information from public records, multiple listing services (MLS), and other reliable sources.
   • Data Verification: Verify the accuracy of the collected data through multiple sources and physical inspection when possible.
   • Analysis: Analyze the collected data to identify relevant market trends, determine the strengths and weaknesses of the subject property, and select the most appropriate comparable properties.

4. Application of Approaches to Value:

   • Sales Comparison Approach: Estimate value by comparing the subject property to similar properties that have recently sold. Adjustments are made to the sales prices of the comparables to account for any differences in features, location, or market conditions. This approach is often the most reliable for residential properties.
   • Cost Approach: Estimate value by determining the cost to reproduce or replace the subject property, less depreciation, plus the value of the land. This approach is often used for new construction or specialty properties.
     • Value = Cost of Reproduction or Replacement - Depreciation + Land Value
   • Income Approach: Estimate value based on the property’s potential to generate income. This approach is typically used for income-producing properties such as apartments, office buildings, and retail spaces.
     • Value = Net Operating Income / Capitalization Rate
   • Application to Course Description: Directly covers appraisal methods used to conduct “comprehensive property evaluations.”

5. Reconciliation of Value Indications and Final Opinion of Value:

   • Analyze the value indications derived from each of the approaches to value.
   • Reconcile the different value indications to arrive at a single, final opinion of value.
   • The reconciliation process involves weighing the reliability and relevance of each approach based on the specific characteristics of the subject property and the available data.
   • Consider: A Sales Comparison approach would be given the most weight for a single-family home.
   • Consider: The Income Approach carries the most weight when appraising an apartment building.

6. Report Definition and Final Report:

   • Clearly and accurately communicate the appraisal results in a written report.
   • The report must comply with all applicable standards and regulations, including USPAP.
   • The report must include a description of the property, the scope of work, the data and analysis used, the approaches to value, the reconciliation process, and the final opinion of value.
   • Certify the findings.
   • Application to Course Description: Ensures the appraisal meets “secondary market requirements” by following USPAP.

3. Common Appraisal Pitfalls & Avoiding Them:

Appraisal deficiencies can have significant consequences, including legal liability, regulatory sanctions, and financial losses. Avoiding these pitfalls is crucial for maintaining professional integrity and ensuring the accuracy and credibility of appraisals.

• 3.1. Failure to Properly Identify the Problem:

  • Pitfall: Incorrectly identifying the property rights being valued or the intended use of the appraisal.
  • Solution: Carefully review the appraisal request and clarify any ambiguities with the client. Ensure a thorough understanding of the legal description and the purpose of the appraisal.

• 3.2. Inadequate Scope of Work:

  • Pitfall: Failing to collect sufficient data or to employ the appropriate approaches to value.
  • Solution: Develop a comprehensive scope of work that addresses the specific requirements of the appraisal assignment. Consider all relevant data sources and approaches to value.

• 3.3. Biased Data Selection:

  • Pitfall: Selecting comparable properties that support a predetermined opinion of value.
  • Solution: Use objective criteria to select comparable properties, and document the rationale for their selection. Consider a wide range of comparables, even those that may not initially appear to support the desired value.

• 3.4. Inadequate Data Verification:

  • Pitfall: Failing to verify the accuracy of the data collected from various sources.
  • Solution: Cross-reference data from multiple sources and conduct physical inspections whenever possible. Verify sales data with both the buyer and seller, if feasible.

• 3.5. Use of Inappropriate Adjustments:

  • Pitfall: Applying adjustments to comparable properties without adequate justification or support.
  • Solution: Research and document the market reaction to specific property features. Use paired sales analysis to determine the appropriate adjustment amounts.

• 3.6. Failure to Reconcile Value Indications:

  • Pitfall: Failing to adequately explain the reconciliation process and the weighting assigned to each approach to value.
  • Solution: Clearly articulate the rationale for the reconciliation process and the reasons for assigning different weights to each approach.

• 3.7. Inadequate Report Writing:

  • Pitfall: Failing to clearly and accurately communicate the appraisal results in a written report.
  • Solution: Follow a standardized report format and ensure that the report is well-organized, easy to read, and free of errors.

• 3.8. Compliance Issues:

  • Pitfall: Failing to comply with USPAP, state regulations, and secondary market requirements.
  • Solution: Stay current with all applicable standards and regulations. Seek guidance from experienced appraisers and appraisal organizations.

4. USPAP and its relevance to appraisal procedures:

• USPAP dictates ethical standards in appraisal practice.
• Guides appraisal process, ensuring that property is valued accurately and fairly.
• Promotes transparent appraisal practice and avoids appraisal bias.

Conclusion:

Mastering the principles and procedures of real estate appraisal is essential for success in this field. By understanding the underlying economic principles, following a systematic appraisal process, and avoiding common pitfalls, appraisers can develop credible opinions of value that meet the needs of their clients and comply with industry standards. This chapter has provided a foundation for further exploration of specific appraisal techniques and applications, enabling you to excel in the field of real estate appraisal, particularly in navigating the complexities of secondary market requirements and ensuring the integrity of your appraisals.