Appraisal Process: Data Analysis and Valuation Approaches

Chapter 4: Appraisal Process: Data Analysis and Valuation Approaches

Introduction

This chapter delves into the core of the appraisal process: data analysis and the application of valuation approaches. This knowledge is essential for understanding property rights and how easements, co-ownership, and partial interests impact property value. By mastering these techniques, you’ll gain the practical insights needed for informed real estate appraisal and investment decisions, as well as navigate the world of property rights with expertise.

I. The Appraisal Process: A Foundation for Data Analysis

The appraisal process is an eight-step framework guiding appraisers to a credible value estimate:

1. Defining the Appraisal Problem: Clearly identifying the scope, purpose, and property rights being appraised.
2. Preliminary Analysis: Determining the necessary data sources for the appraisal.
3. Data Collection: Gathering and verifying data from various sources.
4. Highest and Best Use Analysis: Determining the most profitable and legally permissible use of the property.
5. Site Valuation: Estimating the value of the land separately from any improvements.
6. Applying the Three Approaches to Value: Utilizing the Sales Comparison, Cost, and Income Approach❓❓❓❓es.
7. Reconciliation of Value Indicators: Weighing and synthesizing the value indications from each approach.
8. Reporting the Value Estimate: Presenting the appraisal findings in a clear and concise report.

II. The Importance of Site Valuation in the Appraisal Process

As outlined in the provided material, independent site valuation serves crucial purposes within the appraisal workflow:

• Foundation for Valuation Techniques: The cost approach and building residual technique explicitly require a distinct site valuation as a starting point.
• Legal and Regulatory Requirements: Property tax assessments and condemnation proceedings often mandate separate site and improvement valuations.
• Highest and Best Use Analysis: Evaluating the highest and best use “as if vacant” often necessitates determining the unimproved site value.

III. Delving into the Three Approaches to Value: Data Analysis and Application

The appraisal process culminates in applying three primary approaches to estimate value: the Cost Approach, the Sales Comparison Approach, and the Income Approach. Each approach utilizes distinct datasets and analytical methodologies, leading to a “value indication” that must be reconciled.

A. Cost Approach: Replicating Value Through Reconstruction

The Cost Approach theorizes that a property’s value is derived from the cost of acquiring the land and constructing a substitute structure, less any accrued depreciation.

1. Scientific Principles and Rationale:

   • Substitution Principle: A prudent buyer will not pay more for an existing property than the cost of acquiring a comparable site and constructing a functionally equivalent improvement.
   • Depreciation: Acknowledges the decrease in value of improvements due to physical deterioration, functional obsolescence, and external (economic) obsolescence.

2. Formulaic Representation:

   Property Value (Cost Approach) = Site Value + Cost New of Improvements - Accrued Depreciation

3. Data Analysis & Valuation Steps:

   1. Site Valuation: (Detailed methods discussed in Section IV).

   2. Cost Estimation (Improvements):

      • Reproduction Cost: Cost of creating an exact replica, using identical materials and design.
      • Replacement Cost: Cost of creating a functionally equivalent improvement using current materials and construction methods. (More commonly used).

   3. Depreciation Calculation:
      Depreciation is the reduction in value of an asset over time, due to wear and tear, obsolescence, or other factors. The appraiser needs to estimate the difference in value between the cost (new) of the improvements and their current value. The primary types of depreciation are:

      • Physical Deterioration: Loss of value due to wear and tear, age, and deferred maintenance.

      • Functional Obsolescence: Loss of value because the improvements are outdated in terms of design, layout, or features.

      • External Obsolescence: Loss of value due to factors external to the property itself (e.g., changes in zoning, increased traffic, economic downturn).

   4. Value Indication: Calculating the final value estimate using the Cost Approach formula.

4. Practical Application & Experiments:

   • Example: A house is built on a lot valued at $75,000. The estimated replacement cost of the house is $250,000. The appraiser determines accrued depreciation to be $30,000.
     Therefore: Property Value = $75,000 + $250,000 - $30,000 = $295,000.

   • Experiment (Comparative Analysis): Compare the Cost Approach value indication with those derived from the Sales Comparison and Income Approaches. Significant discrepancies warrant re-evaluation of data inputs, particularly depreciation estimates.

B. Sales Comparison Approach (Market Approach): Value Mirroring Market Transactions

The Sales Comparison Approach posits that a property’s value is directly related to the prices of comparable properties❓ recently sold in the same market.

1. Scientific Principles and Rationale:

   • Substitution Principle: A buyer will pay no more for a property than the cost of acquiring an equally desirable substitute.
   • Market Efficiency: Real estate markets, while not perfectly efficient, tend to reflect value changes in similar properties.

2. Formulaic Representation:

   Subject Value = Comparable Sales Price +/- Adjustments

3. Data Analysis & Valuation Steps:

   1. Comparable Selection: Identifying recent sales (within the last 6-12 months) of properties sharing key characteristics with the subject.
      Key characteristics: similar size, location, construction quality, age, amenities, legal rights (fee simple, easement, co-ownership rights), etc.

   2. Adjustment Process: Modifying the comparable sales prices to account for differences between the comparables and the subject property. Adjustments can be either:

      • Quantitative: Monetary or percentage adjustments to reflect specific differences.
        (e.g., $5,000 for an additional bathroom, 5% discount for inferior location).

      • Qualitative: Relative rankings (superior, inferior, similar) to assess overall comparability.

        Common Adjustments:

        • Financing Concessions: Adjustments for unusual financing terms or seller-paid closing costs.
        • Conditions of Sale: Adjustments for sales not at arm’s length (e.g., related parties, forced sales).
        • Market Conditions: Adjustments for changes in market conditions (e.g., increasing or decreasing prices) since the comparable sale date.
        • Location: Adjustments for differences in neighborhood desirability, proximity to amenities, etc.
        • Physical Characteristics: Adjustments for differences in size, condition, features, amenities, etc.

   3. Value Indication: Analyzing the adjusted sales prices to arrive at a value range and a single-point estimate for the subject property.

4. Practical Application & Experiments:

   • Example: A comparable property with two bathrooms sold for $300,000. The subject property has only one bathroom. Market data suggests a $5,000 adjustment for the missing bathroom.

     Subject Value = $300,000 - $5,000 = $295,000

   • Experiment (Sensitivity Analysis): Vary the adjustment amounts to assess the impact on the final value indication. Identify the most sensitive variables (i.e., those where even small changes in adjustment lead to significant value fluctuations).

C. Income Approach: Value as a Function of Income Generation

The Income Approach is predicated on the concept that a property’s value is determined by its capacity to generate income. This approach is most applicable to income-producing properties (e.g., rental apartments, office buildings, retail centers). When applied to single-family homes, this may take on the form of using Gross Rent Multipliers.

1. Scientific Principles and Rationale:

   • Anticipation Principle: Investors purchase income-producing properties in anticipation of future income streams.
   • Present Value: Future income is discounted to its present value, reflecting the time value of money and associated risks.

2. Formulaic Representation (Gross Rent Multiplier - GRM):
   Subject Value = Gross Monthly Income x GRM

3. Data Analysis & Valuation Steps:

   1. Comparable Selection: Identifying comparable rental properties in the same market.

   2. GRM Calculation: Calculate the GRM for each comparable:

      GRM = Sale Price / Gross Monthly Income

   3. GRM Analysis: Determine a reasonable GRM range from the comparable data.

   4. Value Indication: Apply the selected GRM to the subject property’s gross monthly income.

4. Practical Application & Experiments:

   • Example: Comparable rental properties have the following GRMs: 132, 133, 135, 135, 135, 140. The appraiser selects 135 as the multiplier. The subject has monthly rent of $1,525.
     Value by Income Approach = $1,525 x 135 = $206,000.
   • Experiment (Sensitivity Analysis): Altering the selected GRM based on differing estimates of the market and recalculating the value, for comparison.

IV. Site Valuation: Deconstructing Property Value from the Ground Up

As previously stated, separate site valuation is a crucial element in the appraisal process. The following methods are employed:

• Sales Comparison Method: (as detailed above in Approach to Value). This method involves identifying similar vacant land parcels, gathering relevant data, and applying adjustments.

• Allocation Method: This method involves estimating the value of an improved parcel of land as a percentage of the entire appraised property. This value is frequently obtained from the tax assessor.

• Extraction Method: Similar to the allocation method, but instead using a value from a specific element of comparison, such as physical characteristics.

• Development Method:This method may produce unrealistically high value conclusions if the highest and best use analysis is incorrect, income is either overstated or not properly graduated, all expenses are not accounted for properly, or the rate selected is either incorrect or improperly applied. The proper application of the development method utilizes advanced appraisal methodology and is described in more depth and detail in advanced income appraisal texts.

• Land Residual Method: The LAND RESIDUAL METHOD is a form of the income capitalization approach to value.

      The basic formula for income capitalization is:
      V = I ÷ R
  
  To apply the land residual technique, the appraiser must be able to reliably determine four critical pieces of data:
  1.  the value (depreciated cost) of the improvement,
  2.  the market capitalization rates for land,
  3.  the market capitalization rates for buildings, and
  4.  the property’s total net operating income.
  
  By multiplying the building capitalization rate times the value of the improvements, the appraiser can determine the amount of the property’s income that is attributable to the improvements (I = V x R). This amount is then subtracted from the total net income of the property to find the amount of income that is attributable to the land. Finally, the land income is converted to a value figure by means of the land capitalization rate.
  

• Ground Rent Capitalization Method: Groundrentcapitalizationisanothermeansofapplying the income capitalization approach to estimating the value of land.

  In a GROUND LEASE the tenant leases the land from the landlord, and constructs a building on the site. Ground leases are usually long-term leases of 50 or more years, to allow the tenant to have the use of building for the course of its useful life. The rent paid by the tenant of a ground lease is called GROUND RENT.

  When property is subject to a ground lease, its value can be estimated by capitalizing the amount of ground rent, using the formula V = I ÷ R. This is often more complicated than it sounds, however, since other factors (such as the amount of time remaining on the lease, any provisions for escalation of rent, etc.) must be taken into account.

V. Reconciliation: Synthesizing Value Indicators into a Final Opinion

The culmination of the appraisal process is reconciliation: weighting the value indicators produced by the Cost, Sales Comparison, and Income Approaches to arrive at a single, defensible estimate of value. Reconciliation is the process of analyzing the appraisal problem, selecting the most appropriate method of the three, and giving it the most weight in determining the final estimate of value.
The appraiser must consider:
* Data Reliability: The accuracy and verifiability of the data used in each approach.
* Approach Applicability: The relevance of each approach to the specific property type and market conditions.
* Market Evidence: The extent to which each approach reflects the behavior of buyers and sellers in the market.
Ultimately, reconciliation requires professional judgment and cannot be reduced to a purely mathematical exercise.
There is no set formula at all for reconciling the values. The process relies entirely on the judgment and ability of the appraiser to arrive at the most reliable estimate of value.

VI. Implications for Easements, Co-ownership, and Partial Interests

The valuation principles outlined above are particularly important when appraising properties with easements, co-ownership arrangements (e.g., joint tenancy, tenancy in common), or partial interests (e.g., leaseholds).

• Easements: Easements granting access or utility rights can either enhance or diminish a property’s value, depending on the nature and scope of the easement. The Sales Comparison Approach is critical for identifying similar properties with comparable easement burdens or benefits.
• Co-ownership: The type of co-ownership (joint tenancy, tenancy in common) can significantly impact marketability and value. Partition actions (legal proceedings to divide co-owned property) can trigger appraisal assignments to determine equitable distribution of assets.
• Partial Interests: Leaseholds, life estates, and other partial interests require careful analysis of the rights being transferred and their impact on the overall fee simple value of the property. The Income Approach is often used to value leasehold interests, while the Sales Comparison Approach can help determine the market value of comparable partial interests.

VII. Experiments and Additional Knowledge

To aid the acquisition of extra knowledge, the following list may be helpful:
* Perform data analysis based on location: By testing and experimenting with data analysis based on particular locations, the appraiser can have an advantage in finding and presenting important data.
* Use real world examples: By working with real world data, and applying that data to different calculations, the appraiser can more easily identify appropriate and relevant comparable sales.

VIII. Conclusion

A thorough understanding of data analysis and valuation approaches is paramount for accurate property appraisals, particularly when dealing with complex property rights. By applying these scientific principles, employing rigorous data analysis, and exercising sound judgment, appraisers can provide credible and defensible value estimates that inform real estate decision-making.