Appraisal Principles and Procedures

Chapter: Appraisal Principles and Procedures

Introduction

This chapter, “Appraisal Principles and Procedures,” forms the cornerstone of Mastering Appraisal Reconciliation and Reporting. It provides the scientific basis for real estate valuation, ensuring appraisal reports are credible, defensible, and compliant with USPAP standards. This understanding is critical for analyzing value indicators, reconciling conflicting data, and effectively communicating findings.

I. Fundamental Principles of Valuation

A. The Principle of Supply and Demand

1. Theoretical Foundation: The principle of supply and demand, a foundational concept in economics, directly influences real estate values. In a free market, prices are determined by the interaction of supply (the quantity of a property available) and demand (the desire and ability to purchase that property).

a. Mathematical Representation:
Let P = Price, Qs = Quantity Supplied, Qd = Quantity Demanded.
At equilibrium, Qd = Qs. The point where the supply and demand curves intersect determines the market price.

2. Practical Application: A surge in demand (e.g., due to population growth, job creation) coupled with limited supply (e.g., restricted zoning, geographic limitations) will drive prices upward. Conversely, an oversupply (e.g., new construction exceeding demand) will exert downward pressure on prices. Appraisers must analyze market trends to identify shifts in supply and demand dynamics.

3. Related Experiment: Conduct a market analysis by gathering data on building permits issued (supply) and sales volume (demand) in a specific area. Correlate these figures to changes in median home prices to empirically demonstrate the supply-demand relationship.

B. The Principle of Substitution

1. Theoretical Foundation: 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 property. This principle forms the basis of the sales comparison approach to value.

2. Practical Application: In the sales comparison approach, appraisers identify comparable properties that have recently sold and adjust their prices to reflect differences in features, location, and other relevant characteristics compared to the subject property. The adjusted sales prices of the comparable properties provide an indication of the subject property’s value.

3. Mathematical Representation:
   Subject Property Value ≈ Adjusted Sale Price of Comparable 1 ≈ Adjusted Sale Price of Comparable 2 ≈ Adjusted Sale Price of Comparable n

4. Related Experiment: Analyze a set of sales data for similar properties in a neighborhood. Identify differences in features (e.g., square footage, number of bedrooms, lot size). Quantify the value contribution of each feature using paired data analysis (comparing sales with and without the feature). This exercise illustrates how the principle of substitution is applied in practice.

C. The Principle of Anticipation

1. Theoretical Foundation: Property value is based on the present worth of the future benefits of ownership. This includes income generation, appreciation, and personal enjoyment.

2. Practical Application: This principle is fundamental to the income capitalization approach, where the value of a property is estimated based on the anticipated income stream it will generate. It also influences the sales comparison approach by considering factors such as future development potential or neighborhood improvements.

3. Mathematical Representation:
   Value = Σ (Expected Future Benefits / (1 + Discount Rate)^t) where t is time.

4. Related Experiment: Conduct a discounted cash flow analysis for an investment property. Vary the discount rate and projected income growth to observe the impact on the present value. This demonstrates how anticipation of future benefits influences current value.

D. The Principle of Conformity

1. Theoretical Foundation: Property values are maximized when properties are similar to other properties in the neighborhood. Extreme deviations from the norm, either positive or negative, can negatively impact value.

2. Practical Application: Conformity is crucial in neighborhood analysis. Properties that are significantly larger, smaller, or of a different architectural style than the surrounding properties may experience value penalties.

3. Related Experiment: Compare the sales prices of properties that conform to the neighborhood’s character with those that are non-conforming. Control for other variables (e.g., size, condition) to isolate the impact of conformity on value.

E. The Principle of Contribution

1. Theoretical Foundation: The value of a particular component of a property is measured by its contribution to the overall value, not by its cost.

2. Practical Application: This principle is important in cost approach and sales comparison adjustments. Adding a swimming pool may not necessarily increase the value of a property by the cost of the pool. The value is determined by how much buyers are willing to pay for the property with the pool compared to similar properties without one.

3. Related Experiment: Analyze sales of homes with and without specific amenities (e.g., a finished basement, a remodeled kitchen). Use regression analysis to determine the actual contribution of each amenity to the overall property value. Compare the contribution to the original cost of the amenity.

II. Appraisal Procedures: A Systematic Approach

A. Problem Definition

1. Identifying the Client and Intended Users: The appraiser must clearly identify the client and any other intended users of the appraisal report.
2. Identifying the Intended Use of the Appraisal: The appraiser must understand why the appraisal is being performed (e.g., mortgage lending, estate planning, litigation). This dictates the scope of work and the relevant market.
3. Identifying the Purpose of the Appraisal: The appraiser must define the type of value being estimated (e.g., market value, assessed value, insurable value).
4. Identifying the Effective Date of the Appraisal: The effective date is the date as of which the value opinion applies.
5. Identifying the Relevant Property Characteristics: The appraiser must gather information on the property’s physical characteristics, legal rights, and any other relevant factors that may affect value.

6. Defining the Scope of Work: Establish the extent of research and analysis necessary to develop credible results.
   B. Data Collection and Analysis

7. Market Analysis: Analyzing regional, national, and local economic trends to determine their impact on real estate values (See Principle of Supply and Demand).

8. Property-Specific Data: Gathering detailed information about the subject property, including its physical characteristics, location, and legal attributes.
9. Comparable Data: Collecting information on comparable properties that have recently sold or are currently listed for sale. This data will be used in the sales comparison approach.

C. Application of the Three Approaches to Value

1. Sales Comparison Approach: Comparing the subject property to similar properties that have recently sold, making adjustments for differences in features, location, and market conditions (Principle of Substitution).

• Data Verification: Scrutinizing comparable sales data to ensure accuracy and reliability. Verify information with involved parties.
• Quantitative Adjustments: Employing statistical methods (e.g., regression analysis) to quantify the value impact of specific property characteristics and refine sales comparison adjustments.

2. Cost Approach: Estimating the cost to reproduce or replace the subject property, subtracting accrued depreciation, and adding the land value.

• Depreciation Analysis: Applying engineering principles to estimate physical deterioration (wear and tear), functional obsolescence (outdated design), and external obsolescence (negative impacts from surrounding properties).

3. Income Capitalization Approach: Estimating the value of the property based on its potential to generate income. This involves estimating potential gross income, deducting operating expenses to arrive at net operating income (NOI), and then capitalizing the NOI to arrive at a value estimate.

• Discounted Cash Flow (DCF) Analysis: Modeling future cash flows❓❓ (including rental income, operating expenses, and potential resale value) and discounting them back to their present value using an appropriate discount rate. This approach considers the time value of money and the risk associated with the investment.

D. Reconciliation and Final Value Opinion

1. Analyzing the Strengths and Weaknesses of Each Approach: Evaluating the reliability and applicability of each approach based on the available data and the specific characteristics of the property.
2. Weighing the Indicators of Value: Assigning weights to each approach based on its reliability and relevance.
3. Developing a Final Value Opinion: Arriving at a single, supportable value estimate. The final value should reflect a careful consideration of all relevant data and analysis. This process involves considering all approaches to value and the relevance of each.
4. Report Writing: Preparing a clear, concise, and well-supported appraisal report that communicates the appraiser’s findings and conclusions. The report must comply with USPAP standards.

III. Adherence to USPAP Standards

A. Ethics Rule: Appraisers must adhere to the highest ethical standards, including impartiality, objectivity, and confidentiality.
B. Competency Rule: Appraisers must have the knowledge and experience necessary to perform the appraisal competently.
C. Scope of Work Rule: Appraisers must define the scope of work necessary to develop credible results.
D. Jurisdictional Exception Rule: Appraisers must be aware of and comply with any applicable laws or regulations that may affect the appraisal.
E. Reporting Standards: Appraisers must comply with the specific reporting requirements outlined in USPAP.

IV. Advanced Techniques for Value Reconciliation

A. Sensitivity Analysis: Conducting sensitivity analysis to assess how changes in key assumptions (e.g., discount rate, growth rate) affect the final value estimate.

B. Regression Analysis: Using statistical techniques to develop models that relate property characteristics to sales prices.

C. Geographic Information Systems (GIS): Using GIS software to analyze spatial data and identify trends in property values.

Conclusion

A thorough understanding of appraisal principles and procedures is essential for developing credible, defensible, and USPAP-compliant appraisal reports. By applying these principles and procedures in a systematic and rigorous manner, appraisers can provide clients with accurate and reliable estimates of value. This chapter has provided the scientific foundation, equipping appraisers with the tools and knowledge needed to master appraisal reconciliation and reporting, meeting client expectations and upholding professional standards.