Mastering Appraisal Principles and Procedures

Chapter: Mastering Appraisal Principles and Procedures

Introduction:

This chapter, “Mastering Appraisal Principles and Procedures,” forms a cornerstone of the “Mastering Appraisal Reconciliation and Reporting” course. It delves into the scientific underpinnings and practical application of fundamental appraisal principles, equipping you with the knowledge and skills necessary for accurate valuation, confident reconciliation, and the creation of credible, defensible appraisal reports. Adherence to these principles, alongside USPAP compliance, ensures that your valuations meet the expectations of clients and stakeholders. We will integrate the material presented in Huber, Messick, and Pivar’s “Real Estate Appraisal Principles & Procedures” throughout this discussion.

I. Core Appraisal Principles: Scientific Foundation and Practical Applications

A. The Principle of Anticipation:

1. Scientific Basis: This principle rests on the economic concept of present value. The value of a property is not solely determined by its current use but by the anticipated future benefits (income, appreciation, use) it will provide. These anticipated benefits are discounted back to their present worth, reflecting risk and the time value of money.
2. Mathematical Representation: The present value (PV) of a future benefit can be represented by:

PV = FV / (1 + r)^n

Where:

FV = Future Value of the benefit
r = Discount rate (reflecting risk and opportunity cost)
n = Number of periods until the benefit is realized

3. Practical Application:
   a. Example: An appraiser estimating the value of a rental property must consider the anticipated future rental income. Factors such as lease terms, market rent trends, vacancy rates, and operating expenses are analyzed to project future cash flows.
   b. Experiment: Conduct a sensitivity analysis on the discount rate (r) used in the PV calculation. Observe how changes in the discount rate impact the present value, illustrating the importance of accurately assessing risk and opportunity cost.
4. Relation to the book content: It involves estimating income and analyzing the factors that can influence it, such as vacancy rates.

B. The Principle of Substitution:

1. Scientific Basis: This principle is rooted in basic economic theory. It states that a rational buyer will pay no more for a property than the cost of acquiring an equally desirable substitute. This principle underpins all three approaches to value (sales comparison, cost, and income).
2. Practical Application:
   a. Sales Comparison Approach: The principle of substitution is directly applied when selecting comparable sales. Adjustments are made to the sale prices of comparable properties to account for differences with the subject property, effectively creating a “substitute” property at a known price.
   b. Cost Approach: The estimated cost to construct a new, equivalent property (less depreciation) represents the upper limit of value, reflecting what a buyer would pay to obtain a substitute property.
3. Experiment: Gather sales data on similar properties in the same market. Calculate various measures of central tendency (mean, median) for the sale prices and key characteristics (square footage, lot size). Assess how closely these measures align, demonstrating the market’s tendency toward a “substitute price.”
4. Relation to the book content: The book’s content would discuss the importance of selecting comparable sales that are similar to the subject property.

C. The Principle of Supply and Demand:

1. Scientific Basis: This fundamental economic principle states that the price of a good or service is determined by the interaction of supply (the amount available) and demand (the desire and ability to purchase). In real estate, this principle is manifested in the availability of properties for sale and the willingness and ability of buyers to purchase them.
2. Practical Application:
   a. Market Analysis: Appraisers must analyze supply and demand factors in the relevant market area to understand how these forces are impacting property values.
   b. Identifying Market Trends: Changes in supply or demand can indicate emerging trends that may influence future property values.
3. Mathematical Representation: While a precise mathematical model is complex, a basic representation can be given as:

P = f(S, D)

Where:

P = Price
S = Supply
D = Demand
f = a function representing the relationship between supply, demand, and price.

4. Experiment: Track the inventory of available homes in a specific neighborhood over a six-month period. Simultaneously, monitor the number of closed sales. Analyze the relationship between inventory levels (supply) and sale prices (a proxy for demand).
5. Relation to the book content: This principle applies to the market analysis section.

D. The Principle of Highest and Best Use:

1. Scientific Basis: This principle dictates that a property’s value is determined by its most profitable and legal use, considering physical possibility, legal permissibility, financial feasibility, and maximum productivity. It is the foundation upon which all appraisal analysis rests.
2. Practical Application:
   a. Vacant Land: An appraiser must determine the most profitable use for vacant land, considering zoning regulations, market demand, and development costs.
   b. Improved Property: The appraiser must determine if the current use of an improved property represents its highest and best use. If not, the appraiser must consider alternative uses and their potential impact on value.
3. Analysis of the Four Tests: Each test (physical possibility, legal permissibility, financial feasibility, and maximum productivity) should be rigorously analyzed and documented.
4. Relation to the book content: The book content should present the four tests to determine the property’s value.

II. Appraisal Procedures: Ensuring Accuracy and Credibility

A. Data Collection and Analysis:

1. Scientific Basis: Rigorous data collection and analysis are crucial for developing credible appraisals. Statistical methods and spatial analysis techniques are employed to extract meaningful insights from market data.
2. Practical Application:
   a. Sales Verification: Thoroughly verify sales data with all parties involved (buyers, sellers, agents) to ensure accuracy.
   b. Market Area Delineation: Define the relevant market area based on economic and geographic factors.
   c. Statistical Analysis: Employ statistical methods such as regression analysis to identify key value drivers.
3. Experiment:
   a. Conduct a neighborhood survey to collect data on property characteristics, amenities, and recent sales.
   b. Use statistical software to perform a multiple regression analysis, identifying the independent variables that significantly influence sale prices.
   c. Assess the model’s goodness-of-fit (R-squared value) to evaluate its predictive power.
4. Relation to the book content: The book should include information about property characteristics and amenities.

B. Application of the Three Approaches to Value:

1. Sales Comparison Approach:
   a. Quantitative Adjustments: Apply quantitative adjustments (e.g., dollar amounts or percentages) to comparable sales to account for differences with the subject property. Support these adjustments with market data.
   b. Qualitative Analysis: Use qualitative analysis techniques (e.g., ranking, bracketing) to assess the overall comparability of sales.
2. Cost Approach:
   a. Cost Estimation: Use reliable cost data sources (e.g., Marshall & Swift, RSMeans) to estimate the reproduction or replacement cost of the improvements.
   b. Depreciation Analysis: Accurately estimate physical deterioration, functional obsolescence, and external obsolescence.
3. Income Capitalization Approach:
   a. Income Projection: Develop a realistic and supportable income projection, considering market rent trends, vacancy rates, and operating expenses.
   b. Capitalization Rate Selection: Derive a capitalization rate from market data or band-of-investment analysis.
   c. Relation to the book content: The book should present the three approaches to value as well as quantitative and qualitative data.

C. Reconciliation and Final Value Opinion:

1. Scientific Basis: Reconciliation is the process of critically evaluating the results of the different approaches to value and arriving at a single, supportable value opinion. This requires professional judgment and a deep understanding of the strengths and weaknesses of each approach.
2. Practical Application:
   a. Weighting the Approaches: Assign weights to each approach based on its relevance and reliability in the specific appraisal assignment. Explain the rationale for the weighting scheme.
   b. Addressing Discrepancies: Reconcile any significant discrepancies between the value indications from the different approaches.
   c. Final Value Opinion: State the final value opinion clearly and concisely, supported by the analysis and conclusions presented in the appraisal report.
3. Error Analysis: Evaluate potential sources of error in each approach and assess their impact on the final value opinion.
4. Relation to the course description: This section relates closely to the course description.

III. USPAP Compliance and Ethical Considerations

A. Uniform Standards of Professional Appraisal Practice (USPAP):

1. Adherence to USPAP is mandatory for all appraisal assignments. Understanding and applying USPAP standards is crucial for maintaining credibility and avoiding ethical violations.
2. Key USPAP Requirements:
   a. Competency Rule: Ensure you have the knowledge and experience required to perform the appraisal assignment competently.
   b. Ethics Rule: Conduct yourself with integrity and impartiality.
   c. Scope of Work Rule: Develop a credible scope of work that is appropriate for the intended use of the appraisal.
   d. Reporting Standards: Prepare an appraisal report that is clear, accurate, and not misleading.
3. Relation to the course description: This section relates closely to the course description.

B. Ethical Considerations:

1. Independence and Objectivity: Maintain independence and objectivity in all appraisal assignments. Avoid conflicts of interest and disclose any potential biases.
2. Confidentiality: Protect the confidentiality of client information.
3. Relation to the course description: This section relates closely to the course description.

Conclusion:

Mastering appraisal principles and procedures is essential for developing accurate, credible, and defensible appraisals. By understanding the scientific foundations of these principles, applying them in practical settings, and adhering to USPAP standards, appraisers can provide valuable services to clients and stakeholders. This chapter has provided a foundation for further exploration of appraisal reconciliation and reporting, preparing you to excel in this critical aspect of real estate valuation. The book content from Huber, Messick, and Pivar should be reviewed and integrated into this framework.