Understanding and Applying Adjustments

Chapter: Understanding and Applying Adjustments

This chapter delves into the crucial process of adjustments within the Sales Comparison Approach in real estate appraisal. We will explore the theoretical underpinnings, practical application, and potential pitfalls associated with this fundamental technique. The goal is to equip you with the knowledge and skills necessary to make reliable and defensible adjustments when estimating value❓.

1. The Scientific Basis of Adjustments

Adjustments in the Sales Comparison Approach are rooted in the economic principle of substitution. This principle states that a prudent buyer will pay no more for a property than the cost of acquiring an equally desirable substitute. The adjustments aim to make the comparable properties as similar as possible to the subject property❓, thereby isolating the impact of each difference on value.

• The Additivity Principle: This principle, fundamental to appraisal, suggests that the value of a whole property is equal to the sum of the contributory value of its various components or features. Adjustments directly relate to this concept by quantifying the individual contribution of each differing characteristic. For example, the presence of a garage contributes a certain amount of value, and the lack of a garage necessitates an adjustment.

• Paired Data Analysis: The most scientifically sound method for determining adjustment amounts is paired data analysis. This involves identifying two or more comparable sales that are virtually identical except for a single characteristic (e.g., the presence of a fireplace). The difference in their sale prices ideally represents the market’s perceived value of that feature.

  • Formula:

    • Adjustment Amount = Sale Price of Property with Feature - Sale Price of Property without Feature

  • Example:

    • Comparable A: Sold for $300,000 with a fireplace.
    • Comparable B: Sold for $295,000 without a fireplace (otherwise identical).
    • Adjustment Amount = $300,000 - $295,000 = $5,000 (Indicates a $5,000 adjustment).

  • Experiment: Conducting a market survey to identify paired sales provides empirical data for calculating adjustment amounts. This is akin to a controlled experiment where a single variable is manipulated to observe its impact. However, it is unlikely to find properties with only one differing feature.

• Statistical Analysis: When sufficient data is available, statistical methods like regression analysis can be used to estimate adjustments. Regression analysis can control for the influence of multiple variables simultaneously, providing a more robust estimate of individual feature contributions.

  • Multiple Linear Regression Model (Simplified):

    • SP = β0 + β1X1 + β2X2 + ... + βnXn + ε

      • SP = Sale Price (Dependent Variable)
      • β0 = Intercept (Base Value)
      • βi = Regression Coefficient (Adjustment Amount for Characteristic Xi)
      • Xi = Value or Indicator (e.g., 1 for “yes,” 0 for “no”) of characteristic i.
      • ε = Error term

    • For example: SP = β0 + β1(Living Area) + β2(Fireplace Present)

    • Statistical software estimates the β values, giving the adjustment for each characteristic.

2. Types of Adjustments

Adjustments address differences between the comparable sales and the subject property across several key elements. The proper order of adjustments (if used) attempts to reflect market participant reasoning.

• A. Property Rights Conveyed: Adjustments are made to account for differences in the bundle of rights being transferred (e.g., fee simple vs. leased fee). This is always the first adjustment.

  • Scientific Reasoning: The value of a property is directly tied to the rights the owner possesses. A property sold subject to a lease will inherently be worth less than a property sold in fee simple.

• B. Financing Terms: Unusual or creative financing terms can significantly impact the sale price. Adjustments are necessary to reflect the market value assuming typical financing. Cash Equivalent Analysis is critical here.

  • Formula (simplified for illustrative purposes):

    • Cash Equivalent Price = Published Sale Price - (Present Value of Below-Market Financing)
    • The Present Value is calculated using the market interest rate.

  • Example (from PDF): If a buyer secures a loan at 7% when the market rate is 9%, the seller effectively provided a price concession equal to the present value of the interest rate difference.

  • Application: Analyzing the terms of sale in publicly available documents or through interviews is essential for identifying non-market financing.

  • C. Conditions of Sale: This adjustment addresses circumstances that may have unduly influenced the sale price (e.g., a forced sale, a sale between related parties).

  • Practical Consideration: Often difficult to quantify precisely. Appraisers rely on market research and interviews to determine if a sale was truly at arm’s length.

• D. Market Conditions (Time Adjustment): Economic conditions can change over time, impacting property values. Time adjustments are necessary to reflect market appreciation or depreciation.

  • Formula (Straight-Line Appreciation):

    • Adjusted Price = Sale Price * (1 + (Appreciation Rate * Time Elapsed))

  • Example (from PDF): If prices increase at 5% per year, a property sold one year ago would need to be adjusted upwards by 5%.

  • Market research: Analyze sales trends in the subject’s market area. Look for resales of the same property over time.

  • E. Location: Neighborhood characteristics, access to amenities, and proximity to negative externalities (e.g., noise, pollution) can significantly influence value.

  • Scientific Principle: The “location, location, location” mantra is based on the principle of locational economics. A property’s accessibility and surrounding environment directly affect its utility and desirability.

• F. Physical Characteristics: This includes factors such as site size, building size, age, condition, quality of construction, and presence/absence of features like basements, garages, or fireplaces. (from PDF, example of unfinished basement)

  • Additivity Principle Applied: Each physical feature contributes to the overall value. Determine the marginal contribution of each feature.

  • Example (from PDF): Determining the value of a basement involves finding paired sales with and without basements to isolate the basement’s contribution to price.

  • G. Other Considerations: This may include elements like view, landscaping, or unique property features.

3. Applying Adjustments: Best Practices

• A. Quantitative vs. Qualitative Analysis:
  • Quantitative Adjustments: Whenever possible, use objective data and statistical methods to derive adjustment amounts.
  • Qualitative Analysis: In some cases (e.g., view), it may be necessary to use qualitative analysis, relying on market knowledge and professional judgment to make relative adjustments (e.g., “slightly superior,” “moderately inferior”).
• B. Magnitude of Adjustments:
  • Smaller adjustments are generally preferred. Comparable sales that require large adjustments are less reliable indicators of value.
  • Examine the overall percentage adjustment: If the net adjustment is higher than 25% or any single adjustment is higher than 10-15% of the sale price of the comparable, the appraiser should critically examine the use of the comparable.
• C. Consistency:
  • Apply adjustments consistently across all comparable sales.
  • Document the rationale for each adjustment clearly and thoroughly in the appraisal report.

4. Common Pitfalls and How to Avoid Them

• A. Circular Reasoning: Avoid using the subject property’s characteristics to justify adjustments. Adjustments should be based on market data, not on the appraiser’s preconceived notion of value.
• B. Over-Adjusting: Do not make adjustments for minor differences that are unlikely to impact market value.
• C. Ignoring Interaction Effects: The value of one feature may be dependent on the presence of another. Statistical methods like regression analysis can help identify interaction effects.
• D. Insufficient Data: Avoid making adjustments based on limited or unreliable data. Increase the sample size or rely more on qualitative analysis.
• E. Mechanical Application: Do not apply adjustment percentages or amounts without critically evaluating their relevance to the specific property and market conditions.

5. Exercises

• Refer to the exercises provided in the student handbook. The exercises will provide practical application of the concepts covered.

This chapter provides a comprehensive overview of understanding and applying adjustments in the Sales Comparison Approach. By understanding the scientific principles, types of adjustments, best practices, and potential pitfalls, you can develop the skills needed to make reliable and defensible value estimates.