Foundations of Appraisal Reconciliation: Identifying and Addressing Inconsistencies

Chapter: Foundations of Appraisal Reconciliation: Identifying and Addressing Inconsistencies

Introduction

Appraisal reconciliation is the critical process of transforming multiple value indications into a single, supportable opinion of value. This chapter delves into the scientific foundations of reconciliation, focusing on the identification and resolution of inconsistencies that can arise during the appraisal process. We will explore how to critically evaluate data❓, apply relevant principles, and reconcile discrepancies to arrive at a well-supported and reliable valuation. The goal of reconciliation is not simply averaging results, but rather synthesizing the information to determine the most credible value indication.

1. The Scientific Basis of Reconciliation

Reconciliation is not merely an art; it is a process grounded in scientific principles. It involves critical thinking, statistical reasoning, and a deep understanding of market dynamics.

1.1. Hypothesis Testing Framework

The appraisal process, and especially reconciliation, can be framed as a form of hypothesis testing.

• Null Hypothesis (H0): The market value of the subject property is X.
• Alternative Hypothesis (H1): The market value of the subject property is not X.

Each approach to value (sales comparison, cost, income) provides evidence to either support or reject the null hypothesis. Reconciliation involves evaluating the strength of evidence from each approach to determine the most likely market value.

1.2. Weighting and Statistical Inference

Reconciliation involves assigning weights to different value indications based on their reliability and relevance. This is analogous to weighting observations in statistical analysis.
Formula:

• V = Σ (wi * Vi)

  where:

  • V = Final reconciled value
  • wi = Weight assigned to value indication i
  • Vi = Value indication from approach i
  • Σ = Summation across all value indications

The assignment of wi is based on judgment, but it should be informed by statistical principles. For instance:

• Sample Size: Value indications derived from larger, more representative samples (e.g., a sales comparison approach with numerous, well-adjusted comparables) should receive greater weight. This is consistent with the principle that larger sample sizes lead to more reliable estimates.
• Variance: Value indications with lower variance (i.e., less dispersion in the data) are generally more reliable. This relates to the concept of standard error in statistical inference.
• Relevance: The relevance of each approach to the specific property type and market should influence the weight assigned. For example, the income approach may be less relevant for single-family homes.

1.3. Error Analysis

Understanding potential sources of error is crucial for effective reconciliation. Errors can be broadly categorized as:

• Systematic Errors (Bias): Consistent deviations from the true value. These can arise from flawed data, inappropriate adjustments, or biased judgment.
• Random Errors: Unpredictable variations that can inflate or deflate value indications. These are often due to market volatility or limitations in available data.
• Measurement Errors: Errors in the data collection or calculation process.

Reconciliation aims to minimize the impact of these errors by critically evaluating data sources, applying appropriate adjustment techniques, and exercising professional judgment.

2. Identifying Inconsistencies: A Systematic Approach

Identifying inconsistencies requires a thorough and systematic review of the appraisal report and supporting data.

2.1. Internal Consistency Checks

Internal consistency refers to the coherence of data and analysis within the appraisal report itself.

• Data Consistency: Verify that key data points (e.g., property size, age, features) are consistent across all sections of the report, and that those values are properly referenced to supporting documentation.
  • Example: The building area listed in the property description should match the area used in the cost, sales comparison, and (if applicable) income approaches.
• Logical Consistency: Ensure that the analysis follows a logical and supportable reasoning.
  • Example: Adjusting the cost approach for a functional problem (e.g., a poor floor plan) without addressing it in the sales comparison approach creates an inconsistency.
• Procedural Consistency: Confirm that the same techniques and procedures are applied consistently throughout the appraisal process.
  • Example: Using different depreciation methods in the cost approach without justification is inconsistent.

2.2. External Consistency Checks

External consistency refers to the alignment of the appraisal with market data and expert knowledge.

• Market Data Validation: Verify the accuracy and reliability of market data used in the sales comparison and income approaches.
  • Experiment: Contacting the parties involved in comparable sales or rentals to confirm the reported terms and conditions. This is a direct empirical experiment.
• Principle of Substitution: Assure that comparable sales and rentals are truly substitutable for the subject property. A rational buyer won’t pay more for a property than the cost of an equally desirable alternative.
• Highest and Best Use Consistency: Determine that data selection and analysis are aligned with the property’s highest and best use, both as vacant and as improved.
  • Example: Valuing the land under one use and the building improvements under another use violates the consistent use rule.
• Market participants❓’ Perspective: Understanding what is relevant to market participants’ behavior is crucial. If market participants focus on cash flow analysis, the income capitalization approach will be most significant. If the market compares existing properties with new construction costs, the cost approach is the most significant.

2.3. Checklist for Identifying Inconsistencies

• Checklist: A detailed checklist, as described in the provided text, should be used to meticulously evaluate each element of the appraisal, ensuring consistency and accuracy. This includes:
  • Techniques, calculations, and adjustments
  • Logic and consistency with the highest and best use
  • Applicability of the principles of each approach
  • Reliability and accuracy of market data
  • Property features and condition across all approaches
  • Effective date of appraisal
  • Limiting conditions

3. Addressing Inconsistencies: Mitigation Strategies

Once inconsistencies are identified, appraisers must address them in a transparent and supportable manner.

3.1. Data Refinement and Verification

If inconsistencies stem from data errors, the first step is to refine and verify the data.

• Source Verification: Return to original data sources to confirm accuracy.
• Statistical Outlier Analysis: Identify and investigate outliers that may be skewing results.
• Sensitivity Analysis: Assess how changes in input data affect the final value indications.

3.2. Adjustment Refinement

Inconsistencies may arise from inappropriate adjustments.

• Paired Sales Analysis: Employ paired sales analysis to refine adjustment amounts. This involves comparing properties that are identical except for one characteristic.
• Regression Analysis: Utilize regression analysis to quantify the relationship between property characteristics and value.
• Expert Consultation: Consult with other appraisers or industry experts to validate adjustment techniques.

3.3. Justification and Explanation

Even after data and adjustments are refined, some discrepancies between value indications may remain. In such cases, appraisers must provide clear and well-reasoned justifications for the weights assigned to each approach.

• Transparency: Clearly explain the rationale for emphasizing one approach over others.
• Market Support: Support the weighting scheme with evidence from the market, demonstrating that market participants prioritize certain factors.
• Limitations: Acknowledge any limitations in the data or methodology that may affect the reliability of the value indications. If the value opinion is marginalized by a lack of comparable data, say so in the report and tell the client that the value opinion is your best possible estimate but the complexity of the appraisal problem resulted in a value opinion with less support than is typical. Do not try to sell a weak value opinion as a well-supported one.

3.4. Mathematical Tools and Methods

• Weighted Average Cost of Capital (WACC) in Income Approach reconciliation:
• Formula:
  WACC = (E/V * Re) + (D/V * Rd * (1 - Tc))
  Where:
  E = Market value of equity
  D = Market value of debt
  V = Total value of capital (E + D)
  Re = Cost of equity
  Rd = Cost of debt
  Tc = Corporate tax rate

Adjusting Capitalization Rate Components: When reconciling the Income Approach, understanding and adjusting the components of the capitalization rate is crucial. The direct capitalization method relies on a single rate, but this rate encapsulates several underlying factors such as risk, return on investment, and market expectations. It’s essential to dissect the cap rate into its components to understand its sensitivity to market changes and to reconcile it with other approaches.

3.5. Specific examples

• Functional Curable Obsolescence: As noted in the provided text (Page 599-600), it is illogical to claim that an in-ground pool is worthless but also to say that there is no apparent functional obsolescence. A functional problem such as a poor floor plan should be addressed in both the cost and sales comparison approach.
• Depreciation Extraction: Regarding the depreciation extraction table (Page 623-624), inconsistencies in how depreciation is applied must be addressed. If an item (e.g., garage door opener) was not in the overall depreciation extraction, the cost to repair it should not be subtracted from the overall cost estimate. Conversely, if the item was included in the estimate, the cost should be subtracted.

4. Final Opinion of Value and the Range of Values

Most appraisal assignments require appraisers to develop a single, most probable opinion of market value.
Final Value Opinion: A single point estimate is not required by professional valuation standards, but most clients want or need one. The final value opinion should be rounded appropriately to eliminate any implication or unwarranted claim of precision or excessive accuracy. Rounding brings the estimate to a reasonable degree of accuracy consistent with the standards of the local market, the price level or range within which the value estimate falls, and the type of property involved.

Conclusion

Reconciliation is a science-based process that requires critical thinking, statistical reasoning, and a deep understanding of market dynamics. By systematically identifying and addressing inconsistencies, appraisers can improve the reliability and credibility of their value opinions. The ultimate goal is to provide a well-supported and defensible valuation that accurately reflects the market value of the subject property.