Validating Appraisal Quality: A Reviewer's Role

Validating Appraisal Quality: A Reviewer’s Role

Introduction

Appraisal review is a critical process in ensuring the accuracy, reliability, and credibility of real estate appraisals. As an appraisal reviewer, you act as a gatekeeper, verifying that an appraisal adheres to established standards, utilizes sound methodologies, and ultimately, provides a well-supported and unbiased opinion of value. This chapter delves into the scientific principles and practical applications essential for effectively validating appraisal quality.

I. Understanding the Foundation: Appraisal Principles and Theories

Before examining an appraisal, it’s crucial to have a strong grasp of the underlying appraisal principles and economic theories that drive the valuation process. Deficiencies in the original appraisal often stem from misapplication or misunderstanding of these core concepts.

A. The Principle of Substitution:

This principle states that a rational buyer will pay no more for a property than the cost of acquiring an equally desirable substitute. This principle directly influences the sales comparison approach.
Mathematically, this can be expressed as:

VP <= CS1, CS2, …,CSn

Where:
VP = Value of the subject Property
CS = Cost of comparable substitute n

Practical Application: If an appraiser fails to consider available, comparable properties that are similarly priced, leading to an inflated value opinion❓ for the subject property, this principle is violated.

B. Supply and Demand

The principle of supply and demand is a fundamental economic concept that impacts property values. An understanding of current market conditions and how supply and demand forces are affecting value trends is critical to determine the appraisal validity.

Supply (S): The quantity of a commodity that producers are willing to sell at a given price and time.
Demand (D): The quantity of a commodity that consumers are willing to purchase at a given price and time.

Equilibrium Price (Pe): The price at which supply and demand are equal (S = D).
When S>D, Prices decrease
When D>S, prices increase

Practical Application:
Reviewers must analyze market data to determine if the appraisal report has accurately accounted for the current market conditions and any external factors that may be impacting supply and demand. For instance, an appraisal performed during a period of rapidly increasing interest rates should reflect the corresponding decrease in demand and its impact on sale prices.

C. Highest and Best Use Analysis

A valid appraisal must identify and analyze the highest and best use (HBU) of the property, which is defined as the most probable and legal use of a property, which is physically possible, appropriately supported, financially feasible, and that results in the highest value.

HBU is not a single theory, but a combination of legal, physical, financial, and market analysis.
Mathematically it can be represented as follows:

Maximize [NPV(Use1), NPV(Use2),…, NPV(UseN)]
Where NPV= net present value of use 1 to N

Where:
NPV(Use_i) = Present Value of Cash inflows - Present value of Cash outflows for a given use

Practical Application: If the appraisal report does not include a complete and well-supported highest and best use analysis, or uses HBU analysis that is illogical, the conclusions may not be valid. The reviewer is responsible for determining if the HBU is valid.

II. Reviewer Competency and Professional Standards

A. Competency Requirements:

1. Property Type: Reviewers must possess in-depth knowledge of the specific property type being appraised (e.g., residential, commercial, industrial, land). This includes understanding unique characteristics, market dynamics, and relevant valuation techniques.
2. Valuation Methods: Reviewers must be proficient in all three approaches to value (sales comparison, cost, and income capitalization) and understand when each approach is most applicable and how to properly apply them.
3. Market Area: Reviewers must have a thorough understanding of the local market area, including economic conditions, demographic trends, and real estate market activity.

B. Professional Standards:

1. USPAP (Uniform Standards of Professional Appraisal Practice): USPAP is the ethical and performance standard for appraisers. Reviewers are required to follow standard 3❓❓ when performing review assignments.
2. Independence and Objectivity: Reviewers must maintain independence and objectivity throughout the review process, avoiding any conflicts of interest or biases that could compromise the integrity of their opinion.

III. Scope of Work in Appraisal Review

The scope of work defines the extent of research and analysis performed in a review assignment. Reviewers should have an in-depth understanding of the scope of work standards that must be complied with.

A. Data Verification:

1. Sales Data: Reviewers should verify the accuracy of sales data used in the sales comparison approach, including transaction dates, sale prices, financing terms, and property characteristics.
   Example: Checking MLS records, public records, and interviewing parties involved in the transaction.
2. Cost Data: Reviewers must scrutinize cost data used in the cost approach, ensuring it is current, relevant, and reflects the specific property being appraised.
   Example: Verifying cost estimates with reputable construction cost data sources.
3. Income and Expense Data: Reviewers need to validate income and expense data utilized in the income capitalization approach, examining lease agreements, rent rolls, operating statements, and market surveys.
   Example: Comparing the subject property’s operating expenses with those of comparable properties.

B. Methodology Validation:

1. Sales Comparison Approach: Reviewers need to evaluate the selection of comparables, adjustments made, and overall reliability of the analysis.
   Quantitative Analysis Example:
   Paired Data Analysis: Extracting and analyzing differences between similar properties to quantify the value adjustments, can be expressed as:
   Adjustment = Selling Price(Property A) - Selling Price(Property B),
   if property A and B are same except one feature
2. Cost Approach: Evaluate depreciation estimates, land value estimates, and the accuracy of the cost estimates.
3. Income Capitalization Approach: Reviewers need to evaluate the appropriateness of the capitalization rate, discount rate, and income projections.

C. Report Compliance:

1. USPAP Compliance: Reviewers need to ensure the appraisal report complies with all relevant USPAP requirements, including those related to reporting, scope of work, and ethics.
2. Client Requirements: Appraisals often have to meet specific requirements established by the client (lenders, investors, government agencies). The reviewers must verify compliance with these requirements.

IV. Common Errors and Deficiencies in Appraisals

A. Inadequate Market Analysis:
This includes the failure to identify relevant market trends, competitive properties, and supply and demand factors.
Example: A lack of supporting documentation on vacancy rates.

B. Improper Application of Valuation Techniques:
This encompasses the misuse of sales comparison, cost, or income capitalization approaches, leading to inaccurate value conclusions.
Example: The use of inappropriate comparables in the sales comparison approach.

C. Unsupported Adjustments:
Adjustments made in the sales comparison approach must be based on market evidence and sound reasoning.
Example: Lack of sufficient evidence on the adjustment of GLA
D. Lack of Credible Data:
The use of outdated, unreliable, or irrelevant data can significantly compromise the appraisal’s credibility.
Example: The use of outdated sales data from a drastically different market environment.

V. Providing a Supported Review Opinion

A. Communicating the Review Findings:

1. Clearly articulate strengths and weaknesses of the appraisal.
2. Provide specific examples and supporting data to justify your opinion.
3. Maintain a professional and objective tone.

B. Developing an Independent Opinion of Value:

If the scope of work requires it, reviewers must develop their own independent opinion of value.
This opinion must be supported by market data and sound reasoning, even if it differs from the original appraisal.

C. Reporting the Review Results:

The appraisal review report must comply with USPAP standards.

Mathematical Justification:

A reviewer might recalculate the capitalization rate using current market data and determine that the original appraisal used a rate that was too low. The impact on value can be calculated as follows:

Original Value = Net Operating Income / Original Capitalization Rate
Revised Value = Net Operating Income / Revised Capitalization Rate

Where the reviewer can use market data to estimate the revised Capitalization rate and NOI is held constant

VI. Tools and Resources for Appraisal Reviewers

A. Data Sources:

1. Multiple Listing Services (MLS).
2. Public Records (County Assessors, Recorders).
3. Commercial Data Providers.
4. Real Estate Market Reports.

B. Software and Technology:

1. Appraisal Review Software.
2. Geographic Information Systems (GIS).
3. statistical analysis❓ Software.

Conclusion

The role of the appraisal reviewer is critical in upholding the integrity and reliability of the real estate valuation process. By mastering the principles and techniques outlined in this chapter, you will be well-equipped to identify and address deficiencies in appraisal reports, ensuring that they meet the highest standards of accuracy, objectivity, and credibility. Remember that your expertise protects lenders, investors, and consumers, contributing to the stability and transparency of the real estate market.