Its not magic – done correctly, a lot of work goes into the completion of an appraisal. In this essay, I will describe what an appraisal is and what it is appraisers do.
Appraisers estimate market value. Simply stated, Market Value is the price an informed buyer will pay and an informed seller will accept, assuming the property has had reasonable exposure on the open market. Both parties have to be acting in their own interest and not be atypically motivated. On the day of value (the “effective date”), we assume that all of these events have already occurred and render our opinion of what the price agreed upon would likely be.
The Start
The first step in conducting the appraisal is to inspect the subject property. We do this not just to familiarize ourselves with the subject, but to ascertain the subject's highest and best use. Highest and best use is the one most profitable use that is both physically and legally possible. The identification of the highest and best use is, in essence, the determination of why the subject has value and to whom. For example, it may not be appropriate to compare a house to sales homes that families bought, if the subject is surrounded by properties that have all been converted into professional offices. In this example, although the building is a house, we must examine the factors affecting demand by office buyers and the supply of office space.
In this first part of the process we look at all of the factors that impact the subject's value. This includes factors specific to the subject itself, such as its condition or whether there are any leases deed restrictions, as well as factors that are external to the subject. This might include the overall state of the economy or changes in the neighborhood. Developing this whole “plan of attack” is actually the most important part of the appraisal.
The Three Approaches
The next step is to consider the three approaches to value: The sales comparison approach, the cost approach and the income approach. Each approach may be performed, or, if in the appraiser's judgment, an approach is not appropriate, it may be omitted.
When appraising properties being bought by owner occupants, the sales comparison approach is typically given the most weight. Here we compare the subject to sales of similar properties. These sales are referred to as “comparable sale”. A comparable sale is simply one that a buyer might consider if contemplating the purchase of the subject. Whether a sale occurred recently, is nearby, sold at a certain price or has similar features does not make a sale a good comparable. Rather, it is a weighing of these features against the other comparables. The few that can best offer insight into the subject's value should be used. The most similar sale may have occurred quite some time ago. The least useful sale could be located next door. Remember, we are trying to find an answer to a question; we are not seeking support for a conclusion that is already known to us. An appraiser's knowledge of the local market is crucial in being able to weigh the appropriateness of a comparable.
Each sale is thoroughly researched to identify all of the comparable’s relevant characteristics. This data comes from municipal records, county records, local Realtors and their publications, or other appraisers. Every effort is made to verify pertinent facts with a principle to the transaction. When conflicting information is found, the data that seemed the most credible is used. Determining credibility is also up to the judgment of the appraiser and is based upon past dealings with the sources of information, the reasonableness of the information and correlation to other facts known by the appraiser. Because we do not make an interior inspection of each sale, information provided by others must be assumed to be accurate.
If a property that is absolutely identical to the subject, located right next door, just sold for $300,000, our subject is probably also worth $300,000. Unfortunately, it is very rare to find such a perfect comparable. Therefore, each comparable’s sales price must be adjusted in relation to the subject. If something about a comparable is superior to the subject, we subtract, if the comparable has an inferior attribute, we add. The amount of each adjustment comes from the marketplace, including the comparables themselves, conversations with knowledgeable professionals or depreciated cost. Here, the appraiser's experience and education play a vital role. The ability to identify which features the local marketplace values, and to what extent, is of paramount importance in arriving at a credible conclusion.
The comparable’s adjustments are totaled, resulting in a range of adjusted values. Within this range, the appraiser weighs the similarity of each comparable and their own degree of confidence in each adjustment. The approach ends with the selection of an estimate of the subject's value via the sales comparison approach.
The cost approach is used primarily as a test of reasonableness for the sale comparison approach. Appraisers are not contractors and are not qualified to produce a construction estimate for the subject. Rather, the appraiser relies upon published cost manuals, local knowledge and maybe even interviews with contractors. This enables the appraiser to reasonably estimate an approximate cost to replace the subject with a similar but not identical property.
After subtracting for depreciation, the result is added to an estimated land value (which is usually derived by its own sales comparison approach) to indicate the subject's value via the cost approach. Because of the difficulty and subjectivity associated with estimating depreciation, the cost approach is only reliable if the property is impacted by very little or very substantial depreciation.
The income approach is useful if the buyer's motivation includes the anticipation of income or, if renting a similar space is a viable option to buying. Valuing the subject in this manner requires deriving an estimate of the subject's anticipated income. As with the sales comparison approach, this estimate is made by comparing the subject to recently rented similar property. This data comes from the same sources as with the sales comparables, but interviews with agents, managers and owners become even more important.
If the subject's anticipated net income is to serve as the basis of valuation, the subject's expenses are forecast in the same manner. Last, the resulting forecast is multiplied by an appropriate factor, or divided by an appropriate rate to indicate the subject's value. This factor or rate is also derived from the marketplace, typically from other properties that were purchased based upon their income producing potential.
The Value Estimate
Finally, the quality of each approach is considered and a most probable value for the subject is estimated. This is not an averaging process, but rather a weighing of the strengths and weaknesses in each approach.
Returning to the definition of market value, the appraiser estimates the “most probable” value. Implicit in the terminology is the notion that other values may be possible, but less probable. Although one specific value conclusion is usually provided, it is a reasonable estimate of the most probable value. Actually a narrow range of possible values both above and below the estimate actually exists. If the property were shown to be worth $200,000, no reasonable appraiser would argue against a value of $199,000 or $203,000. This range is narrowed by the similarity of the data and widened by any dissimilarity. Unique properties may also have a broader range of possible values.
This range is not the result of error, but rather human emotion. Although specific patterns can be found among the features that contribute to value, there are sometimes less quantifiable factors unique to the buyer. A family may pay just a little more if their best friends live in the neighborhood and they want to be near to them. Therefore, any user of an appraiser's services would best be served to accept the appraiser's estimation of “most probable value” with the knowledge that a value that could be as much as a few percent higher or lower is possible, but less probable than the estimate actually rendered.
The procedures I have detailed comprise the entire appraisal process. However, Standard 1 of the Uniform Standards of Professional Appraisal Practice (USPAP) permits the appraiser to eliminate or modify some of the procedures described here. If the process is complete, that is if no departures from Standard 1 were made, the appraisal is referred to as a "Complete Appraisal". If any of the steps in the process are eliminated, or sometimes simply modified, the appraisal is said to be a "Limited Appraisal". Whether the process is complete or limited, the conclusion should be the same.
Regardless of the type of process, if the appraiser must rely upon an assumption, that must be fully disclosed. Likewise, if we must assume something as fact, when we know something else to be true (such as assuming that a proposed property already exists) that too must be prominently stated. The client must agree to something less than a complete process, as well as to appraiser's decision to rely upon any additional assumptions or hypothetical conditions.
The Report
After completing the appraisal, the appraiser must prepare an appraisal report. There are three report formats: Self-contained, Summary and Restricted use. Self-contained reports are typically associated with full narrative reports. They are fully documented and contain a very detailed description of all material facts and analysis. A summary report is briefer in that it summarizes most information, limits itself to pertinent facts and presents only summaries of all analysis. A restricted-use report contains only conclusions, with very little reporting of facts and analysis; rather than describing or summarizing, relevant facts and conclusions need only be stated. There is also a fourth format: an oral report. If an appraiser provides an oral report, there must be sufficient information retained in the appraiser's file to produce a report in a summary format.
The type of report has no bearing on the appraisal process. The type only refers to the format in which the findings are transmitted to the client. In all cases the format used is agreed upon by prior arrangement with the client; it is specific to their needs.
In conclusion, it is
important to remember that an appraisal is not a number, it is a process. If
the appraiser properly performs each of the steps described here, a credible
estimate of value will result.
Steven H. Berg, MAI, SRA lives in Portsmouth and is the owner of Sargent
Consulting, Ltd. He is a graduate of Connecticut College, where he earned a
Bachelor of Arts degree, cum laude, majoring in economics and sociology. Steven
has been appraising a variety of property types in New Hampshire’s Seacoast
area since 1987. He specializes in providing consulting services and litigation
support and has amassed considerable classroom education on a wide range of
related topics. Steven is both a residential and general member of the
Appraisal Institute. In addition, he is a member of the Portsmouth Housing
Endowment Fund Advisory Committee, is on the board of The Portsmouth Economic
Development Loan Program and serves on an advisory panel to the City’s
Assessing Office.