A Primer on Appraisals
October 5, 2001
Real estate appraisal typically brings to mind a purchase transaction in
which a lender needs an opinion of the value of the security offered for a
proposed mortgage loan. While such financed-sale transactions are certainly
among the more common uses of appraisals, real property valuations are also used
to help set offering or selling prices, to determine a basis for exchanges and
to inform investors whether to purchase mortgages, bonds or other securities.
Appraisals also are used extensively for litigation purposes, particularly in
condemnation and eminent domain proceedings, dispute resolution, and estimating
damages relative to construction defects or environmental impacts. Value
opinions are required for various tax matters including tax assessments, gift or
estate tax determinations, and determining the value of real estate for estate
planning purposes. In addition, appraisal consulting services are beneficial to
the planning and development of real estate projects at various phases such as
preliminary feasibility studies, cost/benefit analysis, establishing rent
schedules and lease provisions, and determining insurance coverage requirements.
What Is an "Appraisal?"
An appraisal is the act or process of developing an opinion of real
property's value and is to be distinguished from the term "appraisal
report," which refers to the written or oral communication of the
appraisal. The valuation process is a systematic procedure employed by an
appraiser to provide the answer to a client's question about the value of real
property. The role of the appraiser is to render services with independence,
objectivity and impartiality. Depending on the purpose of an appraisal, an
opinion of value will be based on a particular type of value, such as assessed
value, investment value, use value, going-concern value, or the most commonly
known type, market value.
Market Value: What Is It and How Is It Determined?
Market value is the focus of most real property appraisal assignments. As a
threshold concept, value must be defined. The term "value" is often
used by laypersons synonymously with "cost." Appraisers, however, use
"cost" relative to production rather than exchange, as, for example,
the development cost of a property, which includes acquisition costs of the land
and all expenditures to bring it to an operational state. To appraisers,
"value" is defined two ways: as the monetary worth of a property to
buyers and sellers as of a given point in time, or as the present worth of the
future benefits that accrue to real property ownership.
An opinion of market value must be based on objective observation of the
collective actions of the real estate market, which appraisers define as the
interaction of individuals who exchange real property rights for other assets,
such as money. The basis of any appraisal assignment is the definition of market
value. Although there are numerous definitions, most are similar conceptually in
terms of reflecting the collective value judgments of market participants. A
current definition of market value agreed upon by agencies that regulate federal
financial institutions is:
The most probable price which a property should bring in a competitive
and open market under all conditions requisite to a fair sale, the buyer and
seller each acting prudently and knowledgeably, and assuming the price is
not affected by undue stimulus. Implicit in this definition is the
consummation of a sale as of a specified date and the passing of title from
seller to buyer under conditions whereby:
- buyer and seller are typically motivated;
- both parties are well-informed or well-advised, and acting in what they
consider their best interests;
- a reasonable time is allowed for exposure in the open market;
- payment is made in terms of cash in United States dollars or in terms of
financial arrangements comparable thereto; and
- the price represents the normal consideration for the property sold
unaffected by special or creative financing or sales concessions granted
by anyone associated with the sale.
While the foregoing definition of market value is widely used in federally
related transactions, individuals performing appraisal services that may be
subject to litigation would determine the exact legal definition of market value
in the jurisdiction in which the services are being rendered.
Highest and Best Use Analysis
Where the purpose of an appraisal assignment is to develop an opinion of
market value, highest and best use analysis identifies the most productive use
to which the appraised property can be put. Highest and best use is the
reasonably probable and legal use of vacant land or an improved property that is
physically possible, legally permissible, appropriately supported, financially
feasible and that results in the highest value.
Each appraisal should consider the highest and best use of the property as
though vacant as well as the highest and best use as improved. When analyzing
the highest and best use as though vacant, the appraiser must determine among
all reasonable, alternative uses, the use that yields the highest present land
value after payments are made for labor, capital and entrepreneurial
coordination. The highest and best use of property as improved is the use that
should be made of a property as it exists. An existing property should be
renovated or retained as-is so long as it continues to contribute to the total
market value of the property, or until the return from a new improvement would
more than offset the cost of demolishing the existing building and constructing
a new one.
For example, if a single-family dwelling is located in an area zoned for
commercial uses where there is market demand for a commercial use, the highest
and best use as though vacant would most likely be a commercial use. On the
other hand, if market demand is for residential uses, the highest and best use
of the property as improved would be continued use as a residence. Generally, if
the value of a property as improved is greater than the value of the land if it
were vacant, the highest and best use will be as improved. In making this
determination, the appraiser must consider which uses are legally permissible
and therefore must investigate the likelihood of a zoning change that might
impact the highest and best use. This requires research into the trends in the
market area, reviewing the local general plan as well as observing new
construction in the area and investigating zoning-change applications and zoning
hearings and interviewing planning and zoning officials.
The Valuation Process
The valuation process is accomplished through specific steps, the number of
which depend on the type of property appraised and the data available for
analysis. The initial step is to define the appraisal problem and to determine
the scope of work required to solve the problem. To define the appraisal
problem, the client and intended users of the appraisal must be identified.
Additionally, the intended uses of the appraisal must be ascertained as well as
the purpose of the appraisal, along with the definition of value to be used. The
characteristics of the property must be identified, including the property
rights to be appraised and the location of the property. Where the appraisal
assignment is to develop an opinion of market value, the appraiser's goal is a
well-supported value conclusion that reflects all of the pertinent factors that
influence the property's market value. To achieve this, the appraiser analyzes
the appraised property using three traditional approaches to value: the cost
approach, the sales comparison approach and the income capitalization approach.
Cost Approach. In the cost approach, value is estimated as the current
cost of reproducing or replacing the existing improvements, deducting accrued
depreciation from the reproduction or replacement cost, adding the estimated
land value and also adding an appropriate entrepreneurial profit. This approach
is based on the principal of substitution-that a prudent buyer would not pay
more for a property than the cost to acquire a similar lot and build equally
desirable improvements.
In calculating replacement or reproduction cost the appraiser must consider
direct costs, such as materials, labor, equipment used in construction, and the
contractor's profit and overhead, and indirect costs, such as appraisal,
accounting and legal fees, marketing costs, and financing and insurance costs
during construction.
Depreciation, in appraisal terms, is a loss in property value from any cause.
In the cost approach, all possible causes for the difference between the cost
new of the improvements and the contributory value of the improvements at the
time of appraisal must be analyzed. These include functional obsolescence, which
is some aspect of the improvements or their design that diminishes their
function or utility; external obsolescence, which occurs when some influence
outside the property has a negative impact on its value; and physical
deterioration from wear and tear and exposure to the elements.
The cost approach is most suited to situations where a lack of market
activity limits use of the sales comparison approach or where valuation by the
income approach is not applicable, as with single-family residential properties
that do not typically generate rent. The cost approach works best with
relatively new construction due to the difficulty of estimating accrued
depreciation in older properties.
Sales Comparison Approach. Using the sales comparison approach, value is
derived by comparing the property being appraised to similar properties that
have been sold recently, applying appropriate units of comparison and making
adjustments to the sale prices of the comparables based on the elements of
comparison. Like the cost approach, the sales comparison approach is predicated
on the principle of substitution: that the value of a property tends to be set
by the price that would be paid to acquire a comparable substitute property.
This approach is appropriate when there is sufficient market data available to
the appraiser from recent sales transactions.
The procedure used by the appraiser in the sales comparison approach includes
researching transactional data, verifying the accuracy of the data and that the
transaction represents an arm's-length sale, determining how the sales
comparables differ from the property being appraised and adjusting for those
differences, then reconciling the various value indications derived from the
comparables into a value estimate for the subject property.
Income Capitalization Approach. With the income capitalization approach,
a value indication is derived for an income-producing property by converting its
anticipated benefits-cash flows and a reversion-into property value. When
applying the income capitalization approach, the appraiser must determine rates
that will reflect the rates of return that investors expect, which is assumed to
include both the return of capital invested as well as a return on that
investment to compensate for the risks undertaken. These rates of return may be
overall capitalization rates (income rates), used in the direct capitalization
method, or yield rates utilized in the yield capitalization method of income
capitalization.
An overall capitalization rate will reflect the ratio of one year's income to
the value of the property. In contrast, yield rates are compound rates that will
reflect a rate of return for a specified period of time and will include all
benefits expected to flow from the ownership of the property for the specified
holding period, along with anticipated proceeds from the sale of the property at
the end of the investment period.
Both methods of income capitalization require analysis of the appraised
property's income and expense history combined with similar analysis of the
comparable properties under consideration by the appraiser. A reconstructed
operating statement is developed for the subject property, based on the market
data analyzed to determine its potential gross income. If a leased property is
being appraised, its income will be based on current leases and expenses. If a
value of the fee simple interest is desired, market rental data will be used
instead. Before applying a capitalization technique, net operating income must
be derived by estimating likely vacancy and collection loss along with total
expected operating expenses and then subtracting these amounts from potential
gross income.
One or more of the three approaches to value will be employed by the
appraiser depending on their applicability to the appraisal assignment, the
nature of the property and the availability of market data. For each approach,
the appraiser will conduct extensive market research and data analysis and will
integrate the information, using the appraiser's skill, experience and judgment
to form a value conclusion, stated either as a single point of estimated value
or, alternatively, as a range within which the value estimate may fall.
Regulation of the Profession and Appraisal Standards
In the aftermath of the savings and loan crisis of the 1980s, Congress passed
the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA),
which set up a real estate appraiser regulatory system that mandated that all
states establish licensing or certification programs to regulate appraisals
utilized in federally related transactions. The Appraisal Foundation, composed
of about 80 affiliate organizations, coordinates two primary boards created by
the congressional Appraisal Subcommittee. The Appraiser Qualifications Board
establishes the qualification criteria for state licensing, certification and
recertification of appraisers. The Appraisal Standards Board sets forth the
rules for developing an appraisal and reporting its results by promoting the use
and enforcement of the Uniform Standards of Professional Appraisal Practice (USPAP),
which contain the recognized standards of practice for real estate, personal
property and business appraisal. As a result of widespread adherence to USPAP,
many states now require licensure or certification for appraisals done for any
purpose and have set minimum standards that appraisers must meet including
educational, experience and testing requirements based on USPAP.
Voluntary professional standards have been in place for appraisers for almost
75 years. The Appraisal Institute was established in 1991 through the merger of
the American Institute of Real Estate Appraisers and the Society of Real Estate
Appraisers, both founded in the 1930s. Approximately 20 percent of licensed or
certified appraisers also have become designated members of the Appraisal
Institute by meeting stringent educational and experience requirements. The MAI
designation is earned by appraisers experienced in the valuation of commercial,
industrial, residential and other types of properties, and who advise clients on
real estate investment decisions. The SRA designation is earned by appraisers
experienced in the valuation of single-family homes and residential income
properties up to four units.
Conclusion
Ownership of and investment in real property is a fundamental aspect of the
modern economy. A better understanding of the process used to determine its
value benefits owners, investors and those professionals who advise them.
Carolyn B. Hall is a lawyer at Holland & Knight LLP and a California
certified general real estate appraiser. For more information, contact Carolyn
at 1-888-688-8500 or via e-mail at cehall@hklaw.com.
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