The Art & Science of Appraisals
A couple years ago, I order an appraisal report for a developer that I was working for. It was primarily intended for internal use, though it was also used to help ascertain how large a construction loan we could potentially qualify for.
The report ended up being 151 pages long, though I only looked at page three. The only thing that seemed to matter at that moment and the only thing that I could appreciate was the actual valuation, the dollar figure written on that third page.
That appraisal report that I ordered was what’s called a narrative report. In other words, the assignment was too complicated to be completed using a pre-printed form. The appraiser took the 151 pages to explain how he came up with the dollar figure, or valuation conclusion, printed on page three. It was just unfortunate that at that time, I couldn’t appreciate all that went into the other 150 pages.
However, now that I’m enrolled in a course on valuation and appraisals, I can finally appreciate some of the work that went into his report. For example, there are three commonly used approaches to determine the value of a property. The first is the sales comparison approach, which compares the subject property (the one we want to value) to similar properties that are currently listed or that have recently sold. The second approach looks at the cost associated with replacing a property; essentially how much money would be needed to duplicate the subject property. Finally, when income-producing properties are valued, an income capitalization approach is used that considers the rental income and eventual sale price of the property. Not surprisingly, if all three approaches were to be applied on the same property you could easily have three different resultant valuations. Thus, an appraiser needs to be able to determine which approach is most applicable in a given situation, giving each approach more or less weight.
But there’s much more than just the methodology to consider. Appraisers usually look at both the land as though it were an empty plot, and as-is, with whatever buildings may be in place. That is, appraisers consider the value of land both as-vacant and as-improved, because one could easily be more valuable that the other. We might instinctively assume that having a building on a piece of land would make the overall property value greater, but that’s not always the case.
Imagine a small farm house that’s been around for decades. Over time, the neighborhood has changed, moving from a rural, residential area to a more commercial and retail-centered part of town. In every direction from that farm house are stores, restaurants, and small businesses. The only exception is that little house. Even if the house is in excellent condition, there’s a real possibility that the land beneath that house would sell for more if the house were not there. Most people looking for a farm house do not want one in the middle of a commercial district. Similarly, those who want to use the land to put up a business, probably don’t want the house.
Of the three approaches to valuation listed above, the sales comparison approach is the most commonly used, especially when it comes to residential properties. In this case, the appraiser is tasked with finding comparable properties, properties that are similar to the one being appraised and then making adjustments to account for the differences.
Determining the amount to adjust a comparable property may seem almost arbitrary, or at least more art than science. Still, there are standard procedures. For instance, using what’s known as paired analysis, if two properties are identical in all but one way, we can attribute the difference in value to that one attribute.
For example, let’s say that we had tract housing and a new development where each house is identical in every way. The only difference is that one house is on the corner where two roads intersect and the other is halfway down a cul-de-sac. Because the house on the corner would provide less privacy, we might expect it to sell for less. If both of these homes sold at the same time and the one on the corner sold for $5000 less, then we could conclude that that $5000 was a discount due to its corner lot location.
We could then use this information when determining the value of a third house about to be listed for sale. If it’s also a corner lot we would expect it to sell with that same $5000 discount.
But things are rarely this simplistic. More often than not, land and buildings are more unique, which makes the valuation assignment that much more difficult. Instead of there being just one difference between two properties, there are likely several and determining the value to be assigned to each difference, or each element of comparison, becomes a challenge.
Let’s say that you’re looking at two houses that recently sold in the same neighborhood. How do you know if the difference in price should be attributed to a larger yard, the condition of the garage, the presence of a fireplace, better insulation, the year that the house was built, or some other attribute? In statistical terms, we would call these confounding variables. We would like to be able to say that A caused B. We would like to say that the difference in price between these two houses is something logical, like the age of the buildings. But we can’t ignore the potential impact of the other factors.
Even just scratching the surface with the few examples I’ve discussed here; you can start to see and imagine how many layers there are and how many related questions there are that need to be answered in order to provide an accurate valuation. Some other considerations include the property rights being appraised (would be landlords may value property differently than an owner-occupant), the information available, what the appraiser was asked to consider (and what they were asked not to consider), and the timing of the valuation (past, present, or future).
This is why I would say that appraisal is both an art and a science. Time tested and proven methods create the science behind best practices, but there is still an art that can lead the valuation provided to vary from one appraiser to the next. This is likely why the industry uses the phrase “opinion of value” as opposed to simply “the” value.
Anecdotally, I was told that it’s not unusual for the opinions of value between two or more appraisers to vary as much as 10%. Given the importance of these conclusions, we all obviously want the most accurate valuation. In some cases, valuations can be used for loan approvals, tax appraisals, setting an asking price, valuing an investment portfolio, defending a lawsuit, or determining how much a homeowner subjected to eminent domain should be compensated.
Perhaps, the moral then is that second opinions can be valuable and worth considering. While you could always hire a second appraiser to create a new appraisal report from scratch, you may also consider using the services of a reviewer. A reviewer is usually a more experienced appraiser who looks over and provides an opinion about the work of another appraiser. This may be a more efficient way of obtaining a second opinion. Does the reviewer agree or disagree with the original appraisal report?
Whether you’re a homeowner, an investor, a developer, or otherwise, having an understanding and appreciation of what goes into an appraisal report can make you a more informed consumer.