A real estate valuation of a specific property may result in different market value estimates depending on who is doing the real estate appraisal. Because the appraised value estimate is considered an “opinion,” a certain amount of variation should be expected from one appraiser to the next. But how can one be sure that the value estimate takes into consideration all aspects of the market and the condition of the subject property? Can differing values indicate error or even bias? How would you know? In the first of a series of articles, we will look at how different valuations may arise and how one can uncover errors and biases.
Three Approaches to Value
Appraisers utilize three approaches in estimating market value of a subject property: the income approach, sales comparison approach and cost approach. Various assumptions go into developing the analysis, resulting in a range of values for each approach. The three approaches are then weighted to determine a final value estimate based on the quantity, quality and reliability of the data that has been collected.
Differences in the assumptions from one appraiser to the next can result in different value opinions, each of which, though different, is a valid appraisal. For example, the sales comparison approach requires the appraiser to review the real estate market for sales that have occurred near the date of valuation and to select comparable sales that best reflect the subject property. These sales are then adjusted based on features of the property that differ from the subject. The comparables chosen and the way adjustments are made will have a direct impact on the final indication of value developed by this approach.
The income approach evaluates a property based on its potential to create income for the owner. Different appraised value estimates may arise based on different assumptions about the income the property will generate. These assumptions will be discussed in future posts.
The cost approach is often a more difficult valuation technique to employ. It requires that the appraiser value the site as if vacant and then add in the costs to develop the property to its current use, then adjust for physical deterioration, functional deficiencies and external factors that may negatively affect the value of the property. In some cases, the current use is not the highest and best use and other adjustments may be required, and therefore, result in a potentially wide variation in value estimates.
Each of these three approaches to value may reveal a different indication of value. That is typical. The above shows that the normal appraisal process can result in different valuation opinions for the same property. Such differences are often perfectly valid.
An Appraisal Review
An appraisal review can uncover information that might be omitted or incomplete, adjustments that are unreasonable or overlooked, and valuation formulas that have been incorrectly applied. Different or unexpected value opinions may indicate bias or fraud in an appraisal report. Some causes are based on specific instructions or pressure applied to the appraiser, withholding or providing insufficient information, scope revisions and appraiser incompetence. In this article, we will take a closer look at the instructions that are given to an appraiser.
In 1966, the Appraisal Review Committee of the American Institute of Real Estate Appraisers (now, the Appraisal Institute) stated that: “One of the most frequent causes of major divergences that have become evident stems from different legal instructions. An appraiser for a property owner is given an interpretation by counsel telling him he is to treat a certain matter in a particular way; the attorney for the condemnation body gives his appraiser an entirely different interpretation.”
Each side in a dispute may choose to interpret legal or accounting concepts differently. It is quite common for the appraiser’s clients to provide different legal or accounting instructions concerning “extraordinary assumptions” or “hypothetical conditions” that may impact the final valuation conclusions. Typically, the application of extraordinary assumptions or hypothetical conditions is allowed under Uniform Standards of Professional Appraisal Practice (USPAP), provided that the extraordinary assumptions are credible and the hypothetical conditions are legal. The credibility of an extraordinary assumption and the legality of a hypothetical condition are points of argument that must be considered in an appraisal review.
An extraordinary assumption is defined as “an assumption, directly related to a specific assignment, which, if found to be false, could alter the appraiser’s opinions or conclusions.” 1 The appraiser is making an assumption about the physical, legal, or economic characteristics of the subject property or about conditions that are external to the property that might impact the final valuation conclusions. Under USPAP, the appraisal report must provide full disclosure. In many instances, an appraiser may not gain access to the improvements, such as real property assessors who are not provided access by the property owner. The appraisal report should include an extraordinary assumption regarding the interior finish and condition which, if found to be false, would impact the final valuation conclusion. In this case, a different appraiser, who may have gained access, may arrive at a different final value estimate because the appraiser noticed that the property suffered from substantial deferred maintenance.
A hypothetical condition is defined as “that which is contrary to what exists but is supposed for the purpose of analysis.”2 The appraiser is making an assumption about the physical, legal, or economic characteristics of the subject property or about conditions that are external to the property that might impact the final valuation conclusions and are known to be false at the time of the appraisal. Again, under USPAP, the appraisal report must provide full disclosure. The appraisal should include a statement that any hypothetical assumption might have affected the assignment results.
The appraiser must have a reasonable basis for making an extraordinary assumption or a legal reason for using a hypothetical condition. These extraordinary assumptions or hypothetical conditions must be read carefully and thoroughly understood to ensure that judges, attorneys, property owners and their agents fully understand the impact that these assumptions may have on the final valuation conclusions.
In the future articles, we will look at the effect of other items that influence the valuation conclusions, such as insufficient information, client pressure, scope revisions, appraiser qualifications and competency and other issues.
Thanks to Noreen Whysel who provided great editorial assistance.
1 The Appraisal Foundation, “Uniform Standards of Professional Appraisal Practice,” July 1, 2006,http://commerce.appraisalfoundation.org/html/2006%20USPAP/DEFINITIONS.htm.
The Appraisal Foundation, “Uniform Standards of Professional Appraisal Practice,” July 1, 2006, http://commerce.appraisalfoundation.org/html/2006%20USPAP/DEFINITIONS.htm.