What is the appraisal process?

Introduction:

Essentially, an appraisal is a conclusion of worth derived by research into the law of probability with specific focus on real estate. Based on education, training, experience, and integrity, an appraiser is able to forecast sellers’ and buyers’ of real estate activities into a calculation or estimate of market value. Due to the character and uniqueness of each property, comparisons between seemingly similar real estate often require that adjustment be made before a value conclusion is reached. But, in some cases, this is not possible and the data may be less than conclusive.

Financial consideration for real property often reflect emotions, compassion, sympathy, bias, politics, specific needs, lack of understanding, and other factors that are rightfully not considered by the objective appraiser. The appraiser cannot be an advocate or else he or she belies the very reason for the existence of the profession.

Unfortunately, an appraisal cannot be guaranteed, cannot be proved; however, the opinion of value can be substantiated and justified. In fact, a value estimate is probably more appropriately given within the context of a range. But, due to the dictates of the users of appraisals, a pinpoint estimate is usually required.

The final opinion of value expressed in an appraisal report is the result of a very thorough analysis of a considerable quantity of physical and economic facts and sometimes anecdotal data. An appraisal must not be considered absolute, but should be used as a basis of negotiation between parties involved in the property, whatever their interests.

The appraisal of real estate is an orderly process involving several processes, the end objective being an estimate of the value as defined. In layman’s terms it could be stated as; what is the “worth”, or “value” of a given piece of real property as of a certain date. Additionally it could be defined as what will the expected sales price of property be when exposed to the market under the prerequisite of a willing buyer and seller both with no undue stimulus to buy or sell.

The appraisal of real estate considers socio-economic conditions as they affect the property being valued. This encompasses the city, regional and neighborhood condition including services and utilities and any other similar conditions that affect the property either advantageously or disadvantageously.

The estimation of value involves a systematic process in which the problem is defined; the work necessary to solve the problem is planned; and the necessary data compiled, analyzed and interpreted into an estimate of value.

Direct Sales Comparison Approach

In the direct sales comparison approach, the subject property is compared to similar properties that have recently sold or that are currently offered for sale. When possible, these properties are adjusted to the subject with regards to the noted differences or similarities in time, age, location, physical characteristics, etc. This approach can, when appropriate, be used for improved property as well as vacant land.

A popular but somewhat controversial method for estimating supportable or appropriate adjustments is the pairing of data sets. This involves two or more comparables where variances are observed. Comparing the sales and not the difference in the unit sales prices will then give an indication of the market reaction to the variance. This type of analysis is usually on a recognized unit of comparison basis that is typical for the type of property being appraised. If sufficient market data does exist for an indicated range attributable to the variation, it can assist the appraiser in estimating the appropriate adjustment. In some cases, this may not be possible. This usually relates to a lack of information or a market with non-definable variations. Sometimes, this approach may not be usable. Typically, this involves special purpose properties of real estate that do not have an active market or non definable parameters. If this approach is not used, the reason is usually explained Sometimes, subjective or intuitive adjustments are considered appropriate.

Income Approach

The income approach to value is basically an analysis of anticipated future benefits and conversion therefore to an estimated present value through a process of capitalization or discounting. Important to the analysis is the estimation of anticipated future income and/or reversions at the end of a typical holding period. One of the most important aspects in this approach is the net operating income (NOI) of the property being valued. The NOI is the remainder after the deductions of expenses, including fixed, operating, and reserves from the effective gross income (EGI), which is the remainder after deducting vacancy and collection loss from potential gross income, (PGI).

The first step in this approach is the estimating of potential gross income for the subject. This is done primarily by comparison with competing properties in the marketing area. Next, an estimation of expenses must be made, either from historical or market data. This data is utilized to determine the projected net income stream. The projection can then be capitalized into an indication of value or further developed for use in discounted cash flow.

There are many methods in which capitalization or discount rates can be estimated. If market data permits, a good indicator of rates for use in valuation would come from actual sales of property rented or leased at the time the transactions occurred. If not, pro-forma data is used. In some limited instances, the use of this approach is not warranted. This usually relates to property that is not readily rented or not used for typical investment purposes.

Cost Approach

The cost approach to value is as market oriented as the other two approaches. It involves comparable sales of land which are used in estimation of site value. Additionally, a cost new of the buildings and other improvements must be calculated. This can be done by consultation with area contractors who specialize in the type of property being appraised or through a recognized cost service manual. Also, sales of property with newly constructed structures which may give an insight into cost new or cost comparables, if available, can also assist in the estimation of cost new. However, it should be pointed out, it is rare that any one building is exactly like another.

After the cost new has been estimated, depreciation from all sources must be approximated. Depreciation is basically a measure of the loss of in value inherent in the property. It is also known as a loss of utility and hence value from any cause. Depreciation falls under three major headings; [1] Diminished utility, as evidenced by actual wear and tear on the structure and its components, or structural defects, decay etc. [2] Functional obsolescence, which is an impairment of functional capacity or efficiency, i.e., over-capacity, inadequacy, or the inability of a property to perform adequately the function for which it is currently used; and [3] Economic or location obsolescence, which is a loss in value due to factors external from the property. This can include economic situations, environmental forces noncomformity to surrounding uses, or an inability to generate sufficient cash flow to justify the cost.

The cost approach is best utilized in new or reasonably new structures. The inherent liability in utilization of this approach to value is the estimation of actual depreciation from all causes. As a property ages, this approach will have lessening validity as an indicator of worth.

Correlation

All preliminary value estimates, as indicated by any of the three separate approaches that are appropriate, are correlated into a final estimate of the property’s worth. In the final correlation, the appraiser must weigh the relative significance and supportability of each approach as it pertains to the type of property being appraised. After the most supportable approach and or approaches is determined, the appraiser will weigh the factors appropriately and then form a pin point estimate of the value as defined.

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