The Approach to Value

Does anyone remember why the “men of old” developed the three foundational approaches to value in the first place? Today, an “appraisal” has become a recitation of the Direct Sales Comparison Approach. Few if any, complete the Income Approach and even less complete a Cost Approach.

These approaches to value were not merely an exercise in academic prowess, they were the fundamental tools that professional appraisers used to determine the market perceptions of the various forces that affect the value of a property. Yes, I am painfully aware that lenders stopped wanting to hear about the cost approach or the income approach. Also, I realize that the “appropriateness of a given approach will depend upon the nature of the appraisal problem and the quantity of available data to develop the approach” (as taught in many textbooks); however, for the majority of single family residential properties all three approaches are reasonable and relevant to develop. “But, what about the difficulty of determining the obsolescence of the property? Or the GRM?”, I have heard this question for 28 years. The answer is simple. All three approaches to value rely on the development, analysis and understanding of competing market data; nonetheless, each approach represents a differing mindset of the prospective purchaser.

There is the purchaser who wants to keep up with the “Joneses” and for them, the Direct Sales Comparison Approach is relevant because it should reflect the buying and selling decisions of the predominant homes in the market. The definition of market value that was handed to us by the federal regulators requests that the value should reflect the “most probable” price, not the highest possible price. Therefore, when an appraisal reports the highs and lows of the market and then compares recent, relevant sales to demonstrate the most probable price, this approach to value is the best indicator 99% of the time. But, what if for some reason the appraiser misses the mark during the research phase and excludes a portion of relevant data, thereby skewing the numbers by not talking about 30% of the homes that were REO sales or the like? Or, by only focusing on the REO market and not taking the time to accurately assess the motivations of the buyers and sellers within the marketplace.

The Cost Approach to value, when developed appropriately, enables the appraiser to recognize physical, functional and external influences that affect value. This approach generally will set the uppermost limits to value, thus when REO markets begin to sell well below cost to reconstruct, a very large red flag should be waved by the appraiser to discuss this depressed marketplace.

The Income Approach to value, when developed appropriately, enables the appraiser to recognize the investor market that considers the anticipation of future benefits of ownership. This approach generally should set the lower limits to value because the value of the property is limited to its ability to produce income. This approach will take into consideration the competing properties in terms of competing rents, vacancy and demand.

Of course the marketplace, driven by Fannie Mae, has dictated the information that an appraiser is expected to present in an appraisal report, but does not diminish the  professional appraiser’s responsibility to develop all relevant approaches to value as required by USPAP.

I will suggest even further, had we as an industry been tougher on ourselves and our colleagues to enforce the use of all three approaches to value, it would have been more difficult to ignore the signs that were in the market that the prices were being manipulated. Yes, an appraiser’s job is to report the market data, then analyze this data and form an opinion on these findings, but when two of the three approaches were taken out of the fray, our opinions were rendered less relevant.

“But wait”, I am hearing you say already, “USPAP always required the development of all three approaches to value, when appropriate. So how could it be that the majority of residential real estate appraisers still only complete the Direct Sales Comparison Approach?”. This is an excellent question, and one that I would love an answer to myself.

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