Back to Basics – part 2 -The Cost Approach – An approach to value, without worth, really?

The foundations of appraisal were based upon three independent approaches to value. A system, when developed correctly, presents a check and balance within the report. The idea being that when an appraiser takes the time to develop each report, the data will show three independent motivations and three separate value conclusions. Nonetheless, the conclusions will support one another because the underlying principle for each approach is the principal of substitution.

For the purposes of valuation or real estate appraisal, the principle of substitution is defined by practical application. Simply the idea that a prospective purchaser will pay no more for a property than the cost of acquisition of an equally desirable substitute  having equal utility and acquired within an equal amount of time. This principle  is accurately assumed to be the underlying principle of the direct sales comparison; however, it should be recognized that the principal of substitution is also the underlying principal for the cost approach was well.

The cost approach, when completed in a serious and professional way, is not only crucial to the appraisal of residential real estate, but also crucial for an underwriter to properly understand other factors that influence the value of the subject. Additional principles that are in play within each real estate market, but few people take the time to identify  these factors or understand their effects. A few of these principals will be listed below, in an attempt to help the average user of an appraisal gain a deeper appreciation for the thought process that goes into each appraisal report.

The Principals of Anticipation, Balance, Change, Conformity, Contribution, Progression, and of course Substitution are the basic tools of analysis that go into the professional analysis of each report.

Anticipation is the underlying fountain of the Income Approach to Value, but it also reflects the motivations of prospective purchasers of residential properties and has a foundational effect within the Direct Sales Comparison Approach as well. The income approach is of course a reflection of the present worth of anticipated income. The Direct Sales Comparison (or Market Approach) reflects what competing purchasers are willing to pay for the anticipated benefits that are attributed to a particular property, or characteristic, like quality, appeal, or location. These motivations are carefully considered when understanding a property and how it relates to its market.

Balance recognizes that the value of a property reaches its greatest potential when the four agents of production achieve the state of equilibrium. The four agents, being labor, management, capital, and land. When these agents are out of balance (in residential properties) you see a loss of value due to an over or under-improvement to the land. This principal comes into play when determining the proper highest and best use and remaining economic life. All three approaches to value are affected by the Principal of Balance.

Change is inevitable – except from a vending machine.  ~Robert C. Gallagher, but I digress. Change is continual therefore an appraisal is only reliable as of the date of value. The very next day, a plant could open in the town that would employe 1,000 workers increasing the purchasing power of the community and creating a demand for immediate housing, or the opposite could happen as well. Nothing ever remains the same in this world, this is a principle that affects all things not just real estate appraisal. It is this principle that lenders today are very concerned about as they are wanting appraisers to decipher the market conditions and decide which stage of change the marketplace is in (i.e. growth, stability, or decline).

Conformity states that maximum value is generally realized when there is a reasonable degree of neighborhood homogeneity. That is to say social and economic characteristics should be harmonious, deed restrictions and/or land uses compatible and property types reflective of these factors. Generally speaking the elements of conformity are not planned, but are borne out by the market forces that shape a community over time. Successful neighborhoods that thrive and enjoy stable or increasing values are communities that have developed amenities that are supportive of the overall needs and expectations of that community.

Contribution reflects the market reaction to a physical improvement of a property, not its cost. The best and well-known example is a swimming pool that today can easily cost $50,000 to $85,000 for a pool with a heater, and filtration system, and spa, and water fall, and all the “accoutrements” relevant to the enjoyment of a swimming pool. But the market generally resists the real cost of such improvements. The amount the market is actually willing to pay is known as the contribution value, of course the loss of value (or buyers resistance) should be shown as functional depreciation, but that is for a different discussion.

Progression, this principle is a politically correct way to discuss the basis for external depreciation and reflects the marketplace today with many REO properties on the market. This principal teaches that when properties of similar quality are adjacent or associated within a particular market area, the inferior properties will benefit from the association of the superior properties. That is to say you have an equal number of inferior and superior homes, the prices of the superior homes can benefit the inferior homes. The inverse is also true. The prices of the superior homes will regress due to this association.

When these principles are understood, employed and correctly analyzed the appraiser is then able to give insight not only to “the three best comparables” but why the market behaves in the way that it does and an appraiser can then anticipate future expectations making certain assumptions about performance based upon previous trends and reactions.

Unfortunately, this material was not sexy, or alluring, but I hope that those underwriters, operations managers, lenders, regulators or even appraisers who may not have had the best training will find some benefit in the information that I have provided above. It is critical for all to you know, understand and acknowledge. Nothing I have presented in this blog, is an original thought and I take no credit for the thoughts or analysis.

I have drawn from several years of study and instruction to give this summary of some of the foundational basics of appraisal to enable the users of our reports a brief insight and hopefully, new-found appreciation of the thought and time involved in the production of a real estate appraisal.

See you around the water cooler!



Like Type Properties

Very recently, I was presented with an appraisal report that was actually a fourth revision. The appraiser had accurately completed a report and submitted the report for consideration to the lender, then over the next six weeks apparently, was barraged with a continual flow of reconsideration requests and alternative comparables, until the report appraiser finally felt pressured enough not only to re-grid alternative comparables, but also to change the opinion of value by almost 20%. I was involved in a quality assurance review and, fortunately for the appraiser, was able to reject the revision that could have ultimately placed the lender in a very bad position and placed the appraiser in jail for a report that was very misleading.

What led to this place of dark descent? This is the question that we will be exploring in the next few paragraphs. I took the time to counsel with the appraiser and offered my personal cell number for anytime that they may be faced with a similar circumstance. “Why?”, you may ask. Because it is my belief that if appraisers did not feel alone they may have the courage of their convictions and not be pressured into a place where they really cannot defend their decisions.

The mistake made in the original report was a common one. The property was vastly over-improved, not only for its site, but also for its neighborhood market area. The appraisal did not 1) take the time to discuss the listing history of the property, showing market resistance to this being an over-improvement; 2) take the time to explain to the reader how the subject related to the surrounding competing sales;   and 3) take the time to find like/type properties with similar over-improvements and market resistance. Without finding the proper comparables, an appraiser is easily challenged even if their sense of value is correct. This is why an appraiser must follow the valuation model when conducting an appraisal; and most importantly – 4) develop friendships with other appraisal professionals. Join some social networks, read some appraisal blogs stay active and interactive.

In this way the appraiser can stand up to the “clients from hell” and not be pushed off the field of practice by making choices that they will regret in the long run. Remember this is a small industry but it is an industry that serves giants. Only if we stand together can we keep from being bullied by the giant.

See you around the water cooler!

Under Valued Appraisers

It is ironic that the one group of people who could have held the line, kept buyers from paying too much and lenders from being over extended, was the one group that nobody wanted to listen to. Appraisers that told the truth found their work limited to forensic review or REO. All others were re-educated to enable them to “understand their part in the process”. The title wave of incompetence has brought us to this point of demise. It is an old story, but one that requires reliving, until everyone understands the significance of this debacle.

There were multiple levels of bad decisions, break downs of safe guard, and self-perpetuating myths that caused the virtual ruination of the appraisal profession.

Myth number one, if the appraiser is aware of the price that the borrower is looking for the appraiser will lose his or her objectivity. Although it is clear that there was a generation of “made as instructed” appraisals (not a reference to the highly sought after MAI designation) this does not mean that all appraisers were finding ways to make a deal work. The fact of the matter is that when the appraiser was informed up front of the clients expectations and it was clear that these expectations did not fit the market, many appraisers were enabled to let the parties down tactfully and salvage a working relationship with the lender for future work.

Myth number two, appraiser independence means that the appraiser should never speak to the client. Without client interaction the appraiser is reduced to a mere report that is supplied by a management company. This disables the client from ascertaining the level of competence of the appraisal professional who is producing this report.

Myth number three, the appraiser’s impartiality will be maintained by using appraisal management companies (AMCs) the current problem with the majority of newly formed appraisal management companies is that no significant oversight was established for the formation of or management of these companies. While individual appraisers can easily be removed for violation of State Law (i.e. USPAP has been adopted as law in most of the States), the AMC is not subject to USPAP and they are free to act as an advocate to their client base. Appraisers are finding all type of subtle and direct pressures to be more flexible in their opinions and presentations of value.

“What about the multiple levels of bad decisions?”,  you may ask. By this, I am referring to the many large lenders that created in-house appraisal companies and hundreds of staff appraisers and review appraisers to shape the lending decisions of the company. The original plan was that this department was reporting to the sales departments that generated loans, by the mid 1990’s this was changed to include an operations division which attempted to stand between sales and appraisal, but the mindset of protect the interest of the lender had already been established. The problem was simple. The appraiser’s job was never to protect the interest of anyone. The appraiser’s job was to accurately report and analyze the market and  determine how the subject fit into the market and the report this in a manner that was not misleading.

The underwriters had the job to protect the interests of the lender; however, since the appraiser was trained to think like an underwriter the underwriters were disabled because they rarely got the straight (or complete) story. Therefore lending decisions were formed based upon the desire to make loans, all possible loans, instead of all prudent loans.

“What about the safe guards that were broken down?”, good question. During the early part of the 21st century many of us were screaming that the process of out of control. Appraisals were being reported in a way that, at best were misleading, and at worse were fraudulent. Reviewers were trying to stop the flow of unreliable appraisals, but this process got out of hand quickly because the lenders created national review teams with pools of available national data to determine the adequacy of the report. And instead of slowing down and getting a local review, when the national reviewer had a question, the management would push the national review to “fix the deficiencies” of the report so a deal could be made. Once reviewers stepped here, the process was broken. The flood gates of greed had burst and the resulting damage is still being uncovered.

So, “where do we go from here?”, this is the trillion-dollar question. There has been some legislation enacted and some proposed, but I am afraid that no one has actually touched on the original problem. We have an entire generation of appraisers who were just “doing their jobs” and few even realize that they contributed to the problem. There are a handful of battle hardened veteran appraisers who have always fought the good fight and tried to stay reasonable and accurate in their analysis and reporting of the markets. These people are generally ignored by those in control of the front end appraisals, because these appraisers are not generally people who will “play ball” or “accommodate the clients concerns”. These appraisers are generally hired on the back-end to try to figure out what happened and where do we go from here.

My suggestion? My suggestion, is one that is fairly simple. Credit policies should be form in such a way that all people have a chance to buy or refinance their homes, but the lenders should never loan above a certain Loan to Value Ratio (LTV) that can be determined by greater minds than mine. Appraisers should produce reports, that require them to show the actual sales they had to consider, and a brief description of why the sales they choose were the best in demonstrating the market reaction to the subject property. All appraisals should be reviewed by local appraisers. These reviewers should be allowed access to the property just like the appraiser was allowed. If the appraisals is later found be inaccurate the origination appraiser and review appraiser should be liable to buy the home at their recommended value.  Unrealistic? probably. But I guarantee that appraisers would no longer render an opinion of value that could not be supported in the marketplace as of the date of value.

Manage This

In an age of information and convenience it is not difficult to understand why appraisers are expected to be “cheaper, better, faster”. With the advent of iPhones and iPads it is assumed that the real estate appraiser will now be able to complete an appraisal while driving down the road, as he/she dictates the findings and conclusions into the voice activated interface that allows the appraiser instant access to the web and all proper appraisal applications.

Of course this must all be accomplished hands free, since the appraiser is driving the comparable sales and inserting the pictures taken from their phone.

“You’ve got mail” was so very cute when AOL first spoke to us. Now we are getting tweets from our clients wondering why we have yet to respond to the email that was sent almost 7 minutes ago.  I was asked recently if I twitter I paused (for effect), only when I am under stress. The poor little dear had no idea to what I was referring.