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!

UncleZev

 

How big is my house?

Do you ever get those questions? “Well ABC appraised my house last year and my house was 3,726 square feet. Why do you say it only contains 3,698 square feet?”. I have always wanted to say, well as your house gets older, the wood begins to shrink… Everyone knows of course that houses come in different sizes, shapes and that walls can be built at angles other than 90, 60 or 45 degrees, thus accurate measuring can be a challenge. When you factor in roof pitch for upstairs rooms, or many shrubs, or rose bushes or other obstacles around the perimeter, any given measurement can be off by a few inches one way or another and then you take the variance of a few inches and multiply that by a run of 45 feet or more. The estimated house size can easily vary due to the different methods that are used to measure the home as well.

Many old timers, like me, still use a 100′ steel tape to measure the exterior perimeter of the home. There are, of course, several alternatives available today:  steel, fiberglass, and vinyl measuring tapes. There are also measuring wheels, and sonic and laser measuring aids. There is no one device that is better or more reliable. However, you must understand the degree of reliability that each device offers before you decide to use it to determine size. For instance, the measuring wheel can skip when it encounters rough terrain. The sonic device may give false readings if there is an obstacle between you and the wall that you are measuring. The laser sight can find interference from direct sunlight, or can give false readings if an obstacle is blocking a clear path between you and the distance you are attempting to measure. A vinyl tape will stretch over time thus 1 inch becomes more than an inch. A steel tape requires maintenance to keep it from rusting and cutting your hands or fingers. The fiberglass tape and steel tape are the most reliable, in my humble opinion.

When measuring a home, the garage, porch, patios, and any non-heated or cooled space is not included in gross living area; however, these spaces are measured so that the appraiser can account for the cost of these items. Additional flatwork, or extra concrete (i.e. driveways, parking pads and the like are also measured for the cost approach). Finished attics can be included if properly finished, including venting for heating/cooling. The pitch of the roof can inhibit the space which is counted due to clear space (overhead). Generally speaking, any space below 3′ is not considered habitable space. Also when measuring a second floor, many appraisers will measure the interior walls of each room and add the space together. This is practical for a small condominium or other type dwelling that does not have a lot of space; however, it is not a practical approach because interior walls should be included in the GLA. In other words a 12 x 12 bedroom right next to a 12 x 12 bedroom (i.e. 144sf + 100sf) will not equal 288 square feet of gross living area. Why? Because there is a 5-1/2 inch wall in between the rooms and exterior walls on each side of the room. Therefore, this span is actually 25.37 x 12 or 304 square feet. How can this space be added to gross living area?, I have been asked this time and time again. Let me ask a question though. When a home is built, do you believe these walls are simply built without cost? Of course there is a cost, and the only proper way to account for cost is to include the space at the time of measuring.

The accepted method of measuring a home is the ANSI method; however, there is no law that requires an appraiser to use this method. The law, USPAP, requires that an appraiser communicate the appraisal report in a way that is not misleading; thus as long as the sketch is presented in a way that is easy to follow, and the dimensions that are presented are reasonably accurate, the appraiser has met the intent or spirit of the law.

Keeping in mind the variables that can come into play when measuring a house, it is understandable why no two appraisers are likely to arrive at the same square footage estimate unless the house is a basic shape, with no angles, no fences, no shrubs and no pets. Any of the oddities or variables can cause appraisers to write different findings, and different findings will cause different results.

All of this being said, appraisers should be able to agree within 10% of size each and every time. If a sketch is off by more than 10%, there is a distinct possibility that someone is in error.

See you around the water cooler!

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.