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!



Time Adjustments

A recent review has prompted this post. It has become painfully clear that many appraisers are still unable to justify time adjustments. It appears that many believe that the MC Addendum is the “perfect” tool to justify increasing or declining prices; however, the reality is that this form was never designed to be an economic forecast model. In order to prove trends, a solid sample is required to show the price changes. Trying to prove a trend with a hand full of sales is a lot like predicting the annual rainfall in Texas based upon the observed weather patterns in Dallas for only six weeks.

Some appraisers are using some pretty wild assumptions and, in my opinion, had better be really careful not to over-analyze the data. The danger is that someone might take them seriously and actually make a lending decision based upon the prediction that they are making; values declining or rising. Either way, if the client loses money based upon this “expert” opinion, this is a lawsuit waiting to happen.

It is every appraisers responsibility to know their individual marketplace and to report prices and the direction of prices as of the date of value; thus, to carry this out, the appraiser should be looking at market areas for a few years and establish an actual trend. Then, the data within the last 12 months can be narrowed to show the subject property. This is, of course, not the only way to show market patterns, but it is one of the safest ways, because then you allow the data to speak for itself. Any adjustments can then be developed using a trend or regression analysis that will give results that are a little more reliable than the Texas weather patterns.

Just a point to ponder. See you around the water cooler!

Market Conditions Form

Has any appraiser found this form to have changed the way in which they analyze or report the market conditions within a residential report? I have read several other blogs and forums regarding this form and it seems to me that there were several appraisers who were already considering this and report these conditions long before Fannie Mae felt the need to provide us with another form.

Still as a review appraiser for several thousand reports in the last two and a half decades, it has not been my personal experience to read more than a handful of residential reports where the appraiser ever addressed the market supply, or absorption, until they were forced to with the creation of this form in 2008.

Still, my concern is that even though Fannie has created a form to force all residential appraisers to address this issue, I am not confident that many appraisers have sought adequate training to understand the point of the information or to present their findings that are representative of the marketplace.

Of course, there have been some training classes to tell the appraiser to fill the number of sales, the number of listings, and calculate the absorption by dividing the number of sales by the number of months analyzed. And then take this absorption rate and divide the current listings to demonstrate housing supply.

But there should be more training for the appraisers and the underwriters to understand the following:

1) This is a sampling of data. Statistically speaking, a random sampling can be an effective measure if the data has been properly qualified and accurately presented; however, if the sample is not reflective of the subject or the subject’s marketplace the results can be quite misleading.

2) The form, as it was designed, only focuses on active listings and sales within a set period of time. It does not take into account the total number of properties that were exposed to the market for that same period of time. For any given neighborhood you could find 10 active listings, 12 sales within 12 months, and 78 properties that were exposed to the market for sale but were withdrawn or expired unsold. In this scenario, even though the absorption rate would show as 1 on the form with a month housing supply, the reality is that 100 properties were exposed to the market for sale and only 10% were reported as sold within 12 months and 10 are actively listed. This information is lost, if the appraiser only fills out a form and does not bother to address the actual market conditions as of the date of value.

I urge appraisers to take the time to understand the dynamics of the market areas in which they appraise and urge underwriters to look for continuity between reports.

There needs to be more extensive training of all real estate professionals to understand the dynamics of the real estate market so that we are not easily mislead and become simple form fillers. If appraisal is simply filling a form and reporting facts why do they require the education? Of course, educational standards of appraisers slipped when they did away with the requirement that an appraiser should be a real estate broker for five years, and the apprenticeship requirements were structured so that hands on training was limited and sponsoring appraisers were able to run sweatshops instead of mentoring the next generation of professionals.

I blame all of us. The ones with unsupervised trainees and the those of us who either never took a trainee or have had one or two in the last several years. It is time that the remaining professional appraisers, and you know who you are, take a stand for the integrity of this profession and take on a responsibility as a teacher, a mentor, or a industry leader of one type or another. Most of us (and I blame myself as well) failed to engage with others. We “fought the good fight” with regard to our personal work, but we stayed quiet in classes, or in forums, or professional meetings when we should have dared to speak up and hold the line of professionalism.

If you agree with me, let me know. If you disagree, good, please allow others to hear your thoughts as well. Remember silence can be considered agreement.

See you around the water cooler!

Score one for the Good Guys

According to FACT, the Texas Governor signed HB 2375 into law on Friday. This legislation modifies the current occupational code that governs how a real estate appraiser conducts business within the State of TexasAmong the more significant changes are:

  • Brings the TALC Statute into compliance with current terminology and State and Federal Laws relating to the regulation of real estate appraisers.
  • Makes it mandatory that a person be certified or licensed under the act in order to perform an appraisal in Texas.
  • Allows the TALC Board to delegate to the Commissioner the authority to approve consent orders and agreements to help expedite enforcement case closure.
  • Allows the board to solicit, accept and administer gifts, grants and donations.
  • Allows for a probationary certificate, license or trainee approval under specified conditions.
  • Allows for up to a 90 day period for late renewal of a certificate, license or trainee approval with payment of 1.5 times the required renewal fee – does not allow appraisal practice during the late renewal period.
  • Requires an applicant to complete additional prescribed education after failing the licensing or certification exam three consecutive times.
  • Repeals the provisional license category.
I applaud the efforts of FACT and encourage Texas Appraisers to check out their site and get involved. It is time we engage and begin to take back our industry.