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

 

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“Measure it in Micrometers and Cut it with an Axe”

Having grown up in an appraisal family, as have so many of my peers, we can all smile when remembering the wisdom and humor that was discussed during family dinners, and “get togethers” of all kinds. I am tempted to write a book some day dedicated to all the one line quips that my father and mother, both appraisers, use to say. My parents were the single driving force that shaped me into the kind of appraiser I am today, so if you don’t like how I do things… Blame them! (smiling).

You are wondering by now why you are continuing to read this particular post, or perhaps even this blog. Actually I am wondering the same thing, but still I have this innate ability to stretch out a punch line until it is almost painful. So what does any of this have to do with the appraisal process? Or does this post have any point what-so-ever?? Great questions. Surprisingly, the answer is that this almost meaningless post has an incredible resemblance to so many appraisals that I have read and perhaps even written over the years, that the process of writing the post is worth the effort.

“What in the heck am I talking about?!” That is my point actually. So many reports are filled with fluff and irrelevant data just so that the appraiser can fill up white space and “impress” the user of the report. Actually, an impression is made, however, I am sorry to tell you that the impression is not one that is favorable.

My father used to say, when developing an appraisal you have to take the time to identify all the relevant information and data that relates to the subject and then measure this data very carefully, very precisely, then once all the analysis is complete, you back up off of the data and take your best guess. His actual words were “measure it in micrometers and cut it with an axe“. This approach should also be used in the presentation as well.

For any of my readers who have ever used an axe, you will appreciate this saying. The use of an axe is final, you don’t hack about or you will completely destroy what ever you are attempting to cut. You plan the strike, you take the proper stand, and you let the blade fall. When you are skilled with an axe you can fell a tree, or cut a very large log to firewood in a matter of moments. Still, the use of an axe is not as precise as one might expect from a “professional appraiser”. Nonetheless, I submit for your consideration, the market data that we often have is not precise, it is often not complete and confirmation or verification is second-hand at best. Therefore, when you read a report that has exact adjustments like $5367 or $3,332 it is clear that the report appraiser did not know how to turn on the rounding feature in the appraisal software. Unfortunately some intended users are not sophisticated enough to realize that these adjustments, although taken from the market, are “best guesses” and these users can be really upset if the “guess” is wrong. Trust me, you have no desire to find yourself in court in front of a judge and have the opposing attorney ask you “So {Insert Name Here}, please share with the court the deductive reasoning that was used to prove why this gross living area adjustment should be $5367 and not $5,500 or $5,000.”  When you take a stance of being so very exacting with your presentation, you place yourself up as being this “all-knowing appraisal guru” but the reality is that the presentation is weakened because anyone who has been in the business longer than a presidential term can tell you that market data is never that detailed and never that exact.

Take time to analyze the data and measure it as precisely as possible, but at the end of the analysis when you are reporting your final conclusions, let your opinion fall where it may. Remember a professional never strives for perfection, a professional strives for excellence.

See you around the water cooler!

Assigning Blame

Even though the redirection of blame is an ancient approach to avoid taking responsibility for ones one actions, this seemingly innocuous tactic has become the leading downfall to the financial industry today.

Consider, the consequences of shifting blame:

1)    The actual party who has made poor lending decisions escapes taking responsibility, and often times will even get promoted. Thus the initial behavior does not change.

2)    Since the poor decision has not been corrected, the pattern will continue.

3)    Redirecting the blame combined with the continuation of the faulty decisions expands the direction of investigation, because now a larger pool of appraisers appear to be at fault – even though the initial behavior was to blame.

4)    Much time and money was devoted to the regulation and education of real estate appraisers, but no actual safeguards were put into place to ensure the soundness of the lending decisions.

Therefore, the consequence of improper decisions only expands and the innocent continue to take the fall.

Those appraisers who do accommodate sale prices or refinance loan amounts are certainly harming the reputation of the rest of us, but the real culprits continue to shape this industry to accommodate a larger objective of repackaging loans and selling them as derivatives.

What can be done? From the position of a real estate appraiser, actually very little can be accomplished. We must continue to be accurate in our reporting and analysis and strive to only produce reports that are supported by the market data.

However as a larger group, I believe it is time for each and every one of us to stand together and direct our legislators to take a courageous stand against those that are encouraging a continuation of unregulated derivatives and support regulations that has enabled the pressure that used to come from mortgage brokers to simply be shifted to appraisal management companies.

I would love to hear some thoughts on this.

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.