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.

Doom or Gloom?

I had an intriguing discussion the other day with regard to the prospects of our economy. The conversation took me back to the good old days when I would sit in my grandmothers living room and listen to my father, my mother and my grandpa discussing the state of the county and the economy. My grandpa would say “whew, when is this bubble going to pop?”. My mother, father and grandpa would talk into the night about the greed of the real estate industry and the odd perceptions of the marketplace.

I cannot help but smile when I remember these discussions. My father and my mother were both well-educated real estate appraisers; my father, a past national president of a prominent appraisal organization. Yet my grandpa, who finished the third grade before he started his long-standing career in the 1920′s, had the greatest understanding of the economy and the motivations of people. Sometimes we need to remember that no matter how “smart” the market analysts are, the market is still made up of people. These people have basic needs, and yes, the market prices are easily driven up by greed, or down by a glut of REO properties. But at the end of the day, when all the dust settles, the real estate economy is still primarily an open marketplace where willing buyers and sellers interact. The basic needs and motivations have not changed and as long as there are families, schools, grocery stores, parks, and centers of employment, the basic considerations of the marketplace will remain unchanged.

This blog entry is not intended to “fix anything” or even recognize anything. It is only intended to remind all of us that are in the profession that the objectivity, impartiality and independence of our analysis is paramount to the overall health of the marketplace so that buyers and sellers have a fair and open marketplace to buy or sell. Too many times I have found appraisers, loan officers and real estate brokers who are so focused on “making the deal work” that they lose focus on the fact that these deals are dependent upon people. It is the people, the general public, that we are here to protect. “How do we protect them?”, you may ask. Just keep it simple. Develop our research with an open mind, looking at all the data, analyzing the data with no preconceived notions and report our findings in a manner that is not misleading. The rest will take care of itself. And, before anyone tells me this is idealistic and naïve, I know, but every once in a while I want to believe the best of people, even regulators, lenders and attorneys. Play nice out there and I will see you around the water cooler.

Rehab Properties

Recently I had conversations with a relatively new real estate investor who was mystified at how an appraiser could derive a market value for a property that had been gutted.

The conversation led me to realize there may be several people, including appraisers who could be misled into believing an appraisal of such a property should be the “value as repaired” minus the cost to repair.

The reality is of course, that cost to repair does play an important part of the process, but the appraiser must also take into account the market reaction to the property, the holding time, the narrow market segment and specialty nature of the prospective purchasers.

When an appraisal is made of a home that is in pristine condition the base of prospective purchasers is open to normal market participants that are interested in the school district, distance to employment, and the like.

But when a property is in need to rehab, the typical prospective purchaser is an investor who is considering holding time, required expertise need to complete the repairs, and any market stigma attached to the needed repairs (e.g. fire damage, or extensive settlement).

Therefore the cost to repair, the holding time and stigma must be taken into consideration when a rehab property is appraised. The absolute best way to reflect the market reaction to such a property is to find sales of other properties that required rehab, track the purchase price, the price of repair, and holding time, marketing time and final sales price (upon completion of the repairs).

Unfortunately, from having reviewed literally 1,000’s of REO Rehab appraisals, I can tell you very few appraisals actually show this type of research or analysis. A few appraisals will present other REO sales and try to address similar (as is) condition. But few actually address the process or the motivations of the prospective purchasers.