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!




Back to the basics

The more I read residential mortgage related appraisals, underwriter comments and comments from the quality assurance departments from major lenders, the more I have come to realize that it is far beyond time to get back to “preaching” about the basics of this industry. For those of you who have been in the business back when you would take the photos, pull it out of the camera, wait a few moments before you pulled the front off the photo before coating it with the “magic wand” to keep it from fading (thank you Polaroid), I would recommend moving on to another post.

But for the so-called experts of residential appraisal, the current brand of underwriters, and quality assurance “experts” that are being paid to “play appraiser, lawyer and industry regulator” please pull up a chair and let’s puzzle through a few of the basic of this business.

First of all, if you are going to challenge the appraisal report, and your basis for this challenge is UAD please understand this a Uniform Dataset that was mandated by Fannie Mae for the purposes of selling the loan packages to Fannie and Freddie. These dataset requirements are important and should be honored by the appraiser; however, there is no actionable items with regard to prosecuting the appraiser.

Secondly, USPAP has been made the law in all fifty states with regard to regulating the appraisal process and how the report should be presented; however, before you wish to challenge an appraisal report using the Standard Rules of this document it is imperative to take a few ethics courses so that you understand the proper use of this document. Standard 1 of USPAP is for the development of the appraisal. It is really difficult to determine if the process has or has not been followed by evaluating the report. Standard 2 was governs the reporting of the appraisal.

This is the first of several posts, the next series will address various sections of the report and presentation that seem to get overlooked more often than others.

See you around, the water cooler!



Will the Madness Ever Stop???

Having spent the day commiserating with my fellow appraisers, I have to admit the policies and procedures of most reviewers, underwriters and lenders  have finally crossed the line from insane to inexplicable.  It was bad enough, 23 years ago when an appraiser was asked to document two independent sources of data or to provide interior photographs to show each room. Then not to long ago some appraisal management companies started to believe that when FHA asked for two photos to show an oblique view, they actually meant the appraiser had to take four photos one showing the front, one side (A), the back and one side (B).

But now appraisers are asked to provide exterior photos, interior photos, multiple views of rooms (for instance if all appliances are not shown in the view of a kitchen, take a second photo to show the dishwasher). But one appraiser called me today, because he provided the second photo of a kitchen to proactively show the dishwasher only to have the lender bounce the report because the sketch and report failed to discuss the second kitchen.

I am sorry, when does alternative view of kitchen constitute a dwelling with two kitchens. I am completely for appraisers presenting a document that is clear, well supported, and correct. I am all for having the appraiser present a detailed summary of the search criteria that was used, and perhaps even a one line listing of the alternatives that were available at the time of the report. But what was the point of the appraiser providing all of this data? Was it so that some nit-wit reviewer (like me) can then beat the appraiser about the head and neck with the extraneous data that was reported?

What happened to a time, when the clients were careful to only use real estate appraisers who had established their reputations for excellence and accuracy? Yes, I understand to find this time you are forced to go back several decades, beyond when my career started. But it used to be enough to do business with people of character, then when they said yes – it meant yes. Should they say no, it was because they were unable to find market support. This system of trust, of course is unrealistic, because there are entirely too many ways to cheat the system and hundreds of billions of dollars can corrupt the hearts of men. So this brings me full circle. We now have a system of review that forces the appraiser on the immediate defensive and without the ability to provide a detailed body of evidence the appraiser is left hanging.

Independent, impartial, and objective, wasn’t that suppose to be the mantra? Today’s legislation has forced appraisers to take all of their business and place it into the hands a few management companies. In turn, if you upset one client, the management company may take you of off their list which then means you could be excluded from the other 35 companies (or more many more) that the management company represents. The character of an appraiser is being tested more now than ever, and I believe that review appraisers need to begin to be the voice of reason within their respective companies. So what’s the problem? The problem is that appraisal management companies are not formed as buffer between the client and the appraiser. They are not formed to protect the interest of the public. They are formed because there is a very large profit to be made. The company that can successfully produce real estate appraisals that please the client will continue to get the work, and when you are representing a nationwide data base of every available appraiser it is not a problem to sift panel until you find those individuals who are willing to give you the product you seek.

Okay, time out!!!! Am I suggesting that in our attempt to make things better, we simply traded one set of task masters for another set? Well, frankly that is exactly what I am suggesting. Do not misunderstand this post, there are reputable appraisal management companies, and reputable lenders who are simply trying to make a profit and keep their employees busy and, well, employed.  There are just as many reputable real estate appraisers who are doing their jobs well and holding up the standards that is to say Uniform Standards of Professional Appraisal Practice (USPAP) with pride. The concern that I have is that we have once again set up a system where a few can dictate the livelihoods of many. This very system places pressure on those who are mandated by law to be Independent, Impartial and Objective.

Okay, so this is the system we have. How do we proceed? For some of us, it is simply time to move over and let younger, stronger, smarter leaders prevail. For others, it is time to engage and to talk and write to anyone who will listen about how systems of production and appraisal need to change so that the client has the ability to receive prompt professional appraisals and the appraiser has the flexibility to produce a well supported opinion of value without the client being able to dictate the predetermined results.

For now – suffice it to say this. Review appraisers, (whether they work for the lender, investor, auditing firm, criminal investigations (like the FBI, or IRS), or they work for an appraisal management company), need to remember that they are bound by the same laws as independent fee appraisers with regard to independent, impartiality and objectivity. At the end of the day, we are the ones who are charged:

1) to have common sense

2) to promote and protect the interest of the general public

3) to use those methods of appraisal that have been tested and proved to be reliable indicators of market reaction

4) to  accurately and objectively analyze the market data to determine value

5) and present our findings in a clear, easy to understand manner.

and as the reviewers, we should make sure the appraisal was presented in a way that reflects all of the above.

The task is daunting, yes, but if we are truly honest with ourselves this entire process is the same process that was supposed to be in place, and for a very large part was in place to start with. So why did it fail? Because key components, checks and balances if you will, were removed from the process and more importantly the character and capacity of the loan was radically changed. As appraisers we are trained to evaluate the collateral, the collateral valuation should be the same whether or not a borrower has a dollar or several million of them. The very idea of “making business decisions” should never have included the review appraiser. By design the underwriters and reviewers were kept apart in doing someone could go to the underwriting manager and say “the collateral is sound, please make an exception on this file” and at the same time go to the review manager and say “the borrower is strong, please make an exception on this file”. Pushing both sides of the deal and creating pools of non-performing loans.

Ok that was then, this is now. How do we keep from making these same mistakes? Simple, pull the power from the all-star sales managers. Keep the operations, underwriting and appraisal managers all on the same page so that everyone understands and knows the level of risk that is being proposed and make sure the loan is priced at a level that accurately reflects its risk.

What has not be discussed, is the investors who purchase this bad paper. There has been some kick back, but I anticipate the ramifications are yet to be felt.

Rather than a post, this is more of a ramble – or a rant. Either way, I feel better.

See you around the water cooler.



Was it something that I said?

How many times have you had a phone call from review appraiser, underwriter or investigator to question your work? The majority of appraisers never get these calls, then why are we so paranoid about how we write a report, what we say, and if we can give evidence to support our statements? The answer is simple, the questions that people ask are not the questions we dread. The questions that we dread are those question that linger in the mind of the reviewer, or investigator. The questions that lead to having us removed from a panel or placed under subpoena. Generally speaking, it is less than 4% of residential appraisers that find themselves in court or a very large percentage of us lose work or our professional standing because of a report that was poorly presented.

When the phone rings or you receive that ominous email, take the opportunity to glean the reviewers thoughts. Don’t waste your time with bluster or posturing, this is not a contest to see who has better control of their urinal flow. It is indeed an opportunity to make a connection with your client, possibly to help them understand your reasoning or your market area, or it is an opportunity to for the appraiser to learn and improve.

Either way, take advantage of this contact and do not waste the limited times that you actually have to interact in person with a real live client, or potential client.

Remember to properly document your work files, and stay focused. A challenge does not mean you have done something wrong, often times it is a client that did not clearly understand the report. Still, if we remember that our first job is to present a report in a way that is easy to follow and not misleading, if we are receiving too many calls it may be time to reconsider the manner in which we are presenting our appraisals.

Remember not to take yourself too seriously. Nobody else does. And for the parents, the next time you feel like you are getting too “puffed up” just spend some time talking to your pre-teens or teenagers and you will be reminded very quickly just how little you really know.

See you around the water cooler!