What is an appraisal?

A real estate appraisal is a service performed, by an appraiser, that develops an opinion of value based upon the highest and best use of real property. The highest and best use is that use which produces the highest possible value for the property. This use must be profitable and probable. Also of importance is the definition of the type of value being developed and this must be included in the appraisal, ie fair market value, condemnation value, quick sale value, etc. Typically, this value is reported on a standardized form, the Uniform Residential Appraisal Report.

The reader should be aware that differences in nomenclature exist between the different countries. Although the overall concepts are very similar, the reader should be careful to ascertain that the proper nomenclature is being used for their particular area.

Types of value

There are several types and definitions of value sought by a real estate appraisal. Some of the most common are listed:

• Market Value – The price at which an asset would trade in a competitive Walrasian auction setting. Market value is usually interchangeable with fair market value or fair value. The legal definition of market value is usually given by some variant of the following: "The most probable price at which a property would trade in an arms-length transaction in a competitive and open market, in which the buyer and seller each act prudently and knowledgeably and in which the price is not affected by any special relationship between them".

• Value-in-use – The net present value (NPV) of a cash flow that an asset generates for a specific owner under a specific use. Value-in-use is the value to one particular user, which may be above or below the fair market value of a property.

• Investment value - is the value to one particular investor, which may be above or below the fair market value of a property.

• Insurable value - is the value of real property covered by an insurance policy. Generally it does not include the site value.

It is important to distinguish between market value and price. A price obtained for a specific property under a specific transaction may or may not represent that property's market value: special considerations may have been present, such as a family relationship between the buyer and seller, or else the transaction may have been part of a larger set of transactions in which the parties had engaged. Another possibility is that a specific buyer would be willing to pay a price higher than the market value. Such situations often arise in corporate finance, as per example when a merger or acquisition is concluded at a price which is higher than the value represented by the price of the underlying stock. The usual rationale for these valuations is that the 'sum is greater than its parts', since full ownership of a company entails special privileges for the buyer for which he is willing to pay. Such situations arise in real estate/property markets as well (see value-in-use). It is the task of the real estate appraiser/property valuer to judge whether a certain price obtained under a certain transaction is indicative of market value.

Market value definitions in the US

In the US, "Fair Market Value" and "Fair Value" are commonly used as accounting terms. The equivalent appraisal term is "Market Value." (USPAP Advisory Opinion 8.) USPAP defines Market Value as "a type of value, stated as an opinion, that presumes the transfer of a property (i.e., a right of ownership or a bundle of such rights), as of a certain date, under specific conditions set forth in the definition of the term identified by the appraiser as applicable in an appraisal".

Forming an opinion of market value is the purpose of many real property appraisal assignments, particularly when the client’s intended use includes more than one intended user. The conditions included in market value definitions establish market perspectives for development of the opinion. These conditions may vary from definition to definition but generally fall into three categories:

1) The relationship, knowledge, and motivation of the parties (i.e., seller and buyer);

2) The terms of sale (e.g., cash, cash equivalent, or other terms); and

3) The conditions of sale (e.g., exposure in a competitive market for a reasonable time prior to sale).

(Definitions: USPAP 2005.)

In the US, a typical definition of market value can be found on the FNMA residential appraisal forms, as the FNMA 1025, which states the following:

DEFINITION OF MARKET VALUE: The most probable price which a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller, each acting prudently, knowledgeably and assuming the price is not affected by undue stimulus. Implicit in this definition is the consummation of a sale as of a specified date and the passing of title from seller to buyer under conditions whereby: (1) buyer and seller are typically motivated; (2) both parties are well informed or well advised, and each acting in what he or she considers his or her own best interest; (3) a reasonable time is allowed for exposure in the open market; (4) payment is made in terms of cash in U. S. dollars or in terms of financial arrangements comparable thereto; and (5) the price represents the normal consideration for the property sold unaffected by special or creative financing or sales concessions* granted by anyone associated with the sale.

'*'Adjustments to the comparables must be made for special or creative financing or sales concessions. No adjustments are necessary for those costs which are normally paid by sellers as a result of tradition or law in a market area; these costs are readily identifiable since the seller pays these costs in virtually all sales transactions. Special or creative financing adjustments can be made to the comparable property by comparisons to financing terms offered by a third party institutional lender that is not already involved in the property or transaction. Any adjustment should not be calculated on a mechanical dollar for dollar cost of the financing or concession but the dollar amount of any adjustment should approximate the market’s reaction to the financing or concessions based on the appraiser’s judgment.(FNMA form 1025, March 2005.)

Types of ownership interest

• Fee simple value - the most common type of value sought. It is the fair market value of thefee simple interest in a property unencumbered by any external factors such as existing leases.
• Leased fee value - is probably the second most common value opinion sought. It is the property owner's interest in a property that is encumbered by existing long term leases which may be at, below, or above prevailing market trends.
• Leasehold value - is the lessee's interest in a leased property

Note that in the US, the above value nomenclature does not apply. In the US, the type of value needs to be examined separately from the ownership interest. Examples of US use would be a market value of a fee simple ownership interest, or an investment value of a leased fee interest, or a liquidation value of a leasehold interest.

Highest and best use

The highest and best use in real estate appraisal is the use that will render the maximum fair market value of a particular property. That use must be legally allowable, physically possible, have demand in the marketplace, and result in the maximum value for the property. The test of highest and best use is given to a property both as if vacant and as improved.

For example, "House A" in a residentially zoned area may have a highest and best use as vacant and a highest and best use as improved that are both the same. A similar "House B" in a commercially zoned area may have a highest and best use as vacant as a commercial lot and ''highest and best use as improved as a residence. If the value of the commercial lot as vacant in "House B" exceeds the value of house as a residence as improved plus demolition costs, the overall highest and best use of this property would be the as vacant value of a commercial lot.

Since vacant lots are not improved, such properties are generally given only the as vacant test.

The highest and best use is critical to real property valuation since in order to value a property at its fair market value, comparable properties with similar highest and best uses must be examined. In the "House B" scenario, comparing that house to other houses that do not have a similar highest and best use would result in an inaccurate value opinion.

In the US, the legally permissible aspect of highest and best use is very important. In some locations, the governing jusrisdiction can use the "police power" concept to destroy illegally built improvements. This would obviously affect the market value of a property. This overall concept is logical, ie. a governing agency would be remiss to allow a toxic chemical plant to be built in the middle of a suburban area.

Three approaches to value

There are three usual approaches to determining the fair market value of a property, cost approach, sales comparison approach, and income approach. The appraiser will determine which of the approaches is applicable and develop an appraisal based upon information from each individual market area. Costs, income, and sales vary widely from area to area and particular importance is given to the specific location of the property.

Consideration is also given to the market for the property appraised. Properties that are typically purchased by investors (ie. skyscrapers) will give greater weighting to the Income Approach, while small retail or office properties (purchased by owner-users) will give greater weighting to the Sales Comparison Approach. Single Family Residences are most commonly valued with greatest weighting to the Sales Comparison Approach.

Cost approach

The Cost approach is sometimes called the summation approach. The theory is that the value of a property can be estimated by summing the land value and the depreciated value of any improvements. It is the land value, plus the cost to reconstruct any improvements, less the depreciation on those improvements. The value of the improvements is sometimes abbreviated to RCNLD—reproduction cost new less depreciation, or replacement cost new less deprecation. Reproduction refers to reproducing an exact replica. Replacement cost refers to the cost of building a house or other improvement which has the same utility, but using modern design, workmanship and materials.

In most instances, when the cost approach is involved, the overall methodology used is a hybrid of the cost and market data approaches. For instance, while the cost to construct a building can be determined by adding the labor and materials costs together, land values and depreciation must be derived from an analysis of the market data. This approach is typically most reliable when used on newer structures, but the method tends to become less reliable as properties grow older.

Observe that as the Cost Approach has non-market based components (costs), the approach may not be a good indicator of market value, even when new. This is most noticable on properties where the market demand is limited. Say for example a military base. The cost to produce the base is not indicative of its market value, even when new. In the US, the government is the only party that would be willing to "buy" this product. This immediate "loss" is a form of obsolescence.

Also observe that this includes "home improvements" that do not recover their costs in the market. A common example in California is the cost of a pool. In most houses, the cost to build a pool is far greater than the increase in market value to the house. This immediate "loss" is again, a form of obsolescence. Accurately determining obsolescence and depreciation (as the property ages) are usually the main problems within the Cost Approach to opine market value.

Sales comparison approach

The sales comparison approach looks at the price or price per unit area of similar properties being sold in the marketplace. Simply put, the sales of properties similar to the subject are analyzed and the sale prices adjusted to account for differences in the comparables to the subject to determine the fair market value of the subject. This approach is generally considered the most reliable, IF good comparable sales exist.

Income capitalization approach

The income capitalization approach, often simply called the income approach, is used to value commercial and investment properties. This appraoch capitalizes an income stream into apresent value. This can be done using revenue multipliers or single-year capitalization rates of the net operating income. The Net operating income (NOI) is gross potential income (GPI), less vacancy (= Effective Gross Income) less operating expenses (but excluding debt service or depreciation charges applied by accountants).

Alternatively, multiple years of net operating income can be valued by a discounted cash flow analysis (DCF) model. The DCF model is widely used to value larger and more expensive income-producing properties, such as large office towers.

Valuation methods

In the UK, real estate appraisal, or property valuation, is regulated by the RICS, which publishes the Red Book. The Red Book takes a more subtle approach to valuation than the three approaches to appraisal outlined above. The Red Book recognises five methods of valuation:

(1) Comparable method. Used for most types of property where there is good evidence of previous sales. This is analogous to the sales comparison approach outlined above.

(2) Investment/income method. Used for most commercial (and residential) property that is producing future cash flows through the letting of the property. If the current rental value and the passing income are known, as well as the market-determined equivalent yield, then the property value can be determined by means of a simple model. Note that this method is really a comparison method, since the main variables are determined in the market. In standard US practise, however, the closely related capitalising of NOI is confounded with the DCF method under the general classification of the income capitalization approach (see above).

(3) Accounts/profits method. Used for trading properties where evidence of rates is slight, such as hotels, restaurants and old-age homes. A three-year average of operating income (derived from the profit and loss or income statement) is capitalised using an appropriate yield. Since any income stream can be simulated by an appropriate choice of yield, this method is comparable to DCF (see above). Note that since the variables used are inherent to the property and are not market-derived, the resulting value is value-in-use and not market value.

(4) Development/residual method. Used for properties ripe for development or redevolopment or for bare land only.

(5) Contractor's/cost method. Used for only those properties not bought and sold on the market. Both the development/residual method and the contractor's/cost method would be grouped in the US under the cost approach (see above).

Automated valuation models

Automated valuation models (AVMs) are growing in acceptance. These rely on statistical models such as multiple regression analysis and geographic information systems (GIS). While AVMs can be quite accurate, particularly when used in a very homogeneous area, there is also evidence that AVMs are not accurate in other instances such as when they are used in rural areas, or when the appraised property does not conform well to the neighborhood.

This is most evident where there is a renewal or "revitalization" of a particular area or neighborhood. There can exist within a single city block homes that are in poor condition to homes that have been completely rehabilitated and are in good to excellent condition. The differential of sales prices can be demonstrated to be from 50% to 125%. This can lead to an inaccurate model. Extreme caution should be exercised when relying on these AVMs.

Because of the limitations, AVMs have begun to fall out of favor with many lenders but are widely used in other appraisal problems such as mass appraisals forad valorem real estate tax purposes.

In the United States, the rules of real estate appraisal are codified in the Uniform Standards of Professional Appraisal Practice (USPAP)developed by the Appraisal Standards Board which is authorized by Congress as the source of appraisal standards. USPAP guidelines set standards for real estate appraisal practice in the United States. USPAP was developed after the Savings and Loan scandal of the late 1980s when real estate appraisal in some states was essentially an unregulated industry. Government regulations such as the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA) called for stricter guidelines on the appraisal industry. USPAP was developed to protect lenders against unethical and incompetent appraisers.

In the US, the appraisal licensing of individuals is left to the states. However all appraisals for a "Federally Related Transaction" must be performed by an appraiser with the appropriate type of license, and conform to USPAP. The individual states decide if licensing is required for other types of appraisals.

The largest and most influential professional organization of real estate appraisers in America is The Appraisal Institute.