Chapter 4
THE VALUATION PROCESS
67 The Valuation Process
The concepts that are fundamental to appraisal thought serve as the basis for all the actions appraisers perform in addressing their clients' needs. These actions constitute the valuation process, a systernatic procedure employed to provide the answer to a client's question about real property value. The valuation process is both a model and a mirror of appraisal activity and, as such, it reflects many attitudes, beliefs, techniques, and methods that relate to questions of value. The theory of valuation, as distinct from the theory of value, began to take form in the late nineteenth century. Alfred Marshall (18421924), the British economist who formulated the neoclassical theory of value as a synthesis of earlier theories, anticipated and developed many of the concepts employed in contemporary appraisal practice. These concepts include the determination of site value through capitalization of income, the impact of depreciation on buildings and land, and the influence of different building types and land uses on site value.
Marshall is also credited with identifying the three traditional approaches to value: market (direct) comparison, replacement cost, and capitalization of income. Irving Fisher (18671947), an influential American economist associated with the neoclassical school, fully developed the income theory of value, which is the basis for the income approach used by modern appraisers.1
As pointed out in Real Estate Appraising in Canada, third edition, 1987, published by the Appraisal Institute of Canada, while the appreciation of the difference between the concepts of price and value dates back at least to the Greek philosophers of 2,500 years ago, and philosophical notions of value pervade the essays of Adam Smith (1723 1790) that for 200 years have provided the foundations of modern economics, the valuation of real estate as an art, not a science, traces its roots to the cradle of capitalism and the great fortunes of the western world. Also logical is that Europe led North America in thinking about and organizing the vocation of real estate appraisal. The first and still eminent organization of
Alfred Marshall
(Historical Pictures/Stock Montage)
68 The Appraisal of Real Estate
real estate appraisers was founded in June 15, 1868 in England. Now called the Royal Institution of Chartered Surveyors, it exists to "elevate and improve the profession of surveyors in England." The American Institute of Real Estate Appraisers now the Appraisal Institute established in 1932, combined many of the institutions and ideas of the British model with North American thinking and philosophies in developing the American appraisal theory and practises.
These appraisal organizations were founded on two underlying principles. First, to establish a logic, or body of knowledge, to guide practitioners in estimating real property values. Second, to engender independence of thought and action among their members.
In Canada, it was the Great Depression of the 1930s that gave impetus to the formation of the Appraisal Institute of Canada. Financial institutions that had eagerly poured mortgage money into prairie homesteads in the booming twenties suddenly inherited title to hundreds of idle or only marginally productive farms, covering thousands and thousands of hectares. Farm inspectors, the equivalent of today's portfolio managers, began to compare notes on the logic and methods they used to appraise their properties.
These informal discussions led inevitably to a recognition of the advantages of organized effort. The leading figures in the movement, scattered across the three prairie provinces, invited D. Howard Doane, an eminent American authority, to speak on the American appraisal system at a conférence attended by 200 managers and inspectors in Winnipeg in 1936. Mr. Doane's logic and eloquence was convincing: on February 21, 1938, the western land inspectors formed an association called the Appraisal Institute of Canada, and elected its first governing council of 10 members.
MODERN APPRAISAL THEORY
The writings of Marshall, Fisher, and other economists of the late nineteenth and early twentieth centuries were read by scholars and business professionals interested in economic thought. At the same time, the field of real estate appraisal was emerging and a few practitioners were gaining experience estimating market value and other kinds of value for properties of various types. In the 1920s and 1930s, several events helped to establish appraisal as a young, but viable, real estate function in the U.S.
One motivating force was the introduction of land economics as an academic discipline. Land economics developed from the interrelationship of several disciplines and attracted scholars and students who contributed significantly to real estate and appraisal literature over the next 40 years. This influential group included Richard T. Ely (18541943), the founder of land economics as an academic subject, Frederick Morrison Babcock (b.1898), Ernest McKinley Fisher (18931981), and Arthur J. Mertzke (18901970). Each of these men participated in research and publication programs that advanced real estate education.
Ely, Babcock, and Fisher contributed to the Land Economics Series published by the National Association of Real Estate Boards, the predecessor of the National Association of Realtors~. The Land Economics Series was the first major publication effort designed to provide real estate professionals with current technical information. The first texts in this series were Fisher's Principles of Real Estate (1923), Ely and Moorehouse's Elements of Land Economics (1924), and Babcock's The Appraisal of Real Estate (1924).2
Another significant event in North American appraisal history was the
69 The Valuation Process
publication of Real Estate Appraising by Arthur J. Mertzke in 1927. In this book, Mertzke used Alfred Marshall's ideas to produce a tangible link between value theory and valuation theory. In the words of one scholar, “Mertzke translated the economic theory of the equivalence between longrun costs, normal value, and capitalizedincome values (under specifically assumed conditions of perfect competition and economic equilibrium) into a working appraisal theory.”3
Mertzke helped establish a clear emphasis on the three approaches to value and explained the use of capitalization rates as indexes of security.
The preeminence of the three approaches to value in the appraisal process was underscored in publications by K. Lee Hyder (18881947), Harry Grant Atkinson (18901979), and George L. Schmutz (18931958).4 Each of these works set forth systematic procedures for applying the direct comparison, cost, and income approaches under appropriate conditions to answer clients' questions about value. Schmutz presented this process in diagram form, suggesting a model in which appraisal activity leads to a conclusion of value. Later, this model was incorporated into The Appraisal of Real Estate, first published by the American Institute of Real Estate Appraisers in 1951.
In the years following these and other early works, appraisal theory continued to evolve in North America. Today, education requirements have become stringent and appraisers make use of many analytical methods and techniques. Applying these methods and techniques to an expanding database presents new challenges and raises questions as to how applicable the valuation model is to actual appraisal assignments, how well it analyzes the forces that affect value, and how accurately it interprets the actions and motivations of market participants.
THE VALUATION PROCESS
The valuation process begins when an appraiser identifies the appraisal problem and ends when lie or she reports a conclusion to the client.
Each real property is unique and many différent types of value can be estimated for a single property. The most common appraisal assignment is performed to estimate market value; the valuation process contains all the steps appropriate to this type of assignment. The model also provides the framework for estimating any other defined value. Furthermore, evaluation assignments often call for value estimates which are derived through application of the valuation process.
The valuation process is accomplished through specific steps; the number of steps followed depends on the nature of the appraisal assignment and the data available. The model indicates a pattern that can be used in any appraisal assignment to perform market research and data analysis, to apply appraisal techniques, and to integrate the results of these activities into an estimate of defined value.
Research begins after the appraisal problem has been defined. The analysis of data relevant to the problem starts with an investigation of trends observed at all market levels international, national, regional, community, and neighbourhood. This examination will help the appraiser understand the interrelationships among the principles, forces, and factors that affect real property value in the specific area. It also provides raw data from which to extract quantitative information and other evidence of market trends such as positive or negative percentage changes in property value over a number of years, the population movement into an area, and the number of employment opportunities available and their effect on the purchasing power of potential property users. These data can be analyzed and employed to estimate a defined value.
70 The Appraisal of Real Estate
Traditionally, appraisal techniques are the specific procedures within the three approaches that are applied to derive indications of real property value. Other procedures such as the use of inférential statistics and economic models also contribute to appraisals. One or more approaches to value may be used depending on their applicability to the particular appraisal assignment.
In assignments to estimate market value, the ultimate goal of the valuation process is a wellsupported value conclusion that reflects all the factors that influence the market value of the property being appraised. To achieve this goal, an appraiser studies a property from three différent viewpoints, which correspond to the three traditional approaches to value.
1. The value indicated by recent sales, listings or offers to purchase of comparable properties in the market the direct comparison approach
2. The current cost of reproducing or replacing the improvements, minus the loss in value from depreciation, plus site value the cost approach
3. The value of a property's earning power based on the capitalization of its income the income approach
The three approaches are interrelated; each requires the gathering and analysis of sales, cost, and income data that pertain to the property being appraised. Each approach is outlined briefly in this chapter and discussed in detail in the subsequent chapters.
From the approaches applied, the appraiser derives separate indications of value for the property being appraised. One or more of the approaches may not be applicable to a specific assignment or may be less reliable due to the nature of the property, the needs of the client, or the data available.
To complete the valuation process, the appraiser integrates the information drawn from market research and data analysis and from the application of approaches to form a value conclusion. This conclusion may lie presented as a single point estimate of value or as a range within which the value may fall. An effective integration of all the elements in the process depends on the appraiser's skill, experience, and judgement.
The valuation process is depicted in Figure 4.1.
DEFINITION OF THE APPRAISAL PROBLEM
The first step in the valuation process is development of a clear statement of the appraisal problem. This sets the limits of the appraisal and eliminates any ambiguity about the nature of the assignment. The statement of the problem should include:
- Identification of the real estate
- Identification of the property rights to be valued
- Use of the appraisal, i.e., its purpose
- Definition of value
- Date of the value estimate
- Description of the scope of the appraisal
- Other limiting conditions
- Agreement with the client
71 The Valuation Process
Figure 4.1 The Valuation Process
Definition of the Problem
IdentificationIdentificationUseDefinitionDate ofDescriptionOther
ofof propertyofofvalueof scope oflimiting
real estaterights toappraisalvalueestimateappraisalconditions
be valued
Preliminary Analysis and Data Selection and Collection
GeneralSpecificCompetitive Supply and Dernand
(Region, city and(Subject and comparables)(The subject market)
neighborhood)
Site and improvementsInventory of competitive
SocialCost and depreciationproperties
EconomicIncome/expenseandSales and listings
Governmentalcapitalization rateVacancies and offerings
PhysicalHistory of ownershipAbsorption rates
and use of propertyDemand studies
Highest and Best Use Analysis
Land as though vacant
Property as improved
Specified in terms of
use, time, and market participants
Land Value Estimate
Application of the Three Approaches
Cost DirectcomparisonIncome
Reconciliation of Value Indications and Final Value Estimate
Report of Defined Value
Identification of the Real Estate
A property is first identified by a street address, a location, or sorne other descriptive data that enable it to be located. A complete legal description specifying the exact location and boundaries of the property is provided later. Examples of property identification follow:
72 The Appraisal of Real Estate
Reference:The Pacific Press Building,commercial offices
Street address:1200 West Pender Street, Vancouver, British Columbia
Legal Description: Lot A, Block 30, District Lot 285, New Westminster District Plan 92
If the property is identified with a legal description, the description should be accurate. Legal descriptions of real estate are usually derived from land surveys and preserved in public records in accordance with provincial law. Appraisers should be familiar with the specific systern or systems used to describe land in various areas and be sure that the legal description is reasonable. Land may be legally described in Canada by a nurnber of systems, including metes and bounds; registered plans of subdivision; refèrence plans; condominium or strata plans; section, range or township concession, and parcel number in a registered land titles plan. (These systems are described in Chapter 9 and in Basics of Real Estate Appraising, published by the Appraisal Institute of Canada).
Identification of the Property Rights To Be Valued
The valuation of real property includes both the physical real estate and the rights that one or more individuals or legal entities may hold or contemplate holding in the ownership or use of the land and improvements. An appraiser may estimate the value of a fee simple estate or of partial interests created by the severance or division of ownership rights. Special attention must be given to any limitations on ownership rights such as easements, encroachments, rights of way, or leases. Financing must also be considered because fee simple estates, leasehold estates, leased fee estates and life estates can all be mortgaged. The specific rights to be valued and the probable or actual financing involved must be ascertained at the start of the assignment because the complexity of these rights and terms will determine the procedures, skills, and time required to complete the assignment.
The fee simple estate in property is often valued before partial interests are considered. However, the dollar value of the fee simple estate is not necessarily equal to the sum of the values of all partial interests; the value of a partial interest may differ from the value of its contribution to the whole. For instance, a 50% interest in a property in which the owner does not have majority control may have significantly less value than 50% of the fee simple value; this lower value could be a direct result of dividing the fee simple estate. To estimate the market value of a partial interest in real property, direct market evidence of market attitudes toward the particular aspects of that partial interest is usually sought.
Use of the Appraisal
The use of an appraisal is the manner in which a client employs the information contained in an appraisal report. The client may specify the purpose or use of the appraisal when requesting it; if not, the appraiser may have to solicit this information, guiding the client to ensure a clear understanding of the question. Because an appraisal provides the basis for a decision regarding real property, the nature of the decision affects the character of the assignment and the appraisal report. A
73 The Valuation Process
value estimate may be needed to determine the following:
- Price at which to buy or sell
- Amount of a loan
- Basis for taxation
- Terms of a lease
- Value of real property assets in financial statements
- Basis for just compensation in expropriation proceedings
To avoid wasted effort, the appraiser and the client must reach a mutual understanding concerning the use or purpose and ownership of the appraisal report and its conclusions.
Definition of Value
The purpose of the valuation process is to estimate the value of a real property interest, so the specific type of value and the interests involved must lie clearly identified. The statement of purpose in the final report of defined value specifies the stated scope of the valuation assignment, i.e., to estimate a defined value of a real property interest. Types of appraised value include market value, use value, goingconcern value, investment value, assessed value, and insurable value.
A written statement of the defined value to be estimated must be included in every appraisal report. This precise statement establishes the question to be answered for the client, the appraiser, and all readers of the report. It explains the data selected for consideration and the methods employed to analyze the data, thus supporting the logic and validity of the final value estimate. The statement also specifies whether the value estimate is reported in terras of cash, terms equivalent to cash, or other precisely revealed terms.
Date of the Value Estimate
The date of a value estimate must be specified because the forces that influence real property value are constantly changing. Although conditions observed at the time of the appraisal may persist for a considerable time after that date, an estimate of value is considered valid only for the exact date specified. Market value is generally seen as a reflection of market participants' perceptions of future economic conditions, and these perceptions are based on market evidence at a specific point in time. Value influences reflect economic conditions at a particular time, and sudden changes in business and real estate markets can dramatically influence value.