An Appraisal Is Performed to Answer a Client's Question About Real Estate. To

Chapter 23

RECONCILING VALUE INDICATIONS

Reconciling Value Indications 543

An appraisal is performed to answer a client's question about real estate. To

answer the question, the appraiser follows the valuation process. In the

J'A course of this process, the appraiser identifies, gathers, and analyzes

general and specific data; determines the property's highest and best use; and

applies the direct comparison approach, income approach (direct capitalization and

discounting), and cost approach as warranted by the question and as suggested by

the available data.

Usually more than one approach is applied, and typically each approach results in a different indication of value. Therefore, if two or more approaches are used, the appraiser must reconcile at least two value indications. Moreover, several value indications may be derived in a single approach. In the direct comparison approach, for example, the analysis of each comparable sale produces an adjusted sale price, which is an indication of value; when the sales are considered together, the various units of comparison may also produce different value indications. For example, apartment properties may be analyzed in terms of price per dwelling, price per room, price per square metre of GBA, or price per square metre of rentable area. In an analysis of income, different indications of value may result from applying gross income multipliers to income streams, directly capitalizing net income, and discounting cash flows.

The appraiser often resolves multiple value indications within a single approach as part of the application of the approach. In other cases, however, an appraiser may choose to resolve these differences after reviewing the entire appraisal. This is acceptable so long as the integrity of each approach is maintained. Resolving the differences among various value indications is called reconciliation. Reconciliation is the analysis of alternative conclusions to arrive at a final value estimate.

REVIEW

To prepare for reconciliation, the appraiser reviews the entire appraisal, making sure that the data available and the analytical techniques, rationales, and logic applied have led to consistent judgements. Data are reviewed to ensure that they are authentic, pertinent, and sufficient. The value defined, the legal estate appraised, and the qualifying conditions imposed are carefully reconsidered to ascertain whether the methods and techniques used in the analysis specifically address each of these items. The appraiser should examine the differences in the conclusions derived from the various approaches, apply tests of reasonableness to these primary conclusions, and resolve any inconsistencies. For example, is the effective age of the property used in the cost approach consistent with the physical condition reported? Is the same physical condition used as the basis for adjustments to rent comparables, expense comparables, and sales comparables in the income and direct comparison approaches? Are the results of all the approaches consistent with the appraiser's determination of highest and best use?

All mathematical calculations should be verified, ideally by someone other than the person who derived them originally. Significant errors can lead to incorrect value indications, but even minor errors can destroy the client's confidence in the appraisal. Finally, the logic employed throughout the valuation process should be scrutinized. Do the approaches and methods applied consider all the available data, and systematically lead to meaningful conclusions that relate directly to the purpose of the appraisal? Does the appraisal provide the type of advice required to solve the client's problem? For example, if the client wants to establish a deprecia

544 The Appraisal of Real Estate

tion basis to compute income tax, does the appraisal give separate values for the improvements and the land? If the client contemplates remodelling, have the costs and benefits of this plan been explored? If the client needs insurance coverage, does the appraisal contain a wellsupported insurable value estimate that is consistent with the carrier's definition? If the client is considering an offer to purchase, has the appraiser adequately analyzed the terms of the proposed contract?

RELATIONSHIP TO THE VALUATION PROCESS

The resolution of differences among valuation procedures may depend on subtle differences in the objectives of the appraisal or in the interests being appraised. For example, if an appraiser is estimating the market value of a proposed office tower both as completed and occupied and as completed but unoccupied, the value contribution represented by stabilized occupancy must be carefully weighed in each approach.

In all appraisals, and particularly in appraisals required for litigation, the definition of the appraised value should be reexamined in reconciliation. Does the clientspecified definition call for the value to be expressed in cash equivalent financing or in simple cash? Does it call for the most probable price or the highest price available in the open market? Does it call for the value to be commensurate with all the uses to which the property is adaptable, or merely the highest and best use? The appraiser should consider the use of the appraisal. Should the value be commensurate with the current highest and best use or with all of the uses to which the property could be put or to which it could be physically, legally, and economically adapted?

Appraisers may also need to answer questions that relate to the potential users of property. Can the investment value of a property as part of an assemblage be reasonably reconciled with an estimate of the property's market value to a typical purchaser? Can the intrinsic value of a new office property be reasonably reconciled with an estimate of its market value for a mortgagee who is contemplating foreclosure? Must an opinion of the insurable value of a property be reconciled with the market value contribution of the insurable improvements?

RELATIONSHIP TO THE MARKET

Appraisers should keep in mind that an appraisal client seeking a professional opinion often wants to know the basis for that opinion as well. The final value estimate represents the application of the appraiser's judgement to mathematical results. An appraiser should employ the quantity of data that market participants would consider appropriate to solve the appraisal problem at hand. These data should be applied consistently in each approach that is relevant to the appraisal problem. The valuation process is a collection of available tools from which an appraiser selects the most appropriate in any given case.

Approaches that are not of primary importance in a specific assignment may be useful in reconciliation. In some cases, for example, the cost approach may not be useful to the appraiser and is thus omitted; nevertheless, the reconciliation may consider the difference between 1) the sum of the reproduction cost new and the land value, and 2) the final opinion of market value. A discussion of the degree of apparent depreciation is often instructive.

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All estimates used in the approaches to value must be consistent with market perceptions. The appraisal conclusion should reflect market value and the data analyzed should support the appraiser's final value opinion, but the data alone do not produce the value estimate. By combining data analysis with professional training and experience, the appraiser is able to exercise good judgement and form a sound value opinion. Sometimes an appraiser must offer substantive, albeit subjective, judgements when precise market information is not available. The effect of these judgements must be evaluated in the reconciliation process. When an appraisal assignment calls for an estimate of market value but market data are scarce, the opinion of an impartial appraiser who has pertinent training and experience may be relied on.

PRINCIPLES OF RECONCILIATION

An essential element of reconciliation involves the review of the basic principles that are fundamental to the valuation process. In reconciliation, preliminary conclusions need to be tested to ensure the report, and its conclusions, adhere to the following principles.

Value is a prediction. The appraiser ought to reexamine the indications of value as objectively as possible, and question whether the result represents a realistic prediction of the behaviour of the forces that make up its market.

Value is subjective. The value of any particular property may vary with different purchasers, due to emotional reasons or particular investment or other requirements. While it is often for very subjective personal reasons that a particular property will trade between two particular individuals, it is the sum of these subjective decisions that make up the marketplace. Is the value concluded reflective of a single sale that is not reflective of the marketplace, or is the value concluded representative of the probable price that will be negotiated between typical purchasers and vendors in the marketplace?

Appraising is comparing. Reconciliation, particularly the final reconciliation leading to the conclusion of value, must take into account a multitude of comparisons made throughout the appraisal process, not an arbitrary or inconsistent selection of partial components from each approach. Comparison is fundamental to the entire process, so great care is necessary when finding and using comparables.

Market orientation. In the final analysis, an appraisal must reflect the marketplace. Blind reliance on financial formulas or units of comparison that, while convenient, do not reflect the thoughts of participants in the marketplace is simply unacceptable without verification and testing of the underlying hypothesis against market behaviour.

Each of the three approaches to value is market oriented to a greater or lesser extent. Costs, depreciation allowances, income and expenses, and capitalization rates are all derived from the marketplace and the people who operate in it. Market data cannot be overstressed in the final estimation of value.

RECONCILIATION CRITERIA

Reviewing an appraisal helps substantiate its accuracy, its consistency, and the logic leading to the value indications. However, an appraiser relies more on professional experience, expertise, and judgement in reconciliation than in any other part of the valuation process. In reconciliation, an appraiser considers and

546 The Appraisal of Real Estate

evaluates varying value indications to arrive at a final value estimate. The appraiser weighs the relative significance, applicability, and defensibility of each value indication and relies most heavily on the approach that is most appropriate to the nature of the appraisal. All factors that influence the assignment are brought into focus and related to the client's question, which ultimately guides the appraiser's deliberations.

Reconciliation requires appraisal judgement based on a careful, logical analysis of the procedures that lead to each value indication. Appropriateness, accuracy, and quantity of evidence are the criteria with which an appraiser forms a meaningful, defensible final value estimate. These criteria are used to analyze multiple value indications within each approach and to reconcile the indications produced by the different approaches into a final estimate of defined value.

Appropriateness

Using the criterion of appropriateness, an appraiser judges how pertinent each approach is to the purpose and use of the appraisal. The appropriateness of an approach is usually most directly related to property type and market viability. For example, an appraisal to estimate the market value of a 30yearold community shopping centre will ordinarily employ procedures associated with the income approach, e.g., the derivation of a gross rent multiplier, net income capitalization, and the discounting of cash flows. The cost approach might not be useful in valuing obsolete improvements, but it may be applied to estimate land value and determine, through an analysis of highest and best use, whether demolition of all or part of an improvement is appropriate. The direct comparison approach can be used to obtain value indications through analysis of physical units of comparison.

Although the final value estimate is based on the approaches that are most applicable, the final value opinion need not be identical to the value produced by the most applicable approach. If two approaches are applicable, the final estimate of value may be closer to one value indication than to the other. For example, assume that the value indication derived from the income approach is lower than the value derived from the direct comparison approach. If market participants are primarily interested in incomeearning potential, the final estimate may be closer to the value indicated by the income approach than the value derived from sales comparison. For a different type of property such as an owneroccupied dwelling, the direct comparison approach is likely to be of primary relevance.

The criterion of appropriateness is also used to judge the relevance of each comparable property and each significant adjustment made in an approach. The appraiser asks whether this comparable property is a valid and reliable indicator of the value of the subject property. Is it similar in terms of physical characteristics and location? Was it developed, rented, or sold in the same market? Are the characteristics of the transaction similar to those expected for the subject property? If relevant, are the expenses of the comparables appropriate indicators of the expenses of the appraised property? Similarly, if relevant, are the estimates of accrued depreciation in the subject justified by comparison of comparable costs and comparable sales?

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Accuracy

The accuracy of an appraisal is measured by the appraiser's confidence in the correctness of the data, the calculations performed in each approach, and the adjustments made to the sale price of each comparable property. For example, are the cost data and estimates of accrued depreciation used in the cost approach as accurate as the adjustments made in the direct comparison approach, or as the income, expenses, and capitalization rates applied in the income approach? An appraiser may have more confidence in the accuracy of the data and calculations used in one approach than in the others.

The number of comparable properties, the number of adjustments, and the gross and net dollar amounts of adjustments may suggest the relative accuracy of a particular approach. If a large number of comparable properties are available for one approach and seem to conform to a reasonably close pattern of market activity, greater accuracy may be indicated and the appraiser may place more reliance on this approach than would otherwise be the case. For example, if there are many properties competitive with the subject property, an appraiser can extract income and expense data and capitalization rates from these properties. In this instance, the appraiser might attribute greater accuracy and confidence to the income approach and less to the cost approach or to estimates of price per square metre.

If fewer total adjustments must be made to one or two comparable properties than to other comparables within an approach, an appraiser may attribute greater accuracy and weight to the value indications obtained with fewer adjustments, particularly if the magnitude of the adjustments is approximately the same. Although the number of adjustments among comparable properties may be similar, the gross dollar amount, i.e., the absolute value, of the total adjustments might vary considerably. For example, in the direct comparison approach, an appraiser may analyze five comparable properties that each require nine adjustments. However, the gross dollar amount of adjustments for one comparable property may total 15% of the sale price, while the gross dollar amount of the adjustments for the other four properties may be less than 5% of each sale price. If the sales are otherwise similar, less accuracy will probably be attributed to the comparable properties that require large adjustments.

In some cases, however, one large adjustment may be more accurate and supportable in the market than many smaller adjustments. For example, an appraiser may find abundant market evidence in a community to indicate the amount of value diminution caused by an atypical vacancy rate in one of the comparable buildings. Even though a large adjustment is required, the appraiser might impute greater accuracy to this sale because reliable market evidence supports the adjustment.

Usually, the net dollar amount of adjustments is a less reliable indicator of accuracy. The net adjustment is calculated by totalling the positive and negative adjustments to a sale and then subtracting the smaller amount from the larger amount. This figure may be misleading because one cannot assume that any inaccuracies in the positive and negative adjustments will cancel each other out. Several adjustments that are all positive (or all negative) may be more accurate and produce a smaller total gross adjustment than a combination of positive and negative adjustments.

Inaccuracies may be compounded when several adjustments are added or multiplied. The precise arithmetic conclusion derived from adjusted data should support, rather than control, the appraiser's judgement.

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Quantity of Evidence