16 Comprehensive Guide to Real Estate Appraisal Principles and Practices and Appraisal Principles
Definition and Scope of Real Estate Appraising
Real estate appraisal is defined as an opinion of value that is grounded in supportable evidence and derived through approved methodology. An appraisal report serves to provide a comprehensive analysis of detailed market information. The individual responsible for this task, the appraiser, is an independent professional who is expected to provide an unbiased opinion regarding the property's value. It is important to note that appraising is a professional service for which a fee is charged; however, ethical standards dictate that this fee must never be based upon the value of the property being appraised. To ensure the integrity of this process, Fannie Mae established the Appraiser Independence Requirements, commonly known as AIR.
Regulation and Oversight of Appraisal Activities
The regulation of appraisal activities is largely governed by the Financial Institutions Reform, Recovery, and Enforcement Act of 1989, abbreviated as FIRREA. This act mandates that appraisals conducted as part of a federally related transaction must be performed by an appraiser who is either state-licensed or state-certified. A federally related transaction is defined as any real estate-related financial transaction involving a federal financial institution or a regulatory agency. There are specific thresholds regarding when a licensed or certified appraiser is required: appraisals for residential properties valued at or less do not strictly require a licensed or certified professional. Furthermore, Fannie Mae does not require a new appraisal for transactions categorized as a limited cash-out refinance. Conversely, for nonresidential properties, any valuation exceeding requires the services of a certified appraiser.
Appraiser Qualifications and Professional Organizations
The Appraisal Foundation consists of several boards that oversee different aspects of the profession. The Appraisal Qualifications Board, or AQB, is responsible for setting the criteria for state licensing and certification. The Uniform Standards of Professional Appraisal Practice, known by the acronym USPAP, were also established by the Appraisal Foundation to provide a standard of conduct. Additionally, the Appraisal Practices Board, or APB, offers detailed guidance on specific valuation methods and techniques. Several professional organizations support the industry, including the American Society of Appraisers, the American Society of Farm Managers and Rural Appraisers, Inc., the Appraisal Institute, the International Association of Assessing Officers, and the International Right of Way Association.
Comparative Market Analysis and Broker Price Opinions
While formal appraisals are conducted by licensed professionals, real estate licensees often perform a comparative market analysis, or CMA, when helping a seller determine a listing price. A CMA relies on data from recently sold properties, currently active listings, and expired listings. Another alternative is the Broker’s Price Opinion, or BPO. This is a less expensive method often utilized by lenders for home equity lines of credit, portfolio management, refinancing, and collections. BPOs are frequently conducted as "drive-bys," where the professional verifies the property's existence and provides a list of comparable properties without a full interior inspection.
The Formal Appraisal Process and Documentation
The appraisal process follows a logic-based sequence of steps. First, the appraiser must define the problem, which includes identifying the specific type of value being sought. Second, the scope of work is determined. Third, the appraiser must gather, record, verify, and analyze necessary data. This data is categorized into general data, which encompasses national, regional, city, and neighborhood factors, and specific data, which pertains to the subject land and its improvements. Both types of data inform the three approaches to value. Following data analysis, the appraiser forms an opinion of value using each of the three approaches. These values are then reconciled to reach a final opinion, which is documented in an appraisal report. The standard form for residential work is the Uniform Residential Appraisal Report.
Core Characteristics and Economic Principles of Value
In the context of real estate, value is defined as monetary worth based on desirability. For a property to have value, it must possess four characteristics, often remembered by the acronym DUST: Demand, Utility, Scarcity, and Transferability. Demand represents the need or desire for ownership coupled with the financial ability to pay. Utility is the item’s usefulness for its intended purpose. Scarcity refers to the finite nature of the supply, and Transferability refers to the ease of moving ownership rights from one person to another.
Several economic principles influence value. The principle of Anticipation suggests value is created by the expectation of future events. Change posits that no physical or economic condition stays constant. Competition relates to the interaction of supply and demand, where excess profits attract more competitors. Conformity states that maximum value is achieved when land use is in harmony with its surroundings. Contribution measures how much a specific part of a property adds to the whole. The principle of Highest and Best Use identifies the single most profitable use of a property that is physically possible, legally permitted, economically feasible, and maximally productive. Other principles include Increasing and Diminishing Returns, where improvements eventually stop adding value, and Plottage, which is the increase in value achieved by consolidating adjacent lots under one owner. Finally, Regression and Progression describe how the presence of lesser or better quality properties affects a subject's value, while Substitution suggests that the maximum value is set by the cost of an equally desirable replacement.
Distinctions Between Market Value, Price, and Cost
It is vital to distinguish between market value, market price, and cost. Market value is an estimate of the most probable price a property will bring in a fair sale within a competitive, open market where both buyer and seller act prudently and without pressure. It assumes a reasonable exposure time on the market and that payment is made in cash or equivalent. Market price, by contrast, is the actual sales price—the amount for which the property actually sold. Cost refers to the actual expenditure for improvements and properties; while cost and market value may be the same when a building is new, they often diverge over time.
The Sales Comparison Approach to Value
The Sales Comparison Approach determines value by comparing the subject property to recently sold comparable properties. Adjustments are made to the sales prices of these comparables to account for differences. Key adjustment factors include property rights, financing concessions (such as owner financing or special mortgage terms), market conditions (like interest rates or supply and demand), conditions of sale (such as a forced sale or family transaction), and physical features or amenities. A dollar value is assigned to each difference. The rule for adjustments is that if a comparable is superior to the subject, its value is adjusted downward. If a comparable is inferior to the subject, its value is adjusted upward.
The Cost Approach to Value and Depreciation
The Cost Approach involves five distinct steps. First, the value of the land is estimated as if it were vacant. Second, the current cost of constructing the improvements is estimated. Third, accrued depreciation is calculated and then deducted from the construction cost. Fourth, the depreciated cost of the building is added back to the land value to reach a total property value. Depreciation is defined as any loss in value and is usually calculated using the straight-line or economic age-life method. Physical deterioration refers to wear and tear and can be curable or incurable based on economic feasibility. Functional obsolescence results from poor design or outmoded features and can also be curable or incurable. External obsolescence, caused by factors outside the property lines, is always incurable. This approach is most often used for new construction or special-purpose buildings like schools and churches.
The Income Approach and Capitalization
The Income Approach is based on the present value of future rights to income. The process begins by estimating the Potential Gross Income (PGI) from all sources. Deductions for vacancy and rent loss are made to find the Effective Gross Income (EGI). Operating expenses—excluding debt service and capital expenditures—are then subtracted to find the Net Operating Income (NOI). To determine value, a capitalization rate is applied. The rate is found by comparing the NOIs of similar recently sold properties to their sales prices. The relationship is expressed by these formulas:
For smaller residential properties of one to four units, the Gross Rent Multiplier (GRM) is used, based on monthly rent. For commercial or larger residential properties of five or more units, the Gross Income Multiplier (GIM) is used, based on annual income from all sources. The multiplier is found by dividing the sales price by the rent or income.
Reconciliation of Final Value
The final step in the appraisal process is reconciliation. Because the three approaches (Sales Comparison, Cost, and Income) often produce different results, the appraiser must weigh the findings. These figures are not averaged. Instead, the appraiser assigns more weight to the approach that is most relevant to the specific type of property being appraised to reach a final professional opinion of value.