Basic Residential Appraisal Methodology - Comprehensive Notes

Overview and purpose

• Basic residential appraisal methodology: a very basic introduction to what an appraisal is, what it represents, and how to interpret the numbers on an appraisal. The speaker is a licensed appraiser giving a non-technical, introductory overview.
• Goal of the section: understand what an appraisal looks like, what the numbers mean, and the meaning of those values when an appraisal is returned.
• Focus: residential mortgage appraisals and the core ideas behind them, not deep appraisal theory or all the nitty-gritty details.

Standards, governance, and key organizations

• After the savings and loan crisis of the eighties, a need emerged for a set standard of appraisal practices to ensure realistic lending values.
• Nine leading professional appraisal organizations formed a committee and created the Uniform Standards of Professional Appraisal Practice (USPAP) (the speaker often refers to it as USEPP in the transcript).
• In 1989, Congress enacted the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA), which authorizes the Appraisal Foundation as the source of appraisal standards and qualifications.
• USPAP is the generally recognized ethical and performance standard for the appraisal profession; compliance is required for state-licensed and state-certified appraisers involved in federally related real estate transactions.
• USPAP is updated about every two years to keep appraisers’ guidance current and maintain unbiased, thoughtful opinions of value.
• The Appraisal Foundation and its independent boards promote marketplace stability and public trust.
• The Appraisal Foundation advances professionalism across appraisal disciplines (including real estate) and is headquartered in Washington, DC; governance is via a board of trustees. The takeaway: know the Appraisal Foundation and USPAP as the rule-setters in practice.

Reports, forms, scope, and documentation

• Appraisers must use the most recent version of appraisal report forms and attach any information that is appropriate to the form as attachments.
• The scope of an appraisal is guided by Fannie Mae’s appraisal report forms; the forms do not limit or control the appraisal process; they guide what is done.
• Appraisers should go beyond the box-filled forms when relevant information exists; add notes and exhibits if needed.
• The extent of data collection, analysis, and reporting is determined by the complexity of the appraisal assignment.
• The standards for the appraisal profession are set forth in USPAP (developed by the Appraisal Standards Board for the Appraisal Foundation).
• USPAP specifies procedures and the ethical rules for appraisal practice.
• An appraisal is the act or process of developing an opinion of value; it is not a guarantee of value or a fact; it is a well-educated, systematized opinion.
• It is important to recognize that an appraisal is an opinion, not an absolute fact, and there are implications if there is disagreement with the opinion.

Regulatory framework and independence

• Under federal lending regulations, the lender initiates the appraisal, must have the first contact with the appraiser, and oversees the appraisal process.
• The lender must be the client; the appraiser must be engaged by the lending institution.
• Under federal law, any bank can use an appraisal prepared for another bank as long as the initiating bank reviews the appraisal and finds it acceptable.
• GSE requirements demand appraisal independence; the appraiser must be independent and not influenced by other parties.
• The appraiser must be licensed or certified by the state where the property is located.
• It is illegal for any interested party to coerce, extort, collude, compensate, induce, threaten, bribe, or influence the development, reporting, result, or review of an appraisal.
• The creditor should not order or use a second or subsequent appraisal unless there is a reasonable basis to believe the initial appraisal was fraudulent or flawed; this is part of quality control.
• The creditor should select the most reliable appraisal rather than the one with the highest value.
• In certain circumstances, a second appraisal is required by law.
• The creditor should not accept an appraisal report prepared by an appraiser who is selected, retained, or compensated by any third party (e.g., mortgage brokers, real estate agents).
• There must be a clear separation between a creditor’s sales/mortgage production functions and the appraisal function; an employee in the sales or production side should have no involvement in the appraisal function.

Approaches to value in residential appraisal

• There are three classic approaches to value:
  1) Cost approach: current cost to reproduce or replace the building minus depreciation, plus land value.
  2) Sales comparison (market) approach: value indicated by recent sales of comparable properties in the market.
  3) Income capitalization (income) approach: value based on the property's net earning power; i.e., the income the property can support.
• One or more of these approaches may not be applicable or appropriate to a given assignment.
• The three approaches provide the basis for the appraiser’s value conclusion, but not all will be used in every appraisal.

Sales comparison (market) approach in practice

• The sales comparison approach is the most useful when a number of similar properties have recently sold or are currently for sale in the subject’s market.
• The appraiser develops a value indication by comparing the subject property with similar properties (comps).
• The sale prices of the most comparable properties tend to indicate a range for the subject’s value.
• The appraiser ultimately selects a single comparable (the best among three or more) to drive the opinion of value.
• Comparables should be as similar as possible (apples-to-apples): similar type, neighborhood, size, and characteristics.
• In practice, perfect apples-to-apples comparables are rare; differences are acknowledged and adjustments are made.
• If the subject is a stick-built home, a manufactured home is not a perfect comparable even if nearby; adjustments are needed to account for dissimilarities.
• The appraisal form grid typically places the subject property alongside three or more comps for comparison.
• Adjustments are made to comps for dissimilarities to the subject; the subject itself is not adjusted.
• Adjustments are quantified via a subjective analysis to translate dissimilarities into a dollar amount.
  • Example: Subject is 2,000 square feet; comp 1 is 2,200 sq ft; comp 2 is 1,800 sq ft.
  • If comp 1 is larger, it may be worth more; comp 2 is smaller, it may be worth less; adjustments reflect these differences.
• The appraiser uses a subjective analysis to quantify dissimilarities (e.g., size, condition, improvements) and adjusts the comps’ sale prices accordingly to align with the subject.
• The most similar comparable, once adjusted, becomes the primary driver of the opinion of value.
• There is no fixed rule for how large net or gross adjustments must be; there are no strict numeric limits on adjustments.
• A minimum of three close comparables must be reported in the sales comparison approach.
• In cases of uniqueness or limited comparables, an additional comparable sale may be reported to support the opinion of market value.
• Comps should generally be from the last twelve months; if unavailable, closer in time (last six months) is preferred; the best practice is within six to twelve months if possible.
• The cost approach often has little impact on the final reconciliation/value in standard residential appraisals.
• Fannie Mae does not require the cost approach to value except for the valuation of manufactured homes.
• The U.S. MAP (as referenced in the transcript) requires the appraiser to develop and report the result of any approach to value necessary for credible assignment results.
• Appraisals that rely solely on the cost approach as an indicator of market value are not acceptable to the GSEs.
• When the cost approach is used, it estimates value based on the cost to produce a substitute residence and is most appropriate for situations like new construction, renovations, unique properties, or properties with functional depreciation to support the sales comparison approach.
• The reliability of the cost approach depends on valid reproduction cost estimates, proper depreciation estimates, and accurate site values.
• If the cost approach is included, the lender should thoroughly review to ensure consistency with the rest of the appraisal.

Cost approach in practice

• The cost approach formula (as described):
  $ext{Value}<em>{ ext{Cost}} = ext{Cost}</em>{ ext{New/Replacement}} - ext{Depreciation} + ext{Land Value}.$
• This approach is often used for new or proposed construction, renovations, unique properties, or properties with functional depreciation to support the sales comparison approach; it is typically not the sole basis for market value.
• The appraisal must consider valid costs, depreciation estimates, and site value when applying the cost approach.

Income capitalization (income) approach in practice

• The income approach assesses value based on the income the property can generate.
• It is required in conforming two- to four-unit property evaluations.
• It may be appropriate in neighborhoods with substantial rental markets for single-family properties, but it may not be appropriate in areas that are predominantly owner-occupied due to lack of rental data.
• The income approach is also known as the income capitalization approach.
• If the appraiser determines that the income approach is necessary for credible assignment results, it must be developed and reported.
• Appraisals that rely solely on the income approach are not acceptable to the GSEs; when used, the report must include supporting rental data and comparable rental data.

Practical implications, credibility, and wrapping up

• Appraisers must balance standardized forms with additional commentary; the forms guide but do not replace professional judgement.
• Appraisals are official opinions, subject to review and potential disagreement; the process is designed to be transparent and defendable.
• The independence and integrity of the appraisal process are critical for market stability and public trust.
• In practice, the appraiser must document the rationale for chosen comparables, adjustments, and the selected approach(es) to value; this documentation supports the credibility of the final value conclusion.
• The overall takeaway: a basic, structured process combines data collection, analysis, several value approaches, adjustments for differences, and professional judgment to arrive at an opinion of value that the lender can rely on within regulatory and market standards.