I've included this article since it discusses some real life situations you will encounter in real estate and the appraisal business. This article is reprinted with permission from Ken Jones.
How Many Valuation Approaches Are Enough?
As I roam around the United States, both literally, by giving seminars and undertaking appraisal and consulting assignments, and figuratively, mostly through my work in the area of appraisal review, I'm continually amazed at statements made by appraisers in their attempts to support/defend their use of multiple (usually all 3) so-called valuation approaches in appraisal assignments wherein Market Value, as defined in USPAP, is the purpose of the assignment.
When in such discussions, I'll always inquire as to why they used either 2 or all 3 so-called valuation approaches. I hope to hear the only answer that is ethically and economically supported, which is, "I researched the market and found that there was no clear cut indication for any 1 of these approaches over another, and also found that the typical market participant actually uses both/all of these approaches in formulating their valuation decision. " However, instead of hearing such a sound reasoning, I find that appraisers almost invariably respond with the following statement, "Although, I developed all 3 approaches, I found that only the (blank) approach was applicable, and that's what I relied upon. ". This statement always prompts me to ask, "Well, if only the (blank) approach was applicable, why did you develop and include the other approach(es) at all? ". Their response is virtually universal: "That's the way the client wanted me to do it."
Well, for a variety of economically and ethically sound reasons, appraisers who continue to develop valuation approaches that are not relevant to the property being appraised are likely to find themselves being exposed to serious questions of competence and ethical propriety, both of which are likely to include some rather adverse legal and financial consequences. Let me begin by stating that there are 2 general underlying premises upon which this article is based:
1. The valuation assignments discussed in this article deal solely with requests for estimates of Market Value, as defined in USPAP, and
2. The valuation assignments discussed deal with real estate which is improved with existing buildings.
NOTE: The valuation of vacant land is specifically excluded from discussion in this article due to the varying and differing methods of land valuation from methods of valuation for existing building improvements.
Within these parameters, we should acknowledge certain facts about the role and responsibilities of an appraiser when engaged to undertake a Market Value appraisal assignment. I'm confident that we are all agreed that, under the Market Value scenario, the appraiser is being asked to provide the client with a conclusion of the estimated value, or a range of values that accurately represents that value or range which is the "most probable" value for which the subject would sell, within and adhering to all of the parameters in the USPAP definition of Market Value. In analyzing this scenario a bit more deeply, I believe that we would also be agreed with the reasonable conclusion that, in order for an appraiser to come to an accurate estimate which would represent what that typical buyer and seller would agree upon as being the value of a specific property, the appraiser must a) employ the same valuation technique(s), and b) develop it/them in the same way as would the typical buyer and seller of that specific property; the rationale being that, the use of any other technique(s) or, developing the appropriate technique(s), but in a manner different from the manner commonly used by the typical market participants, would likely result in a distortion of the final value estimate, thus, failing to provide the answer initially asked of the appraiser.
So, what approach should the appraiser use? In the process of coming to an answer to that question we should first follow the steps of the competent appraiser during the process of undertaking the appraisal assignment. In what should be the normal course of investigating a subjects market area, the most important set of facts to be obtained are 1) the perception(s) of the state of economic conditions at present and into the reasonably foreseeable future, 2) the present and anticipated influence(s) upon local real property values from that/those economic influence(s), and 3) the specific valuation method(s) most commonly developed and relied upon by the majority of local market participants in concluding the value that they feel is fair and reasonable for that specific property type in that market area. In order to ascertain this information, an appraiser must identify and personally interview as many active market participants (buyers, sellers, owners, tenants, managers, and brokers) as possible for the specific type of property being appraised; ideally, the appraiser will interview a majority of those market participants.
It's important to note that, to interview active participants from a different market area or to interview those who are active participants in the subjects market area for a different type of property than the subject, is likely to result in a distorted, inaccurate valuation conclusion for the subject property. To demonstrate the validity of this statement, let's make an analysis of a reasonably common occurrence; the appraisal of a warehouse/distribution building that, for the sake of this example, we'll say is a 5-year old 150,000 SF tilt-up masonry building having a 30 FT clear span, a flat roof, 10 floor-height tailgate doors, a 2,400 SF office area, is in good condition and is well located with good proximity to major highway transportation routes between 2 major northeast markets. Further, this market area, in which there are 20 buildings physically similar to the subject, grew at a rapid rate until about 2 years ago. It's still somewhat active, with the infrequent creation of new buildings, and with sales occurring at the rate of about 1 per year.
As we should, we will make a closer examination of the subject's market area by attempting to interview the owner and occupant of each building which discloses the fact that, of the 20 buildings, 14 are owner-occupied, 5 are tenant occupied and 1 is vacant, having been built on spec(ulation). During our interviews we find that, of the 14 owner-occupants, 9 bought buildings that were existing new buildings built on spec which were vacant and available. Of the remaining 5 owner-occupants, 3 bought existing buildings from former owner-occupants, 1 was a tenant in his building who bought it from the bank in possession of the title, and the last had his building built-to-suit by a local developer through the efforts of a broker. During our interviews we were told that each buyer based his purchase price on the sales prices that other buildings had sold for; a few owners commented that it was, "pretty much like buying a house.".
When we asked them if they ever considered how much rent they could get from the building, they all agreed that they hadn't given it a thought because they weren't in the business of buying real estate for the purpose of generating rental income, rather, they were only interested in the use of the building for the purpose of housing their specific enterprise. Trying all angles, we asked if they ever considered the cost of building a new building; buying the lot and hiring sub-contractors to construct the building. To a man, after having a good chuckle, each said that they didn't know the first thing about constructing a building, didn't have the time to "fool around" with such a venture, and wouldn't know if they were getting a better or worse deal. Although he did admit that he talked to a developer about constructing a new building, he followed quickly by stating that, since there would have been virtually no physical nor financial benefit, he decided to buy an existing building.
In the process of interviewing the 5 tenants in the 5 rented buildings, we found that there were 2 different corporate owners of these 5 buildings. During the interviews with these 2 corporate owners, we found that each were land developers and building contractors who had built their buildings for the sole purpose of holding them as an investment and obtaining rental income, having no intention of selling any building within the next 10-15 years. Our interview with these developers also disclosed that one of them was the owner of the currently vacant building. When questioned as to their intentions for that building, the owner stated that his original intention was to rent this building as he did the others he owns in this market area. He also stated that, since the building has been standing vacant for almost 2 years with little or no hope for obtaining a tenant, he's now changed his strategy and will be seeking to sell the building to an owner-occupant, a decision based upon his analysis of the current trend of sales in this market area as being the only way to successfully market that building. The owner also stated that he will be formulating his sale price based upon the sales prices of similar buildings that were recently sold in the immediate market area.
In conferring with the brokers who are known to be active in marketing this type of property in this market area, as well as interviewing the actual buyers, owners, and sellers of the same type of building as the subject, we've gained insight into the thinking of the local market participants and found that all provided valuable information as to the valuation methods they use to estimate the value of this type of property in this market area, leading us to reasonably conclude:
1. 70% of all buildings of this type are owner-occupied.
2. Appraisal Cost Approach is an irrelevant methodology.
3. There is virtually no current nor reasonably anticipated probability of obtaining tenants for buildings of this type in this area, thus, there is no relevancy to development of the Income Capitalization Approach.
4. The current state of the market activity for this type of building in this market area is now, and is anticipated to remain primarily directed toward owner-occupied buildings, dictating the use of the Sales Comparison Approach.
Therefore, now that we have obtained market direction to answer the question of what valuation method(s) should be used in coming to an estimate of the value that would reasonably represent the price that would probably be paid for the subject property, it seems clear that, to use any method other than the Sales Comparison Approach would not be representative of the actions of the typical market participants in this market area, therefore, would result in:
1. A value estimate that would not represent what the typical market participant would conclude to be the value of the subject, AND
2. A misleading conclusion, which is an unethical act according to USPAP Ethics Provision/Conduct, that would have occurred as the result of failures to comply with USPAP Standards Rule 1-1(a), (b) and (c), as well as failure to comply with USPAP Standards Rule 2-1(a).
Further, in addition to being irrelevant to develop any other approach(es), to do so would likely be both confusing as well as misleading to the reader(s) and/or user(s) of the report. And, while this lesson has shown us how, in real life, something that we might think of as being perceived as a harmless "traditional " work habit actually has substantive consequences beyond what we might realize. The following is a real-life example of how the "harmless", and all too common, misuse of a so-called valuation methodology actually had a significant negative impact upon one appraiser.
In a real-life litigation event, an appraiser, who made an appraisal of a detached 1-family dwelling for a lender in a sale transaction, was named a Defendant in a lawsuit by a buyer who claimed that the appraiser intentionally mislead him (the buyer) into thinking that the house was worth substantially more than its actual value which caused him to purchase the house at a time when he (the buyer) knew that he could be placing himself at financial risk due to a possible negative change in his income. However, the buyer claimed, that, based upon the appraiser's "misleading" appraisal report, specifically the appraiser's estimate of the value of the house as indicated by the Cost Approach, the buyer had been convinced that the purchase of the house was a safe undertaking since, based upon the appraiser's Cost Approach indication, the buyer was convinced he could sell the house for more than he was paying. The buyer claimed that he was damaged when it turned out that, within 1 year, he could not sell the house for the same amount paid, much less the higher amount indicated in the Cost Approach section of the appraiser's report. This ultimately resulted in foreclosure, causing the buyer the loss of his equity investment, damaging his credit, and causing him severe emotional harm.
During a pre-trial procedure, the appraiser's lawyer attempted to have the suit dismissed citing a lack of merit and pointing out to the Court that:
1. The appraiser knew that the Cost Approach was inappropriate for the property type in that market area,
2. Stated in the report that it was an inappropriate method for that type of property in that market area, and
3. Also stated in the report that he (the appraiser) did not rely upon the indication of the Cost Approach in reaching his value estimate which was solely based upon the indication of the Sales Comparison Approach.
In its response, the Court concluded that, the appraiser, knowing the use of the Cost Approach was inappropriate for this type of property in the market area, could find no reasonable explanation for its inclusion in the appraiser's report other than for the specific purpose of misleading the reader(s) and user(s) of the report into thinking that the value of the house may have been substantially higher than its actual value. The Court further justified its conclusion by saying that, if the appraiser did not intend to mislead the reader(s) and user(s) of the report, he would not have included such a misleading indication.
The lesson to be learned is, there are definite and serious consequences that may (and do) result from the actions and words of an expert, such as an appraiser. The message: An appraiser must act in an honorable, responsible manner. What appraisers are supposed to do is quantify, in monetary terms, human activity as it relates to their actions in real estate markets. It logically follows that, if an appraiser 1) fails to sufficiently investigate that market area, 2) fails to identify the market participants, and interview those market participants for the purpose of a) obtaining and understanding their perceptions of value and the influences upon it for a specific property type, as well as b) understanding the methods that they use to determine the value of a specific property type, THE APPRAISER HAS FAILED to live up to his/her moral, ethical, and legal responsibilities. Failure to emulate the activity of those humans who are the makers of the market activity in a given area for a specific type of property is incompetent.