Article Summary
Appraisals Are Purpose Driven
Introduction:
Understanding the various methods used to determine a property's value is not just crucial; it's empowering. Different value conclusions are defined separately depending on the appraisal assignment's purpose and intended use. The original intended and actual use may differ in many cases, as noted in the appraisal examples below. This understanding can give you a sense of confidence and knowledge in the real estate market.
Market Value:
The seasoned real estate agent, a key player in the process, plays a pivotal role in developing a market value estimate to list and sell a property on the open market. Their experience and familiarity with the local market, coupled with a comprehensive comparative market analysis (CMA) that includes data from closed sales, pending sales, and available listings, instills confidence in their proposed value. They adjust the value for amenities, location, quality, and views to arrive at a suggested listing price.
A listing price will be affected by sellers' motivation and knowledge, including input from their agents, which are generally subjective.
Understanding the actual definition of market value is not just essential; it's empowering. It means the most probable price for selling a property in a competitive and open market. This clarity can guide your decisions and actions in the real estate market, making you a more informed and knowledgeable participant and, ultimately, more confident in your real estate transactions.
Conditions include: A fair sale ensures equitable transactions for all parties involved, a cornerstone of the real estate market's integrity. This principle guarantees that buyers and sellers are treated fairly, fostering trust and confidence in the market. A fair sale is one where both parties have equal access to information, are not under undue pressure, and act in their best interests, providing security and trust in the transaction.
- Willing buyers and sellers to act prudently and knowledgeably.
- Assuming the price is not affected by undue influences.
Appraiser-Professional Opinion of Value:
An appraiser will take an assignment to establish an estimated value on the following:
- Comparable closed sales (sales comparison approach)
- Replacement cost estimate (cost approach)
- Income approach (capitalization approach for income-producing properties.
- Rent surveys are also needed when determining income property values.
- Some appraisers will include pending sales and available listings when similar comparables are challenging to find.
- Market Value and Appraiser's Value: Understanding the Distinctions
Appraiser's Value: The appraiser's task differs from the realtor's. Their role is to identify objective closed transactions as comparables. This means they will look at similar properties that have recently sold in the area to determine the value of the property in question. The appraiser's responsibility is to provide an unbiased and professional opinion of the property's value based on their expertise and the data they collect.
The appraiser should skip distressed property sales and non-arms-length sale transactions. A distress sale occurs when a seller urgently needs to sell and, as a result, will accept offers substantially below the market price. Short sales, where the amount owed exceeds the market value, are generally priced considerably below the market value. The bank may face a financial loss (haircut) below outstanding principal, accrued interest, arrearages in property taxes, and homeowner association dues.
Foreclosure sales are almost always sold at below-market prices. A foreclosure sale and a short sale may be the same transaction. Purchase offers will consider the occupancy requirements and removal of the principal owner subject to foreclosure. The foreclosing lender has the same consideration plus any other outstanding liens and encumbrances that may be senior to their loan. There may be none.
Suppose the property is subject to a foreclosure procedure. In that case, a seller may list a property for sale with a real estate agent at less than the outstanding balances of all liens and encumbrances. An offer to purchase will be subject to negotiating a lower payoff amount with the lender. This means the property may be sold for less than its market value, as the seller is pressured to sell quickly and may accept a lower offer than in ordinary circumstances.
A non-arms-length sale transaction may be between family members, personal friends, or business associates. Because of the close relationship, the price may be discounted below market value. For instance, a sale between siblings or a property gifted from a parent to a child could be considered a non-arms-length sale. I would refer to this group as related parties.
Uniform Standards of Professional Appraisal Practices (USPAP)
The Appraisal Foundation, as the governing body for the appraisal industry, plays a crucial role in promoting quality control standards applicable to real property, personal property, intangibles, and business valuation reports in the United States territories. Its publication, the Uniform Standards of Professional Appraisal Practices (USPAP), which Congress adopted in 1989, is a testament to its commitment to maintaining high standards in the industry, ensuring the quality and accuracy of appraisals.
https://appraisalfoundation.org/imis
The USPAP manual is an excellent reference resource that mortgage professionals may use when considering a property's value and deciding whether an existing appraisal needs to be reviewed.
Applying USPAP standards and the resulting value estimate may be flawed, not because of USPAP but due to an appraiser's negligence, incompetence, ignorance, or intentional deceptions. When an appraiser departs from a prescribed standard, the result may be a worthless and deceptive pile of paper. Some negligent appraisers will return to the estimated value conclusion based on the principal's needs. What value do you need? I will figure out how to get there.
I have observed hundreds of examples of flawed written appraisals. Appraisers vary significantly between highly competent, marginally competent, incompetent, and just plain deceptive.
Insurable Value for Property Insurance Purposes:
Lenders will usually require replacement cost insurance coverage to make the loan. Calculations for insurable value are generally for the replacement cost if the structure is destroyed. The appraiser will calculate the cost estimate for rebuilding, using current materials, and conforming to existing building and zoning regulations for a rehabilitation project. The cost of these upgrades would have been multiple times higher 40 to 50 years ago.
The land value is segregated from the structure since the ground will not burn down. The appraiser will also calculate the replacement cost of outbuildings and appurtenant structures and issue a value conclusion for the land component only.
Additionally, the insurance company will provide coverage for outbuildings and personal property. The actual insurance company has a matrix for replacement cost calculations.
Actual Cash Value: This insurance policy covers losses at depreciated value rather than replacement costs. If an insured loss occurs, the insurance adjuster calculates the replacement cost and subtracts depreciation for age, wear, and tear. A policy payout for a loss or damage will be substantially greater for replacement cost coverage than cash value coverage. Actual cash value coverage considers the property's age, wear, and tear, and the policy will only pay out its depreciated value, which may be significantly less than the cost of replacing the property.
Appraisal for Property Tax Assessments: Municipality Assessed Value for Taxation Purposes.
Assessed valuation approaches have distinctly different meanings for establishing value and should not be considered interchangeable.
In some states, such as California, assessed values are limited. Proposition 13 was an amendment to the California Constitution, approved by the voters in 1978. Prop 13 was a Tax Revolt and a massive win for the taxpayers. The State wants to take Proposition 13 away first, using a split-roll strategy that applies only to commercial properties. Later comes single-family homes.
Proposition 13 made constitutional changes resulting in a limitation on raising property taxes passed to the benefit of property owners:
It requires that properties be taxed at 1 percent of their total cash value shown on the 1975-1976 assessment rolls. It limits annual increases of assessed (taxable) value to the inflation rate or 2 percent, whichever is less.
Upon transferring properties, allow them to be reassessed at one percent of their sale price and reset the annual assessed value increase limit.
Prohibits the state legislature from enacting new taxes on the value or sale of properties.
Property tax is a term used to describe the taxes imposed on real estate by various levels of government, including municipalities, counties, and states. These taxes are usually based on the property's assessed value and are used to fund different public services and infrastructure projects. Governments have a voracious appetite for more taxes.
Local governments must refer special taxes to the ballot and require a two-thirds vote of electors.
Their first attempt was California Proposition 15 (2020), which would have added additional taxes on commercial and industrial properties to benefit education and local government funding. It Failed! Never fear; California leadership will continue to work diligently to undo Prop 13 because there is a vast storehouse of fresh new cash for the government to tax (confiscate) from property owners.
Tenants were not naive because raising taxes would be transferred by higher rents. Also, homeowners were on board with the rejection because they understood that the next step to increasing property tax would be them. In that case, many homeowners would be unable to afford to stay in their homes and would be forced to sell. Massive numbers of distressed sellers led to an enormous drop in home values. Hallelujah for public awareness.
State leadership will never give up. They will be back for a second bite at the apple. Their prize is tax money for useless or semi-useless programs that appeal to non-taxpayers and non-property owners. Public employees could also use a fat 100% wage raise per annum to shore up their fat pension system reserves, couldn't they? That is their skewed vision of fairness. Of course. I am being facetious. Treating heartrending issues with deliberately inappropriate humor eases the pain.
Variables that Contribute to Overall Property Value:
Many variables contribute to a real property's current perceived value. A few of these variables include:
- A list of variables includes location, property condition, age, functional and economic obsolescence, interior and exterior amenities, pool, view, hardscape and trees, noise, site variables such as topography, ingress/egress, garages, appurtenant structures, on-site vs. off-site parking, access to utilities, above-ground vs. below-ground electrical and telephone lines in the neighborhood, etc.
- Zoning, property setbacks, architectural style, and land parcel size also contribute to the analysis.
- The market value may rise when property values accelerate due to inflation and lack of inventory.
- Expecting a 5% value differential between two different appraisers is not unrealistic. Good judgment comes from a bad experience, and impaired judgment comes from bad decisions.
A prospective buyer and the buyer's agents can assess all the above characteristics, including the buyer's family circumstances, motivation to own, timing needs, and the availability of affordable financing. Affordable finances are a significant factor.
Property values increase or decrease based on market conditions:
Property values may go up, down, or remain static for years. Here are a few variables that contribute to the rise:
- Limited inventory, which may cause multiple offers and bid-up prices.
- General inflationary pressures.
- Financing is exceptionally favorable.
- Property tax and state income taxes are fair.
- Neighborhoods and surrounding communities are developing.
- The business environment is bright, with many small businesses doing well.
- School districts are excellent.
- Medical facilities are extremely high quality.
- Large employer(s) are arriving in town.
- Quality of life is considered superior.
- Neighborhood green belt corridors and open spaces are abundant.
Variables that contribute to declining values: Variables are almost the opposite.
- Inventory of homes rises to the point where some owners will discount their prices to sell the property.
- Inflation of property values causes borrowers to lack affordability.
- Financing is beginning to tighten as interest rates rise. They will increase significantly over what they are today.
- With rising interest rates comes a lack of affordability.
- Prohibitive government intervention in ownership rights
- Prohibitive regulations and fees are attached to new buildings, including rehabilitating existing buildings.
- Some state governments, such as California, are now contemplating a 25% punitive tax on property owners' net profits.
- Property and income taxes become onerous and, therefore, unaffordable.
- Neighborhood crime and blight.
- Large employers are leaving, and small businesses are closing.
- Living standards become prohibitive, and people move away.
No one has a 100% clear crystal ball about the future of real estate investments. Will values continue to go up? Or will values go down, and if so, by how much? Governments always manipulate markets in their favor, which is seldom in the public's best interest. Inflation and devaluation of worldwide currencies have been around for thousands of years. The Federal Reserve Banking System has driven inflation and dollar devaluation in the U.S. since 1913. Unlimited Injections of fiat currency into the financial system cause inflation and dollar devaluation. The Feds are the primary driver of inflation.
Discussions about how much property values may rise or fall can be subjective. For those of us with many decades of experience in the real estate business, we have watched valuations go up and down a few times too many.
Flawed Appraisal Example:
Two different appraisers cannot be correct when each appraisal is vastly different.
A mortgage broker/lender received a call from another broker who represented a prospective borrower requesting a loan on a property in Malibu, California. The borrower's broker presented a completed appraisal to a law firm for a property settlement in a divorce between the prospective borrower and an ex-husband.
The ex-wife wanted an exceptionally high-value estimate because she thought it would force a higher divorce settlement. Her appraisal was not arm's length, but she was ordered to negotiate a better financial settlement. Go figure. Is there greed and deception in the world?
However, the actual use of the appraisal turned in a different direction. The borrower submitted her appraisal to a lender for a proposed loan on her property. The appraisal document had a condition that only the principal party may rely on its contents. All appraisals have limiting conditions. A subsequent lender is not the principal and cannot rely on the appraisal's contents.
The mortgage broker/lender explained to the prospective borrower that a Lender could not accept a non-arms-length appraisal when the purpose was other than to establish a fair market value. Most lenders with four quarters and a dime ($1.10) of intelligence require independent third-party licensed appraisals.
The independent third-party appraisal came substantially below the appraisal ordered for the divorce proceeding.
The broker/lender refused to originate this loan because of the potential legal predicament between questionable value and a jerk-of-a-borrower. The borrower had hissy fits, emotional tantrums, and threatened legal action. Most brokers/lenders will decline to originate the loan whenever a borrower threatens legal action.
Appraisal #1- The borrower ordered MAI designation for a divorce proceeding.
The subject property was a 19-acre parcel in a semi-rural setting with a lovely home, barn, corrals, and outbuildings for horses and livestock. It also contained 10 acres of avocados grown for resale.
Borrower's appraisal: The borrower (ex-wife in the middle of a divorce proceeding) submitted an appraisal report from an MAI-licensed appraiser. His value conclusion was $3,400,000. The borrower must have pressured the appraiser to increase the estimated value.
Most comparable closed sales were more than 1.25 miles south of the subject property in a neighborhood of custom homes with terraced custom lots, all with dramatic unobstructed ocean views.
The value of an unobstructed ocean view in a custom home neighborhood is exceptionally high. The comparable properties used in the appraisal were far more desirable.
Appraisal #2-Certified General Appraisal ordered by the lender.
Lender/Broker Appraisal: The broker/lender who processed the prospective loan transaction and engaged a licensed general appraiser ordered and received the appraisal. The appraiser submitted a value estimate of $1,400,000. The report was considered an unbiased third-party report that the broker and lending principals could rely on.
The appraisal used comparable properties similar to the subject property. Since the subject was in a semi-rural location, the ocean views were somewhat distant.
The appraiser only considered comparable(s) ranch-style homes in Malibu, CA, with distant ocean views. The subject property was a mile from the oceanfront.
Summary:
Licensed mortgage brokers/lenders are not appraisers. However, they have a fiduciary obligation to protect the interests of their principal clients. The borrower's broker is a fiduciary of the borrower, and the lender's broker is a fiduciary of the lender. Fiduciary laws vary in different states. A dual agency may sometimes become an issue when a broker represents the Borrower and Lender.
A broker/lender should hire competent third-party licensed appraisers familiar with the property type and the area. They should also ensure that the appraiser is at arm's length and not pressured by the borrower to increase the value artificially.
Consult a competent attorney if you have real estate transactional difficulties. Counsel may need to address consumer purpose vs. business purpose, defaulting tenants, purchasing a foreclosure property, and many others.