Appreciating Appraisals

July 2005

Greg Pitts

I’ve heard many rehabbers complain about appraisals, both when they are buying and selling. Since much gnashing of teeth has been spent, I want to point out some of the shortcomings, but appreciate the place they serve in our business.

When I hear “appraisal”, I may have something totally different in mind than you do. It’s important to think about what question the appraiser is hired to answer. Here are a few possibilities:

• What is the market value of this property given a willing buyer and willing seller? What should I expect to see it for?
• Will the collateral satisfy the loan should the borrower default?
• Is the buyer over-paying for this property? Is it worth the investment she is making?
• What’s the value of the house for tax purposes?
• What’s the tax basis of the property for the heirs?
• What will the value of this property be after the repairs and improvements are made?

The answer he derives will vary depending on which question is asked.

All appraisals are driven on data which influence market value. These include comparable sales, income stream, condition, and neighborhood. Additionally, personal judgment can be influenced positively or negatively depending on the individual’s traits, background, experiences and psyche of the appraiser themselves. For example, it the appraiser is “bullish” on the market and believes an upturn is likely, that may be reflected in the appraisal, esoteric though it maybe. If she doesn’t care for a particular neighborhood, it may be hard for her to keep her opinion from influencing the results.

Income method: The property’s income and expenses are used in a calculation to determine value. Often hard data can be difficult to come by or unreliable. Rents charged by other landlords may not be a perfect reflection of the market. In fact, the density of housing may drive the rents up or down. Or some industry change may be about to force a housing scarcity on a particular market. How can the appraiser’s appraisal be accurate with out complete information? Many property owners don’t maintain good historical records or are unwilling to share them. Expenses can also be understated or misunderstood.

Example: water usage which many landlords of multi-family property include in rent. Families with small children use a tremendous amount of water where as the elderly use practically none. How mixed are these groups in the unit in question and how likely to stay that way?

Maintenance (or the lack thereof) must also be considered. If the current owner has let things go then real maintenance costs will appear very low when in fact they are just deferred. The appraiser may be able to see the evidence of deferred maintenance and reflect it in the results. Only time will paint a real picture.

Replacement Costs: This method depends on the local construction industry to a large degree. If contractors are “hungry” replacement costs will be low, if they aren’t (such as right after a hurricane) then they will be high. Furthermore, what is a “replacement”? Something over forty years old can’t be replaced since we don’t build that way nor do we have the same materials available. Most appraisers would not be equipped to value special materials.

Example: Some of the houses in my area are actually constructed of solid brick or stone, not veneer. I once lived in a house with walnut trim. Imagine trying to replace that! Another house of mine had solid cherry cabinets. In neither case was one penny added to the value for such features.

Also, the appraiser is probably not trained as a construction estimator. He must use a formula or software that cannot take into account all the variables.

Sold Comparables: This method allows you to compare properties based on type of structure and environmental context. Multi-family properties may be difficult to compare because what drives us to build a certain type of commercial building in the first place is scarcity in the neighborhood. So it isn’t likely you will find a good “comp” because the type building will be so rare to begin with. It will certainly be some distance between the two comparables so you have to ask yourself is the value of the other building reasonable. That makes you ask yourself about the context of the two buildings. Would someone living in one reasonably choose to live in the other? What amenities are available in each?

Tax appraisals: In many areas, tax appraisers use square footage to determine value. The average value per square foot of living space is multiplied by the square footage of the target property. You can see where this calculation could go wrong, but on the main it’s not a bad method of assessing thousands of properties across-the-board. A cynic will tell you it’s all about a government’s need for money. One easy way to raise taxes is to raise values.

MY BOTTOM LINE: Appraisals…

• …serve the necessary purpose of a third party attesting as to the value of a property for all kinds of uses.
• …use hard facts and data, but they must be viewed as more art than science.
• …are intended to answer one question and shouldn’t be used to try to answer another. I often have homeowners
     site the tax appraisal value as if it were a reflection of reality! Be prepared to answer that one.