How to Read An Appraisal Report When Buying a New Home

An appraisal is an estimate of value of a specific property based on the appraiser's professional judgment. The appraisal report is a detailed description of the process the appraiser used in estimating the stated value. Appraisers collect market data that they analyze by accepted methods. Based on this analysis, they derive the value of the subject property.

Appraisal reports can be presented in different forms, but each includes standard sections and types of information. A typical narrative report contains an introduction, factual descriptions, data analysis, the appraiser's opinions, and an addendum. In reviewing and evaluating the report, the user can work through each section systematically, giving specific attention to the purpose, relationship with other parts of the report, and appropriateness of the data.

The introduction establishes the appraisal's purpose and states limitations. Following that will be a geographic and market analysis, a physical and legal analysis, a highest and best use analysis, a description of valuation techniques, and the reconciliation -- the section that explains the reasoning behind the final value opinion.

An appraisal report is simply a tool of the methodology used to aid someone making a real estate decision. The user's instructions to the appraiser about the reason for the appraisal affects the usefulness of the report.

Appraisal reports can be complex, including detailed analyses of market data and structured procedures for estimating value. Unless the user is a trained real estate appraiser, the narrative may be hard to follow and the report's quality may be difficult to evaluate. Worse yet, the meaning of the value opinion may be misunderstood, particularly if the concept of market value is not clear to the user.

Types of Appraisal Reports

The report must be communicated meaningfully and clearly to the client in a way that is not misleading. The appraisal can be presented as an oral report, a letter report, a form, or a narrative report.

An oral report is used when the client does not need a written report. This report should include a description of the property and the facts, assumptions, conditions, and reasoning on which the conclusion is based. The appraiser must keep all notes and data with a complete memorandum of the analysis and conclusions.

A letter report usually contains only the appraiser's investigations and analyses. To be meaningful, certain items must be included: the certificate, adequate property identification, the valuation date, all limiting conditions, indication of the contributions of others, and a statement of non-bias. Use of the letter report is limited.

The letter-form appraisal is used predominately by governmental and financial institutions to expedite the review process and enable standardization for decision makers. The form ensures that no item required in the review process is omitted. Unfortunately, it restricts additional information, which must be introduced as a supplement. The form also allows reviewers to identify and locate the information sought. Lenders often use the Federal National Mortgage Association (FNMA) format.

Narrative reports are the most complete appraisal format. This report enables the appraiser and appraisal service user to present and receive thorough documentation of all reasoning and data in the appraisal process (within financially feasible constraints).

The narrative report typically is organized in the following manner:

Part One, or Introduction includes:

Part Two, or Factual Descriptions, contains:

Part Three, or Data Analysis, together with the appraiser's opinions, includes

The final section, or the Addendum, contains:

Reading the Appraisal Report

Each part of the report should have a distinct purpose and should add to the user's understanding of the basis for the value determination. The sections should build on one another and point to the same conclusion. Information used to make adjustments and reconciliation in the last portions of the report should be drawn from earlier sections. The following discusses the purpose of each section, how they relate to other parts of the report, as well as several points that the user should consider.

Introductory Material

The introduction establishes the appraisal's purpose and relates any limitations or qualifications to the value opinion. The specific type of value should be identified and, possibly, defined. This should clear up any misunderstanding about why the appraisal was done. Most appraisals estimate market value according to the accepted definition established in the appraisal profession. Most of the limitations stated are routine. However, there may be special considerations that affect the value of a specific property and these should be clearly stated.

Geographic and Market Analysis

The geographic and market analysis describes the market environment and the forces shaping property value. This section details the property's economic setting, ranging from the general market area to the property's specific surroundings.

If the user is unfamiliar with the area around the property, this section can be very helpful. It provides an image of how the local economy is structured and the current condition of its markets. The strength of demand for properties like the subject's should be described, as well as how many similar properties there are in the market. Also, it describes the area surrounding the property and the relative desirability of the location.

Physical and Legal Analysis

The physical and legal analysis describes characteristics of the subject property that will be used later in applying valuation methods. This usually is divided into a description of the site and its improvement.

Even if the user is familiar with the property, it is still worthwhile to see how it is described by a professional trained in critically examining properties. The description should point out features of the property that affect its value, such as the quality of construction and the adequateness of the site for its current use. Legal analysis indicates any restrictions that may exist, either as local ordinances or as components of the property deed, that affect how the property may be used.

Highest and Best Use Analysis

The highest and best use analysis establishes the specific usage that supports market value. Most properties are purchased with the intention of continuing the current way it is used. However, some properties are valued primarily for conversion to, or redevelopment for, an alternative use. Market value, then, is based on the property's highest and best use.

In most cases, this analysis will merely state that the current usage is the most appropriate one for the property. Nevertheless, in most cases, the current use may be for an interim period or where the neighborhood may be changing so that the current use is no longer appropriate. If so, this should be pointed out with a discussion of what types of uses are most appropriate.

Valuation Techniques

The core of the appraisal report is the valuation techniques section, in which all facts and inferences from previous analyses are applied to derive an estimate of property value. In general, the problem is approached from three independent directions: market comparison, cost reproduction, and income capitalization. Each approach uses evidence from market data in different ways to reach the same objective. If these techniques faithfully follow market reasoning, the estimates should be similar. However, data limitations may produce significant differences. A final reconciliation process is needed to address these and to settle on a defensible estimate.

Market Comparison Approach

The purpose of the market comparison approach is to derive a value based on recent sales prices of similar properties. The method assumes that the typical buyer pays no more for a property than the cost of purchasing an identical property.

Data are collected on recent sales of properties similar to the subject, called comparables. How recent and how similar the comparables are depended on the availability of data. Because comparables will not be identical to the subject, some price adjustment is necessary. The idea is to simulate the price that would have been paid if the comparables were actually identical to the subject. Differences that do not affect value are not adjusted. If the comparables are superior to the subject, an amount is subtracted from the sales price. Inferior features require that an amount be added to the sales price. From the group of adjusted sales prices, the appraiser selects an indicator of value that is representative of the subject.

How are comparables selected? To minimize the amount of adjustment required, comparables should be closely similar to the subject. The following are common shortcomings in the selection process:

• The sale is too old (the market may have changed since the sale took place).
• The location is too different (location and surroundings have important effects on value).
• Special financing was used in comparable sales (part of the price may have resulted from favorable financing terms).
• Too few comparables are found (one or two sales may not represent the market).

When the subject is unusual or when market activity is slow, these problems may be unavoidable. However, if this is the case, it should be acknowledged and taken into consideration when the final value opinion is rendered.

Cost Approach

The purpose of the cost approach is to indicate a value based on the cost to replace the property, using current materials and methods. The underlying cost is thought to be a basis of the long-term value that is not sensitive to market fluctuations. Cost may be the only indication of value for unique properties, or for properties without active markets.

The value of improvements, as well as the land, are estimated separately. For improvements, reproduction cost is estimated. This figure represents what it would cost to produce the building with current methods. It is not necessary to simulate production of an exact replica. The reproduction should be one that a typical purchaser would consider as a perfect substitute. Any depreciation on the subject property is estimated and subtracted from the new reproduction cost. Depreciation includes physical wear (incurable physical), needed repair and replacement of components (curable physical), outmoded design and materials (functional obsolescence), and incompatibility with surroundings (locational). Site value generally is estimated by market comparison using site comparables.

Improvements should represent the property's highest and best use. If they do not, then they do not contribute fully to the site's value. Therefore, an estimate of the value of such improvements, even when diminished by accrued depreciation, will overstate the contribution made to property value. Improvements should agree with the previous findings of the property's highest and best use.

Income Approach

The purpose of the income approach is to indicate a value based on the capitalized worth of the projected income stream. Accordingly, this approach assumes the property is purchased for its productivity as an investment. For owner-occupied properties, the value is based on the value of imputed income in the form of services provided by the property.

Usually, a value indication is derived through direct capitalization of net operating income. Net operating income for the subject property is projected based on market level rents and operating expense ratios. If income fluctuations are expected, the net operating income must be stabilized to reflect its long-term level. Capitalization rates (net operating incomes divided by selling prices and known as "cap rate") are abstracted from market transactions. The value indication then is calculated as the net operating income divided by the market cap rate.

For properties that do not generate rental income, a related technique is used. Comparables are selected from recent sales of similar properties that do generate rental income. The ratio of sales price to gross rent (gross rent multiplier) is calculated for each comparable. A representative gross rent multiplier is selected and multiplied by the market rent for the subject property to indicate value.

In most cases, the cap rate will be selected from market data of actual transactions. The process is similar to the use of comparable sales in the market comparison approach. How well the subject fits its comparables affects the method's reliability. While cap rates should be similar for the same property type in a comparable location, other factors may cause the rate to vary. These factors should be recognized and accounted for in the analysis. They include:

• What is the expected duration of the income stream? In a highly competitive market, income may fall as the building ages, resulting in a higher cap rate.
• What are expected increases or decreases in future value? If neighborhood trends are positive, the cap rate may be lower than for properties in declining areas.
• What are the purchaser's motivations? If comparable sales occurred prior to changes in tax policies or lending rates, the indicated cap rate may be too low or high for current conditions. Rate selection should be supported by the same type of reasoning used to adjust comparable sales prices.
• What if direct capitalization is not used? If a discounted cash flow method is used, all assumptions should be justified. The most important ones are the application of an appreciation rate and a discount rate to derive net present value. One test of an appreciation assumption is to calculate an overall rate (net operating income divided by sales price) at the end of the projection period. If lower than the first year rate, the analyst should explain why the property is expected to be more attractive in the future.

The discount rate should be comparable to currently available yields on investments with similar risks and rewards, such as high-risk growth stocks, new issue stocks, or desired returns of pension funds an real estate investment trusts (REITs).

Reconciliation

This section explains the reasoning behind the final value opinion which generally is expressed as a single figure. However, a range of values may be appropriate in some appraisals.

Reconciliation then is the culmination of the appraisal investigation. It should draw on all of the preceding information and analyses. It is the report's most essential statement.

An appraisal is simply an opinion based on the analysis of economic concerns that can influence the price of the property to be sold. Establishing a price before a sale is necessary for conducting business in a dynamic or even problem economy. The appraisal report is a tool or methodology to aid someone in making a decision; however, it is not an end in itself.

Appraisal Designations

More than 17 appraisal designations are awarded by professional organizations, the best recognized being the Appraisal Institute. Most organizations require specialized course work, professional experience, and preparation of approved demonstration reports. Designations include:

1. Appraisal Institute

Member, Appraisal Institute (MAI)

Senior Residential Appraiser (SRA)

 

2. American Society of Appraisers

Senior American Society of Appraisers (ASA)

Accredited Member (AM)

Fellow American Society of Appraisers (FASA)

 

3. American Right of Way Association

Senior Member Right of Way Appraiser (SR/WA)

 

4. National Association of Independent Fee Appraisers (NAIFA)

Independent Fee Appraiser (IFA)

Senior Independent Fee Appraiser (IFAS)

Independent Fee Appraiser and Counselor (IFAC)

 

5. American Society of Farm Managers and Rural Appraisers (ASFMRA)

Accredited Rural Appraiser (ARA)

Accredited Farm Manager (AFM)

 

6. International Association of Assessing Officers (IAAO)

Certified Assessment Evaluator (CAE)

Accredited Assessment Evaluator (AAE)

Certified Personalty Evaluator (CPE)

Residential Evaluator Specialist (RES)

 

7. National Society of Real Estate Appraisers (NSREA)

Master Real Estate Appraiser (MREA)

Certified Real Estate Appraiser (CREA)

Residential Appraiser (RA)

Source: Barron's Real Estate Handbook, Third Edition