Appraisal Scoop

Industry Spotlight: The New Cost Approach

About the author: Gretchen Gary is a real estate professional who specializes in the Cost Approach. From 2003 to 2006, she published articles warning about the pending housing market crash, and promoted the Cost Approach as a quality control for property valuations.

Industry Spotlight: The New Cost Approach By Gretchen Gary

 Years of unrestrained lending practice have delivered the most tumultuous housing market since the Great Depression. And speaking from the perspective of the appraisal industry, it doesn’t come as much of a surprise.

These days, it’s no secret that appraisers were pressured to hit the target price of a sales contract as common practice throughout the housing boom. The market was hot, and demand relentless. Market-based appraisals were turning out hyper-inflated values with outrageous appreciation, and most everyone knew it. A housing bubble was bulging unchecked and real estate prices were through the roof.

Now in the wake of a massive housing crisis, industry heavyweights and government officials are stepping in to bring some regulation to the industry. Unfortunately however, only appraisers really know what is needed to ensure honest valuations. The proposed guidelines of Freddie Mac’s Home Valuation Code of Conduct miss the mark.

While the prevalence of inflated home values originated from unbridled lending, only responsible appraisal practice can bring this crisis to head. The industry already has its own valuation quality control method in the Cost Approach. Now is the time for appraisers to define their own professional code of conduct by re-evaluating the common valuation process.

The Cost Approach Today The demands and disappointments of today’s housing industry have created a renewed interest in the Cost Approach.

Typically recommended for unique properties, new or proposed construction, and properties with specialized improvements, the Cost Approach appraises a property based on the value of the land plus the estimated replacement cost new of the building less depreciation. Its practical approach to value also provides a trustworthy benchmark that can be used to validate market-based appraisals. With a cost-based perspective on the market, the appraiser gains insight on value sustainability and a more comprehensive picture of the property valuation.

Historically, the Cost Approach has always served a quality control function, used to help identify a potentially runaway or rapidly declining market. Throughout the housing boom, Cost Approach valuations were signaling inflated market-based values beyond sustainable levels. The subsequent bust came as little surprise to proponents of the Cost Approach.

As the industry reels from the effects of questionable lending, the Cost Approach presents a way to prevent another bubble scenario in the future.

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Who’s Measuring America? - Creating a Measurement Standard

Most real estate professionals (and homeowners) perceive real estate values based on a simple philosophy; price per square foot. The two amounts which provide this powerful number are the sales price and the size of a home. The sales price is a fact recorded at the county courthouse. The size or square footage is a number which has been taken for granted for so long, no one really thinks about where it comes from. The current trend (by real estate professionals, homeowners, insurance companies, and especially AVM’s) is to use the square footage information recorded in public records.

The property assessor uses a mass appraisal process and in most states never enters the dwelling. The errors in square footage should alarm us all. 50, 200, 500, many over 1,500 square feet, and mistakes are more often the rule, rather than the exception. Measuring and calculating square footage from the outside of a home is virtually impossible. The county assessor’s department is creating an estimate of size, for assessment purposes only. That information was never meant to be used as a detailed source of square footage. County officials have no liability (to homeowners or the real estate industry) in reporting square footage details and they don’t have to worry about errors and omissions.

The real estate industry is simply taking information, meant for use within the assessor’s department only, and trying to force that data to work in the real estate information system. Property values are being determined based on information which is wrong more often than it is right.

Automated Valuation Reports (computer generated value systems) base their values on some formula, which includes the square footage of the home. Any “value” conclusion based on faulty data can only provide unreliable results. Use of these inexpensive value services are gaining momentum among lenders, often due to the quality of the profits, not the quality of the product. Many consumers are now being forced to pay for an Internet based report as well as a traditional appraisal.

The Realtor® organization was founded (and grew to prominence), being the providers of real estate data. Known as providers of “the most trusted source of real estate information in the world,” agents have fallen prey to the easily accessible, free, and without personal liability, public record system. So, does this mean that public records are now the providers of the most trusted source of real estate information? Over the past five years, the use of public records within the real estate industry has skyrocketed. During the same time period a real estate crisis continues to grow.

After years of investigation, I believe there are two things which must happen to get the real estate industry back on tract. First, Realtors® must measure houses. This seemingly simple number, controls real estate loans and values across the country. Public records were never meant to be used for this purpose and cannot accurately provide this vital data. The second step is one that real estate professionals have been unable to agree on for over a century . . .

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Downturn in Market Leads to Upturn in BPOs - May not be legal!

According to the Appraisal Institute's newsletter article: "Inside the Beltway: Downturn in Market Leads to Upturn in BPOs" -

Over the last year, there has been a tremendous increase in the use of broker's price opinions (a.k.a. comparative market analysis, broker's estimate of value, etc.) that are being performed by real estate brokers and salespeople, in lieu of appraisals. While BPOs were previously used for very limited purposes, they are now being used as valuation products in the finance arena, primarily for the review of distressed properties prior to short sales or foreclosure. They are also being used in areas previously unimagined several years ago, including segments of the commercial market. However, the BPO work being done by brokers and salespeople may not be legal...

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Allegedly Inflated Appraisal Made Prior to Construction of New Home Cannot Support a Fraudulent Misrepresentation Claim: Court Endorses "Cost Approach" - TN

I think that appraisers will find this case very interesting from a variety of perspectives!    The case went all the way to the Court of Appeals in Nashville, TN and was ultimately decided in favor of the appraiser, but not without some interesting twists and turns along the way.

JOSEPH AND KIMBERLI DAVIS v. PATRICK J. MCGUIGAN, ET AL. (Tenn.Ct.App. September 11, 2008).

One of the key elements in the case was a citation Byrd v. Hall, 847 S.W.2d 208, 215 n.5 (Tenn. 1993).

To sustain a cause of action for fraudulent misrepresentation, the Homeowners must show:

1. the Appraiser made a representation of an existing or past fact;
2. the representation was false when made;
3. the representation was in regard to a material fact;
4. the false representation was made either knowingly or without belief in its truth or recklessly;
5. the Homeowners reasonably relied on the misrepresented material fact; and
6. Homeowners suffered damage as a result of the misrepresentation

Download Davis_v_McGuigan_091108.pdf

"The Appraiser contends that the appraisal is an estimation or opinion, and is not a representation of an existing or past fact. Therefore, the Appraiser argues, an essential element of the Homeowners’ claim for intentional misrepresentation is conclusively negated and summary judgment was proper on this claim. Homeowners argue that the appraisal value was not the opinion of the Appraiser, but rather an opinion he gave which the Appraiser did not have or knew to be false. Although Homeowners’ argument applies to the fourth element for fraudulent misrepresentation, their contention does not change the requirement of the first element - that the defendant make a representation of an existing or past fact. In Tennessee, appraisals are not considered facts, but rather estimates or opinions." Id.

"Further, we note that when the Appraiser conducted the Appraisal, he was appraising a home that had not yet been constructed. The Appraiser used the “cost approach” analysis, and referred to, among other resources, the specifications and building plans provided by the Homeowners. At that point, the Appraiser only had plans for the future Home on which to base his appraisal; he could not verify that the materials planned for in the Home were actually used in the construction or examine the workmanship of the construction. In Tennessee, conjecture or representations concerning future events are not actionable even though they may later prove to be false." Id. (citations omitted).

To read the FULL case . . . click here: Download Davis_v_McGuigan_091108.pdf

Tip of the hat to the Tennessee Construction Law blog for finding and reporting this judgement.

Press Release: Drive for Appraiser Accountability Spurs Marshall & Swift’s Certification Program

Marshall & Swift (M&S), a MacDonald, Dettwiler and Associates, Ltd. (MDA) business, and the leading worldwide provider of residential and commercial building cost data to the real estate appraisal market, announces new support for the appraisal process through its appraiser certification program.

As the appraisal industry experiences increased regulatory oversight and a demand for evidence that appraisers use best practices, M&S, (a co-founder of one of the professional appraisal organizations that in 1987 helped to establish the Appraisal Foundation) has joined the fight to demonstrate the quality of valuations performed by appraisers. M&S demonstrates this by giving appraisers proof of licensed access to its industry-standard replacement cost data for their property valuations.

The new M&S Licensed User Certificate is available to M&S licensed customers at https://certification.marshallswift.com, and is for attachment to any appraisal report. The certificate is written confirmation that the appraiser maintains current building cost information in accordance with appraisal best practices, and supports the residential appraisal form requirement that the appraiser list a source of current data when calculating a cost approach valuation. Marshall & Swift also provides an online registry of certificate holders should lenders wish to confirm appraisers’ access to current building cost information as part of their underwriting process.

M&S President Peter M. Wells notes, “Marshall & Swift cost data remains one of the most important and defendable sources of property valuations in the lending process required by the mortgage and appraisal industries today.” Wells states that he believes there will be a resurgence in the use of the cost approach in the lending process because the current debacle in the mortgage industry was fueled by uncertainty in valuations and the market approach alone was unable to find the low point for valuations.

“Restoring the cost approach to the underwriting process is inevitable,” says Wells, “since it is a measurable component to valuation that is not at the whim of emotion.”

Overlooked since 1996, the cost approach has always helped define objectively the total amount of money that can justifiably be lent against a property. It also serves as a baseline to compare market trends with the cost trends of real property.

ASFMRA & LandsOfAmerica.com Team Up - Central comparable sales program for rural properties

The American Society of Farm Managers and Rural Appraisers (ASFMRA), the premier organization for rural consulting services announced today a partnership with LandsOfAmerica.com, LLC (LOA), the nation's leading rural land listing service. Together the two leaders in the industry will provide comprehensive services to members.

The ASFMRA and LOA partnership will provide a central comparable sales program for rural properties to ASFMRA members as well as listing opportunities. The program will benefit not only members and rural real estate professionals but also the buying public by providing and promoting the vast database of rural land properties for sale on the LandsOfAmerica.com website.

Jake Massengale, CEO of LOA says, "It is a big undertaking and a long term program, but with the reach that both of our groups have within the rural real estate market, we think it is a goal that can be accomplished."

LOA provides listing services for rural properties including farms, ranches, timberland, mountain, and waterfront real estate on their network of over 250 rural real estate websites. Members of LOA can utilize this beneficial new program to share information about properties they are involved with selling. As a result, they are able to search the entire program for comparable sales through their main website at  http://www.LandsofAmerica.com

The ASFMRA provides members with management, valuation and consulting services to the agricultural and rural property community with their immense network of professionals. "We are pleased to have this great new partnership with LandsOfAmerica.com. This has proven to be a great new tool in the tool box for managing, valuing and selling rural property," says Merrill E. Swanson, ARA, District VP, serving on the Executive Council for ASFMRA, "I have found that LandsOfAmerica.com is a very cost effective and successful advertising medium to expose rural land listings to a wide variety of prospects. The ability to advertise listings not only on LandsOfTexas, as in my case, but on all of the associated websites provides very good exposure on a national basis. The knowledge of these listings on LandsOfAmerica.com provides appraisers a head start for confirming comparable sales. The new comparable sales data system being developed by LandsOfAmerica.com should greatly aid Appraisers, Managers and Brokers in the American Society."

With the ASFMRA and LOA teaming up to provide these services to their membership base, it increases the exposure of rural properties nationwide and provides valuable tools for sharing information and valuing properties. This information is intended to be a starting place and used in a general way. Members are cautioned to always verify the integrity of the information by a professional.

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What’s in Your Appraisal File Memorandum? - The integrity of our profession relies on THREE approaches to value

The real estate appraisal process is based on considering three approaches to value when providing an opinion of value for a specific portion of real estate. Cost, Income, and Sales Comparison. Yet, what is consideration without verification that an approach was indeed considered and deemed viable or not in the final conclusion of value?

Here's the fundamental question:

"Do the principles of our profession, regardless of USPAP, allow us to totally dismiss the income and cost approach without verification that the conclusion made by the appraiser can be substantiated?"

Let’s review USPAP

Standard Rule 1-4 In developing a real property appraisal, an appraiser must collect, verify, and analyze all information necessary for credible assignment results.

(b) When the cost approach is necessary for a credible assignment results, an appraiser must: etc.

(c) When the income approach is necessary for a credible assignment results, an appraiser must: etc.

Standard Rule 1-2(f) states “identify the scope of work necessary to complete the assignment;

Comment: The scope of work is acceptable when it is consistent with:

• The expectations of the participants in the market for the same or similar appraisal services; and
• What the appraiser’s peers’ action would be in performing the same or a similar assignment in compliance with USPAP.

It continues to say:

An appraiser must have sound reasons in support of the scope of work decisions and must be prepared to support the decision to exclude any information or procedure that would appear relevant to the client, an intended user, or the appraiser’s peers in the same or a similar assignment.

An appraiser must not allow assignment conditions or other factors to limit the extent of research or analysis to such a degree that the resulting opinion and conclusions developed in an assignment are not credible in the context of the intended use of the appraisal.

Does USPAP allow us to make the statement that an approach to value is not applicable without any substantiation?

Which brings rise to another question: What is in your file memorandum? Do we need to have support that substantiates that an approach is not applicable?

I believe that part of the problem with appraisals that misrepresent the fair market value is in part due to the appraiser not utilizing three approaches to value to insure there are checks and balances to support the final conclusion.

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Outside the Boxes; Part 13 - "To Cost or not to Cost- that is the Question"

AUTHOR:  Patrick Egger is a Certified General Appraiser located in Las Vegas, NV. He teaches continuing education classes on the housing market, appraisal issues for real estate agents and appraisers. He can be reached at [email protected] 

The URAR includes a number of sections that seem to be straight-forward, when in fact they are anything but. Continuing from Part 12 - Overlooked & Under-Reported, let's look at another often misunderstood area of the URAR . . .the Cost Approach!

Is the cost approach applicable and if so why? Before you automatically include the cost approach, consider the following.

1. In a neighborhood that is void of vacant land or lots, similar to the subject site; does a potential buyer have the "construction new alternative"?
2. In areas where housing is build in tracts or as builder production units (with economies of scale the typical individual does not have), is the cost approach valid?
3. If (based on the above) you present the cost approach (whether or not any reliability is placed on it), by it's inclusion have you created a misleading report?

If building a new home is the "alternative to a home purchase", why use the cost approach when there is no land purchase option and or similar improvements can't be cost effectively duplicated?

URAR: Provide adequate information for the lender/client to replicate the below cost figures and calculations.

The space in this section is not sufficient to provide the level of detail for a reader to follow you sources and logic, step by step. If you include the cost approach, also include an addendum to expand on the methods used, land sales data, cost services, etc.

URAR: Support for the opinion of site value (summary of comparable land sales or other methods for estimating site value).

Vague statements or references ("from the appraiser's files" or "extracted") will cause a reader to question your support for the site value. Inexperienced appraisers often "pad" building cost estimates or minimize depreciation to make up for under-valued land in the cost approach. An experienced reviewer will recognize this type of mis-step immediately.   

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Proving Appraisal Adjustments the Easy Way - Managing Your Risk

AUTHOR: Steven R. Smith, MSREA, MAI, SRA, Smith Realty Advisors, 936 San Jacinto St., Redlands, CA 92373, Real Estate Appraisals, Consulting, Expert Testimony, Forensic Reviews, Fraud Research and Analysis, Litigation Support, Fraud Training  909-798-8855, fax: 909-798-0139

In a lot of the suits against appraisers that we see, the allegations of negligence often make up a long list. Violations of good appraisals procedures are most often characterized as a competency issue.

Whether the licensed appraiser went to a cram course school, or took their course work through a major appraisal association or university; when the suits come, the allegations are almost always the same.

How can an individual appraiser manage their risks in soft of declining markets, which is when suits increase?

A key area that is attacked by lawyers is the Market Analysis and the Market Data Approach. Having a basis for the check boxes on the front of the report about Value Trends, Supply & Demand and Marketing Times is a good thing.  Especially if based upon the appraisers own objective research and analysis. Those who understand housing markets and report them accurately, minimize their risk. However, housing market analysis is not the point of this writing.

There is not time or fee allocation for residential appraisers to prove their adjustments.  On any given report, stopping to do so and spending the time to do it would substantially lengthen the preparation time and probably be financially ruinous.

A simple way to accomplish having proof or support for adjustments is to simply watch the sales as they are reported, when one pops up that is inordinately high or low for any reason, it might be worthy of checking on.

Most residential appraisers were given what to use as adjustments. Some have used the exact same adjustments for 20-30 years, in every neighborhood, price range and for every quality home.  Counter intuitive if you think about it.

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Say Goodbye To The Gross Income Multiplier

You may be familiar with the gross income multiplier. This simple formula for determining the value of rental real estate has been around for ages.

The first book I read on investing in real estate advised me to "never buy a property with a GIM of more than 8." GIM is the acronym for gross income multiplier, of course, and the formula is this: divide the price by the gross annual rents to get the GIM.

In other words, the author was advising me to never pay more than 8 times the annual rent for a rental property. That seemed simple enough. I started looking at properties in terms of GIMs. If it was selling for 6 times rent it must be a good deal. If it was 12 times rent it had to be bad. It was great to have such a simple rule to follow - except that it never was a good rule to begin with.

Using a gross income multiplier is a crude way to put a value on a property. It is just too simplistic. Suppose two buildings each are selling for eight times their gross annual rent collections. One however, includes all utilities in the rent that tenants pay. That changes things, doesn't it? Of course, you could try to subtract out the utilities, to see what rents would be if they weren't included, and use that for the GIM. But that's not the only problem.

You need to constantly change the GIM expectations to reflect interest rates, because a property might be profitable at 12 times rent when interest rates are low, but a money loser at eight times rent if the financing is expensive.

Also, there are just plain different expenses for different properties, whether higher maintenance costs, insurance premiums, or whatever. Gross rent doesn't say much about the factor that really makes a rental property valuable: the net income.

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