Appraiser Beware; The three approaches are related

[Michigan CG]

For some people these made-up cost approaches along with the really bad “list of adjustments” can come back to haunt them. Many appraisers either forget or were not taught that all three approaches to value are intertwined and related to each other.

The GRM or a cap rate for an income approach comes from sales. The GRM for an income property can be used to derive an adjustment for a garage or a bedroom.

For those that find the magical “matched pairs” those adjustments are the result of depreciated cost. If an appraiser finds a matched pair for a full bathroom and this matched pair supports an $8,000 adjustment when the cost new of a full bathroom is $10,000 then the attributed depreciation from cost new is 20%. This is a function of cost whether one realizes it or not.

When someone uses unsupported adjustments (list of adjustments) and then also completes a cost approach with completely made up numbers they are looking for problems as the included cost approach can be used against the appraiser in the Sales Comparison Approach.

Many folks do not believe in the Cost Approach and find it to be worthless but it can actually be a GREAT tool. There are many residential appraisers who do a cost approach on the subject property and ALL of the comparable properties for every assignment they do.

The Cost Approach can be used as a test of reasonableness.

Here is a real life example that some will think I am making up and I am not (I have changed some numbers to make the math easier). The made-up cost approach comes in at a COST NEW of $260,000. The land value was based on an average of land sales that DID NOT EXIST. The appraiser stated that the land value was based on an AVERAGE. The land value is stated to be $50,000 when comparable sales show the land value to more like $20,000.

The depreciation applied to the made-up cost approach is 35% which results in a contributory value of the improvements at $170,000 plus land value of $50,000 (inflated by 2.5 times) to conclude a cost approach of $220,000.

Now let us go to the SCA and the adjustments used. The home is a ranch home in decent shape with a newer kitchen and average bathrooms. The home does not have a basement.

The adjustment for a full bathroom is $2,000 in the SCA but cost new is ~$10,000. The appraisal report just stated that the bathroom’s contribution to the overall value of the property has depreciated by 80% while the home has only depreciated overall by 35% according to the (fake) cost approach.

A very similar home was used as a comparable property and the report states that basements are adjusted at $5/SF. This property has a basement while the subject property does not have a basement. The cost new of a basement here is about $25/SF so the appraisal report is telling us that the basement has depreciated by 80% but the entire house has only depreciated by 35% according to the cost approach.

The report adjusts the cheap finished basement area at $10/SF, double the contributory value of the basement itself.

Appraisers need to remember that all three approaches are related to each other and one can be used to discredit another if one or more are not developed correctly.

How can this come back to haunt an appraiser? If an appraiser is involved in a litigation situation the entire report can be discredited; I did it last year for a divorce.

If a lender is facing a buyback and decides to have the report reviewed a good reviewer can put this all on the appraiser just by discrediting one approach and applying that to the other approach (this could be done with the SCA, IA or the CA).

This particular report concluded an opinion of value of $100 over the contract price. Those small bathroom adjustments and basement adjustments sure helped it get there along with other issues.

My cost approach for the property comes in at 15%-20% total depreciation but that is another discussion.

 

[CANative]

I roll my eyes when I read someone post "the cost approach was not applicable cuz the house is 27 years old."

 

[Sid Holderly]

If you do the cost approach on every appraisal you learn what the depreciation rate needs to be for the quality and condition of the updated or not updated house you just waked though.
It keeps you in tune with the market. Here in the flatlands of the Midwest, most basements are not totally dry, thus the value is much less (depreciation is greater). When you find a finished basement
It generally has more features to keep it dry therefore the depreciated is less. A fully finished walkout basement as the main level is completed may equal near main level value.

For our education doing the cost for older homes yields more benefits than the time it takes to do it.

Generally, there are lot sales for lot value, you may have search 3 years, but it gives a better indication than using assessed value (my pet peeve).

 

[Joe Flacco]

I often think through the cost approach and use cost approach concepts in the sales comparison approach but I don't usually fully develop or report the cost approach.

 

[Joe Flacco]

Cost approach may be applicable for a 27 year old house but you are probably going to have physical, functional, and maybe even external depreciation depending on what is going on in the market. It's not just replacement cost new with physical depreciation unless it is a 27 year old house that has been renovated / modified and functional issues have been cured.

I only fully develop and report the cost approach if it is brand new, almost brand new or very recently fully renovated.

 

[Sid Holderly]

It helps you identify the functional percentage, lack of a bathroom on the second level, etc.

 

[ucbruin]

How about bedroom count???

 

[Sid Holderly]

I rarely find support for a bedroom count adjustment. A 1 bedroom yes, between 2 & 3 it depends where it is, on the golf course or lake generally no.
Around the golf course required septics when most of the homes were built, so bedrooms were limited to 2 by the health department, but most had dens or dining rooms that could be easily converted.
When the regional sewer went in many were converted or added onto and new homes are 3 or 4 bedrooms. On the lake, many homes/cottages have many rooms areas that are used as bedrooms, but cannot be counted. Deciphering what a comp has by the way agents list them makes sorting for a comparison nearly impossible. The only parameter in local government is that it has to be at least 90 square feet, many on the lake do not meet that.

Using the cost approach just keeps you better informed of the relationship between cost, the local market, and various applicable depreciations.

 

[BRCJR]

For some people these made-up cost approaches along with the really bad “list of adjustments” can come back to haunt them. Many appraisers either forget or were not taught that all three approaches to value are intertwined and related to each other.

The GRM or a cap rate for an income approach comes from sales. The GRM for an income property can be used to derive an adjustment for a garage or a bedroom.

For those that find the magical “matched pairs” those adjustments are the result of depreciated cost. If an appraiser finds a matched pair for a full bathroom and this matched pair supports an $8,000 adjustment when the cost new of a full bathroom is $10,000 then the attributed depreciation from cost new is 20%. This is a function of cost whether one realizes it or not.

When someone uses unsupported adjustments (list of adjustments) and then also completes a cost approach with completely made up numbers they are looking for problems as the included cost approach can be used against the appraiser in the Sales Comparison Approach.

Many folks do not believe in the Cost Approach and find it to be worthless but it can actually be a GREAT tool. There are many residential appraisers who do a cost approach on the subject property and ALL of the comparable properties for every assignment they do.

The Cost Approach can be used as a test of reasonableness.

Here is a real life example that some will think I am making up and I am not (I have changed some numbers to make the math easier). The made-up cost approach comes in at a COST NEW of $260,000. The land value was based on an average of land sales that DID NOT EXIST. The appraiser stated that the land value was based on an AVERAGE. The land value is stated to be $50,000 when comparable sales show the land value to more like $20,000.

The depreciation applied to the made-up cost approach is 35% which results in a contributory value of the improvements at $170,000 plus land value of $50,000 (inflated by 2.5 times) to conclude a cost approach of $220,000.

Now let us go to the SCA and the adjustments used. The home is a ranch home in decent shape with a newer kitchen and average bathrooms. The home does not have a basement.

The adjustment for a full bathroom is $2,000 in the SCA but cost new is ~$10,000. The appraisal report just stated that the bathroom’s contribution to the overall value of the property has depreciated by 80% while the home has only depreciated overall by 35% according to the (fake) cost approach.

A very similar home was used as a comparable property and the report states that basements are adjusted at $5/SF. This property has a basement while the subject property does not have a basement. The cost new of a basement here is about $25/SF so the appraisal report is telling us that the basement has depreciated by 80% but the entire house has only depreciated by 35% according to the cost approach.

The report adjusts the cheap finished basement area at $10/SF, double the contributory value of the basement itself.

Appraisers need to remember that all three approaches are related to each other and one can be used to discredit another if one or more are not developed correctly.

How can this come back to haunt an appraiser? If an appraiser is involved in a litigation situation the entire report can be discredited; I did it last year for a divorce.

If a lender is facing a buyback and decides to have the report reviewed a good reviewer can put this all on the appraiser just by discrediting one approach and applying that to the other approach (this could be done with the SCA, IA or the CA).

This particular report concluded an opinion of value of $100 over the contract price. Those small bathroom adjustments and basement adjustments sure helped it get there along with other issues.

My cost approach for the property comes in at 15%-20% total depreciation but that is another discussion.

This post is exactly what the forum is, or should, be all about.

 

[BRCJR]

Cost approach may be applicable for a 27 year old house but you are probably going to have physical, functional, and maybe even external depreciation depending on what is going on in the market. It's not just replacement cost new with physical depreciation unless it is a 27 year old house that has been renovated / modified and functional issues have been cured.

I only fully develop and report the cost approach if it is brand new, almost brand new or very recently fully renovated.

....and atypical properties?