Accurately Calculate Market Value (m = c - d + r)

[George Hatch]

Good point

 

[RCA]

I think the "beauty contest" analogy is as accurate an expression of cost/benefit comparisons as any.

Going back to the ROI, maybe it would be helpful to go back to the fundamentals. The premise of each approach to value is to that we are attempting to emulate the behavior of the market participants in these transactions. In the income approach it is the investor's position we are trying the emulate. In the cost approach it is the developer's position whether that developer intends to self-occupy the property or not. So the developers profit margin IS baked into the CA, and that margin IS distinct and separate from the contractor's margins.

Let's say you were an owner-user and you decided that your options for the existing home of your dreams sux. Your CA would consist of

Site acquisition
materials and labor
contractor's overhead in addition to the labor
fees, permits, bonds, etc
financing costs
contingency factor for the unknown costs which might pop up at random during the process
holding costs of the project during however long it takes to complete the project

and finally,
your potential savings (aka profit) coming from building your own instead of buying someone else's finished project. Because after all, you're not going to undertake the time/effort and risks of this project for free. You gots to be paid. We even call it the profit margin, or developer's profit or investor incentive or whatnot.

That potential savings (vs buying the existing unit) is your return on investment, whether you're an owner-user or a spec builder.

So going back to the CA in the GSE forms, they have aggregated ALL of the above factors (other than the site acquisition) into the "cost/sf". That "cost/sf" for the main structure includes the ROI for the entire project under the assumption that the other site improvements will be typical in scope and contribution.

That's why the base costs that go into that CA swing so widely, depending on where in the RE cycle the effective date is. During a bust there may be no margin for the developer; they sometimes end up losing. But during a bull run their potential margins might be in excess of 30%. The CA is a market approach and it does include consideration of the current market conditions whether we explicitly break that factor out or not.

As I've been saying, the development of the CA using the commercial cost guide actually uses different base costs because M&S doesn't aggregate the indirects and profit factors into their base costs in the commercial book - the appraisers tally those separately in those analyses based on what's applicable for that location and the current market conditions.

Long story short, the CA the GSE forms use is a simplified and abbreviated format which employs an aggregate "cost/sf" factor that assumes (at fixed/arbitrary rates) all those other elements in addition to the labor+material. The fixed/arbitrary nature of all those other assumptions is one of the main reasons the CAs which are performed in this manner sometimes don't turn out similarly to the results of the Sales Comparison. It's not that "the CA never works" so much as it is "the CAs which are performed using these fixed assumptions sometimes don't work".

You can do a very good job on the CA. In many cases you see that it's mostly a matter of repair costs - which you may very possibly be able to estimate. You won't catch everything, but you can get most of it.

Nonetheless, at the end of the day, you have to add in "market reaction". That is to say, I might calculate that by spending $50K I can bring some property up to a certain standard for which I have good estimates of market value, say $500K. But then the market value doesn't justify the $50K, when I could have sold the property for $40K less than market value. that is $460K without repairs. And so, you might very well wonder what all that work in estimating the CA was for, when you simply could have gone straight for "market reaction". Well, if I were the seller interested in selling, then it make sense if I have to decide between repairing or not. But as an appraiser for a loan, I don't need to know this. It's going to be SCA, i.e. beauty contest stuff.

 

[Sadie]

You can do a very good job on the CA. In many cases you see that it's mostly a matter of repair costs - which you may very possibly be able to estimate. You won't catch everything, but you can get most of it.

Nonetheless, at the end of the day, you have to add in "market reaction". That is to say, I might calculate that by spending $50K I can bring some property up to a certain standard for which I have good estimates of market value, say $500K. But then the market value doesn't justify the $50K, when I could have sold the property for $40K less than market value. that is $460K without repairs. And so, you might very well wonder what all that work in estimating the CA was for, when you simply could have gone straight for "market reaction". Well, if I were the seller interested in selling, then it make sense if I have to decide between repairing or not. But as an appraiser for a loan, I don't need to know this. It's going to be SCA, i.e. beauty contest stuff.

You have to remember that when you are updating/upgrading, you are typically removing something of use/value and replacing it. So the cost of the updating/upgrading has to be tempered with the value of what is removed.

 

[RCA]

You have to remember that when you are updating/upgrading, you are typically removing something of use/value and replacing it. So the cost of the updating/upgrading has to be tempered with the value of what is removed.

Yea, I know. You have a roof with 20 years on it and another 10 to go. If you want to make it look new, you are throwing away 10 years of value. So, it may not be cost effective. Likewise, in the other direction, you have an old shake shingle roof with thick moss growing on it, dry rot and the roof sinking inward at several places due to dry rot and/or infestation -- and probably as a consequence suffering from other serious problems not visible.

A lot of my statements are simplified, the assumption being you can tweak them as much as you think worthwhile to get greater accuracy. ... Because I have to give higher priority to work I have to do.

 

[Sadie]

Yea, I know. You have a roof with 20 years on it and another 10 to go. If you want to make it look new, you are throwing away 10 years of value. So, it may not be cost effective. Likewise, in the other direction, you have an old shake shingle roof with thick moss growing on it, dry rot and the roof sinking inward at several places due to dry rot and/or infestation -- and probably as a consequence suffering from other serious problems not visible.

A lot of my statements are simplified, the assumption being you can tweak them as much as you think worthwhile to get greater accuracy. ... Because I have to give higher priority to work I have to do.

Why did you respond this way? My comment was not in disagreement with yours.

 

[App3000]

However, as a residential appraiser you better get very comfortable with the Market Approach. If you are using a GSE form, the primary approach to value is the Market Approach. Read the boiler plate. And just wow if you the M & S is very accurate. Try some new construction appraising or just talk to builders that you know and trust.

New construction is essential to understanding the market. I agree that it is wise to talk with local builders. For instance, in my area, builders do not install pools or finished basements. The reason builders give me is that there is no positive ROI. Inground pools, in my area, have a negative ROI until you reach a certain price point, and then there is zero ROI. Finishing the basement has a zero ROI as well. Builders only build when there is a positive ROI. Thank you for your response.

 

[RCA]

Why did you respond this way? My comment was not in disagreement with yours.

Well actually, I had thought about adding that issue in with the post, but thought it was an unnecessary complication. The problem with repair is that it is very often all or nothing. You can't just upgrade a 20 year old roof to make it look new and somehow retain the useful life of the original. So, if you are using repair costs to determine depreciation, you have to somehow factor in that issue. So, in the case of that roof, maybe take 2/3's of the repair cost as an estimate for depreciation. That's an easier one.

The other one is where the RE Agent tells the seller that he can sell the house for $X, only if he updates various features such as the kitchen layout, cabinets, counters and appliances. Even though most could go another 30 years easily (except for appliances). It's probably functional utility, aesthetics, quality and to a lesser extent condition, so maybe mostly functional obsolescence. But you never know for sure usually.

We deal with these depreciation issues in the Sales Grid, where we have to make adjustments and justify them with some kind of rational. So, you never really get away from that cost approach. It's always there, in one way or another. -- And understand, I personally "contain" such adjustments through the IVCA approach, and the adjustments that I have to make manually are simply a redistribution for explanatory purposes. So, to be precise, my adjustment depreciation calculation has no impact on the sales comp adjusted value, it only helps explain why there is a total intangible value of $Y that was assigned by my method. So, since it is not critical to value, I only need to be somewhat approximate. And indeed that is all you can be since, there is no way to accurately directly measure market reaction to the roof condition on some particular home.

Part of the genius of the IVCA approach, is that by first calculating the value contribution of all features and then subsequently taking the difference with the subject value contribution to get the adjustments, the estimation of intangible adjustments is "grease smooth," i.e. no need to burn the midnight oil with insane calculations. The only bump in the road, is that it has to make reasonable sense in respect to your information (MLS pictures and descriptions and your observations) on the sales comparable and subject properties.

And if the AMC asks why you didn't include such and such a comp in the grid --- you should already have it in your regression output with all adjustments. And you tell them - I can give you 200 more like this -- but I do have to take time to manually and personally verify the adjustments, and I need to be paid for that.