Lee Lansford
Elite Member
- Joined
- Mar 29, 2002
- Professional Status
- Certified Residential Appraiser
- State
- Illinois
The Cost Approach is applicable more often than it is necessary in order to communicate a credible appraisal.
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Cost Approach "violation of USPAP"
- Thread starter Jo Stinett
- Start date
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CANative
Elite Member
- Joined
- Jun 18, 2003
- Professional Status
- Retired Appraiser
- State
- California
PIA = Entrepreneurial Incentive.
CANative
Elite Member
- Joined
- Jun 18, 2003
- Professional Status
- Retired Appraiser
- State
- California
Message sent to me a long time ago from a forum member who no longer posts... (it was the last communication in a long chain of correspondence from my "virtual mentor.")
For those who don't mind using former USPAP terms, the two best phrases to explain not doing an approach are (IMO)
"does not address factors and conditions present in the assignment" (it's not an investment property
"and would not produce meaningful results" (would not or should not get weight of reliance).
Greg,
I clicked your link and browsed some of these Boddy essays. He writes well.
I noticed a couple of things that relate to some of our prior shenanigans. There was a thread about easements. I kept pushing this idea of seller’s loss and buyer’s gain and you were one of the few who warmed to the idea. Here is Boddy
Boundary line adjustments involve a branch of economics called “bargaining theory,” which predicts that a buyer and seller with this kind of bilateral monopoly would share any cooperative surplus equally. In other words, they would split the difference between the seller’s loss and the buyer’s gain.
Unfortunately, game theory is a science unto itself, NOT a “branch” of economics. Also, the oxymoron “bilateral monopoly” hurts my head. But Boddy has the right idea.
This has amazed me since I got into this business. Appraisers are taught “the form” and the “three approaches” in a cocoon. The cocoon shields out common sense and real-world decision-making and uses the rote applications of formulas. What “approach” measures the buyer’s gain and seller’s loss? What “form” does that go on?
If the “profession” could just formally recognize that we are using the tools of other disciplines, use the name of the discipline and the right name of the tool – we would have a shot a not being 80,000 headless chickens running in infinite and endless circles.
One of the follies I enjoyed attacking has been the cost approach. I managed to keep one long thread fixed on a core idea. The textbooks and dictionaries give three definitions of depreciation and appraisers use them interchangeably, even within the same sentence.
1 Wear and tear (which is really deterioration)
2 Loss in value (which may result from deterioration or any other factor)
3 The difference between cost and value.
The folly of the cost approach fits into one of the larger themes that fascinate me, that appraisal though driven by rote applications don’t work and lead to incongruous statements, and somehow nonsensical statements don’t seem to violate appraisers’ senses or uniform standards of practice. In the cost approach, nonsense reigns supreme. Here is Boddy bouncing back and forth between depreciation as loss in value and depreciation as wear and tear creating serial nonsense.
Another real estate maxim is that land does not depreciate. Technically, this is true. Land can decrease in value, but it’s not called depreciation. Improvements depreciate, but land loses value.
I think he is trying to say that land doesn’t wear out in the conventional sense - although agricultural and mineral land does wear out. See how these tie together with what I said before about using the tools and terms of other disciplines without being aware of it?
Does land depreciate? Not on an income statement or a tax return in the sense of “taxable value,” because the IRS won’t allow depreciation expense against land. They only allow gain or loss on sale.
Does land depreciate? Using the “loss in value” appraisal definition, it does.
Does land wear out? Yes, but not the same way buildings do. In business and taxation, this reduction of productive capacity is called depletion. In appraising, it has no name. It just shows up implicitly as reduced future benefits.
I am not an expert in chaos theory, but I wonder if things could get this disorganized by accident.
EP/EI
Well, I am flattered that you think I might know. I can give you MY answer, some of which you probably can anticipate. First, I can't imagine ever relying on the cost approach for an opinion of market value, so that part of it is a riddle, inside a mystery, wrapped into a conundrum that I won't EVER have to unravel. Second, as you have seen me try to feebly explain for years, I have a decisions-based approach to appraising. I see the "scope-of-work project" moving USPAP closer to that. I will try to give you an overview of what I think I know.
I can easily see where lump-sum or percentage EI is part of property development decisions in transitional properties: in theory and confirmed by market extractions. Development decisions are basically: build versus don't build. That can be either form: decisions about whether to develop "vacant" land or decisions about redeveloping (e.g. renovating) already "improved" land.
In development decisions (and this language may not be precise), there is only one property. The developer (or speculator, sometimes) looks at the property "as is" and "as if" to determine if there appears to be sufficient EI to make a move. Also, these are property "investor" (not property user) decisions. That is, the "incentive" of anticipated "profit" drives the decision. Because it is an investor decision, that also drives the appraisal method. That's because the present value of the property is based on the as-completed value, less the cost to complete, less the incentive to complete. That incentive is the anticipated return on investment. Also, these are "transitional" properties because they are not at their current or ultimate HBU.
Good little rule of thumb to be extracted from the above - factoring incentive into a decision makes value lower, not higher. If the incentive is zero at $2, then it is 100% at $1. Little food for thought - doesn't that make incentive a form of depreciation in cost approach "theory?"
However, once you switch from decisions made by producers about whether to develop or not develop to decisions made by consumers, the basis of "incentive" either disappears or changes radically. You are leaving the world of transitional properties that are not at their ultimate or current HBU and need risk-takers to get them there, to patent properties that are at or near the HBU whose buyers love them just the way they are.
In this latter class of properties, you are now talking about people not making decisions about one property versus itself (as is versus as if), you are talking about decisions based on one property versus another. I don't see where incentive based on cost to construct enters the decision, because no one is going to be constructing anything. This includes any type of property where the buyer profile is someone who is unwilling or unable to build instead of buy, and this includes the vast majority of patent properties.
That leaves the segment of markets that is willing and able to build instead of buy patent properties. For SFR's these are usually wealthy people and for commercial property this are usually large business who want improvements to suit their use. They are not building to capture the incentive of value less cost in the short run, so incentive as a function of cost does not enter their decisions. Rather than go into what incentivizes these decisions, I think I'll put the ball back in someone else's court to explain why an existing home is worth $600k instead of $700k, because it would cost some wealthy couple $1 mil to custom build their "perfect" home.
For those who don't mind using former USPAP terms, the two best phrases to explain not doing an approach are (IMO)
"does not address factors and conditions present in the assignment" (it's not an investment property
"and would not produce meaningful results" (would not or should not get weight of reliance).
Greg,
I clicked your link and browsed some of these Boddy essays. He writes well.
I noticed a couple of things that relate to some of our prior shenanigans. There was a thread about easements. I kept pushing this idea of seller’s loss and buyer’s gain and you were one of the few who warmed to the idea. Here is Boddy
Boundary line adjustments involve a branch of economics called “bargaining theory,” which predicts that a buyer and seller with this kind of bilateral monopoly would share any cooperative surplus equally. In other words, they would split the difference between the seller’s loss and the buyer’s gain.
Unfortunately, game theory is a science unto itself, NOT a “branch” of economics. Also, the oxymoron “bilateral monopoly” hurts my head. But Boddy has the right idea.
This has amazed me since I got into this business. Appraisers are taught “the form” and the “three approaches” in a cocoon. The cocoon shields out common sense and real-world decision-making and uses the rote applications of formulas. What “approach” measures the buyer’s gain and seller’s loss? What “form” does that go on?
If the “profession” could just formally recognize that we are using the tools of other disciplines, use the name of the discipline and the right name of the tool – we would have a shot a not being 80,000 headless chickens running in infinite and endless circles.
One of the follies I enjoyed attacking has been the cost approach. I managed to keep one long thread fixed on a core idea. The textbooks and dictionaries give three definitions of depreciation and appraisers use them interchangeably, even within the same sentence.
1 Wear and tear (which is really deterioration)
2 Loss in value (which may result from deterioration or any other factor)
3 The difference between cost and value.
The folly of the cost approach fits into one of the larger themes that fascinate me, that appraisal though driven by rote applications don’t work and lead to incongruous statements, and somehow nonsensical statements don’t seem to violate appraisers’ senses or uniform standards of practice. In the cost approach, nonsense reigns supreme. Here is Boddy bouncing back and forth between depreciation as loss in value and depreciation as wear and tear creating serial nonsense.
Another real estate maxim is that land does not depreciate. Technically, this is true. Land can decrease in value, but it’s not called depreciation. Improvements depreciate, but land loses value.
I think he is trying to say that land doesn’t wear out in the conventional sense - although agricultural and mineral land does wear out. See how these tie together with what I said before about using the tools and terms of other disciplines without being aware of it?
Does land depreciate? Not on an income statement or a tax return in the sense of “taxable value,” because the IRS won’t allow depreciation expense against land. They only allow gain or loss on sale.
Does land depreciate? Using the “loss in value” appraisal definition, it does.
Does land wear out? Yes, but not the same way buildings do. In business and taxation, this reduction of productive capacity is called depletion. In appraising, it has no name. It just shows up implicitly as reduced future benefits.
I am not an expert in chaos theory, but I wonder if things could get this disorganized by accident.
EP/EI
Well, I am flattered that you think I might know. I can give you MY answer, some of which you probably can anticipate. First, I can't imagine ever relying on the cost approach for an opinion of market value, so that part of it is a riddle, inside a mystery, wrapped into a conundrum that I won't EVER have to unravel. Second, as you have seen me try to feebly explain for years, I have a decisions-based approach to appraising. I see the "scope-of-work project" moving USPAP closer to that. I will try to give you an overview of what I think I know.
I can easily see where lump-sum or percentage EI is part of property development decisions in transitional properties: in theory and confirmed by market extractions. Development decisions are basically: build versus don't build. That can be either form: decisions about whether to develop "vacant" land or decisions about redeveloping (e.g. renovating) already "improved" land.
In development decisions (and this language may not be precise), there is only one property. The developer (or speculator, sometimes) looks at the property "as is" and "as if" to determine if there appears to be sufficient EI to make a move. Also, these are property "investor" (not property user) decisions. That is, the "incentive" of anticipated "profit" drives the decision. Because it is an investor decision, that also drives the appraisal method. That's because the present value of the property is based on the as-completed value, less the cost to complete, less the incentive to complete. That incentive is the anticipated return on investment. Also, these are "transitional" properties because they are not at their current or ultimate HBU.
Good little rule of thumb to be extracted from the above - factoring incentive into a decision makes value lower, not higher. If the incentive is zero at $2, then it is 100% at $1. Little food for thought - doesn't that make incentive a form of depreciation in cost approach "theory?"
However, once you switch from decisions made by producers about whether to develop or not develop to decisions made by consumers, the basis of "incentive" either disappears or changes radically. You are leaving the world of transitional properties that are not at their ultimate or current HBU and need risk-takers to get them there, to patent properties that are at or near the HBU whose buyers love them just the way they are.
In this latter class of properties, you are now talking about people not making decisions about one property versus itself (as is versus as if), you are talking about decisions based on one property versus another. I don't see where incentive based on cost to construct enters the decision, because no one is going to be constructing anything. This includes any type of property where the buyer profile is someone who is unwilling or unable to build instead of buy, and this includes the vast majority of patent properties.
That leaves the segment of markets that is willing and able to build instead of buy patent properties. For SFR's these are usually wealthy people and for commercial property this are usually large business who want improvements to suit their use. They are not building to capture the incentive of value less cost in the short run, so incentive as a function of cost does not enter their decisions. Rather than go into what incentivizes these decisions, I think I'll put the ball back in someone else's court to explain why an existing home is worth $600k instead of $700k, because it would cost some wealthy couple $1 mil to custom build their "perfect" home.
Tim Hicks (Texas)
Elite Member
- Joined
- Jan 15, 2002
- Professional Status
- Certified Residential Appraiser
- State
- Texas
I thought I was your virtual mentor???
We were on-line together when your car was stolen. I guess I didn't distract you enough so my minions could accomplish the deed without notice.
We were on-line together when your car was stolen. I guess I didn't distract you enough so my minions could accomplish the deed without notice.
Tim Hicks (Texas)
Elite Member
- Joined
- Jan 15, 2002
- Professional Status
- Certified Residential Appraiser
- State
- Texas
A cost approach can be worthless, but as long as you explain your client requires it as a part of your scope of work and you give it little weight in the opinion of value, then I doubt it is a USPAP violation.
CANative
Elite Member
- Joined
- Jun 18, 2003
- Professional Status
- Retired Appraiser
- State
- California
I consider you one of my virtual mentors.
If a valuation method is predicated on a principle that does not exist in the assignment how can the result be credible?
Lee Lansford
Elite Member
- Joined
- Mar 29, 2002
- Professional Status
- Certified Residential Appraiser
- State
- Illinois
If the CA is "worthless" (understood as "not credible"), and if included in an appraisal due to the client's request, I'd give the CA "zero" weighting (with explanation for its inclusion) in the reconciliation.
Lee Lansford
Elite Member
- Joined
- Mar 29, 2002
- Professional Status
- Certified Residential Appraiser
- State
- Illinois
"A blind squirrel will eventually find a chestnut."
OR
"A broken clock is correct 2 times per day."
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