Blog #102: “Sometimes I Like to Sit Here in the Dark and Put Umbrellas in my Car”

Introduction

Believe it or not, I recently overheard a snippet of a conversation in which the speaker said, “Sometimes I like to sit here in the dark and put umbrellas in my car”.  Yes, in this blog this internally incongruent quote is totally out of context.  However, it makes no less sense out-of-context than it made in-context.  But that is not the point, which is, in the context of a real estate appraisal, we must make sense in reporting the results of our appraisal by avoiding internal incongruencies (inconsistencies).  Unfortunately, both practical experience and a non-scientific survey have indicated to me that one of the major issues with real estate appraisal reports is that of internal inconsistency.

Both an appraisal and an appraisal report are complex undertakings.  It is clear to appraisers that both have too many moving parts. When you get this many moving parts with but merely one person charged with keeping track of all of them, keeping them in some semblance of order, making them all come together at the end to make sense, may simply be a task too big for one person (think of herding cats). And yet, that is the state of the appraisal art in 2019, especially if the appraiser is using a form to report the appraisal (for example, the 1004 or 1004P forms).  And especially if the appraiser is a one-appraiser shop (which many are).

The purpose of this blog is not so much to solve the problem of internal incongruencies on inconsistencies, as it is to illustrate the problem, and then let those illustrations function as a genesis for potential solutions to the problem.  So let’s consider some common internal incongruencies we can find in many appraisal reports.

#1 One-unit Housing Trends

Referencing the Fannie Mae Selling Guide (FMSG) makes it clear that she assumes the appraiser will fill this out this part of the 1004 form vertically, not horizontally.  The reason for this is that, under standard economic theory, if property values are increasing, then supply and demand can’t be in balance.  The reason for this is that it is the imbalance of demand over supply that causes prices to increase.  Further, if demand exceeds supply, then marketing time will be three months or less. 

Therefore, it is internally incongruent (or inconsistent) to represent to the client that property values are increasing, that demand and supply are in balance, and marketing times are under three months when, per that theory, this relationship is impossible. 

Now, we all understand that real estate markets never studied basic economics.  Therefore, there may be some isolated instances in which it is market-oriented to fill out this part of the 1004 form horizontally.  However, that is an anomaly the appraiser must carefully and patiently explain with market data.

#2 Highest and Best Use

In residential real estate appraisal, the concept of highest and best use is controversial.  This controversy stems from at least two sources: (1) in “appraisal school”, appraiser wannabes receive absolutely no training in the theory, practice, and analytics of highest and best use; and (2) “hey, its a house on a residentially zoned lot!  The highest and best use is as-is.  What’s the problem?!”  This, frankly, is true.  But, in this situation, that the property’s Highest and best use is obvious is (i) utterly irrelevant in the context of what both USPAP and Fannie Mae expect from an appraiser relative to this complex situation; and (ii) begging the question that every appraisal goes to Fannie Mae.

First of all, SR1-3(a) requires the appraiser to identify and analyze the effect on the use and value of the  property of (I) the existing land use regulations, (ii) any reasonably probable modifications of such land  use regulations; (iii) supply and demand; (iv) the physical adaptability of the real estate; and (v) market area trends.  Then, SR2-2(a)(x) requires the appraiser to summarize within the report the support and rationale behind his/her conclusion(s) of highest and best use.  Is it wise to conclude the appraiser has met these analytical requirements merely by the hopeful fiat there really is nothing to analyze since the subject is an SFR in an SFR neighborhood?  Fannie Mae and USPAP want to see a summary of the analyses, not merely a fiat statement there was nothing to analyze.

In the FMSG, the appraiser must summarize the analyses supporting the appraiser’s conclusion that the improvements contribute at least one net dollar to the value of the underlying site as if it were vacant and ready to be put to its highest and best use.  In turn, these require the appraiser to (1) form a value of the subject site as if it were vacant and available, etc.; and (2) do a cost approach to show the improvements indeed add at least that one net dollar. Is it wise to conclude the appraiser has met these analytical requirements merely by the hope there really is nothing to analyze?

Now turn to the Certification.  In it, the appraiser certifies that “…every statement of fact in this appraisal report is true and correct”.  Now, because the appraiser’s conclusion of highest and best use is an opinion, not a statement of fact, that opinion, as an opinion, need not be both true and correct.  However, what about the facts underlying that opinion?  Items (i) thru (v), above, are facts to whose veracity and correctness the appraiser certifies.  How can the appraiser certify to these requirements if the appraiser has not verified and analyzed the facts underlying them first?

So the property’s highest and best use conclusion may, in all candor, be obvious.  But neither USPAP (i.e., a state appraisal board) nor Fannie Mae looks for an appraiser’s restatement of the obvious since it is…obvious.  What these two expect of the appraiser are the analyses necessary to show the conclusion is obvious.  To imply the property’s highest and best us is in its present use, yet not be able to support that conclusion, is an internal inconsistency that is easy to overcome, thus easy to avoid. When that support is not present, its omission is also easy to prove – to the appraiser’s detriment.

One final point here:  does this mean the appraiser must have the equivalent of a chapter from War and Peace to report his or her findings on highest and best use.  Clearly not.  A precis will and should suffice.  The volume of data should be in the workfile however if, for no other reason, than to show the appraiser complied with the requirements of Standards 1 and 2.  When an appraiser intimates s/he has engaged in these analyses, when in reality s/he has not, that is misleading, a significant USPAP violation.  It is also a USPAP violation easily avoided.

#3 The Subject is in Good Condition?…the Subject is in Average Condition?…What the Hell Condition is the Subject Really In?

As far as internal inconsistencies go, this one is one appraisers can easily avoid.  What happens is that on page one (p. 1) of the appraisal report, in the improvements section, the appraiser will indicate, for example, the improvements (even after depreciation) are in “good” condition (ignore the fact no one has a clue what “good” condition means, nor any metric for it).  Nevertheless, later in the report, the sales comparison approach will show the comparable sales condition are in some other condition (such as “average” – which now renders the concept of condition even more ambiguous), yet there is (1) no adjustment for these differences, or (2) no explanation as to the presence of this of this difference but no adjustment for it. Not only is is important for the appraiser to indicate consistently the subject’s condition, it is also important that the appraiser explain the market-evidence behind how/why s/he reached that conclusion.

#4 Yes, I Cloned that Sheep, but The Two of Them Are Totally Different!

Many years ago a bank hired me to review an appraisal and report.  In that report was a statement to the effect that, of the three approaches to value, the sales comparison approach was the best way to appraise a single family residence.  All other things being equal, that statement was and is correct – for a residential property. But this particular appraisal (on a 1004 form!) was of a 6,000 square foot metal warehouse on an industrially zoned site of over six acres, in a fairly rural part of a generally rural state.  

This was a major internal inconsistency because the appraisers cloned a residential report to appraise an industrial property.  This is not merely a major internal inconsistency.  This is a major internal inconsistency of Biblical proportion.  Such a Grand Canyon-like error showed the appraisers’ lack of intimacy with USPAP and its facets (i.e., it screamed incompetency). 

Therefore, if there is a lesson to appraisers here, it is to avoid cloning.  If there is a problem with a sheep clone, it can always be turned into lamb chops and new carpet.  But when there is a problem with an appraisal clone, chances are it will be turned into the state, a far less savory solution, as well as one seasoned with danger for the appraiser. 

#5  Entrepreneurial Incentive?!  We Don’t Need No Stinkin’ Entrepreneurial Incentive!

Entrepreneurial Incentive or profit (EI/P) is a component of new construction.  It is also a component of new construction that the costing manuals do not include as a component of their per-square-foot costs.  This exclusion is a function of the market:  only the market rewards an entrepreneur with a profit.  EI/P is NOT contractor’s overhead and profit, which definitely is a component of the costing manuals.  Here is an example:  on pure speculation, I hire you to build a house.  You are the general contractor and I am the entrepreneur.  You won’t build that house unless you are going to make a profit, so you build one into the costs you will charge me.  However, when the City issues the CO and I pay you your final construction draw (i.e., your profit), who pays me a profit?  If the market does not reward me with a profit, then it penalizes me for failing to recognize that I should not have brought together the land, labor, and capital to create that spec house.  Therefore, only the market determines if the entrepreneur earns an EI/P, not the costing manual.

Typically, in the standard first-mortgage residential real estate appraisal, there is no EI/P as a component of the cost approach (for the above reasons).  Many appraisers justify this omission by concluding that whatever profit there was, the market absorbed when the house sold new from the builder/developer to the first retail buyer.  Since the house is not new, therefore, there is no EI/P to compose part of the cost approach.   It is likely true that this profit (if any) has long-since been absorbed.  It is also utterly irrelevant to the architecture and structure of the cost approach.  Why is it irrelevant?  It is irrelevant since the cost approach in an appraisal assumes cost new.  Therefore, it is internally inconsistent to assume that an EI/P is available only when the house sells new, yet not include one in the cost-as-if-new the appraiser shows as one of the components of the cost approach.

In addition to all of this, there is what the omission of an EI/P means as part of the appraisal.    On page one of the URAR 1004 form, it is common for appraisers to indicate that, as part of one-unit housing trends, prices are either stable or increasing.  Then, per SR1-3(a)(v), an appraiser is to analyze market trends.  When the appraiser marks stable or increasing prices, the appraiser has made a statement of fact pertaining to the current market’s trends; i.e., a statement of market-based fact.  This implies, therefore, the appraiser has done the necessary analyses to support this statement (and trends), should it be necessary to present the support for such a statement, because that is exactly what the appraiser certifies s/he has done. 

Assuming an increasing market, i.e., one in which prices are increasing over time, therefore with a reasonable expectation this expansion will continue into the future, it is also reasonable to assume that, all other things being equal, were an entrepreneur to build a house in that market, that (competent) entrepreneur could reasonably expect to build and sell it at a profit.  Therefore, an increasing market carries with it the potential of an EI/P. 

It follows, therefore, that a market featuring an excess of supply over demand, i.e., a falling market, would not support such an EI/P assumption.  And, from a standpoint of internal inconsistencies, this is the major highest and best use complaint charging the appraiser’s scroll:  When an appraiser includes a cost approach as part of the report, yet does not include an allowance for an EI/P, the appraiser is telling the client,

“My analyses of the subject indicated there is not an entrepreneurial incentive or profit in the market since there is an excess of supply over demand.  This lack of that potential profit indicates a falling market (or one is about to fall).  Just ignore the fact that on p. 1 of this report I indicated the market was increasing.  Nope, its really decreasing.  I know this because entrepreneurs are investing their excess cash in safe investments for small returns, not in the construction of houses, a riskier investment.  They have chosen not to make the risky investments (e.g., real estate) that will generate greater potential returns. I show this as part of my analyses of the subject’s market by indicating there is no such profit.  If there were, I would have included it as a component of the cost approach.  Please understand what I meant to say, not what I actually said.  Thanks!”. 

Really, that above paragraph is about as internally inconsistent as saying, “Sometimes I like to sit here in the dark and put umbrellas in my car”. 

How the cost approach, and EI/P, external obsolescence, and highest and best (as vacant and as improved) all fit together is the topic of another blog, so there is no reason to consider that relationship here.

#6  I Can’t be Held Responsible for What’s in the Certification!  I’ve Never Even Read It!

Standard 1, and its six (6) Standards Rules (SRs) are the metric against which clients, state boards, and so forth, measure the credibility of an appraisal.  SR2-3 contains the Certification, as part of which the appraisers makes (and then signs) these two following affirmative statements.  These are not aspirations on the appraiser’s part.  These are statements of fact the appraiser makes without intent to reserve or evade:

  • “I certify that, to the best of my knowledge and belief…the statements of fact contained in this report are true and correct…” and;
  • “…my analyses, opinions, and conclusions were developed, and this report has been prepared, in conformity with [USPAP]…”

Given these two affirmative statements, the internal inconsistency is not that the appraiser somehow omits these statements from the Certification, since that is not the case.  Rather, the internal inconsistencies are that (1) the appraiser makes statements s/he merely hopes are true and correct; and (2) the appraiser in reality did not develop the report, etc., in conformity with USPAP.  Some examples follow.

Typically, the standard 1004 form contains anywhere from thee (3) to seven (7) comparables (some sales and some listings).  While neither USPAP nor Fannie Mae defines a comparable sale, there is a definition in the 4th ed. of Appraising Residential Property.  In the context of the subject site as if vacant, p. 223 states,

“…vacant parcels can only be truly comparable to the subject site if they have similar highest and best uses…[t]he sites of potentially comparable properties should have the same or a highly similar highest and best use as though vacant as the site of the subject property.  If they do not, the sale properties are not comparable” (ibid). 

Then, on page 225 of that same authoritative source, relative to improved properties, it is clear that “[c]omparable properties should have the same or a similar highest and best use as improved  [as does the subject]” (ibid). 

Given these statements, it is clear that a sale is not a comparable until the appraiser analyses it to determine if that similarity exists.  Because the appraiser must analyze any particular sale to determine this similarity, the results of that analysis must be in the workfile.  Therefore, to declare a sale is a comparable, the appraiser is also declaring s/he has (i) done the analyses to support this conclusion; and (ii) those supporting analyses are in the workfile.

Therefore the internal consistency is to certify the appraiser has engaged in these analyses when, in reality, the appraiser has not (or has not to the necessary depth) supported these statements of fact that the comparable sales indeed have the same highest and best use as the subject.

#7  Are There More Examples of Internal Inconsistency out There?

Yes, unfortunately, there are.

Conclusions

In residential real estate appraisal, the issue of internal inconsistency is currently one of major concern.  Yet it appears to be one of concern more to the mortgage lending industry than it is to the residential real estate appraisal community.  That it is an not an area of major concern to appraisers is what concerns this old appraiser.  Many appraisers succumb to the mind-set that “…if it ain’t broke, don’t fix it!”.  This is a philosophy with which I usually agree.  However, it begs the question nothing ever breaks, which we know is not true.   It also presumes that, in the rare case something breaks, we have the ability to fix it.  This is not the place to discuss if real estate appraisal is “broken”.  The point is, however, whether it is or is not, there are a whole bunch of folks out there determined to fix it, anyway – and most of them are not even appraisers. How can that possibly bode well for us?

An appraisal and report have a lot of moving parts.  For good or ill, it is our job as the appraiser to keep them all straight, keep them all separate, keep them all in line, and make sure they all make sense.  Sometimes it is as frustrating as trying to staple jell-o to a wall. 

Nevertheless, let’s remember the competition facing us, especially the more computer-oriented of them, generally do not have a problem with internal inconsistency, which puts us at a disadvantage to the benefits they offer.  However, when that lender (who wants to see us out of the business since we kill deals) wants to know what that custom-built mansion on the hill is worth in foreclosure,  then that lender will reject the AVM that got him/her in that foreclosure position in the first place, but will have to come to one of us for an opinion of value, not merely an indication of price.  Therefore, let’s capitalize on that demand for our services by (1) making sure the report we submit to the client has no internal inconsistencies (2) charging that client a fee worthy of our services, expertise, and problem-solving capacities.

Worried about internal inconsistencies or other USPAP and state appraisal board issues?  Let the Appraiser’s Advocate, Tim Andersen, help you.  Contact me at tim@theappraisersadvocate.com.  I look forward to working with you!

1 thought on “Blog #102: “Sometimes I Like to Sit Here in the Dark and Put Umbrellas in my Car””

  1. Pingback: What’s the Shelf Life of An Appraisal? – Cleveland Appraisal Blog

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