Use of Comparables. Claims Prevention Bulletin [CP-17-E] March 1996

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1 March 1996 The use of comparables arises almost daily for all appraisers. especially those engaged in residential practice, where appraisals are being prepared for mortgage underwriting purposes. That is not to say that the issue has any less importance to appraisers in commercial practice or even those not in fee practice. because of the frequency with which allegations of problems with comparables arises in insurance claims, the Professional Liability Insurance Committee is publishing this Claim Prevention bulletin, adapted from the Insurance and Demonstration Report Writing columns in the Spring 1995 issue of Canadian Appraiser /Évaluateur canadien. The adoption of USPAP standards by the Institute now clearly and definitively requires that all appraisers, fee nor non-fee, adhere to those standards, One of the prime concerns of the Professional Liability Insurance Committee is that underwriters at banks and other lending institutions sometimes set unrealistic restrictions on the use of comparables in the sales comparison approach. Any adherence to such guidelines to suit the particular needs of the client must comply with USPAP, so an inaccurate and misleading report does not result and the chance of a claim against the Insurance Program is reduced. The appraiser must believe that such guidelines are a reasonable tool for increased accuracy. In most cases, adhering to a client s guidelines is not a problem but, in others, doing so does not produce the best comparables. The appraiser may provide the number of comparables required according to the client s standards, then can use as many supplementary comparables as they feel necessary, and these comparables need not comply with the client s standards. The appraiser should wonder whether he or she would comply with a client s request for a value higher than market. Hopefully not, but there is absolutely no difference in the two situations: both are a breach of the Institute s standards. While comparables that require no adjustments are actively sought by most appraisers, they are found infrequently in the marketplace, even within similar units of a single development. The integrity of the comparable sales is maintained, however, by reasonable and appropriate adjustments. If any adjustments are made, the comparable sales can accurately reflect a market value estimate for the subject. The focus, therefore, should not be on net, gross or line adjustments, but on the reasonableness and appropriateness of the adjustments. Homes with extraordinary features such as swimming pools, saunas, tennis courts, elaborate built-in equipment, waterfront, golf course amenities, etc., or properties with atypical lot sizes for the neighbourhood, require large individual line and gross/net adjustments. If adjustments are accurate and properly abstracted from the marketplace. the subsequent value indication need be no less than instances where small adjustments are required.

2 In a perfect world, adjustments to sales comparables will not exceed I 0 percent for each line item in the adjustment grid, or a cumulative 25 percent gross adjustment for all adjustments, whether they are plus or minus or a 1 5 percent net overall adjustment. However, while the standards require that, in the selection of sales comparables, (late of sale, location, size, age, condition, style and special features of the improvements are to be taken into account, they (10 not deal with whether or not they meet guidelines imposed by a client. If adjustments exceed the ideal, it is due to at least one of the adjustment factors differing significantly between the subject and tile comparable sales. Despite the careful selection of comparable sales data, the heterogeneous nature of the residential real estate market dictates that such variances are not uncommon, especially when the subject property may be atypical and/or there has been a relatively low volume of recent sales to select from within the subject neighbourhood and adjacent or similar neighbourhoods. This same applies to the common client request that the subject be bracketed by appraiserselected comparables. This is not always acceptable practice because, although it is tile ideal situation, some properties are either the lowest or highest priced recent sale within the neighbourhood. In this situation, it is riot acceptable for the appraiser to use the excuse of client guidelines to select a comparable that has less comparability and is outside the immediate area, while ignoring a more reasonable comparable within the immediate vicinity. In such cases, tile solution may be to consider both tile sale in close proximity and the one that is outside the neighbourhood and weight them accordingly in the reconciliation process. Sales dates of the comparables often conflict with a client request that only sales within the last six months (or some similar time frame) can be considered by the appraiser. This is a serious potential cause of error, since a virtually identical property could have sold seven months ago and been ignored by the appraiser. The appraiser should make every effort to secure comparable sales which transpired within the six-month period immediately preceding the effective date of the appraisal report. Use of sales which occurred beyond the optimum period will indicate that more recent sales were unavailable. The comparables, therefore, will reflect the selection of those sales deemed most representative of the subject property, regardless of time frame. If the time frame is expanded, this should only indicate that it has been done to recite sales which have characteristics most similar to the subject, and to provide the most accurate indicators of value. The client should be made aware that lack of more current sales in the neighbourhood does not necessarily mean that adverse neighbourhood conditions exist. A very challenging aspect of an appraisal report is adjustment support. Members of the national Report Grading Subcommittee have contributed the following advice. Members should refer to USPAP for the appropriate order of the adjustments, as they are described in random order. 2

3 1. Time Adjustment When analyzing resales or paired sales to support a time adjustment, it is important to remember that tile pertinent time frame is analyzed from the most dated comparable sale to the effective date of the report. Solid support. where data is available, for a time adjustment is an analysis of resales (i.e., properties that have sold and then re-sold without any substantive change in their characteristics between the two dates, other than the passage of time). Alternative support is an analysis of sets of paired sales (i.e., the sale d)f two properties whose characteristics are highly similar, such that the only substantive difference between them is the passage of time). Finally, support may be provided by the analysis of statistical information. In this case, the data may not always demonstrate that, subject to the statistical analysis, the data is homogeneous and most reflective of the subject property type, be it vacant land or an improved property. The important thing to note is that some form of substantiation in your file can be a very useful aid in tile face of a claim. 2. Each Approach to Value Must Stand on Its Own Market-derived adjustments in the land value section cannot be used in the direct comparison approach, or vice versa. For example, it is inappropriate to use the land size adjustment derived from an analysis of vacant land in the land value section as the basis for lot size adjustment for improved properties in the direct comparison approach. Consider whether the time adjustment derived from the sales of improved sites is applicable to the time adjustments for vacant sites in all instances. 3. Lump Sum Adjustments When applying lump sum dollar adjustments, it is important that the dollar adjustment amounts are adjusted to the effective date of the appraisal. When developing the paired sales method to indicate a lump sum adjustment, both sales in each pairing must be adjusted to the effective date of the appraisal. In this circumstance, it is not acceptable to adjust the more dated sale in the pairing to the date of the more recent sale in the pairing, since the lump sum difference would not be relevant to the effective date of appraisal. The resulting error may be substantial in a rapidlyincreasing or decreasing market. 4. Percentage Adjustments When paired sales are used to justify a percentage adjustment. it is only necessary to adjust the date of sale of the more dated sale to that of the more recent sale. Percentage adjustments indicate the relationship between sale prices. Therefore, it is important to minimize the number of interim adjustments for the paired sales to isolate the percentage difference in sale price. The report should state the assumption inferred by this analysis (i.e., that the relationship demonstrated by the paired sales is valid for the subject property and the comparables analyzed, as at tile effective date of tile appraisal). Even here, the closer to the effective date, tile more reliable the result of such an analysis. 5. Questionable Adjustment Support Reliance without verification on the market opinion of hearsay sources that were not a party to any actual comparable sale can lead to problems. Another common mistake is to rely on a cost 3

4 figure without its reconciliation as a market-based adjustment. For example, it may be acceptable to use the advice of the purchaser as to the cost of fill and how that affected the price paid for the property. Otherwise, cost-based adjustments are not acceptable particularly if market evidence is clearly available. 6. Consistency With Unit of Comparison Before the adjustment analysis is indicated, it is expected that the appropriate unit or units of comparison would be supported from the market. Ideally, the report should clearly indicate how the market values the subject property (e.g., sale price per lot, sale price per square metre, sale price per front metre, sale price per unit, etc.). The adjustments must be derived in a manner consistent with how the final adjusted prices will be reconciled into a market value estimate. In many practical circumstances, particularly when using a report form, USPAP would require that you complete this analysis, but you may keep the support in the file. For example, it may not be appropriate to make an adjustment for differences in lot size when sale price per square metre is to be used as a unit of comparison. This is not necessarily true in all cases. It would be appropriate to make an adjustment for size, even when using sale price per square metre as the unit of comparison, when larger lots sell for a lower unit rate than smaller lots. It is important to ensure that the report accurately describes how the adjustment has been derived and applies, and that there is no double counting of the same adjustment through the process applied. 7. Reconciliation of Adjusted Sale Prices The adjustment process should narrow the range of final adjusted sale prices, not broaden it. Typically, the value of the subject property should fall within the indicated range. The reconciliation of the adjusted sale prices should not rely on the arithmetic average. Instead, it should provide a rationalized evaluation of the comparables and of the degree of objectivity and subjectivity in the adjustment analysis, as well as a weighting of the comparables as indicators of value for the subject. 8. Net Rent and Gross Rent Adjustment for Expenses Appraisers often use net rent where the subject property rents on that basis. in most cases, a net rent situation is one where operating costs pass to the tenant as additional rent. Care should be exercised when analyzing this type of income stream. In net rent situations, the landlord not only foregoes rental revenue during times of vacancy, but also must pay those costs that would normally be covered by the tenant when in occupancy. In a tenanted building, gross income includes operating costs paid by the tenant, and effective gross income equals potential gross income less the vacancy and collection loss allowance. Where tenant space is metered separately for utility costs, and where these costs would not accrue to the landlord in tile event of vacancy, they would not be included in gross income. Tile report should carefully detail the treatment of expenses in order to present an accurate description of the situation. 4

5 9. Adjustments in Building Costing Typically, the calculation of the reproduction cost new of the basic improvement can be demonstrated several ways: by using quotes from two local contractors and/or the application of a nationally-recognized cost manual. In this situation, the appraiser must ensure that the ensuing reconciliation of the various cost estimates compares these estimates on an apples to apples or identical basis. If the contractors quotes include other items which must be costed separately, such as landscaping or other site improvements, adjustments must be applied to their cost estimates to ensure that they are compared one to the other and to the cost manual on the same basis. Adjustments may be required to ensure that no components of the improvements to the subject site have been double costed. While adherence to USPAP may not totally eliminate the potential for a claim, it most certainly reduces that potential. Perhaps some of the risk could be eliminated by including clauses within the report, such as those following. However, such clauses should be adapted to fit the specific circumstances of the assignment at hand. Comparable Date of Sale Every effort has been made to secure comparable sales which occurred within the six-month period immediately preceding the effective date of this report. Use of earlier sales indicates that more recent sales were unavailable. Comparables, therefore, will reflect the selection of those sales deemed most representative of the subject property, regardless of time frame. If the time frame is expanded, this has been done to recite sales which have characteristics most similar to the subject and to provide the most accurate indicators of value; this is a common and necessary appraisal practice in the area. Lack of more current sales in the neighbourhood does not necessarily mean that adverse neighbourhood conditions exist. Adjustment Percentages The best available comparable sales have been selected with respect to date of sale, location, size, age, condition, style and special features of the improvements. However, if adjustments are large, at least one of these factors differs significantly between the subject and the comparable sale. Despite the careful selection of comparable sales data, the heterogeneous nature of the local residential real estate market dictates that such variances are not uncommon, especially when the subject property may be atypical and/or there has been a relatively low volume of recent sales to select from within the subject neighbourhood and adjacent or similar neighbourhoods. While comparables that require no adjustments are actively sought, they are relatively infrequently found. However, the integrity of the comparable sales is maintained by reasonable and appropriate adjustments. If any adjustments are made, the comparable sales can accurately reflect a market value estimate for the subject and the focus should, therefore, not be on net, gross or line adjustments, but on the reasonableness and appropriateness of the adjustments. Homes with extraordinary features such as swimming pools, saunas, tennis courts, elaborate built-in equipment, waterfront, golf course amenities, etc., require large individual line and gross/net adjustments. As adjustments are accurate and properly abstracted from the marketplace, the subsequent value indication is no less accurate than instances where small adjustments are required. 5

6 Such clauses should persuade most clients that inappropriate constraints on the individual judgement of the appraiser is not in their own interest, let alone that of the appraisal profession. The preceding would suggest that there are often conflicts between the dictates of your client and practice consistent with USPAP or other standards. The key to balancing these demands is in effectively communicating the rationale behind the selection of comparables. When selection of the best comparables conflicts with underwriting criteria, a comment explaining the selection will usually answer the lender s questions before they are asked. This not only saves time (and therefore money), but also provides a more professional product. as it presents a full picture of the process leading to the value conclusion. While criteria on the timeliness and the extent of required adjustment are useful guidelines, they should not supersede good appraisal practice. Note: As with all claim prevention bulletins, this publication is not intended to set out all professional/ethical responsibilities or regulatory requirements, nor to identify all valuation or theoretical aspects of the subject matter. The purpose is simply to raise areas of potential liability exposure in ordinary day-to-day practice to the attention of members, and to suggest professional practices that can help avoid liability insurance claims. Members are encouraged to suggest topics and/or writers for future bulletins by contacting the AIC offices at info@aicanada.ca. 6