Monday, November 11, 2013

Critical Thinking Skills Needed for Real Estate Appraisers and Valuers

My posts on Scotland and Trinidad in September were critical of "chartered surveyors" who allowed false information to enter the valuation process with exculpatory phrases such as “the developer informs us that…” without verifying such information, even if it seemed preposterous. I did not intend to suggest that chartered surveyors were worse than valuers and appraisers elsewhere.  The same problem exists  throughout the world, including my home country of the USA.

Part of the problem is that “critical thinking” skills are not part of the valuer’s training in any nation where I have interacted with local valuers. 

In the English-speaking world, valuers are trained using “business school” methods.  Instructions in problem-solving start with set, unchallenged assumptions, and the question is not asked, “What if the information and assumptions are wrong?” or "What if the property owner is lying?" There is an intermediate step which is being neglected, the step that consists of verification, exemplified by such questions as "How do we know that the building measures 25,000 square feet?" Did we measure it? Did a government entity measure it?  Did we get the number off the rent roll (rentable areas are often inflated by landlords)? Or were we just "informed" by the owner?

Consider, for instance, that the larger the property, the less likely it is that the appraiser will measure it.  In a recent appraisal of a 44-structure industrial campus, the owner represented building area as 256,000 square feet, claiming the measurements to be from the county tax assessor's office. The assessor's measurements were 54% smaller.

In Latin America and some other nations, valuers enter the profession through the field of architecture or engineering, and their more scientific education is even more dependent upon problem-solving that starts with set, unchallenged assumptions. I find many of these architects and engineers overly rely on the Cost Approach and also lack skill in discerning current market conditions (which need to be known in adjusting the Cost Approach for “external obsolescence”, the loss in value due to unfavorable market conditions or external adverse influences).

Imagine if all appraisers and valuers verified the information about the subject property that they relied on.  The world would receive more accurate valuations.  Instead, trainers of valuers indoctrinate their students into providing multiple “Assumptions and Limiting Conditions” that merely serve as disclaimers that complete due diligence was not performed, and then they have the nerve to call this "good appraising"! (Some U.S. appraisers even have the curious habit of rigorously verifying comparable sales while failing to verify the subject property's imminent sale.) Remember that "Assumptions and Limiting Conditions" serve to protect appraisers and valuers from liability and not to protect the client.  Take the following example:

In the Scotland post, (, I spoke of a former munitions site appraised as the site of a new, 5-star hotel, with the valuer stating the assumption that no environmental contamination was present (almost never the case with a munitions site), even with abundant metal scrap visibly leaching oxides into the soil, underneath signs warning persons to keep out due to ongoing asbestos removal. 
Making this assumption in the “Assumptions and Limiting Conditions” section of an appraisal is not good appraising; it is aiding and abetting fraud. Sure, a valuer is not professionally trained in measuring environmental contamination, but a valuer does not have to be an environmental expert to state visible evidence in his or her report.

Once I had a debate with another appraiser on an on-line appraisers' forum.  I mentioned that I had one client who insisted that I inspect the roof on every building that I appraised for them.  This other appraiser insisted that roof inspections were outside the scope of an appraiser’s duties and that it was even unethical to state my observations because it would infer that I was representing myself as a roofing expert. That had been what he was taught.

I remember a situation with a former Honeywell building in Minnesota in which missing or worn-out roof flashings resulted in rain and snow melt leaking down inside the exterior walls and destroying several hundred thousand dollars of computer equipment. Now which appraiser is more likely to get sued – the one who pointed out the obvious hazard, or the one who performed an incomplete property inspection and had the attitude of “That’s not my job”?

The truly concerned appraiser or valuer (who cares about his clients) needs to think about whatever may affect the market value of the property.  This includes being properly informed in matters of construction and design, environmental hazards, flood zones and protected wetlands, demographic analysis, and microeconomic analysis of the equilibrium between supply and demand.  Anything less could make the valuation a meaningless academic exercise and is an abdication of professional responsibility.  It can also hurt the client.

This also answers a question I occasionally get asked, which is why do I get sent overseas to perform valuations where local appraisers are available?  The answer is that I offer my clients extra due diligence that they have learned not to expect from other appraisers or valuers, who instead provide pages and pages of disclaimers and limiting conditions. When others say "That's not my job" I say "I will make it my job."

But let us take "critical thinking" to an even higher level.  Shouldn't we as appraisers and valuers also question valuation techniques that may be incomplete or unsound to begin with? 

Take, for example, sales comparison analysis.  In many real estate downturns, one can find comparable properties listed for sale at prices below yesteryear, and these listing prices often set a new, lower ceiling for market values. I've been witnessing this since 1985, but the most widely used appraisal textbook in the U.S., The Appraisal of Real Estate, did not discuss how appraisers should be looking at listings until its 13th edition in 2008.

In a previous post, I pointed out the disconnect between academia and various professional organizations on the proper use of discounted cash flow analysis.  I studied at SMU under William Brueggeman, author of the most widely read Real Estate Finance Textbook, and many of his compatriots at Ivy League business schools also teach that in a discounted cash flow model of a building, expenses should be increasing faster than income. Why?  To account for the deterioration of the building.  In my first job at Jones Lang Wootton, I sat near the property management department and got to see real property operating statements which continually showed this trend over the long term.

Contrarily, the Appraisal Institute prevented me from writing this empirical fact in the last article and book I wrote for them, telling me that their leaders believed that the same rate of inflation should be applied to income and expense projections.  If that were really the case, though, expense ratios would never increase and buildings would last forever.  This also explains why discounted cash flow models generally overvalue properties. 

PS:  For younger or foreign readers, the above illustration is of a television character named "Sergeant Schultz", an incompetent prison guard played by John Banner in the 1960s television sitcom "Hogan's Heroes". His stock phrase was "I know nothing, NOTHING!" even though he sometimes knew that his prisoners were up to no good, but he could be persuaded to look away by a piece of chocolate.  


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Dusty said...

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I am a residential appraiser in rural Colorado. I recently read a book on critical thinking and found that everything in the book applied directly to my profession. The objective of this profession is to provide a reliable opinion. Your article confirms my conclusion that the rigors of critical thinking are what make an opinion reliable.

If you know of any appraiser continuing education specifically focused on critical thinking and real estate appraisal please let me know.

Dusty Little
Colorado Realty Reports

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