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Real Estate Litigation

A Cross-Examiner's Primer: The Real Estate Appraisal Expert

By Kevin H. Brogan – December 13, 2012


This is the first in an occasional series of articles on practical skills for new and experienced real estate litigators. We start with appraisers because real estate litigation often centers on valuation issues, and values are set by appraisers. For instance, condemnation cases focus on just compensation for the condemned property, which is its fair market value. Damages in breach of contract and fraud cases may involve the difference between the purchase price actually paid and the fair market value of the property being sold. In each of these cases, the expert real estate appraiser is a key witness. The purpose of this article is to arm the real estate litigator with tools to analyze the appraiser’s testimony and ideas on how to undermine those opinions of value.


What Appraisers Really Do
Let’s first look at what a real estate appraiser does. The appraiser is generally retained to render an opinion of value on a particular date, which may be the date of the sale of the subject property or some other date set by law or determined by counsel. The appraiser should analyze the property in its current condition, determine zoning and land use entitlements (or impediments), and investigate the availability of utilities, topography, access, and other attributes of the property. If the property is improved, the appraiser should inspect the improvements, determine their physical and economic obsolescence and remaining useful life, and investigate whether the existing improvements constitute a legal use under the site’s zoning.


Once this background work is completed, the appraiser should analyze the highest and best use of the property, both as vacant and as improved. Highest and best use is defined as the most profitable use that can be made of real property. Appraisers use four tests to determine the highest and best use of property:


  1. The use must be a legal use.
  2. The property must be physically adaptable to the use.
  3. The use must be economically feasible.
  4. The use must be the maximally productive use of the land.

What Is the Right Definition of Value?
Once the appraiser completes an "analysis" of the highest and best use of the property, he or she must determine which approach to take to value it. There are three commonly used and generally accepted methods of finding the fair market value of a property at its highest and best use. But before we get to those, you should first determine which definition of “fair market value” applies to your case. The definition varies by jurisdiction, but there are several commonly used definitions, including “market value” (the most probable price, as of a specified date, for which the specified property rights should sell after reasonable exposure in a competitive market) and “fair market value” (the highest price the property would sell for on the open market, with neither the buyer nor seller being under any compulsion to buy or sell). Once you’ve sorted out which definition of fair market value applies to your case, you need to understand the approaches to valuation commonly used by appraisers and accepted by the courts.


The Tripod: Three Approaches to Value
There are three commonly used approaches, or methods, to valuing real property. Each of these methods is based on the appraisal principle known as substitution. The principle of substitution recognizes that buyers and sellers of real property have options, or other properties available for similar uses, and that the availability of substitute properties affects what a buyer will pay or a seller will demand for the property. Courts and jurors recognize this concept of substitution; have likely used it in buying a house, renting an apartment, or even leasing a car; and will readily apply it through evaluation of the appraiser’s opinion against their own view as to the pros and cons of proposed substitute or comparable properties.


First, the market approach is the most commonly used and perhaps most reliable method of valuation. In this approach, the appraiser finds sales of comparable property within a reasonable period of the date of value and compares those “comps” to reach an indicated value of the subject property. To be truly comparable, the sale must be within a reasonable distance of the subject property, capable of similar uses as the subject, and in a similar neighborhood. If the subject is improved, the comparable should have similar improvements because other than in a residential subdivision, no two properties are alike. Neither the buyer nor seller in a “comparable” transaction should be under any compulsion to buy or sell the property. The appraiser sorts out these comparables, adjusts them to compare the attributes of the comparable with the attributes of the subject, and concludes on a unit value (for example, $50 per square foot for vacant land or $150 per square foot of improvements). Applying that unit value to the subject, the appraiser reaches an indicated value of the subject by the market approach.


The second approach is the income approach, in which the appraiser determines the value of property based on the cash flow it can generate. In this method, the appraiser uses comparable lease transactions to determine the fair rental value of the property. After deducting certain expenses or other charges, the appraiser determines the net operating income (NOI) for the subject property. The NOI is then capitalized (by dividing the NOI by the capitalization rate) to reach an indicated value, as shown in the table below. 


Sample NOI Calculation

Income – Potential Gross Income                   $10,000

Less vacancy and collection loss at 5%                 500

Effective Gross Income                                  $ 9,500

 

Operating Expenses

Real estate taxes                                             $  500

Insurance                                                         $  500

Management                                                   $ 1,000

Total Operating Expenses                               $ 2,000

 

Net Operating Income                                    $ 7,500

 

Capitalization Rate:                            5%                              

 

Formula:                                  NOI/Cap Rate = Indicated Value

                                                                       

                                                                        $ 7,500 = $150,000
                                                                            .05


The third approach, which is available only for improved properties, is the “reproduction cost new less depreciation” or “cost” approach to value. In that approach, the appraiser will determine the cost to reproduce the improvements, deduct for physical depreciation and obsolescence, and add that net amount to the fair market value of the land to arrive at the opinion of value. The cost approach can be highly subjective, as the appraiser must estimate depreciation and obsolescence, and is generally disliked by the courts. With a tip of my hat to Casablanca, “I’m shocked, shocked to find” how often appraisers stretch to make their opinions using this approach reach indicated values close to the market or income approaches.


Appraising the Appraisals
With that background, next you need to know what to do if confronted with an appraisal expert during discovery. First, make sure you get a copy of his or her report. Do not settle for just the litigation report; demand the full appraisal report. Under the Uniform Standards of Appraisal Practice (USPAP), the appraiser is almost always required to prepare a written report of the investigation, analysis, support, and opinion. If the appraiser uses the market approach, the report should contain details about the comparable sales he or she relied on in valuing the property and adjustments he or she made to those comparable sales to reflect how they compare to the subject property. The appraiser should also have detailed work files with backup documents, including deeds, on each “comp.” Similarly, if the income approach is used, the report should contain comparable lease transactions, deductions to get from gross rent to net operating income, as well as the basis for the cap rate the appraiser used to determine value. Finally, if the cost approach is used, the appraiser should include the foundation for his or her opinions on the reproduction cost of the improvements (which will generally be some recognized service that estimates the cost of constructing new buildings, such as Marshall and Swift), as well as comparable sales for the land value component of the analysis. A careful review of these documents is critical to an effective cross-examination.


Next, you will want to compare the other side’s appraisal report with your own report, assuming you have one, to identify the key issues on which the appraisers agree or disagree. A simple spreadsheet—in essence, a side-by-side comparison listing each appraiser’s views on the size of the parcel, the size of the improvements, zoning, highest and best use, comparable sales, comparable leases, adjustments to net income, and cap rates—will help you focus on where the appraisers agree or disagree. If the appraisers agree that three comps apply to the subject property, your cross-examination (and eventual argument) should be focused on not only the agreement but also the disagreement. If both sides agree that three are comparable, why did the appraiser use six more that are lower, or higher, than the three not really in dispute?


Get Out in the Field
Once you have reviewed and compared both sides’ appraisals, the next thing you should do is “drive the comps.” Visit each comparable sale and compare its features with the subject property. Look carefully at the comparable. Does it have evidence of contamination? Is it next to an undesirable use? Is there a chicken ranch next door? Is there a fabulous new development across the street? Jurors respond to learning about differences between the comparables and the subject, and they know (or will learn through your cross-examination) the negative (or positive) attributes of the comparable that do not apply to the subject property. Or maybe the comparable is a virtual clone, a Dolly the sheep version of the subject property, and if Dolly sold for X on the date of value, the subject must be worth X on the date of value.


Get Out of the Field
But do not just do field work on the comps—check out the paperwork and county recorders’ data for each comparable to determine whether it was sold for reasons that might affect its price. For example, was the seller subject to a foreclosure proceeding? Was there a court order requiring that the property be sold quickly? Were there judgment liens on the property? You will want all this information available in the event the other side’s appraiser testifies that in his opinion the comparable property was an arm’s-length transaction, with neither the buyer nor the seller being under any compulsion to buy or sell. There is nothing more rewarding on cross than pulling out a certified copy of a foreclosure sale notice that was recorded days before the “fair and open market” sale.


Don’t Forget the Appraiser’s Notes
In many jurisdictions, the appraiser’s notes are fair game, particularly while he or she is on the witness stand. As the cross-examiner, with the court’s permission, you can “frisk” the witness of his or her notes. These notes will generally be part of the appraiser’s file and will include the appraiser’s observations of the property and the neighborhood. The appraiser will almost always take notes when confirming a comparable sale or lease. This confirmation is a key part of determining whether a sale is a fair and open market transaction. I have encountered a number of experts who testify that a sale was at “arm’s length” when their own notes say something akin to “seller had to sell because of financial problems.” Cross-examination does not get much more effective than watching the appraiser read those notes to the jury.


There’s More to Come
This is a start to give you the lay of the land and some ideas of how to cross-examine a real estate appraisal witness. Many cases will require more involved analysis, so we’ll be back in future issues of the newsletter with discussions on topics such as reasonable probability of a change of zoning, the developer’s approach to value, and how not to bore a jury in presenting evidence on reproduction cost.


Keywords: real estate litigation, appraisers, cross-examination, valuation


Kevin H. Brogan is a partner at Hill Farrer & Burrill LLP in Los Angeles, California. He is also a cochair of the Condemnation Subcommittee of the Section of Litigation Real Estate Litigation Committee.


 
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