It’s often said that real estate values are driven by “location, location, location,” but the reality is there are other issues at play. Value is generally a reported number, which, broken down, represents a summation of human emotions and perceptions about real estate. These emotions and perceptions must be accurately measured using the proper valuation techniques.
Negative perceptions may diminish value. The perception may be unreasonable, unsubstantiated or even based on publicity. The loss created may be rational or irrational and may be temporary or permanent. Diminution in value is the difference between the unimpaired and impaired value of a property. The value difference is generally attributed to an increased cost or risk caused by an adverse condition. The impact will vary based on the property and its environment so each case must be evaluated carefully. In addition, agents and appraisers must recognize the difference between an actual adverse condition, which might require diminution, and implicit bias, which cannot be allowed to factor into a valuation.
Just What Diminishes Value?
There are tangible harmful conditions that can exist within or outside the envelope of a property and that affect value. Examples include construction defects (failed foundations), geotechnical issues (ground slippage), health-related issues (mold caused by water intrusion), or environmental concerns (flooding, soil contamination, electrical and gas transmission lines, adverse light/noise/sound pollution). Then there are the intangibles, such as murder, suicide or cult activity. I’ve seen such events result in a 10% to 25% diminution of value, and research has shown similar effects. Adverse conditions can be created by Mother Nature or manmade. They may be curable or incurable, but all can exert a negative impact on value and marketability.
How Diminution Is Valued
Calculating a loss in value can challenge the most experienced real estate professional. A full understanding of the market is critical to properly address value impairments and their significance to the general and specific market, especially to the subject property. The impairment can affect an entire community, a specific neighborhood, or a single property. The impaired value is not determined by simply deducting the remediation or cost to cure from the unimpaired market value. Its overall effect can be realized only by measuring the before and after, including any post-repair market resistance.
When no impairment exists, the valuation process includes three approaches to value: the sales comparison, the income approach, and the cost approach. This process is used for an unimpaired property but also the first step in determining impairment impact. When an impairment exists, the valuation process includes three damage approaches. These include: (1) cost effect, (2) use effect and (3) risk effect. The cost effect considers the cost to repair or remediate the impairment. The use effect measures the change to the overall utility and use of the property. The risk effect (stigma) relates to any change in the perception of increased risk or uncertainty. The cost-use-risk method parallels the three traditional approaches and must be carefully used in the impairment valuation process.
A common word tossed around with diminution in value claims is stigma, which is the loss in value over and above the cost of repair. Stigma is synonymous with risk—the uncertainty factor. It’s the damage to the property’s reputation. A damaged car is an example of stigma in play. Even after an auto is repaired, consumers generally consider the car’s reputation flawed. The pre-accident value is greater than the repaired post-accident value due to the diminution created by a damaged product perception. Simply mitigating the damage is generally not enough. Repair compensation rarely accounts for stigma.
In real estate, common types of stigmatized properties include those in which murder or suicide took place, those in which prior owners had debt that resulted in a default or foreclosure, those where criminal activity occurred, and those reported to have experienced unexplainable phenomena (haunted houses). Although a stigma connotes an adverse condition, there are conditions that add to the value. Having been once occupied by a famous movie star or athlete is one such condition. Nearby railroad tracks carry a stigma, whereas a rails-to-trails conversion is good for value.
Most real estate agents, brokers and appraisers encounter harmful property conditions during their career. As professionals with skills and knowledge in real estate matters superior to that of the average person, practitioners in most states have the fiduciary and/or contractual duty to exercise reasonable care and diligence with their clients regarding factors affecting real estate. Awareness of adverse conditions and understanding disclosure requirements will help reduce a real estate professional’s exposure to misrepresentation claims.
The Uniform Standards of Professional Appraisal Practice, or USPAP, stipulates the appraiser has the duty to recognize, know and analyze all factors that are harmful, damaging or causing a loss in property value. This duty demands the appraiser to remain educated and current with the proper valuation techniques when addressing factors that could negatively influence value.
Whether you’re helping a seller price their property or conducting an appraisal for a lender or other client, it’s important to be aware of how to value material factors—both tangible and intangible—that may trigger those human emotions and perceptions that ultimately impact the buying decision.