An integrated cost-based approach for real estate appraisals

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  • An integrated cost-based approach for real estate appraisals

    Jingjuan Guo Shoubo Xu Zhuming Bi

    Published online: 13 February 2013

    Springer Science+Business Media New York 2013

    Abstract Real estate appraisal information systems have

    been studied by many researchers in the past including

    those systems that have integrated geographic information

    systems, artificial neural networks, etc. This paper proposes

    a new integrated approach for real estate appraisals which

    can be used in real estate appraisal systems to improve

    efficiency and accuracy. Motivated by the identified limi-

    tations of existing cost approaches for real estate apprais-

    als, we integrate some elements from sales comparison

    approach and income approach into the cost approach to

    improve the accuracy of the valuation of real estate

    appropriately. As a result, the new integrated cost-based

    approach is capable of taking all of the major factors into

    accounts; these factors are closely related to the assets of

    real estate in one way or another. In the implementation of

    the new approach: (1) the concept of replacements cost is

    revisited and expanded to consider dynamic, environ-

    mental, and cultural factors in real estate appraisals; (2) the

    conventional depreciation values and depreciation rates are

    replaced by adjustment values and coefficients to include

    both the positive and negative impact on the changes of

    real estate value; (3) the theory of technology economics is

    applied, six forces have been systematically analyzed to

    determine replacement costs; and finally, (4) different

    methods for value adjustments, including the algorithm

    based on artificial neural network, have been utilized to

    deal with the randomness and uncertainties of mass data for

    the determination of adjustment values and coefficients.

    Keywords Technological economics Informationmanagement for real estate appraisals Financialinformation systems Financial information management

    1 Introduction

    Real estate appraisal is to estimate the value of real estate

    based on the highest and best use of the property. Real estate

    appraisals play significant roles to the health and soundness

    of the worlds financial environment. Appraisals are essential

    steps before properties can be transacted. Besides the trans-

    actions, public interest in real estate markets and investments

    trusts has also been grown rapidly [1]. Real estate appraisals

    are extremely important to multiple participators: property

    sellers and buyers have the great interests in estimating their

    personal assets, municipalities and governments need to

    determine the revenues which are largely depended on real

    estate taxes, the financial institutions need to make their

    banking policies and grant mortgage loans with the mini-

    mized risks, and properties brokerages need to evaluate real

    estate properties to help their clients make judicious deci-

    sions [15]. Since the real estate is usually the significant

    assets to most of people, undervalued or overvalued real

    estates would cause an irreversible loss to owners or buyers.

    Besides, since the purposes of appraisals are to estimate the

    propertys equity, an over-valuation results in the under-

    estimation of the default risk, which can be passed to buyers

    or secondary mortgage providers.

    It is critical to select an appropriate approach for real

    estate appraisals. The statistics has shown that real estates

    J. Guo (&) S. XuSchool of Economics and Management, Beijing Jiaotong

    University, Beijing 100044, China

    e-mail: guojingjuan@sina.com

    S. Xu

    e-mail: xusb@263.net

    Z. Bi

    Department of Engineering, Indiana University Purdue

    University Fort Wayne, Fort Wayne, IN 46805, USA

    123

    Inf Technol Manag (2014) 15:131139

    DOI 10.1007/s10799-012-0152-7

  • can be easily undervalued or overvalued. For example,

    Cannon and Cole [4] indicated that real estate appraisals

    have been over 12 % lower or higher than the subsequent

    sales prices; the conclusion was drawn based on the

    National Council of Real Estate Investment Fiduciaries

    (NCREIF) National Property Index in 19842010, which

    consisted of two up and down market cycles. It had shown

    that appraisals are differed from true values to real estate

    significantly; in particular, an appraisal was too low when

    the market was hot while too high when the market is cold.

    Poor appraisals from inappropriate approaches or inexpe-

    rienced appraisers would obviously delay or miss the

    opportunities for sales and transactions. The appraisal

    errors are actually systematic errors which can be remedied

    by improving an appraisal approach and taking into all of

    the major factors related to properties assets.

    Three common types of real estate appraisals are cost

    approach, sales comparison approach, and income capi-

    talization approach [11]. Since the cost, sales, or incomes

    related to the properties vary significantly from one place

    to another and from time to time, at a specific location and

    a specific time; an experienced appraiser should be able to

    select the right appraisal approach for a specific property.

    When the regional transactions are inactive or real estate

    markets are immature, neither sales comparison approach

    or income capitalization approach is applicable due to

    the lack of historical transactions or income benchmarks.

    In this situation, a cost approach is recognized as the most

    appropriate approach for real estate appraisals. A cost

    approach is established based on the fact that the value of a

    property can be determined by summating the land value

    and the depreciated value of further improvements made on

    the property.

    Real estate appraisals are challenging tasks that require

    intensive efforts; the study in developing and enhancing

    various appraisal approaches has been very active research

    field. For examples, Gonzalez and Laureano-Ortiz [11]

    argued that a real estate appraisal resembled to the psy-

    chological process humans follow in utilizing their past

    experiences to solve new problems; therefore, they pro-

    posed to use case-based reasoning in valuating real estate.

    Note that most popular methods are driven by sales market

    data; in particular, for the automated software tools of

    property appraisals. In applying these methods, it is com-

    mon that comparable properties are similar to the subject

    property; in this case, the value adjustments must be made

    to deal with the differences. Narula et al. [20] modeled the

    real estate appraisals as a multiple linear regression model

    for optimization. It has been found difficult to define proper

    predictor variables for real estate appraisals; and the ridge

    regression technique has been improved by a combination

    with genetic algorithm to estimate the values of real estate

    appropriately. Ann et al. [1] suggested that cost is not

    always the good source of adjustments. To address the

    forecasting problems of real estate appraisals, artificial

    intelligence and multiple linear regressions were applied to

    valuate residential property. In comparing different

    investment options in the real estate market; Seck [22]

    discussed the substitutability of securitized real estate asset

    and appraisal-based real estate assets. The empirical data

    showed that the prices for the securitized assets, such as

    real estate investment trusts or stock price index of home

    building industry, could be changed randomly while the

    prices of the appraisal-based assets can be more likely

    predicted. Diaz and Hansz [7] proposed a taxonomic

    approach to consider the impact of incentives and pressures

    for real estate to provide favorable valuations. Lins et al.

    [18] proposed a new approach called data envelopment

    analysis to estimate the range of values for real estate.

    It had shown some advantages in comparison with con-

    ventional regression analysis methods which are commonly

    used in real estate appraisals. Shiller and Weiss [23] pro-

    posed a framework to compare various valuation systems

    for real estate appraisals. Since the framework was devel-

    oped for mortgage lenders, the best interest was confined to

    the maximized benefits of mortgage lenders. Isakson [14]

    developed a multiple regression analysis method to verify

    the appraisal results of real estate; it was based on the

    simplifications that the covariance between the adjusted

    sale price of comparable properties and the characteristics

    where adjustments are properly made is negligible for a

    specific property. Traditional real estate appraisal approa-

    ches have been found inefficient and not correct enough.

    In financial information management systems, real

    estate appraisal information systems have been studied by

    many researchers in the past [6, 12, 21, 27, 38]. For

    example, Liu et al. [19] developed an appraisal system

    while the geographic information system was used as one

    source of the real estate information, and artificial neural

    network was applied to improve the reasoning process. The

    system was implemented in the Matlab programming

    environment and the result had shown the improved effi-

    ciency and accuracy of system.

    In this paper, the solution to the limitation of a cost

    approach will be focused. In real estate appraisal, the cost

    approach is suitable for the immature markets and the sit-

    uations where sales comparison approach or income

    approach are inapplicable due to the lack of transactions.

    Besides, cost approach can also be expanded and applied in

    the insurance valuations and damage claims. The underling

    idea of a cost approach is to estimate the assets of real

    estate by deducting the value loss from the replacement

    cost. Obviously, conventional cost approaches do not take

    into accounts of dynamic, cultural, or positive market-

    demanding factors. These drawbacks affect the accuracies

    of real estate appraisals. In most cases, the estimated values

    132 Inf Technol Manag (2014) 15:131139

    123

  • are much lower than the market values of real estate. The

    recent progress on cost approaches have been limited to

    perfect modeling processes and take advantages of modern

    mathematic tools in real estate appraisals. For example, the

    fuzz set theory is applied in selecting transaction cases and

    determining adjustment factors; in addition, the multiple

    regression method, Markov chain prediction, grey system

    theory prediction model and artificial neural network are

    also proposed for forecasting the changes of properties

    values [3, 9, 16, 17, 26, 39, 40]. However, the investiga-

    tions on the root causes of appraisal discrepancies are

    spare.

    In applying a cost-based approach, we have observed

    that no consideration of dynamic, environmental, and cul-

    tural factors is the major cause to the inaccuracies of real

    estate appraisal. Therefore, we propose to integrate some

    major components from sale comparison approach and

    income capitalization approach for the value adjustment of

    appraisals. The main purpose is to apply our proposed

    method to the development of a more effective real estate

    appraisal information system. The rest of the paper is

    organized as follow. In Sect. 2, the replacement costs are

    revisited to take more significant factors into account; in

    Sect. 3, the limitation of conventional cost approaches are

    discussed; in Sect. 4, the new methodology has been pro-

    posed to adjust the costs based on valuation adjustments

    and valuation coefficients; in Sect. 5, the integration of cost

    approach with the income capitalized and sales comparison

    approach is introduced; in particular, back-propagation

    (BP) artificial neural network (ANN) has been applied to

    quantify the subjective data in real estate appraisals;

    finally, the reported work and new contribution have been

    summarized.

    2 Replacement cost: revisit and analysis

    Replacement cost in a cost approach refers to a summation

    of all of the necessary costs, payable taxes and anticipated

    profit to acquire or rebuild the new real estate project

    equivalent to the subject property. A replacement cost

    represents a typical cost of a specific real estate, which can

    be valued as the amount of cost to construct this property

    under a given market environment; therefore, it is also

    called fair cost [31, 37]. Based on the principle of substi-

    tution, the value of an existing property can be measured

    by the cost of constructing a substitution with the same

    utilities within the property [5]. From this point of view, a

    replacement cost also reflects the cost of an equivalent

    property with the same utilities of the subject property. The

    replacement cost can be different from the value of the

    same property based on the highest and best use. In other

    words, real property with the same replacement cost can be

    of different use. It is unnecessary to correlate replacement

    cost to functions, utilities and the ways to make profits.

    Traditionally, the replacement cost in a cost approach

    focuses on the long-term cost with a hidden assumption of

    an equilibrium of market in a long period of time. The

    replacement cost under this assumption represents the

    construction cost at the specified market environment when

    the appraisal is conducted; however, it does not take into

    consideration of other important factors such as those

    caused by the relations between supplies and demands.

    Based on the aforementioned discussion, it is our

    observation that traditional replacement cost in a cost

    approach has a narrow meaning which covers only the part

    of the market price of the real estate. To enhance real estate

    appraisals, we propose to integrate some major components

    from sales comparison approach and income capitalization

    approach in assessing the replacement cost. The replace-

    ment cost will be revised to include (1) the cost with the

    best functions and utilities, (2) some invisible costs which

    cannot be represented by the price under the highest and

    best use, and (3) the adjustment cost reflecting the influ-

    ences of the relations of supplies and demands when the

    appraisal is performed. As a result, the revised replacement

    cost will be an average market price of the subject property

    with the given functions and utilities in a market at long-

    term equilibrium.

    3 Limitations of traditional cost approaches

    In this section, the discussion is focused on the limitations

    of traditional cost approaches in dealing with the adjust-

    ment of price factors.

    3.1 Influence of price factors

    The market value of a real estate property can be deter-

    mined based on the principle of substitutions; the major

    factors under consideration include the market environment

    and its fluctuation, the relations of supplies and demands,

    surrounding economic atmosphere, and income capitali-

    zation. Most of the researchers have emphasized on the

    influence of external factors on the value of real estate, and

    the significant external factors are material, economic,

    social and governmental factors. Based on the theory of

    technology economics, the evaluation criteria of technol-

    ogy proposals are eight elements, i.e., politics, defense,

    society, culture, technology, economy, environment and

    natural resources [2]. In applying the theory of technology...

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