Are You Asking the Right Appraisal Question?

by John Schmick

Uniform Standards of Professional Appraisal Practice (USPAP) are the minimum appraisal requirements that guide appraisers in providing appraisal services. In Minnesota, these requirements are codified into law requiring state licensing of real estate appraisers (Chapter 82B.195). An important part of USPAP is the Scope of Work Rule which requires that the appraiser “…identify the problem to be solved; determine… the scope of work necessary to develop credible assignment results”. Identifying the problem to be solved starts with client discussions to determine what questions they have relative to their real property interests. While many assignments simply need to determine market value for business or personal decisions, in the area of litigation or transactions, asking the wrong appraisal question can nullify the entire appraisal. This is especially true with ground leases and easements where less than the whole property is burdened with lease/easement. A recent pipeline case in California illustrates the pitfall of asking the wrong appraisal question.

In 1953, a local water company entered into a pipeline easement agreement on a branch of a national railroad corridor. Terms called for the annual rent to be adjusted to market rates every ten years. For adjustment year 2013, the two sides had drastically different opinions on what market rent should be. The appraiser for the railroad opined to $862,000 annually while the appraiser for the pipeline company opined to $125,000 annually. Both appraisers used a common form of Across-the-Fence (ATF) methodology but used different sales data, different adjustments, and different rates of return. Ultimately both appraisal reports relied on the wrong appraisal question and were unreliable. A summary of the appraisals is presented in the graph below.

To understand the appraisal question, we first look back to the start of the easement in 1953. At that time, the pipeline company wanted to occupy excess space on the railroad corridor and the railroad was willing to permit such use. Excess railroad space is defined as space not currently needed for railroad operations. General valuation questions at that time were how much of the railroad’s property would be occupied and how much was the railroad’s land worth? These questions form the framework of what does the railroad give up or lose and what is the appropriate compensation?

Over time the original appraisal question can get lost as the parties try to simplify the issue. Staff for either party may not understand the significance of correctly defining the appraisal question and communicate the assignment as valuing an easement for annual rent adjustment. In this case, both appraisers defined the subject property as the easement area. The subtlety changes the framework from what does the railroad/seller lose or give up to what does the pipeline company/buyer own or control?

While the subtle change in defining the appraisal question seems harmless, the results are far reaching. By defining the subject property as the easement area, one appraiser attempted to define the larger parcel as the easement area, defining unity of ownership as the pipeline company, unity of use as a subsurface water pipeline, and contiguity as an assembled pipeline corridor. The appraiser carried this theme into the highest and best use defining economic demand for the pipeline easement was 100% because water is in high demand in California and if the current pipeline company did not provide the service, another pipeline company would. Nowhere in either appraisal did the two appraisers consider the whole railroad property, the economic profile of the corridor, or any portion of the railroad corridor outside the easement area. This is a common flaw in ATF corridor valuation appraisals.

Understanding the assignment and identifying the appraisal problem is related to the intended use of the appraisal. In this case, the intended use was to assist two parties in negotiating a fair market rent for the next adjustment period. The pipeline company owned an easement (dominant estate) that gave it the right to occupy space on the railroad’s property. The railroad retained fee simple interest in the entire corridor subject to agreements to allow others to occupy space within their ownership. Thus, the valuation question starts with identifying the railroad’s larger parcel of land from which a portion is burdened by the pipeline easement. If rent is to be paid on that portion of railroad land value captured by the easement, then the larger parcel must be defined as railroad land and not the ownership rights of the pipeline company.

By failing to understand the appraisal problem and the appraisal question, both appraisers failed to research and analyze several important relevant facts that impacted valuation. First, both appraisers acknowledge that railroad operations on the active tracks were low volume. Using estimates of railcar activity and average operating income attributed to land, per railcar per mile of track, it was discovered that current rail operations supported a land value for the center track section of less than $0.05 per square foot. This is less than one percent of typical land prices in the area. The track section occupied 34% of the corridor width.

Second, land area occupied by pipelines was 29% of the corridor width. The remaining 37% of corridor width had not attracted any economic demand in over sixty years. As a result, a total of 71% of the corridor width produced little to no income to the land. Under the ATF methodology used by both appraisers, this type of analysis is not performed.

Ultimately, using an incorrect appraisal question led to a very narrow understanding of the assignment and a land value analysis that was significantly higher than the economic profile of the railroad land. Imagine standing on the railroad property with your left foot on the pipeline easement area and your right foot on the vacant excess land. How would your appraiser answer the question: How can the land under my left foot be so valuable when the land under my right foot has no economic demand for over sixty years when it all has the same owner (railroad), is used for the same purpose (corridor), and is contiguous? Facing this and similar questions, this case settled shortly after exchanging reports, including a review report, and before scheduled arbitration. The settlement was a compromise reflecting an ongoing business relationship but favored the pipeline company.

While the case presented here may be an extreme example of using the wrong appraisal question, this issue is not limited to railroad corridors. Overlapping easements, ground leases, sale of property with existing easements, multi-parcel properties, and other situations can suffer from incorrect appraisal questions which can impact assignment results. When engaging an appraiser (real property, business, or personal property), set aside some time to thoroughly discuss the intended use, intended users, and the appropriate appraisal question to be addressed in the assignment. This will minimize unwanted surprises in the use of the appraisal at a later date.