Quality Point: A Contemporary Approach to Sales Comparison

1. Quality Point: A Contemporary Approach to Sales Comparison Presented to the Fine Appraisers of Eastern Ontario on Behalf of the Ontario Association – Appraisal Institute of Canada by Charlie Abromaitis & George Canning October 24-25, 2003 Peterborough, Ontario

2. Presentation Goals • Outline the current state of practice of the Sales Comparison Approach; is it broken, and if yes how do we fix it? • Discuss the movement to a qualitative analysis, outline the current state of practice, and show why it stops short of its potential. • Present Quality Point as a logical and workable extension of qualitative analysis.

3. Building ValuationModels ...

4. What is a Model? • a representation that captures the essence of reality. • often a mathematical expression. • often describes relationships between variables

5. What Did He Mean? “All models are false, some are useful” George E. P. Box

6. Direct Comparison Modelsas Currently Practiced • Two basic approaches - gridestimator and multiple regression analysis (MRA). Both models are based on hedonic theory • Use of approaches polarized - MRA widely employed in assessment appraisal and grid estimator institutionalized in private industry sector

7. Institutionalized (traditional) Direct Comparison Approach • Described in Appraisal Literature as far back as the 1930’s • This approach has had very little modification over the last 70 years • Essence of approach: differences between the comparables and the subject are made equal through an adjustment grid

8. Traditional Grid SalesAdjustment Process - Set Theory The sale price adjustment is an effort to remove the price variation that exists between the comparables and the subject so that they can all become members of the same set. They are adjusted to equality except for random error

9. Selecting Comparable Sales • would the buyer of the comp property have seen the property to be valued as a substitute? • pick sales of properties with the least differences to subject; • seek some comps better and some worse than subject (bracketing).

10. In an Ideal World, Good Comps are Restricted to: • same use, same vicinity, same price band; • similar size; • recent transactions; • and probably many other shared features and conditions of sale.

11. How Many Comparable Sales? • enough to have confidence in predicting value of subject; • a few close comparables are better than lots of dubious ones; • in practice, “3 or 4 good ones” that point to the same value often suffice; • failing this, the search is broadened.

12. Grid Estimator- Plug inand Play For each comp, place a value on each difference between comp and subject.

13. Adjustments Cannot beDirectly Observed • How to find adjustments for the comps is one of the most important issues in the valuation theory of the sales comparison approach

14. Where Do We Get the Plug In Attribute Prices? Four Methods to obtain non-observable and, therefore, implied values: • Matched Pairs • find 2 similar comps and isolate value of a specific item • Cost • depreciated value of items • Survey • Regression

15. The Dichotomy Between Theory and Practice • Many appraisals, particularly non-residential, are made in data poor environments. Pulling back the curtain we find: • lack of attribute pricing data leads to ad hoc implementation of grid method • ad hoc methods include: all in the head analysis, statement of sales used, written ranking descriptions, qualitative ranking grids, and WAG “Pay no attention to the man behind the curtain…”

16. Two Casual Approaches to Adjustments 1. The “all in the head” adjustment process (favoured by old-timers). 2. (Mentally) ranking and bracketing the sales prices of comps - place subject within a sequence of prices of comps estimate how close subject lies to the comp ranked immediately above and below. HANDOUT REFERRAL ... Example of bracketing

17. Example – Ranking and Bracketing • S1 $140,000 for a 3 bed, 1 bathroom house • S2 $170,000 for a 4 bed, 2 bathroom house • S3 $150,000 for a 4 bed, 1 bathroom house • Subject has 3 beds, 2 bathrooms. • Can you rank Subject?

18. Model Validation - Checking the Adjusted Prices 1. For consistency • range of adjusted prices 2. For reliability of each comparable sale • minimum value of gross adjustments • minimum number of adjustments • think back to reliability of data collected. Re-interpret sales? Find more sales?

19. Review – Did the Adjustment Process Work? • Not if the adjusted prices varied by much; • Otherwise, are you confident of the likely selling price?

20. What’s Wrong with the Ad Hoc Approach to Adjustments? • Non-consistent or explicit, therefore, non-reproducible • No testing if correct variables selected or adjustments valid • Not defendable under close scrutiny of courts, reviews

21. Current State of Practice Bipolarized between heavy reliance on WAG method and sparse use of sophisticated models that merge expert intuition with statistical data analysis and techniques from decision science. HANDOUT REFERRAL ... Output from Taurean AVM showing traditional grid approach with attribute pricing supplied by regression analysis.

22. Letting Go of Old Battle Scarred Adjustment Techniques A valuer knows in advance that often the number of sales will be small, the property characteristics will have considerable variance, and the commonly taught methods to equalize the data will not be practically applicable.

23. Plausible Solutions Would … • recognize the competitive business environment that appraisers work in; • at the very least use the market pricing information within the comps employed • allow expert intuition, but recognize that a more analytic rather than intuitive approach to data processing will improve forecasting; • provide some measure of appraisal accuracy in the approach.

24. Rethinking Comparability … Qualitative Comparison: Beyond Traditional Market Comparison Methods

25. The Principal of Substitution Acornerstone of established valuation theory, this principal states a property’s value tends to be set at the cost of acquiring a substitute property with equally desirable utility, assuming that no costly delay is encountered in making the substitution.

26. What Does Observation of Transacting Individuals Tell Us? Qualitative comparisons, NOT plus and minus percentage or dollar quantitative adjustments, most reliably replicate the decision making behavior of the majority of real estate market participants.

27. Qualitative Descriptions • buyers have personal values they attach to combinations of attributes • by process of evaluation and elimination, buyers match attributes between alternative properties to decide which property provides the most satisfaction relative to cost • application of qualitative comparison requires an inventory and description of the utility attributes of both comps and subject

28. Principle of Rank Substitution • Donald Wilson refines the Principle of Substitution with the logic of the Principle of Rank Substitution: “Buyers and sellers do not generally deconstruct the value of alternative properties into price-per-unit attribute adjustments, either systematically or intuitively. They grade and measure the substitute properties on ordinal and cardinal tradeoffs between price and aggregate property attributes … they always grade, measure, compare, rank, and choose among several of the most fitting ones” HANDOUT REFERRAL ... Paper by Donald C. Wilson, The Principle of Rank Substitution, The Appraisal Journal, January 1997.

29. Traditional Attribute Descriptions • appraisers using a qualitative approach often describe a property’s relative attributes in words or with symbols. • quality word descriptors like superior, inferior, much better, similar or symbols like ++, -, > are nominal measurements; they are not conducive to further analysis.

30. Qualitative Description by Recoding • A statistical thinking approach suggests nominal data should be recoded as ordinal data to allow further quantitative analysis. Quantitative analysis generally builds on and works with rigorous qualitative analysis. • Analysts have to make counts, take measurements, sort into classes, and assign ratings.

31. Value = Utility Premise Appraisers infer that transaction price equals utility and that transaction price may be substituted for the value of subject properties with equal utility

32. The Quality Rating-Price Comparison Approach • around for over 30 years in various guises • has received scrutiny from courts and tribunals • taught in land economics courses • described in the appraisal literature HANDOUT REFERRAL ... Bibliography of appraisal literature dealing with traditional sales comparison with the grid estimator and alternative approaches

33. Why Quality Rating-Price Comparison is not Mainstream • inertia to change in appraisal societies and court and tribunal decisions that tend to enforce traditional methods; • general lack of commitment to lifelong learning on part of busy practitioners due to pressures of commercial practice; • communication barriers hinder crossover of ideas between academics and practitioners. • when everything is going fine and you’re getting your piece of the pie – why risk change?

34. QP A Quality Rating-Price Comparison Approach Quality Point: An Overview ...

35. What is Quality Point (QP) • A 2nd generation quality rating/price comparison model that compares overall utility scores of comps and their sale prices. • A utility score is a composite variable that numerically summarizes as a crisp number the aggregate qualitative attributes of a comp inventoried by the appraiser using a systematic rating process. • relationships between overall utility scores and sale prices can be expressed as a linear function where value = utility. Existing sales directly compared to appraised property supply the needed market pricing information.

36. Genesis of QP This seminar outlines one implementation of the quality rating-price comparison approach called QP that borrows heavily from the work of Richard Ratcliff, James Graaskamp, Gene Dilmore, Halbert Smith, Terry Grissom and Michael Robbins. HANDOUT REFERRAL ... Paper by Gene Dilmore that outlines history of QP and his implementation using a software program written in Basic.

37. Advantages of QP OverTraditional Grid - Part 1 • eliminates need for “guesstimating” adjustments – a rampant practice, particularly in data starved environments. No need for outside pricing of differences between sales and subject. All information needed to fit QP model extracted from sales as rated by appraiser. • makes comparison analysis explicit, reproducible, and professional. • simple to use for market knowledgeable appraisers.

38. Advantages of QP OverTraditional Grid - Part 2 • forces appraiser to pay attention to sale details. • QP model validates itself by checking accuracy through prediction of the prices of the comparable sales and their comparison with actual prices. • efficient in valuing multiple properties of like kind. Once a valid model is built, it can be used over and over by the rating of only the subject properties. • approach is general and broadly applicable to many types of properties

39. Computational Assistance Several software programs have been written to assist appraisers with the computations needed for QP. However, a commercial spreadsheet program provides the linear programming routines needed to fit the weights and can easily implement the necessary simple linear algebra calculations

40. Making QP Productive: Harnessing the Spreadsheet QP adapts well to the matrix grid of a good spreadsheet program and its built-in linear programming tools like Excel’s Solver

41. Steps in QP Technique: • Select comparable sales. • Choose appropriate unit of comparison. • Adjust sale prices to a common baseline using traditional quantitative methods. • Choose value influencing qualitative attributes. • Outline the range of utility displayed by comps and subject in the attributes and score on ordinal scale. • Find variance minimizing attribute weights using optimizing program (Solver in Excel). Traditional New

42. Steps in QP Technique – Cont’d: • If required (reduces variance further), apply size adjustment based on fitting power curve. • Evaluate model by using it’s derived mean price/utility function to predict the baseline adjusted prices of the sales. Compare predicted prices with actual comp prices. • If model predicts prices of comps within acceptable range of error, score the subject’s utility consistent with the sales. • Use the mean price/utility function or regression coefficient to predict price of subject. New

43. Circular Analysis • part of QP process is a circular analysis • includes checking remaining variation in price not explained by model and error shown by residual price analysis. • feedback of model error guides selection of retained comparables, accuracy of attribute choices and appraiser’s rating judgement.

44. QP A Quality Rating-Price Comparison Approach Quality Point: The Details ...

45. Quantitative Property Characteristics • Based on interval data that can be measured and compared in a precise manner. • Sales should be adjusted to a common base prior to the other adjustments • Property Rights • Financing • Motivation • Market Conditions

46. Multi-attribute Utility Analysis 4 step process for mapping comp and subject utility: • determining value influencing attributes for property type appraised • mapping utility by defining categories of quality for attributes and assigning ordinal scale • rating of comp attributes using defined ordinal scale • optimal fitting of rated comp attributes to sale prices through attribute weighting

47. Qualitative Property Attributes • Qualitative property characteristics consists of data that are based on subjective measures, whereby the data tend to fall into nominal or ordinal categories. • They need to be systematically ranked or treated. • Location • Building Quality • Income • Condition etc.

48. Mapping Utility • Coding reduces a description to a more manageable size through the use of letters, numbers, or symbols. • In QP applications, descriptions of relevant property characteristics are ultimately reduced to numerical values so that mathematical calculations may be performed.

49. Mapping Utility with Operational Definitions • Use operational definitions when rating - avoid crude descriptors i.e. good location ranked 5 is near an interchange with the expressway. • Operational definition says good location ranked 5 is no more than 1 block from an interchange with the expressway. • An analogy: the operational definition of a food dish is its recipe and not a description of its smell, color, texture, etc. HANDOUT REFERRAL ... Samples of coding with operational definitions for varied property types.

50. Ranking Property Characteristics • Qualitative NOT quantitative property characteristics are ranked in a very simple order for easy referencing. • An ordinal scale is the best ranking procedure for this. • 1=below average or fair • 3=average • 5=above average