The Diminution in Value Appraisal, Explained

The Diminution in Value Appraisal, Explained

The standard value to be addressed in most real estate appraisals is that of “Market Value”. Most court cases as well as collateral evaluation appraisals for lending purposes are based upon Market Value. That being said, on occasion appraisers are asked to determine a ‘Value in Use” for a property. How is this different and why would anyone want a value that does not conform to what the market will pay for a property? It has been my experience that many who use appraisals do not fully understand the difference in the two values. Both values are rooted in the term “use”, in spite of fact that the term “Market Value” makes no reference to “Use” in its name. Market Value is based upon the Highest and Best Use of a property, rather than the Actual Use of a property as of the effective date, which is required to perform the Value in Use Appraisal. The term Value in Use is defined below.

Value in Use: “The value of a property assuming a specific use, which may or may not be the property's Highest and Best Use, on the effective date of the appraisal. Value in Use may or may not be equal to Market Value, but is different conceptually”. (The Dictionary of Real Estate Appraisal, 6th Edition). The terms Value in Use and Use Value have the same meaning in the dictionary.

The when and why of the Value in Use Appraisal, is addressed next. Stated another way, when and why, is it necessary or appropriate to perform a Value in Use Appraisal? The answer to this question varies with particular circumstances and is often debated among knowledgeable professionals. First, I should state that I have observed situations where clients, in an effort to obtain a value conclusion favorable to them, have questioned whether a Value in Use Appraisal should be performed as opposed to that of Market Value. This is the wrong question. The question should be, what type of value is appropriate to solve the specific problem? In an attempt to further address this issue, the following are examples demonstrating markedly different Values in Use vs Market Values, given the same property.

Example 1

Value in Use Appraisals can be beneficial in situations where a property is performing below that of which the property would, if utilized at its Highest and Best Use, rather than its Present Use. My best example is a property in the path of growth, zoned commercially, improved with an older residential structure and used as a residence. For demonstration purposes, lets say that the site as vacant, has a Market Value of $200,000 and the property is rented at a rate of $1,000 per month, which is commensurate with a value of $100,000. In years past the Market Value of the site as vacant, may have been much lower, say $25,000, however current growth trends for vacant commercial land have raised the value currently to $200,000 after consideration of demolition cost. In this case the Value in Use is $100,000 and the Market Value is $200,000. The property should sell on the open market for twice that of its Value in Use.

Example 2

In a case which is the opposite of the above, there are situations were properties perform at a much higher level, given their Current Use, rather than what would be the case assuming a property's Highest and Best Use. Lets take for example a factory building, which is used by a company requiring a highly specialized design, with many small rooms and special electrical components. The tenant required the owner to make improvements and was willing to pay extra. For demonstration purposes, lets say the Contract Rent is $50,000 per year, in a market where a property sells for seven times gross rent. Thus the Value in Use is $350,000. The Market Rent for the property with the improvements is only $40,000, given that there are no other tenants willing to pay such a premium for the property. Thus the Market Value is $280,000. The property's Highest and Best Use given the market, is that of a factory building not requiring as many rooms or specialized electrical. Here the property if placed on the open market, will likely sell for $70,000 less, or 20% less, than the Value in Use.

Therefore, understanding how the values are developed and the result produced, permits a more professional use of the valuation concepts.

Value in Use Appraisals are performed less frequently than Market Value appraisals. Most appraisers usually expect to provide a Market Value when performing an appraisal, unless directed otherwise. The list below offers insight into when these two very different processes are typically pursued.

  • Value in Use Appraisals are not appropriate for collateral evaluations involving mortgage lending, as they typically do not address what the market will pay for a property in the event of a foreclosure.
  • Value in Use is employed in some cases by local property taxing authorities, where state law permits. The laws in some states, require a Value in Exchange basis for property tax assessments or what we commonly refer to as Market Value, valuations. In such cases Value in Use is not permitted. Many taxing authorities prefer using Value in Use evaluations on specialty properties, since this method usually provides a higher tax value on such properties.
  • The title insurance industry may use either Market Value or Value in Use Appraisals in connection with settling title claims, depending upon local state law and the details of the claim. While some believe that Value in Use Appraisals always favors the title company, this is not the case, especially with specialty properties. Most title policies do not address the method for computing damages under the policy, therefore a decision as to the type value sought is necessary in each case.
  • The resolution of contract disputes involving real estate, often require appraisals. Depending upon the nature of the dispute, language in the contract, case law and / or statutory law, these influences may dictate that Value in Use be sought in an appraisal to demonstrate damage or other value specific information.
  • In my experience, I have found that most statutory law involving damage compensation, such as eminent domain, contract law, etc., specifies the use of Market Value, rather than Value in Use.

In conclusion, there is no one size fits all rule of thumb dictating whether an appraisal for a particular property type be Market Value or Value in Use. Each decision stands on its own merit, given the circumstances surrounding the problem to be solved. One of the first and primary guiding factors driving such a decision, is that of local state statutes. Discussions with the appraisal provider, will offer direction as to the scope of work and the proper value to be sought in a particular situation.

It should be noted that the term Value in Use, is used outside the realm of real estate appraisal and it may have different meanings and interpretations when applied to other assets such as personal property, businesses and intangible properties. This article is intended only to address Value in Use of real estate.

Charlie Elliott, MAI, ASA, SRA, a Certified General Appraiser is the founder and CEO of ELLIOTT & Company Appraisers. Elliott & Company is an Appraisal Management Company specializing in complex title claim valuations for the title insurance industry. Mr. Elliott is not an attorney and nothing contained herein should be construed as a legal opinion or legal advice. All statements and opinions contained herein are those developed by Mr. Elliott given his three decades of education, training and experience as a complex property appraiser. He can be reached by telephone at 336-854-3073.