To a layperson, the terms value, price, and cost may seem to mean pretty much the same thing. However, to the professional appraiser, the terms each have a specific meaning. And the meanings are most certainly not the same thing.
Market Value is the focus of many appraisals. Market Value is an opinion. In simplest terms, it is most probable sale price in an “arm’s length” transaction. However, simple terms rarely suffice. The definition is usually modified with certain assumed conditions. In a definition often used by professional appraisers in the United States (from the Comptroller of the Currency), the conditions assumed are very specific. Market Value is defined as the most probable sale price when the buyer and seller are typically motivated and reasonably well informed. Further, it is reflective of a typical marketing period and payment in terms of U.S. dollars with no influence from sales concessions or special financing.
There are many variations of the definition. The sources include the California Civil Code, the California State Board of Equalization, U.S. Treasury, Civil Jury Instructions, Internal Revenue Service, International Valuation Standards, and many more. As an example, the market value definition for reporting federal estate taxes is not exactly the same as the definition for local property tax assessment. In most cases, the definitions are intended to mean the same thing (or very nearly the same thing) as the definition referenced above. However, there are exceptions. In eminent domain actions (State of California rules), damage assessment in litigation, and a few other instances, the market value definition specifies “highest” price rather than “most probable” price. The intent is clear; the benefit of the doubt is intentionally extended to the property owner.
Finally, no discussion of Market Value would be complete without reference to the term “Fair Market Value”. The term is often encountered when dealing with legal matters. The various definitions of Fair Market Value do not suggest that the meaning is any different from simply Market Value. In fact, the U.S Supreme Court, in an eminent domain case (United Stated States vs. Miller), observed, “the term ‘fair’ hardly adds anything to the phrase ‘market value.’“ Most appraisers do not use the term. It has been observed that the term “Fair Market Value” suggests that there could be an “Unfair Market Value.”
Sale Price is a fact. Sale price is the agreed upon consideration upon which a buyer and seller agree to a transfer of property. Sale prices can be reflective of value but are not necessarily so. In a situation where a seller is under pressure, the price accepted might be lower than market value. Similarly, a buyer under pressure or motivated by other considerations (e.g. owning adjacent property) might pay more than market value. A property that has to be sold quickly might sell at below market value. There are any number of things that could impact sale price.
When undertaking Data Comparison Approach valuation analyses, professional appraisers survey markets for evidence of sales of “comparable” properties. The sale price for each property needs to be analyzed to determine if it was impacted by any influence that could cause the price to be something other than market value. It is as a group that the analyzed sales data help point to an indication of market value for the subject property.
Construction Cost is the cost to build a structure or other improvement. If Construction Cost refers to numbers compiled prior to actual construction, it is an estimate. It is often prepared by a contractor or cost estimator. If Construction Cost refers to numbers put together reflecting actual costs of construction which has been completed, it is factual. In either case, it is a unique number to a specific project and prepared by a particular person. Anyone familiar with construction knows that costs can vary depending on the project and the preparer.
Replacement Cost is most often used by appraisers when performing a Cost Approach valuation analysis. As such, it is an opinion. It is an estimate of costs to construct a structure comparable to the subject using current standards, materials, and practices. The Cost Approach valuation analysis is based on the premise that the cost to acquire a comparable site and construct similar improvements should be suggestive of value. However, an often quoted mantra amongst appraisers is “cost does not equal value.” Generally, people expect that the value will exceed the estimated cost. If it were not so, things would rarely get built.
Reproduction Cost is the estimated cost to build an exact replica of the subject. It is used by appraisers when a structure has unique components that are not reflective of current materials or practices but are considered desirable and therefore could add value. It also might be appropriate when a cost evaluation is being prepared for insurance purposes.
Professional appraisers regularly deal with value, price, and cost. The concepts overlap and influence one-another but the terms are not synonymous.
Mr. Arnold is a principal at Hammock, Arnold, Smith & Company. They are a general practice appraisal firm providing valuation and evaluation services to a variety of clients including corporations, government agencies, the legal community, financial institutions, private individuals, and others.