Even though the term hypothetical condition has been used in the appraisal profession for decades, some appraisers continue to struggle with the concept, specifically:
- What is the appropriate use of a hypothetical condition?
- What are the disclosure requirements for a hypothetical condition?
- What is the difference between a hypothetical condition and an extraordinary assumption?
What is a hypothetical condition?
In an appraisal assignment, a hypothetical condition is used to appraise a property under a condition that is contrary to what is known by the appraiser to exist on the effective date of the assignment results. If a hypothetical condition is not properly disclosed in an appraisal report, it could be significantly misleading for the client and intended users.
When are hypothetical conditions used?
The purpose of hypothetical conditions is to enable appraisers to evaluate scenarios that differ from the current reality, such as assessing a property’s value as if a known detrimental condition did not exist.
Example 1: Appraising proposed improvements
When appraising proposed improvements as of a current effective date, a hypothetical condition may be employed to appraise the improvements as if they were 100% complete as of the effective date. Of course, the appraiser knows the improvements are not completed as of the effective date of the appraisal.
Example 2: Environmental contamination
A hypothetical condition might be used in the appraisal of a property that is subject to a detrimental condition (e.g., environmental contamination) under circumstances where the property is being valued as though the detrimental condition does not exist.
USPAP requires that in order to use a hypothetical condition in the development of an appraisal, it must be “clearly required for legal purposes, for purposes of reasonable analysis, or for purposes of comparison.” If the hypothetical condition does not meet one of these three tests, it cannot be used.
For example, in an appraisal of an environmentally contaminated property that is the subject of litigation, it would be appropriate to value the property as if uncontaminated to assist the court in determining the diminution in the property’s value attributable to the contamination.
In this situation, the hypothetical condition would be required for legal purposes.
Conversely, if a property owner engaged an appraiser to value a contaminated property as if uncontaminated for purposes of obtaining private mortgage financing, this would likely be inappropriate, even if disclosed in the report.
Why is it so important to disclose a hypothetical condition?
In the case of proposed improvements (Example 1), without clear and appropriate disclosure, a lender could potentially make a loan on a property that they believe is improved with a building, only to find later that it is a vacant lot. In the case of environmental contamination (Example 2), a buyer could overpay, or a lender could make an undercollateralized loan, based on the mistaken belief that the property is “clean.”
USPAP disclosure requirements
Just as with extraordinary assumptions, USPAP Standards Rule 2-2 requires that hypothetical conditions must be clearly and conspicuously stated. Also, USPAP requires the appraiser to state that use of the hypothetical condition might have affected the assignment results.
USPAP provides no roadmap for “clearly and conspicuously.” It is a best practice – but not specifically required by USPAP – that disclosure of a hypothetical condition should be made everywhere in the report where the value conclusion appears.
Disclosure statement examples
Example 1
If an appraiser is completing an appraisal on the proposed new building from Example 1, based on plans and specifications, he or she might use the following disclosure statement:
The appraised value is based on the hypothetical condition that improvements have been completed as of the effective date of the appraisal, per the plans and specifications dated ________. The use of this hypothetical condition might have affected the assignment results.
Example 2
If an appraiser is completing an appraisal on the environmentally contaminated property from Example 2, he or she will want to disclose the use of the hypothetical condition everywhere in the report that the value conclusion is stated. The appraiser might use wording similar to this:
The subject property is subject to known environmental contamination; however, for the purposes of this appraisal, it is appraised as though it is uncontaminated. This appraisal involves the use of a hypothetical condition, as the property is appraised contrary to what is known to exist as of the effective date of the appraisal. The use of this hypothetical condition might have affected the assignment results.
The appraiser can provide further explanation if he or she wishes to. But assuming there are no additional disclosures required by law, regulation, or agreement with the client, the appraiser is only required to comply with the minimum disclosure requirements of USPAP. If the appraiser is using a form report, he or she may or may not check the “Subject to” box. USPAP does not instruct appraisers on how to fill out appraisal report forms. USPAP requires the appraiser to “clearly and conspicuously” disclose the use of the hypothetical condition.
Hypothetical condition vs. extraordinary assumption
A hypothetical condition is not the same thing as an extraordinary assumption. An extraordinary assumption is used when the actual condition of the property is unknown by the appraiser, while a hypothetical condition is used when the actual condition of the property is known.
A practical example of a hypothetical condition vs. extraordinary assumption
Here is an example to help illustrate when to use an extraordinary assumption vs. a hypothetical condition. Let’s say you’re doing an appraisal on an acreage property that was formerly used as a farm. If you suspect the property might be contaminated but you have no knowledge of contamination, you might employ an extraordinary assumption:
This appraisal was developed using the extraordinary assumption that the acreage being valued is assumed free of any environmental hazards, i.e., pesticides, herbicides, underground storage tanks, etc. The appraiser is not aware of any environmental screening of the property as of the effective date of the appraisal. The use of this extraordinary assumption might have affected the assignment results.
Conversely, if the property has been tested and you are aware that the property is contaminated, and it is appropriate to value the property as if uncontaminated, you would employ a hypothetical condition:
There is known contamination within the subject property; however, this appraisal has been developed using the hypothetical condition that the subject property is not contaminated or otherwise environmentally affected. The use of this hypothetical condition might have affected the assignment results.
Final word on hypothetical conditions
In summary, a hypothetical condition is used to appraise a property contrary to what is known by the appraiser to exist as of the effective date. The hypothetical condition must be appropriate for the assignment, and its use must be clearly and conspicuously disclosed in the report.
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