In an appraisal assignment, a hypothetical condition is used when a property is appraised 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. Here are some helpful examples.
When are hypothetical conditions used?
When appraising a proposed new dwelling with a current effective date, a hypothetical condition is often employed to appraise the dwelling as if it were 100% complete as of the effective date. However, in reality, the property is known to be a vacant lot as of the effective date of the appraisal.
A hypothetical condition might also 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.
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Why is it so important to disclose a hypothetical condition?
In the case of new construction (Example 1), without a disclosure, a lender client could make a loan on a property that they believe is a large new house, only to find later that it is a vacant lot. In the case of environmental contamination (Example 2), a buyer could overpay for the property, based on the mistaken belief that he or she is buying a “clean” property.
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 a statement that use of the hypothetical condition might have affected the assignment results.
USPAP provides no roadmap for “clearly and conspicuously.” It is prudent to follow the rule of thumb that the disclosure of a hypothetical condition should be made everywhere in the report where the value conclusion appears.
Disclosure statement examples
If Beverly is completing an appraisal on the proposed new building from Example 1, developed from plans and specifications, 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.
If Beverly is completing an appraisal on the environmentally contaminated property from Example 2, she will want to disclose the use of the hypothetical condition everywhere in her report that the value conclusion is stated. She 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.
Beverly can provide further explanation if she wishes to. But assuming there are no additional disclosures required by law, regulation, or agreement with the client, she is only required to comply with the minimum disclosure requirements of USPAP.
If Beverly is using a form report, 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 Beverly to make her disclosure clear and conspicuous.
Hypothetical condition vs. extraordinary assumption
Here’s an additional example to help illustrate when to use an extraordinary assumption vs. hypothetical condition. Let’s say you’re doing an appraisal on an acreage property that was formerly used as a farm.
If you have no knowledge of contamination, you would 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.
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.
Want more examples and helpful guidance related to appraisal disclosures? Enroll in our top-rated CE course: Essential Elements of Disclosures and Disclaimers.