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The role of professional designations as quality signals.

An appraisal firm may be defined as an agent employed to produce information for a principal, the client. The appraisal firm's production of information involves the discovery and disclosure of information to the client in the form of an estimate of value for real property. During this process, a variety of incentive problems arise. The first type of incentive problem is the temptation to minimize costs by omitting certain steps in the process that might uncover information relevant to valuation. A second problem is the appraiser's temptation to overstate his or her qualifications with respect to expertise regarding the specific appraisal situation. These issues are compounded by the fact that the client's monitoring of the appraisal firm is a costly process. Whether we choose to refer to these problems as a single agency problem or a bundle of problems, the important point from the client's perspective is that the quality of appraisal services is not immediately apparent. Thus, some researchers, including Patricia Rudolph,(2) have been led to question whether the presence of a sufficient number of bad appraisals will drive out good appraisals. In this article, we reexamine the issue using the literature of economic game theory. Originally developed by John Von Neumann and Oskar Morgenstern,(3) game theory involves the actions and strategies pursued by a limited number of parties who lack complete knowledge of and communication with each other. Since the client is not in a position to accurately judge a "good" appraisal and the appraiser cannot directly communicate his or her expertise, game theory strategy should provide insights regarding the actions of both parties.

COSTS AND INCENTIVES FOR APPRAISERS TO ESTABLISH A HIGH-QUALITY REPUTATION

Milton Harris and Arthur Raviv(4) and Bengt Holstrom(5) have examined the incentive problem in which information is costly and the principal incurs costs to monitor the activities of the agent. This situation results in the agent's having an incentive to produce low-quality, high-cost work if the probability of being discovered is sufficiently low. Critical issues involve how much effort the agent expends and how diligent the principal should be in attempting to monitor the agent's efforts. These issues are a problem in appraisal, because the very reason for hiring the appraiser in the first place may be that the client is not equipped to perform the valuation function. Thus, the client is often in no position to evaluate the quality of these services when performed by another party. The developing field of appraisal review is an attempt to address client concerns regarding competency.(6) While compliance standards are required, no standardized process for appraisal reviews has been developed to date.

If costs incurred are the primary determinant of appraisal quality, then only agents with low incremental costs will have the incentive to produce high-quality work in response to a given compensation structure. However, Richard Selten(7) points out the shortcomings of focusing solely on a producer's cost function. Selten considers the situation of a monopolist (single producer) with a low-cost structure. One of the monopolist's main concerns is deterring new competitors from entering the market. Should the monopolist try to establish a reputation for "toughness" (i.e., low cost pricing) to discourage new competition? Using game theory, Selten shows that in the final stage of the "game," the monopolist will produce low-quality, high-cost work, since he or she has nothing to gain from quality if tile competition has been eliminated. Consequently, a monopolist has nothing to gain from establishing a reputation in the next-to-last stage, since all parties already perceive tile monopolist's final period behavior. Thus, attempting to establish a reputation within battles over market share will not work.

David Kreps and Robert Wilson(8) reexamine Selten's conclusions and propose a monopolist could establish a credible reputation for "toughness" if it were generally believed that some monopolists receive a nonmonetary payoff from pursuing a "tough" strategy. This assumes, however, that the monopolist's strategy becomes immediately apparent to entrants it faces in the next period. The problem for an appraiser is whether developing a reputation for producing low incremental cost, high-quality reports conveys credibility.

LICENSING AND PROFESSIONAL DESIGNATIONS

Another problem is that non-conscientious appraisers could mimic the conscientious appraiser for a time and then switch to low-quality reports. Because the value of reputation is directly related to the length of time remaining in which it is expected to provide benefits, the temptation to switch to low-quality work increases with the passage of time. Benjamin Klein and Keith Loeffier(9) examine the case of a producer facing the choice of producing high- or low-quality goods, with quality not observable for purchasers. They note that by investing in certain firm-specific assets that become worthless if the producer is caught switching, the producer is able to signal to the market the intention of being a long-term participant. In incurring the costs of these assets, the producer signals to buyers a long-term horizon and ready incentive to produce high quality.

An appraiser's acquisition of a professional designation is an example of such a specific asset. Hayne Leland,(10) Peter Colwell and Joseph Trefzger,(11) and Rudolph(12) have addressed the issue of voluntary designations, such as those conferred by the Appraisal Institute, as a way of differentiating appraisers who produce reports of minimally acceptable quality from those who produce high-quality reports. Rudolph notes that the market worth of professional designations is indicated by the fact that appraisers continue to invest their time and money to obtain designations clients recognize. An appraiser must incur certain costs to gain the voluntary designation, and he or she must maintain a minimum level of continuing education to keep the designation. Once obtained, the cost of the designation is sunk since it is nontransferable and nonrefundable. Consequently, for the designation to pay off, the appraiser has an incentive to pursue high-quality production strategies (i.e., "good" appraisals).

A good example is the current situation in corporate real estate. Sally Mertens(13) documents the efforts by corporate real estate executives to signal the importance of their work. One result has been a strong increase in candidates seeking the Master of Corporate Real Estate (MCR) and Master of Corporate Real Estate Services (MCRS) designations conferred by the National Association of Corporate Real Estate Executives as a method of communicating high standards and special training.

DO BAD APPRAISALS DRIVE OUT GOOD?

George Akerlof(14) shows that a sufficient number of low-quality dealers can cause a market breakdown, if no means is available to distinguish "good" dealers from "bad" dealers. The question in appraisal is whether voluntary designations, such as the Appraisal Institute's designations, provide the market with a means of quality distinction and thus, the incentive for the production of good appraisals. This analysis points out the need for such designations in identifying those appraisers with good characteristics.

The importance of such voluntary designations is not based on any policing powers of the designating organization or the effectiveness of their training course work. Rather, these conclusions are based on the incontestable fact that such designations are costly in that they involve the expenditure of both time and money. It is precisely because of this cost factor that such voluntary designations provide valuable information to prospective purchasers of appraisal services.

This reasoning can also be extended to the continuing education requirements associated with such designations. The temptation for an appraiser to switch to low-quality production increases with time. Accordingly, it follows that the appraiser's commitment to high-quality production should be revalidated periodically. This is precisely the purpose of continuing education requirements. Whether the willingness to incur voluntary designation costs is interpreted as a signal that the appraiser is a long-term producer, expects to be a high-volume producer, or is protecting the value of a purchased name, is irrelevant. In each case, the willingness to incur the costs of acquiring and maintaining a designation is a compelling indication that the appraiser will follow a high-quality production strategy in the future. Client perception of such intentions insures a continuing market for high-quality, low-cost appraisal reports.

CONCLUSION

Rudolph(15) concludes that as long as a market exists for high-quality appraisals, some producers will continue to meet their demand. The problem for clients is trying to evaluate and monitor appraisal report quality.

Game theory shows that producers have the motivation to provide the market with signals when quality assessment is uncertain and costly. The fact that some appraisers continue to invest in and clients continue to recognize professional designations are indications of their market worth. Appraisers have an incentive to invest in designation assets such as Appraisal Institute designations if the acquisition of such assets conveys their intention to be long-term participants in the market. Such an intention is consistent with the production of quality, or good, appraisals, because reputation has economic value only over an extended time frame. By incurring the costs associated with such designations, appraisers signal to the market their intentions to continue to produce high-quality work.

1. Patricia Rudolph, "Will Bad Appraisals Drive Out Good?," The Appraisal Journal (July 1994): 363-366.

2. Ibid.

3. John Von Neumann and Oskar Morgenstern, Theory of Games and Economic Behavior (Princeton, New Jersey: Princeton University Press, 1944).

4. Milton Harris and Artur Raviv, "Optimal Incentive Contracts with Perfect Information," Journal of Economic Theory (1977): 231-259.

5. Bengt Holstrom, "Moral Hazard and Observability," The Bell Journal of Economics 10 (1979): 74-91.

6. Tony Sevelka, "Appraisal Reviews: An Emerging Discipline," Canadian Appraiser (Winter 1996): 38-40.

7. Richard Selten, "The Chain-Store Paradox," Theory and Decision 9 (1977): 127-159.

8. David Kreps and Robert Wilson, "Reputation and Imperfect Information," Journal of Economic Theory 27 (1982): 253-279.

9. Benjamin Klein and Keith B. Loeffler, "The Role of Market Forces in Assuring Contractual Performance," Journal of Political Economy, v. 89, no. 4 (1981): 615-641

10. Hayne E. Leland, "Quacks, Lemons, and Licensing: A Theory of Minimum Quality Standards," Journal of Political Economy, v. 87, no. 6 (1979): 1325-1346.

11. Peter E Colwell and Joseph W. Trefzger, "Impact of Regulation on Appraisal Quality," The Appraisal Journal (July 1992): 428-429.

12. Rudolph, 363-366.

13. Sally K. Mertens, "Corporate Real Estate: The Making of a Profession," National Real Estate Investor (March 1997): 88-94.

14. George A. Akerlof, "The Market for Lemons: Quality Uncertainty and the Market Mechanism," Journal of Economics 84 (1970): 488-500.

15. Rudolph, 363-366.

J. Howard Finch, PhD, is the J. C. Bradford Associate Professor of Finance at the University of Tennessee. He received his PhD in finance from the University of Alabama and has had articles published on valuation and real estate finance in various finance and economics journals. Contact: University of Tennessee; Dept. of Finance; 615 McCallie Ave.; Chattanooga, TN 37403. (423) 755-5250. Fax 755-5255. Howard-Finch@utc.edu.

Larry Fogelberg, PhD, is assistant professor of finance at Allentown College in Center Valley, Pennsylvania. He received his PhD in finance from the University of Alabama. His research centers on applications of game theory in economics and finance.

H. Shelton Weeks, PhD, is assistant professor of finance at Florida Gulf Coast University in Fort Myers. He received his PhD in finance from the University of Alabama. His research focuses on real estate valuation and appraisal.
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Author:Finch, J. Howard; Fogelberg, Larry; Weeks, H. Shelton
Publication:Appraisal Journal
Date:Apr 1, 1999
Words:1860
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