Real Estate Basics: Real Property Appraisal
The Essentials to Determining Market Value
- The most probable price is NOT THE AVERAGE or highest price. - The buyer and seller must be UNRELATED AND ACTING WITHOUT UNDUE PRESSURE - Both buyer and seller must be WELL INFORMED about the property's use and potential, including both its defects and its advantages - A REASONABLE TIME must be allowed for exposure in the open market - Payment must be made in CASH OR ITS EQUIVALENT - The price must represent a NORMAL CONSIDERATION for the property sold, UNAFFECTED BY SPECIAL FINANCING AMOUNTS OR TERMS, SERVICES, FEES, COSTS or CREDITS INCURRED in the market transaction
The Income Approach Steps
1. Estimate annual potential gross income. An estimate of economic rental income must be made based on market studies. Current rental income may not reflect the current market rental rates, especially in the case of short-term leases or leases about to terminate. Potential income includes other income to the property from such sources as vending machines, parking fees and laundry machines. 2. Deduct an appropriate allowance for vacancy and rent loss, based on the appraiser's experience, and arrive at effective gross income. 3. Deduct the annual operating expenses, from the effective gross income to arrive at the annual net operating income (NOI). Management costs are always included, even if the current owner manages the property. Mortgage payments (principal and interest) are debt service and not considered operating expenses. 4. Estimate the price a typical investor would pay for the income produced by this particular type and class of property. This is done by estimating the rate of return (or yield) than an investor will demand for the investment of capital in this type of building. This rate of return is called the capitalization rate (or "cap" rate) and is determined by comparing the relationship of net operating income with the sales prices of similar properties that have sold in the current market. For example, a comparable property that is producing an annual net income of $15,000 is sold for $187,500. The capitalization rate is equal to $15,000 divided by $187,500, or 8 percent. If other comparable properties sold at prices that yielded substantially the same rate, it may be concluded that 8 percent is the rate that the appraiser should apply to the subject property. 5. Apply the capitalization rate to the subject property's annual net operating income to arrive at the estimate of the property's value.
Estimating value based upon the cost approach involves five steps:
1. Estimate the value of the land as if it were vacant and available to be put to its highest and best use. (Note that the value of the land is not subject to depreciation) 2. Estimate the current cost of constructing buildings and other improvements 3. Estimate the amount of accrued depreciation resulting from the property's physical deterioration, functional obsolescence and external depreciation. 4. Deduct the accrued depreciation from the construction cost 5. Add the estimated land value to the depreciated cost of the building and other improvements to arrive at the total property value
Financial Institutions Reform, Recovery and Enforcement Act (FIRREA)
A comprehensive law passed in 1989 to provide guidelines for the regulation of financial institutions. One part of the law created the Appraisal Foundation and requires the use of state-certified or state licensed appraisers to appraise properties involving a federally insured or federally regulated industry such as banks.
Scarcity
A finite supply
Capitalization
A mathematical process for converting net income into an indication of value, commonly used in the income approach to value.
Front Foot
A measurement of property frontage abutting the street line or waterfront line. Commercial land is often priced based upon the amount of property that is visible from the street (the "front foot").
Square-Foot Method
A method of estimating a building's construction, reproduction or replacement cost whereby the structure's square-foot floor area is multiplied by an appropriate construction cost per square foot.
Quantity Survey
A method of estimating the construction cost or reproduction cost; a highly technical process used to figure the cost estimate of new construction and sometimes referred to, in the building trade, as the price take-off method
Gross Income Multiplier
A numerical factor that expresses the relationship of gross income to sales price or value. It is calculated by dividing price by gross annual income. A rule of thumb for estimating the market value of industrial and commercial properties
Comparative Market Analysis
A report complied from research of the marketplace, primarily similar properties that have been sold -provides information about the local market by providing the list price, time on the market and other important information about current listings, expired listings and listings that sold within the past 12 months for other similar properties in the area
Gross Rent Multiplier
A useful rule of thumb for estimating the market value of income-producing residential property. The multiplier is derived by using comparable sales divided by the actual or estimated monthly rentals to arrive at an acceptable average.
Anticipation
According to this appraisal principle, value is created by the expectation that certain events will occur. Value can increase or decrease in anticipation of some future benefit or detriment. For instance, the value of a house may be affected if rumors circulate that an adjacent property may be converted to commercial use in the near future. If the property has been a vacant eyesore, it is possible that the neighboring home's value will increase. On the other hand, if the vacant property had been perceived as a park or play lot that added to the neighborhood's quiet atmosphere, the news of its replacement might cause the house's value to decline -The appraisal principle of anticipation means that value is impacted by the expectation of benefits from future events
Appraisal
An appraisal is an estimate of market value
Unit-in-Place Method
An appraisal method of computing replacement cost, which uses prices for various building components, as installed, based on specific units of use such as square footage or cubic footage.
Substitution (Market Data Approach)
An appraisal principle that states that the maximum value of a property tends to be set by the cost of replacing it with an equally desirable and valuable substitute property. The principle of substitution of the basis for the sales comparison approach (also called the "market data" approach) to value
Progression
An appraisal principle which states that the worth of a lesser object is increased by being located among better objects. The opposite of regression.
Incurable Obsolescence
An appraisal term meaning the external or functional obsolescence of an improvement that is not economically feasible to repair or correct.
The Income approach to Value
An approach to the valuation or appraisal of real property as determined by the amount of net income the property will produce over its remaining economic life. The formula for calculating value based on the income approach is *income divided by capitalization rate equals value (IRV).* The income approach is used for income producing properties such as retail, office buildings, apartments, etc. When using this formula, be sure to remember that, if the income is known, enter it into your calculator first, hit the division sign then enter the known number from the bottom of the formula to get the other number. If the capitalization rate and value are known, multiply them to get the income Income ÷ Rate = Value Income ÷ Value = Rate Rate x Value = Income
Economic Principles that can affect the value of real estate
Anticipation Change Competition Conformity Contribution Highest and Best Use Increasing and Diminishing Returns Plottage Progression and Regression Substitution Supply and Demand
External Obsolescence
Anything that is not on the property that causes a loss in value is classified as external obsolescence.External obsolescence might include environmental, economic, locational or social forces that cause a loss in value. This type of depreciation is always incurable. The loss in value cannot be reversed by spending money on the property. For example, proximity to a nuisance, such as a polluting factory or a deteriorating neighborhood, is one factor that could not be cured by the owner of the subject property - always incurable -
Homogeneous
As used in appraisal, this term describes an area or neighborhood in which the property types or uses are similar and harmonious and the inhabitants have similar cultural, social and economic backgrounds. A homogeneous neighborhood tends to stabilize property values in the area.
Physical deterioration
Deterioration results from wear and tear and includes things such as peeling paint, a leaky roof, cracks in foundation walls, sloping floors, etc. Curable: an item in need of repair, such as painting (deferred maintenance), that is economically feasible and would result in an increase in value equal to or exceeding the cost Incurable: a defect caused by physical wear and tear if its correction would not be economically feasible or contribute a comparable value to the building. The cost of a major repair may not warrant the financial investment
Cost Approach Formula
Estimate the replacement cost of the building - depreciation + land value = Market Value Cost - Depreciation =Value For example: Using the sales comparison approach, an appraiser estimates that the current land value of a property is $25,000, the current cost of construction is $85,000 and the accrued depreciation is $10,000. So: Cost of construction $85,000 LESS: Accrued depreciation -10,000 PLUS: Land value +25,000 Indicated Value = $100,000
Appraiser
Estimates Market Value - This persons task is to render an objective opinion or estimate of the market value of the property, not to determine or establish the value of the property. The local market establishes the value of properties in the area. An appraisal is an estimate of the price a knowledgeable buyer is likely to pay for a property under normal market conditions. Therefore, the tendencies of buyers in the local market is of most importance to an appraiser.
Amenities
Features, both tangible and intangible, that enhance and add to the value or desirability of real estate.
Increasing and Diminishing Returns
Improvements will add to the value of a property up to a certain maximum amount, after which they will add nothing to the value. As long as money spent on improvements produces an increase in income or value, the law of *INCREASING RETURNS* applies. At the point where additional improvements do not increase income or value, the law of *DIMINISHING RETURNS* applies. No matter how much money is spent on the property, the property's value does not keep pace with the expenditures. For instance, a remodeled kitchen or bathroom might increase the value of a house; adding restaurant-quality appliances and gold faucets, however, would be an investment that the owner probably would not be able to recover.
Progression and Regression
In general, the value of a poorer property is increased if it is located in a neighborhood of more expensive properties. This is known as the principle of PROGRESSION. Conversely, the value of a better-quality property is adversely affected by the presence of a lesser-quality property. Thus, in a neighborhood of modest homes, a structure that is larger, better maintained or more luxurious would tend to be valued in the same range as the less lavish homes.
Functional Obsolence
Indicates a condition that is out of date. For purposes of your test, the easiest way to differentiate functional obsolescence from physical deterioration is to remember that functional obsolescence is a condition on the property that causes a loss in value that does not result from wear and tear -ex. A floor plan Curable - outmoded or unacceptable physical or design features that are no longer considered desirable by purchasers. Such features, however, could be replaced or redesigned at a cost that would be offset by the anticipated ultimate increase in value. Outmoded plumbing, for instance, is usually easily replaced. Room function may be redefined at no cost if the basic room layout allows for it. A bedroom adjacent to a kitchen, for example, may be converted to a family room or office Incurable - currently undesirable physical or design features that could not be easily remedied because the cost to cure would be greater than its resulting increase in value. An office building that cannot be economically air-conditioned, for example, suffers from incurable functional obsolescence if the cost of adding air-conditioning is greater than its contribution to the building's value. ex. older 4 bedroom 1 bathroom home.. builder more bathrooms.
Depreciation
Loss of Value - A loss in value due to any cause, any condition that adversely affects the value of an improvement. - Remember Land does not depreciate
Plottage
Merging or consolidating adjacent lots into a single larger one produces a greater total land value than the sum of the two sites valued separately. For example, two adjacent lots valued at $35,000 each might have a combined value of $90,000 if consolidated. The process of merging two separately owned lots under one owner is called assemblage.
The Sales Comparison Approach explain
Most Reliable approach - (also known as the MARKET DATA APPROACH or DIRECT MARKET APPROACH) is really a more sophisticated form of competitive market analysis and is the main method used for appraising single-family homes. An estimate of value is obtained by comparing the property being appraised (the subject property) with recently sold comparable properties (properties similar to the subject). Because no two parcels of real estate are exactly alike, each comparable property must be analyzed for differences and similarities between it and the subject property and the sales prices of the comparables adjusted upward or downward for the differences.
The Income Approach
Most appropriate for income producing and commercial properties
The Cost approach
Most reliable in the appraisal of brand new construction and unique properties that do not produce an income and for which there are no comparable sales
The Sales Comparison Approach
Most reliable in the appraisal of existing single family homes and raw land
The 3 Classes of Deppreciation
Physical Deterioration Functional Obsolesce External Obsolesce
The principal factors for which adjustments must be made include the following:
Property Rights - An adjustment must be made when less than fee simple (the full bundle of legal rights) is involved. This includes land leases, ground rents, life estates, easements, deed restrictions and encroachments Financing Concessions - The financing terms must be considered, including adjustments for differences such as mortgage loan terms and owner financing Conditions of Sale - Adjustments must be made for motivational factors that would affect the sale, such as foreclosure, a sale between family members or some nonmonetary incentive Date of Sale - An adjustment must be made if economic changes occur between the date of sale of the comparable property and the date of the appraisal. Location - Similar properties might differ in price from neighborhood to neighborhood or even between locations within the same neighborhood Physical Features and Amenities - Physical features, such as the structure's age, size and condition, may require adjustments
Property Rights as an Adjust
Property Rights. An adjustment must be made when less than fee simple (the full bundle of legal rights) is involved. This includes land leases, ground rents, life estates, easements, deed restrictions and encroachments.
Comparables
Recently sold or leased properties that are similar to a particular property being evaluated and are used to indicate a value for the subject property.
Replacement cost new
Replacement cost new is the cost to construct an improvement similar to the subject property using current construction methods and materials, but not necessarily an exact duplicate
Replacement cost vs reproduction cost
Replacement cost uses current construction methods and materials while reproduction cost uses the same methods and materials that were used when the building was originally constructed.
4 Methods of Cost Approach
Square footage method: Involves calculating the cost of construction by multiplying the square footage of the structure by the construction cost for that particular type of building. For example, you'd multiply a $ 100 per square foot cost to build the kind of house you're appraising by the 2,000 square foot total area of the house to arrive at a cost estimate of $ 200,000 to replace the structure. The square footage method is the one more commonly used by appraisers to estimate replacement or reproduction cost Unit-in-place method: Provides the cost to construct a building by estimating the installation costs, including materials, of the individual components of the structure. So if you know you need 1,000 square feet of sheet rock to cover the walls, you need to find out the cost of buying, installing, and finishing the sheet rock on a per-square-foot basis and then multiply by 1,000 square feet. Another approach to this method is to estimate the four main steps (units) to building a house. For instance, cost of foundation, cost of roof and framing, cost of mechanicals, and cost of walls and finish work. Each step is estimated separately and then all are added together Quantity survey method: More detailed than the previous method, it requires you to break down all the components of a building and estimate the cost of the material and installation separately. So in the sheet rock example, you estimate so many dollars each to buy the sheet rock, screws, and tape, and to pay for the installation Index method: Requires you to know the original construction cost (without land) of the subject building. You then multiply that original cost by a number that takes into account the increase in construction costs since the building was built. National companies that do this kind of research publish these numbers. If a building cost $ 20,000 to build originally, and the current index in that area for this type of structure is 1.80, the calculation is $ 100,000 × 1.80 = $ 180,000, or the cost to construct the same building today
Cost Approach 4 methods
Square-foot method - The cost per square foot of a recently built comparable structure is multiplied by the number of square feet (using exterior dimensions) in the subject building. This is the most common and easiest method of cost estimation. For some (usually nonresidential) properties, the cost per cubic foot of a recently built comparable structure is multiplied by the number of cubic feet in the subject structure Unit-in-place method - In the unit-in-place method, the replacement cost of a structure is estimated based on the construction cost per unit of measure of individual building components, including material, labor, overhead and builder's profit. Most components are measured in square feet, although items such as plumbing fixtures are estimated by cost. The sum of the components is the cost of the new structure Quantity-survey method - The quantity and quality of all materials (such as lumber, brick and plaster) and the labor are estimated on a unit cost basis. These factors are added to indirect costs (for example, building permit, survey, payroll, taxes and builder's profit) to arrive at the total cost of the structure. Because it is so detailed and time consuming, this method is usually used only in appraising historical properties. It is, however, the most accurate method of appraising new construction Index method. A factor representing the percentage increase of construction costs up to the present time is applied to the original cost of the subject property. Because it fails to take into account individual property variables, this method is useful only as a check of the estimate reached by one of the other methods
Effective Age
The apparent age of a building based on observed condition rather than chronological age.
Assemblage
The combining of two or more adjoining lots into one large tract to increase the value of the individual lots because a larger building capable of producing a large net return may be erected on the large parcel. The resulting increase in value is referred to as "plottage."
The Cost Approach explained
The cost approach is based on the idea that the components of a piece of real estate, or the land and buildings, can be added together to arrive at an estimate of value, if they're valued separately. The cost approach is particularly useful for unique properties that have few comparable sales and for new construction. If you were asked to appraise a church for example, you may use the cost approach because it would be rare to find many sales of churches.
Replacement Cost
The cost of constructing a building with current materials and techniques that is identical in functional utility to the structure being appraised and that is designed in accordance with current styles and standards.
Reproduction Cost
The cost to construct an exact duplicate of the subject structure at today's costs including both the benefits and the drawbacks of the property
Economic Life
The economic life of a building reflects the number of years it contributes to the value of the land. he estimated period over which an improved property may be profitably utilized so that it will yield a return over and above the economic rent attributable to the land itself.
Reconciliation
The final step in an appraisal process, in which the appraiser reconciles the estimates of value derived from the three approaches to arrive at a final estimate of market value for the subject property.
Competition
The interaction of supply and demand create competition. Excess profits tend to attract competition. For example, the success of a retail store may cause investors to open similar stores in the area. This tends to mean less profit for all stores concerned unless the purchasing power in the area increases substantially
Straight - line - Method
The most common and easiest but least precise way to determine depreciation. Depreciation is assumed to occur at an even rate over a structure's economic life, the period during which it is expected to remain useful for its original intended purpose The property's cost is divided by the number of years of its expected economic life to derive the amount of annual depreciation For instance, a $120,000 property may have a land value of $30,000 and an improvement value of $90,000. If the improvement is expected to last 60 years, the annual straight-line depreciation would be $1,500 ($90,000 divided by 60 years). Such depreciation can be calculated as an annual dollar amount or as a percentage of a property's improvements
Narrative Report
The most complete, comprehensive type of appraisal report in which the appraiser presents all information pertinent to the property, and the market for the property, along with his or her analysis, opinions and conclusions leading to an estimate of value.
Market Value
The most probable price a property should bring in a competitive and open market under the assumption that the buyer and seller acted prudently and knowledgeably, the price is not affected by undue stimulus, the property was left on the market for a reasonable period of time and payment is made in terms of cash in U.S. dollars or in terms of comparable financial arrangements. The price for which the property should sell under normal market conditions
Highest and Best Use
The most profitable single use for a property, or the use that is most likely to be in demand in the near future, is the property's highest and best use. The use must be legally permitted, financially feasible, physically possible and maximally productive The highest and best use of a site can change with social, political and economic forces. For instance, a parking lot in a busy downtown area may not maximize the land's profitability to the same extent an office building might. Highest and best use is noted in every appraisal
Demand
The need or desire for possession or ownership backed by the financial means to satisfy that need
Capitalization Rate (CAP rate)
The percentage selected for use in the income approach to valuation of improved property. The CAP rate is designed to reflect the recapture of the original investment over the economic life of the improvement, to give the investor an acceptable rate of return (yield) on his or her original investment and to provide for the return of the invested capital.
Market Price
The price a property actually sells for
Utility
The property's usefulness for its intended purposes
Transferability
The relative ease with which the ownership rights are transferred from one person to another
Contract Rent
The rental income as stipulated by the parties in a lease. Appraisers often contrast this with market rent, which is the amount of rent that the market will bear.
To arrive at an accurate estimate of value, appraisers traditionally use three basic valuation techniques:
The sales comparison approach, The cost approach The income approach
Net Income (Also net operating income)
The sum arrived at after deducting from gross income the expenses of a business or investment, including taxes, insurance and allowances for vacancy and bad debts. Net income is what the property will earn in a given year's operation. It is generally calculated before accounting for depreciation.
Supply and Demand
The value of a property depends on the number of properties available in the marketplace—the supply of the product. Other factors include the prices of other properties, the number of prospective purchasers and the price buyers will pay.
Contribution
The value of any improvement is measured by its effect on the value of the whole. Installing a swimming pool, greenhouse or private bowling alley may not add value to the property equal to the cost. On the other hand, remodeling an outdated kitchen or bathroom probably would. In other words, improvements may contribute to the value of a property or they may not, depending upon the improvement and its cost.
Value
To have value in the real estate market—that is, to have monetary worth based on desirability—a property must have the following characteristics or basic elements Demand Utility Scarcity Transferability
Change
Value fluctuates as economic conditions change. This is the principle of change. Real estate is subject to natural phenomena such as tornadoes, fires and routine wear and tear. The real estate business is subject to market demands, like any other business
Conformity
Value is created when a property is in harmony with its surrounding land uses. In single-family residential neighborhoods, for instance, buildings should be similar in design, construction, size and age
Broker's Price Opinion (BPO)
When a broker, for a fee, simply drives by the property, takes a picture of it, obtains information on comparable sales and fills out a form to give to the bank or attorney.
A salesperson is preparing a market analysis of a retail shopping center. A review of several comparable properties in the area has revealed that the subject property is earning $260.00 per month less than the comparable properties. At a capitalization rate of 9%, what is the loss in value of the subject property? $28,889. $34,667. $23,400. $32,120.
You must use the formula IRV, but first you must convert the net operating loss to an annual figure. So: $260 x 12 = $3,120 ÷ .09 (or 9%) = $34,667.
