TX Marketing I: Building a Real Estate Practice

Transcription

1 TX Marketing I: Building a Real Estate Practice

2 MODULE SIX: REAL ESTATE APPRAISAL... 2 MODULE DESCRIPTION... 2 MODULE LEARNING OBJECTIVES... 4 KEY TERMS... 4 LESSON 1: THE ROLE OF AN APPRAISER & REGULATION... 8 LESSON 2: THE VALUE PRINCIPLE LESSON 3: THE DYNAMICS OF THE REAL ESTATE MARKET/APPROACHES TO VALUE LESSON 4: THE APPRAISAL PROCESS & REAL ESTATE APPRAISAL PRACTICE... 45

3 Module Six: Real Estate Appraisal Module Description In order to own and convey property in a market economy it is necessary for that property to be assigned a specific monetary value. This process, unlike, say, that of assigning value to durable goods which have specific materials, production, and marketing costs can be somewhat more involved. With property, the fixed costs building materials and labor costs are always accompanied by more esoteric factors that go to make property more (or less) valuable. Becoming a member of the group that understands and applies these factors is a bit more complex than simply being able to understand a balance sheet. The objective of this module is to familiarize the student with the principles, theories, duties, and activities that pertain to real estate appraisal and valuation. 2

4 Developing an opinion of value is what the real estate appraiser does, but, as we have alluded to, this is far from an effortless process. Understanding the obligation of the real estate industry to promote professionalism and ethical business practices is a beginning to being able to carry out this process such that it is beneficial to licensees, consumers, and the market in which they do business. As well as touching upon general standards by which the value of property should be established, this module is broken down into separate lessons which cover: The Role of an Appraiser & Regulation Three Value Principles The Dynamics of the Real Estate Market/Approaches to Value The Appraisal Process & Real Estate Appraisal Practice Completing this module will leave the student with a good understanding of fundamental principles of appraisal, methods of real estate valuation, the various kinds of appraisal licensure and certification, the diverse types of appraisal, and what license or certificate is appropriate for given ones. In addition, the module examines the ways in which appraisal can affect both the larger economy and the availability of housing. The module concludes with a real-world practice lesson in which students will apply their new knowledge to examples and case studies. While completing this module, watch for recurring themes addressed in the learning objectives. 3

5 Module Learning Objectives Upon completion of this module, you should be able to: Comprehend the fundamentals and terminology of real estate valuation and appraisal. Identify the characteristics of a qualified appraiser. Recognize the principles of value used in real estate appraisal. Apply value theories to arrive at purchase prices of real estate. Characterize a favorable market for real estate sales. Describe the three approaches to value. Follow the eight steps to the appraisal process to arrive at an accurate purchase price. Read an appraisal report. Differentiate between appraisal licensure and certification. Key Terms Appraisal: The act or process of developing an estimate of value. Appraisal Report: An appraiser s written or oral estimate of value submitted to a client based on a specified definition of value for the subject property as of a specific date, giving all details of the data utilized in the appraisal process. Appraised Value: The value estimate made by an appraiser of a certain property; type of value differs depending on what the appraisal is needed for. Appraiser: A person who engages in the procedure of estimating the value of real property or personal property. Balance: The appraisal principle that states that the highest property values are realized when improvements are proportional to one another and the land in size and type. 4

6 Capitalization Rate: The interest rate used in the income capitalization approach to appraisal that represents an expected annual rate of return on one's investment. (V=I/R) where: V=Value, I=Net Operating Income, and R=Capitalization Rate. Comparables: Properties which are substantially equivalent to the subject property to be used in the process of determining value of a subject property. Cost Approach: A method of appraising property based on the depreciated reproduction cost (new) of all improvements, plus the market value of the site. Cost of Credit: The amount one pays on borrowed money; an interest rate. Depreciation (Accounting): A method of allocating the cost of an aging asset over its estimated useful life. For income tax purposes, depreciation is a provision for the estimated wear and tear of an asset. Depreciation deductions can be claimed as a tax deduction on real estate improvements, not land, regardless of whether the market indicates an increase or decrease in the value of the property. Depreciation (Real Estate): A loss in value from wear, use, or obsolescence (disuse). Equity (Equity Buildup): Funds applied to the actual principal on a loan, rather than the interest, plus any gain in property value through appreciation. External Obsolescence: Reduction in property s value caused by factors outside the physical boundaries of the subject property, such as social, environmental, or political factors; also known as economic depreciation. Usually cannot be rectified by owner. 5

7 (Preferred) Functional Depreciation: A loss in value within a structure due to changes in tastes, technical innovations, market standards, or any outdated style. The item in question may be curable, such as lack of air conditioning in Florida, or incurable, such as exceptionally low ceilings in a warehouse, depending on the costs of correcting the item as compared to the benefits expected if the correction is made. Highest and Best Use: The one most profitable and efficient use of any given tract of land, which must be legal, financially viable, productive, and physically plausible. Income Capitalization Approach: A method of estimating the present value of the property s anticipated income benefits. Leverage: The use of loaned funds to finance an investment. Market: A particular geographic region or demographic section in which there may be a demand for certain goods or services; for our purposes, the goods demanded would be realty. Market Value: In a normal and fair real estate market, this is the price that will most likely result in a sale and be deemed acceptable by both buyer and seller. Physical Depreciation: A reduction in a property s value (or its improvements) resulting from a decline in physical condition; can be caused by action of the elements or by ordinary wear and tear. Price: The amount of money requested or exchanged for a piece of property. Price: The accepted contracted amount, transaction charge or the value at which the property actually sells. 6

8 Real Property: All interests, benefits, and rights involved in owning real estate. Sales Comparison Approach: A means of estimating value by comparing recent sales of comparable properties to the subject property after making appropriate adjustments for any differences. This method is effective in an active market in which sales comparables can be identified and information collected and verified. The comparable properties selected should be substantially similar to the subject property and should be arm s-length transactions. USPAP (Uniform Standards of Professional Appraisal Practice): An annual publication printed by the Appraisal Foundation that defines key appraisal terminology and offers guidelines for completing non-biased and accurate appraisals. URAR (Uniform Residential Appraisal Report): A widely used form for VA, FNMA, HUD, FHLMC, and FMHA loans in estimating the market value of properties. Value: The power of a good or service to command other goods or services in exchange; the present worth of future rights to income and benefits arising from ownership. 7

9 Lesson 1: The Role of an Appraiser & Regulation Lesson Topics This lesson focuses on the following topics: Introduction Characteristics of a Reliable Appraiser Qualifications of an Appraiser Appraisal Employment and Job Functions The Appraisal Foundation FIRREA USPAP

10 Lesson Learning Objectives By the end of this lesson, you should be able to: Identify and discuss the fundamentals and terminology of real estate valuation and appraisal. Identify the characteristics of a qualified appraiser. Identify the professional societies and organizations that promote professionalism and integrity in appraisal practice. Describe the basic role of the appraiser. Describe employment opportunities for appraisers. Identify the principles of value used in real estate appraisal. Introduction The Uniform Standards of Professional Appraisal Practice (USPAP) defines an appraisal as the act or process of developing an opinion of value. An appraisal report functions as an independent and impartial presentation setting forth an opinion or estimate of defined value. An appraisal should not be confused with a market analysis (CMA) or a broker s market analysis (BMA), which is a report on the marketability of a home. Before a homeowner lists a property, he or she must know a marketable price to ask. If a homeowner wishes to obtain insurance or refinance her or his home, then a lender or insurance company needs to know the value of the proposed property in order to make a decision to lend the necessary funds. Lenders will not finance a mortgage if they think the obtainable title upon default is worthless. Potential buyers, potential sellers, lenders, and insurance companies all require the market value of real estate for marketing, financing, and insurance purposes. This is where an appraiser s services are required. An appraiser is a specially trained professional who utilizes a standard series of steps to obtain the value of any property. In essence, an appraisal functions as a detailed report of a property s value compiled by a state-licensed or certified appraiser. 9

11 It takes into account both tangible commodities and improvements, such as houses, as well as intangible commodities, such as amenities and reputation. It should be noted that the information contained within this lesson may become dated and the student may need to update his or her knowledge on the issues presented here. Characteristics of a Reliable Appraiser Real estate licensees, such as brokers, make informal value assessments on potential listings called Comparative Market Analysis or CMAs. While a licensee may suggest or approximate market value, his or her opinion should never replace that of a qualified licensed or certified real estate appraiser. An appraiser s best tools are formal education, field experience, and complete objectivity. With these skills and the completion of all state and federal licensing requirements, few professionals may come close to the expertise in real property value than that of an appraiser. Formal Education An appraiser is a very specific type of real estate professional. The job is specific and, as when this is the case, the education required is comprehensive. A truly qualified real estate appraiser must obtain thorough understanding of courses from statistics and economics to geography and sociology. Appraisers must keep up with real estate trends, architectural movements, and city planning to acquire the information needed to assess the value of any property. Many high school courses lay the foundation for solid appraisal education upon which the numerous colleges, professional organizations, private schools, and distance educators may expound. The number of educators and availability of information would seem to indicate the indispensability of formal coursework in the appraisal industry and in any good appraiser's career. 10

12 The Appraisal Foundation, discussed in detail in the next lesson, sets the minimum requirements for appraisal education. The Appraisal Foundation monitors the education requirements for all types of appraisal licenses and certifications, and has set the education requirement to increase between 35 percent and 60 percent over the next two years. Given this, an appraisal license will soon require 140 hours of education, whereas appraisal certification will require 200 hours of education with an associate s degree. For now, however, the Appraisal Foundation requires 90 hours of coursework for a license and hours for certification. Field Experience Professional, academic and technical education programs usually require some period of apprenticeship or internship and real estate appraisal is no exception. Most aspiring appraisers work under the direct supervision of an experienced appraiser, sometimes for years, prior to starting their own professional careers. It takes a lot of experience before a newly certified or licensed appraiser commands the professional esteem that gives his or her appraisal report its merit. Some universities, as well as some states, require an internship before graduation. For those students searching for an internship on their own, many appraisal companies will hire interns for research and field assistance. Objectivity Like all real estate licensees, an appraiser should be as objective as possible. Any personal interest she or he has in a particular property must be disclosed to all relevant parties. Those appraisers known for professional objectivity tend to reap the most monetary benefits of their profession and the respect from both fellow licensees and the public. 11

13 Appraisers should avoid those circumstances that are contrary to maintaining their objectivity, such as: Having personal or family relationships with a party involved with a transaction Owning property or being related to someone owning property close to or adjacent to a subject property Having an appraisal fee based upon a percentage of a property s value If an appraiser accepts an assignment with any such personal interest, then the final value estimate s credibility is lessened. USPAP and the ethics of most appraisal organizations requires that any bias or interest in a property be identified in the appraisal report, although such a disclosure will not necessarily validate an appraisal with a conflict of interest. In fact, banking regulators and federal legislation will not allow banks to accept appraisals if the appraiser has any type of interest, even if disclosed. For the sake of practicality, appraisers should simply avoid any project in which they have personal interest. In particular, it is extremely important that an appraiser's compensation is never contingent upon his or her final value estimate. Competency A value estimate is directly related to the competency of the appraiser. An appraiser can prove and improve her or his competency by: Belonging to an organization that requires mandatory continuing education Continually improving his or her skills, even when not required by law Establishing relationships with other well-respected professionals, such as bankers, brokers, and lawyers Having or obtaining experience with specific property types Having no interest in the property and not having a relationship with anyone involved in a transaction Obtaining an appropriate license or certification 12

14 Never making compensation contingent upon a report's results Foreseeing possible complications and preventing them Qualifications of an Appraiser Although there are state licensing and certification programs, the actual qualifications of individual appraisers will vary. Often, appraisers join independent appraisal organizations to prove qualification and dedication to continuing education. Professional Designations Until licensing and/or certification (discussed in the next lesson), professional designation was the primary benchmark for assessing an appraiser's qualifications. Professional appraisal associations have been in existence for many years. Some of these associations helped establish the industry standards we now take for granted. A good, professional appraisal organization: Promotes ethical standards in appraising Increases competency Gains recognition for their members as qualified appraisers Most organizations require candidates or applicants to: Prove their actual appraisal field experience Pass at least one written examination Prove their ability to complete an appraisal report by submitting a demonstration report or samples of their work product A good way to judge the validity of an association membership is to weigh it against state and federal standards. If an organization has more stringent qualification requirements and ethical standards than state and federal legislation and agencies (covered in subsequent scenes) require, then it is probably a reliable association. 13

15 For example, obtaining a designation from the National Association of Independent Fee Appraisers (NAIFA) requires that candidates prove their ethical character and field competency beyond the average state and federal requisites. Before the federal government mandated licensing, the public often confused designations given by professional associations with a state license or some other type of government permit. The public often referred to appraisers as certified even though no certification process existed. Professional Societies Taking a membership in an appraisal society helps one maintain his or her professional credentials and keep up to date in the appraisal field. These societies have gatherings, meetings, courses, and seminars. The prerequisites for membership vary widely; some are more rigorous than others. Most appraisal organizations require extra education and proof of experience to join. Below is a list of appraisal-related societies. In general, a good, professional organization will set membership requirements in excess of the Appraisal Foundation's minimum requirements. Please keep in mind that one should carefully weigh the professional benefits of joining any one of these organizations. Accredited Review Appraisers Council Publisher of The Review Appraiser Member designation: AAR (Accredited in Appraisal Review) American Association of Certified Appraisers, Inc., Cincinnati, Ohio Member designations: Non-certified: Affiliate and R-1 (Residential-First Level); Certified: CA-R (Certified Appraiser-Residential), CA-S (Certified Appraiser- Senior), and CA-C (Certified Appraiser-Consultant) 14

16 American Society of Appraisers Publisher of Technical Valuation, a professional journal, and the Appraisal and Valuation Manual Member designations: ASA (Senior Member), ASR (Senior Residential Member) and FASA (Fellow) American Society of Farm Managers and Rural Appraisers, Inc., Denver, Colo. Member designations: AFM (Accredited Farm Manager) and ARA (Accredited Rural Appraiser) American Society of Professional Appraisers, Atlanta, Ga. Member designations: CRRA (Certified Residential Real Estate Appraiser) and CCRA (Certified Commercial Real Estate Appraiser) American Society of Real Estate Appraisers, Atlanta, Ga. Member designations: RSA (Residential Senior Appraiser) and CSA (Commercial Senior Appraiser) Appraisal Institute Publisher of The Appraisal Journal and Valuation Insights and Perspectives, as well as a number of special reports and books Member designations: MA1 (Member of the Appraisal Institute) and SRA (Senior Residential Appraiser) The Appraisal Institute was created in 1990 by the merger of the American Institute of Real Estate Appraisers and the Society of Real Estate 15

17 Appraisers. Appraisal Institute members who were members of one of the earlier organizations also may have one of the following designations, although these are no longer issued by the Appraisal Institute: RM (Residential Member), SRPA (Senior Real Property Appraiser), and SREA (Senior Real Estate Analyst). Appraisal Institute of Canada Publisher of The Canadian Appraiser, a technical journal, and Appraisal Institute DIGEST, a newsletter Member designations: CRA (Canadian Residential Appraiser) and AACI (Accredited Appraiser Canadian Institute) Foundation of Real Estate Appraisers Publisher of Communicator magazine International Association of Assessing Officers Publisher of The International Assessor and the Assessors Journal, as well as many specialized booklets and manuals Member designations: CPE (Certified Personality Evaluator), AAE (Accredited Assessment Evaluator), CAE (Certified Assessment Evaluator), and RES (Residential Evaluation Specialist) National Association of Independent Fee Appraisers, Inc. Publisher of The Appraisal Review Member designations: IFA (Member), IFAS (Senior Member), and IFAC (Appraiser-Counselor) 16

18 National Association of Master Appraisers Publisher of The Master Appraiser Member designations: MRA (Master Residential Appraiser), MFLA (Master Farm and Land Appraiser), MSA (Master Senior Appraiser), and CAO (Certified Appraisal Organization) National Association of Real Estate Appraisers Publisher of Appraisal Times Member designations: CREA (Certified Real Estate Appraiser) and CCRA (Certified Commercial Real Estate Appraiser) National Association of Review Appraisers and Mortgage Underwriters Publisher of Appraisal Review Journal Member designations: CRA (Certified Review Appraiser) and, in Canada, RRA (Registered Review Appraiser) National Residential Appraisers Institute Publisher of Appraisers News Network Member designations: CMDA (Certified Market Data Analyst), GSA (Graduate Senior Appraiser), and SCA (Senior Certified Appraiser) National Society of Real Estate Appraisers, Inc., Cleveland, Ohio Publisher of National Report Member designations: RA (Residential Appraiser), CRA (Certified Real Estate Appraiser), and MREA (Master Real Estate Appraiser) 17

19 Appraisal Employment and Job Functions A professional real estate appraiser evaluates the worth of a property. Anybody may request an appraisal (an individual or a company) and it may be sought for any reason, such as determining a loan value or for insurance coverage. An appraiser submits his or her evaluation in the form of an appraisal report, for which she or he must conduct a thorough study of the property. An appraiser will take on many roles as he or she prepares the report: broker, surveyor, economist, and possibly even accountant. However, an appraiser should not engage in any activities, either expressly or implied that they do not possess education, license, or certification to practice. Employment Opportunities Many appraisers choose to join pre-existing organizations and companies. The following is a brief list of those employment opportunities of which many appraisers take advantage. Federal Agencies All agencies involved in road conservation or construction hire appraisers. In addition, the Department of Veteran s Administration (VA) and the Federal Housing Administration (FHA) appraise properties before insuring or mortgaging. There are many opportunities within both agencies. Large Businesses and Corporations Large corporations and businesses commonly employ appraisers to weigh various development plans. When considering a proposed or possible expansion site, office location, project or investment, such organizations may use appraisers to evaluate a number of financial feasibility principles, including the highest and best use (discussed at length in coming lessons). In addition, investment and commercial properties pose complex value calculations. 18

20 An experienced appraiser often needs to gather the necessary data and complete necessary computations before submitting a valuation. Appraisal Companies There are many appraisal companies networked from coast to coast that employ hundreds of appraisers within their offices. While not all appraisal companies are this big, larger appraisal companies require many licensed and certified persons to get through their daily workload. Individuals and businesses may contact such companies, or smaller, local businesses, to contract an appraiser for a particular job. Self-employment Many single-family appraisers are self-employed. Usually, homeowners call upon this type of appraiser for single-family, residential homes. Compensation Appraisers evaluating single-family homes, most frequently on behalf of the buyer or the buyer s lender, receive an appraiser's fee. These fees vary according to a job's complexity. The more time allocated to an appraisal the higher the fee. This fee is open to negotiation because outside factors, such as incurred cost and market competition, influence it. The most important thing to remember when establishing compensation is that it should not be contingent on the final value of the property in question, as this would lead to a direct conflict of interest. Federal Regulations & National Agencies The 1980s struggled with high inflation and instability in the real estate market. Idle or soft monitoring of the savings and loan industry, over estimations in the real estate market, and loose bank insurance policies contributed heavily to this economic upheaval. Federal appraisal legislation is one way that the federal government offset the 1980s economic troubles. 19

21 This lesson explains the biggest components that formed the legislation we now use: the Appraisal Foundation, FIRREA, and USPAP. These three components work together to regulate the appraisal profession. As you complete this lesson, pay close attention to how the three overlap. The Appraisal Foundation The Appraisal Foundation is not a government agency. It is a national, non-profit organization founded in 1987; however, FIRREA (an act passed by Congress in 1989 and discussed on subsequent scenes within this lesson) provides that states must adhere to the standards developed by the Appraisal Foundation. More information can be found at the agency's website. Two boards make up the Appraisal Foundation: the Appraisal Standards Board, or ASB, and the Appraiser Qualifications Board, or AQB. The Appraisal Standards Board (ASB) The Appraisal Standards Board (ASB) is responsible for establishing the rules for completing an appraisal and compiling its report. In addition, the ASB enforces the Uniform Standards of Professional Appraisal Practice (USPAP), which outlines the ethical and professional standards of real estate appraisal. Coming scenes present more information on USPAP. The Appraiser Qualifications Board (AQB) The Appraiser Qualifications Board (AQB) develops the minimum standards for state agencies to use in their respective licensing and certification laws for real estate appraisers. The AQB establishes the minimum qualifications for licensing, certification and recertification of appraisers nationwide. 20

22 FIRREA While economic cycles are complex and typically not due to a change in one economic indicator or single event, a noticeable downturn in the 1980s occurred with the deregulation of the savings and loan industry. Once deregulated, savings and loan institutions immediately involved themselves in the purchase and construction of private developments. Because these powerful institutions had a direct interest in the value of property developments, they began urging the unregulated appraisers to hit certain values. These appraisers were not subject to state or federal regulation, so many responded to the institutions' pressures by submitting false or exaggerated value reports. This singular problem coupled with the overall weak 1980s economy signaled to Congress the need for action. Congress responded to the problems with the Financial Institutions Reform, Recovery and Enforcement Act, or FIRREA. FIRREA changed more than just the appraisal industry; however, for our purposes, the provisions of FIRREA were aimed at protecting federally insured banks from fraudulent or incompetent appraisals and preventing dishonest industry pressure. FIRREA requires: That the states develop and maintain a system of licensure and certification for appraisers That the bank regulators adopt policies regarding the performance and utilization of appraisals That federal bank regulators instituted individual regulations by August (These regulations are commonly known as the final rule by lenders and appraisers.) That appraisers for bank use must be either certified or licensed That a national list of all licensed and certified appraisers is available to lending institutions 21

23 Licensing vs. Certification One aspect of FIRREA designates the difference between a licensed and certified appraiser and the professional qualifications of both: A report involving a property worth over $1 million or a one-unit to four-unit residential complex with a value over $250,000 must be completed by a certified appraiser. Any report involving a one-unit to four-unit residential complex/dwelling worth less than $250,000 or most non-residential property worth less than $250,000 may be completed by a licensed appraiser. If a licensed appraiser finds that a property is particularly large or that the appraisal report is particularly difficult, then a certified appraiser should assume the project. An accurate appraisal is important to the parties involved in any given transaction. As we learned in the 1980s, it is also important to the real estate industry and, consequently, the economy as a whole. Therefore, FIRREA requires that all state licensing and certification qualifications either meet or exceed those set by the Appraisal Standards Board (ASB) and the Appraiser Qualifications Board (AQB), the two sub-organizations that comprise the Appraisal Foundation. USPAP The Uniform Standards of Professional Appraisal Practice, or simply USPAP, is comprised of the standards set forth by the ASB for developing and reporting an appraisal that all appraisers should meet and exceed. The original USPAP was approved by The Appraisal Foundation on January 30, All 50 states quickly adopted the requirements as the minimum standards for appraisal licensure and certification once FIRREA took effect. 22

24 One should keep in mind that the Appraisal Foundation updates and publishes the standards annually and that small, as well as large, changes may occur every year. USPAP covers the following issues, among others: Appraisal Definitions Ethics Competency Rules and Jurisdictional Exception Supplemental Standards and Statements Real Property Appraisal and Reporting Review Appraisal and Reporting Real Estate/Real Property Consulting and Reporting Mass Appraisal and Reporting Personal Property Appraisal and Reporting Business Appraisal and Reporting Lesson Summary According to the USPAP (Uniform Standards of Professional Appraisal Practice), an appraisal is the act or process of developing an opinion of value, which may be requested for a variety of reasons, such as refinancing, mortgaging, insuring, and buying real property. Only a state licensed or certified appraiser (addressed in subsequent lessons) with adequate education, experience in the field and complete objectivity can render an accurate and reliable appraisal. The employment opportunities for an experienced appraiser, in both the private and public sector, are numerous. Most often, self-employed appraisers complete single-family appraisals, for which the hiring party (most likely the home buyer or lender) compensates them. While there are many ethical issues relating to home appraisal, this lesson raises one very important point: whatever the decided appraisal fee, it cannot relate to or depend on the final value estimate. 23

25 The formation of the Appraisal Foundation (a national, non-profit regulatory body) in 1987 marks the beginning of appraisal regulation. Although the society began publishing ethical and professional standards in 1987, federal law did not require adherence to the society's standards until 1989 with the enactment of FIRREA. Two boards form the Appraisal Foundation: the ASB (The Appraisals Standards Board) and the AQB (the Appraiser Qualifications Board). The ASB publishes the USPAP (the Uniform Standards of Professional Appraisal Practice) annually. This publication details the guidelines for impartial, accurate appraisals; offers definitions of key terminology; and explains the process for compiling an appraisal report. The AQB establishes the minimum standards that all states must now either meet or exceed in the education, training, licensing, and certifying of appraisers. The Financial Institutions Reform, Recovery and Enforcement Act, or FIRREA changed more than just the appraisal industry; but for our purposes, FIRREA sought to end unscrupulous lending practices and regulate the appraisal business. Initially, it required that states develop and maintain a system of licensure and certification for appraisers that met or exceeded those set by the AQB. It provided that the bank regulators adopt policies regarding the performance and utilization of appraisals. In addition, it stated that federal bank regulators needed to institute individual regulations by August (These regulations are commonly known as the final rule by lenders and appraisers.) 24

26 Lesson 2: The Value Principle Lesson Topics This lesson focuses on the following topics: Introduction Price Cost Value Value Principles and Theories 25

27 Lesson Learning Objectives By the end of this lesson, you should be able to: Apply value theories to arrive at purchase prices of real estate. Explain the differences between price and value of real estate. Explain the different characteristics of the types of real estate values. Explain how the different economic principles affect real estate values. Explain how the Principle of Highest and Best Use affects real estate values. Introduction While the previous lesson discussed what an appraiser does and the agencies and legislation which an appraiser must deal with, this lesson moves into the more specific elements of real estate appraisal concerning value. This lesson discusses the difference between basic methods of real estate valuation, including purchase price, cost, and value. It also covers the principles and theories which affect valuation and how they relate to one another. It should be noted that the information contained within this lesson may become dated and the student may need to update his or her knowledge on the issues presented here. Price Price is the accepted contracted amount, transaction charge or the value at which the property actually sells. Although it usually relates to some type of assessed value (market value, insurable value, investment value, etc.), it is not necessarily the same. Frequently, the purchase price is either equal to or less than market value. A property may sell for below an assessed value for a variety of reasons. If time is a serious factor, then an owner may accept a below-market price for the property. If a transaction is between friends or other familiar associations, then an owner may accept a below-market sale price. 26

28 Cost of Credit Few purchasers can or prefer to pay the entire amount up front and in cash when closing a real estate transaction. Almost everyone borrows at least part of the price. The amount of money it costs to borrow those funds, or the interest paid on a longterm loan, is the cost of credit. When the market is very tight and the cost of credit is very high (that is to say, interest rates are very high), few people can afford to purchase homes, as a high interest rate on a long-term loan can significantly increase the overall amount of money spent. The two sources of capital most commonly used when borrowing money are: the money market, which provides short-term financing, and the capital market, which describes the trading and funding of long-term loans. Short-term financing ranges from U.S. treasury bills, notes, and securities, to Euros and certificates of deposit. Long-term financing usually describes mortgages, deeds of trust, stocks, and bonds. For the purposes of real estate and for this course, we are chiefly concerned with the capital market, to which all of our lending institutions that fund the purchase of real estate belong. Lending institutions are, in a sense, investors. They loan individuals money with the hopes of generating profit off accrued interest. Generally, all investors fall into one of two categories: they are either debt investors or equity investors. Debt investors are more conservative; they are passive investment managers that require security interest in the property being financed. Equity investors utilize venture capital unsecured investment money that usually demands a very high interest rate and take a more active, although unsecured, role in their investment. 27

29 Cost Cost is the money paid for a good or service supplied. For example, if one builds a farm on a particular parcel of land, then cost refers to the amount spent on the land and all the supplies and labor used to construct the farm. This amount may vary greatly from an assessed value. Value Value refers to the worth of an item relative to some function or indicator for a given date. Values change as a result of various indicators; for example, the market value of real property, such as homes, often changes due to the cost of credit and inflation. A specific value estimate only relays the value opinion relative to some specific date. Consequently, an appraiser should always include both the type of value assessed as well as the assessment date. Most often, when we speak of value we are referring to market value; however, there are other value expressions. The following list covers many types of value that an individual or lending institution may ask an appraiser to estimate. Assessed Value Cash Value Rental Value Market Value Improved Value Salvage Value Mortgage Loan Value Insurable Value Depreciated Value Capitalization Value Appraised Value Replacement Value Book Value Exchange Value Leased Fee Value Inheritance Tax Value Liquidation Value Leasehold Value Value in Use Investment Value Going-Concern Value 28

30 Types of Value A few of the more common value assessments relate to market value, value in use, assessed value, and insurable value. The difference between these types of value and their use in the real estate industry. Market Value We take our definition of market value, perhaps the most important value estimate for our purposes, from USPAP (printed by the ASB of the Appraisal Foundation): The most probable price which a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus. USPAP definition of market value assumes the following: Buyer and seller are motivated Both parties are well informed or well advised Both parties are acting in what they consider their best interests A reasonable time is allowed for exposure in the open market The price represents the normal considerations for the property sold, unaffected by special or creative financing The transaction is impersonal or at an arm's length Single-family residential homeowners often ask their real estate agent or broker for a market value assessment for the purposes of sale. Likely, market value is the single most commonly assessed value estimate that real estate brokers and salespersons come across. Market value helps to establish a reasonable sale price. 29

31 Insurable Value Insurable value refers only to the amount for which an insurance company insures a property. Insurance companies only insure improvements and not the land. For example, if a farmer purchases a parcel of land on which he constructs a barn, then the insurable value could only relate to the barn. Insurable value is another common value assessment. A broker or salesperson may come across this method of assessment when helping clients with financing. Many loans require the home insurance and insurable statements. Assessed Value Assessed value refers to the value determined by the local taxing authority, which it uses for ad valorem taxation. Usually a local authority levies ad valorem taxes through property taxes. Property taxes can play a big role in the decision to purchase a particular home. Although licensees are not expected to be taxation experts, a licensee who can relay the implications of an assessed value, and/or mention the role it plays in setting property taxes will stand out from other real estate licensees. Value in Use Value in use attributes a property's worth to its ability to fulfill its intended purpose, which applies mainly to commercial businesses. Some properties are worth more than the sum of their assets because of their popularity, reputation, or integrity. For example, a very popular restaurant is worth more than a failing restaurant, even if the two restaurants are otherwise equal (same building, property lot, tools, etc.). Although this relates more directly to commercial real estate, it is important that real estate licensees understand that not all value is tangible. 30

32 Value Principles and Theories Many people in our cost-conscious society could probably look at a home and estimate its general worth, and they might not even be far off in their estimates. Almost all of us understand that certain factors influence value in certain ways. Appraisers know exactly what those factors, or principles, are and exactly how they influence value. Only a complete understanding of value principles, theories and their relationship to value can truly yield an accurate value statement. Value principles are interrelated. As the following passages indicate, sometimes it is impossible to evaluate one principle without another. Consequently, this lesson will first define a principle in-and-of-itself and then it will state to which other principles the principle in question relates. In addition, not all principles affect value equally. Some value principles are more important than others are. Generally, the importance of a particular value principle depends upon the approach to value or the method that a particular appraiser uses in a particular situation to estimate value. The dynamics of the real estate market are complex. The next lesson illustrates how different value principles interact and affect value in this complex system. For now, just focus on the meaning of a value principle, the definitions of individual principles, and the relationships between them. Anticipation The principle of anticipation states that value may change due to a predicted event. Generally, real estate, held as a commodity, appreciates. That is to say, we expect real estate to increase in value in most instances, though this is in no way guaranteed. 31

33 Various outcomes appeal to people in different ways, depending on what they stand to gain or lose (anticipation) from a particular result. For example, consider a gas station owner near a small residential neighborhood and the residents living in the neighborhood. If the city builds a large freeway right next to this neighborhood, then residents nearest to the road may anticipate a decrease in value due to noise while their neighbors five blocks away and the gas station owner might anticipate an increase in value due to a perceived increase in convenience and business traffic. Anticipation closely relates to three other principles: Change Competition Supply and demand Balance The principle of balance states that the proper relationships between supply and demand, land, labor, capital, management and consumers and producers increases value. A balanced, strong, and active economy yields higher property values, while a struggling economy hinders property value. Property values reach their highest when there is a supply that is proportional to the demand; i.e., when there is an adequate population to consume and a collection of businesses to supply. In addition, adequate land, enough laborers, a source of capital or financing, and a population of management will also contribute to high property values. Balance closely relates to these other principles: Four agents of production Conformity Contribution Surplus productivity 32

34 Change The principle of change states that no commodity remains constant and value fluctuates due to natural phenomena and market demands. This is one reason why experience is so important in regard to real estate appraising. While one may not be able to predict severe meteorological and geological phenomena, an experienced appraiser understands the principle of change and the cycles associated with it. Change closely relates to the following principles: Anticipation Inclining and declining periods Supply and demand Competition According to the principle of competition, the availability of similar properties in a local area affects the value of the particular property in question. If only a few properties of a certain type compete for the attention of many buyers, then those properties will command much higher prices than they would if there were an abundance of such properties for sale. The principle of competition is particularly important for our purposes because in appraising residential single-family homes, the availability of properties which could be substituted is one of the main ways we determine market value. The principle of competition closely relates to two other principles: Anticipation Supply and demand 33

35 Conformity The principle of conformity states that when all the homes in a given area are of similar design, age, size, maintenance, and market appeal, value increases. In essence, the principle of conformity implies two things: progression and regression. Progression Progression refers to the higher values attained when homes conform to one another. For example, a new home that appeals to current market preference is worth more when it is surrounded by other new homes in line with the current market preference. Regression Regression refers to how ill placement or a lack of conformity adversely affects value. Consider our previous example: a new home in adherence to current market preference. If this home was located around older homes with obsolete floor-plans, then its value would be less than the same home surrounded by homes with desirable floor-plans. This principle of conformity relates closely to the principle of balance. Contribution The principle of contribution states that an improvement to a home is only worth as much as it adds to the property s market value and does not relate to the improvement's actual cost. Consequently, an appraiser evaluates an improvement's contribution value, not its cost (the money paid for a good or service supplied.) Please note that value is not always directly related to cost. For example, a great landscaping plan completed by an owner can enhance the value of the home significantly, even though the cost may have been minimal. 34

36 The principle of contribution closely relates to these other principles: Balance Four agents of production Substitution Conformity Externalities The principle of externalities states that property values are influenced by outside factors such as currency rates, world conflict, the stock market, a change in tax code, and/or the development of governmental services. External influences that affect the value of a property exist at all levels (i.e., city, county, state, federal, school district, etc.) The principle of externality closely relates to the following principles: Inclining and declining periods Supply and demand Inclining and Declining Periods The student may recall the principle of change, which states that no commodity remains constant and that value will always shift as a result of natural phenomena and market demands. This occurrence creates what is called inclining and declining periods, or the three stages of a commodity's existence: growth, stability, and decline. The following explanations of these periods utilize a property as an example. Please understand that not any given property will follow this layout exactly. The following examples assume a well-built and successfully marketable home. 35

37 Growth Generally, a new property experiences a period of growth in which its short supply will drive up demand and, consequently, value. (Coming passages discuss the principle of supply and demand in detail; however, for our purposes here, understand that a high demand and low supply increase value.) A new property probably corresponds to current market tastes and needs. Because new homes are generally in short supply and, assuming no fundamental design flaw, one can conclude that, for a period of time, the property's value will continue to increase. This defines the growth period. Stabilization Some change in market taste, environment, market strength, etc., is inevitable. Consequently, either by natural phenomena, aging materials, or altering tastes, the value levels off. This initiates the stabilization period. A property enters its second stage when steady value increase stops. Decline Physical commodities diminish. While a well-laid foundation yields a valuable home for a long period, nothing retains use forever. Once demand no longer justifies the high maintenance on a property, the property enters into its third stage: decline. Inclining and declining periods relate closely to these principles: Change Externalities 36

38 Theory of Increasing and Decreasing Returns The student may recall the principle of contribution, which states that an improvement's value relates only to the value it adds to the property and not the improvement's cost. As we discuss periods of growth, stabilization, and decline, we can apply such periods to a particular improvement on a particular property. The theory of increasing and decreasing returns states that as long as the cost of a contribution's upkeep does not rise above the value of it to a property, then it justifies maintaining. This, as in inclining and declining periods for the property as a whole, is ascertained by two determining periods: one of increasing returns and one of decreasing returns. Increasing Returns When the money spent on a particular improvement yields a proportionate or greater value contribution, the law of increasing returns applies: i.e., the improvement's maintenance or the new construction proves useful. Decreasing Returns Once additional improvements or maintenance on an improvement no longer yield a positive cash flow or value contribution, then the law of decreasing returns applies: i.e., the improvement or maintenance is no longer cost-effective and should stop. The theory of increasing and decreasing returns relates closely to the following principles: Change Inclining and declining periods Opportunity cost 37

39 Opportunity Cost In economics, opportunity cost relates to the expense of time and money relative to other applications, or expense opportunities. For example, if one goes to school, then the opportunity cost, in addition to direct costs such as books and tuition, is the money lost from not working while in school or doing schoolwork. In appraisal, we use this idea to appraise income-producing properties. An appraiser takes a particular business' rate of return and then finds the rates of return among similar investment properties. The value of the subject property is relative to the investment returns of the other properties. That is, the appraiser sets a value relative to the income not gained by placing one's money elsewhere. Opportunity cost relates to these four principles: Competition Four agents of production Substitution Supply and demand Substitution The principle of substitution states that the price someone is willing to pay for a property is only as high as the amount that it takes to acquire a similar or comparable property. This idea is very important in appraising residential homes and forms the basis for the sales comparison approach to appraisal, covered in detail in the next lesson. To understand the principle of substitution, please consider the following summary of this approach. While all appraisals utilize the principle of substitution to an extent, its most direct use is in the residential appraising of single-family homes with the sales comparison approach to appraisal. According to this approach, the appraiser collects data on similar, recently sold homes within the same neighborhood. 38

40 The appraiser then adjusts the selling price of the comparable properties to reflect the subtle differences between the comparable (properties that are substantially equivalent to the subject property) and the subject home (the home currently being appraised). In general, if a buyer makes an offer on a home with an asking price of $200,000 and then finds a similar property for which the owners want only $150,000, then the potential buyer will withdraw his or her original offer and make an offer on the second home. Although the owner always sets the asking price, it is important that members of the real estate industry communicate this idea to an owner prior to the owner's final decision. The principle of substitution relates closely to the principle of contribution. Supply and Demand Similar to any other product, a property's price directly relates to the demand for the property and its availability, or supply. Property prices rise when supply decreases and/or demand increases. In appraisal, supply and demand relate to the availability and demand for a particular kind of home within a given neighborhood. This principle relates to the following principles: Change Substitution Surplus Productivity For the four agents of production land, labor, capital, and management each has a cost and profit associated with it. For example, we must initially buy land, pay taxes on it and pay for its upkeep; however, there is a return on land, which is called rent. 39

41 When considering property value, especially of income producing properties, an appraiser estimates the surplus productivity, also called the entrepreneurial incentive, which refers to the net income minus the expenses of ownership (wages from labor and management, property taxes, maintenance, etc.). An appraiser attributes a property's value to its potential to produce profit. This principle is very important to appraising investment or commercial properties and it is the principle concern of the income capitalization approach to appraisal (discussed in the next lesson). This principle is closely related to these other principles: Balance Contribution Four agents of production Highest and Best Use Of all those factors that influence value, the single most important principle to consider is the highest and best use. This principle states that there is one most profitable and efficient use of any given tract of land and that this best use should dictate a tract's development. Only a plan that fits the following criteria may be the highest and best use. Legal Financially viable Productive Physically plausible The highest and best use changes over time. A property's current use is not necessarily the highest and best use. A highest and best use study determines the current, best use by comparing present incomes, if any, against the potential incomes of the various proposals. 40

42 This study differs depending on whether or not the lot is improved or vacant at the time. Unimproved land evaluations, referred to as separate site valuations, are discussed in the coming lesson. For now, consider the ways an appraiser sets the standard for a highest and best use study when a parcel is already improved upon. Highest and Best Use Study on an Improvement When conducting a highest and best use study on an improved lot, one may use any one of the following approaches to create a standard with which to judge each potential use against the current use and one another: One could consider the lot vacant and subtract the demolition costs of destroying an existing home from the new proposals' potential incomes. She or he then compares that amount to the current use's income. One could establish the renovation cost to convert the current building and then subtract that amount from the proposed uses' incomes. He or she then compares that amount to the current use's income. One could consider the structure used as is, with the potential incomes compared directly with the current use's income, provided that the building fulfills the various proposals' needs. Lesson Summary Initially, this lesson differentiates between cost, purchase price, and value. Although these amounts often relate, they are not the same. Purchase price is the transaction charge, or the value at which the property actually sells. This price is heavily influenced by the cost of credit. Cost is the money paid for goods or services supplied. Value refers to the worth of an item relative to some function or indicator at a given date. There are different types of value. This lesson concerns itself primarily with market value the most probable price which a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus (USPAP). 41

43 Many factors, or principles, influence value. This lesson also introduces those factors that an experienced appraiser uses as she or he writes a report. Anticipation, balance, change, competition, conformity, contribution, externalities, progression and regression, inclining and declining periods, law of increasing and decreasing returns, opportunity cost, substitution, supply and demand, surplus productivity, and the highest and best use all influence value statements. Their importance depends on a job's particularities; however, it will be useful to remember the following for the continuing discussion of appraisal approaches: highest and best use, supply and demand, the principle of substitution, and contribution. The principle of highest and best use states that there is usually one most productive use for any given property, which determines the utility of a current improvement. The highest and best use of a property is not necessarily its current use. An appraiser must decide if there is a better use for a tract of land before he or she can confidently state the value of the given property. A home's value relates to the economic interaction of supply and demand at the time of the appraisal. Price varies directly with demand and inversely with supply. For example, if supply is low, then price is high; if demand is high, then price is high. For our purposes supply and demand relate to the local real estate market, such as a neighborhood. The principle of contribution states that an improvement on a property is only as valuable as the difference it causes in the property's overall value. The contribution of a particular improvement is not necessarily how much the improvement cost to add. For example, if an owner landscapes a property, then the contributing amount may be significant even though the cost of the contribution was quite small. 42

44 The principle of substitution, particularly important to the sales comparison approach to real estate appraisal, states that a buyer only pays as much as he or she would have to pay for a comparable house in a comparable area. For example, if two houses that are very similar to the subject house sell for $120,000, then it is likely the home in question will sell for around the same amount. If two houses are alike in almost every way, then a potential buyer will purchase the less expensive home. 43

45 Lesson 3: The Dynamics of the Real Estate Market/Approaches to Value Lesson Topics This lesson focuses on the following topics: Introduction Market Influences Elements that Create Value Combining Market Characteristics with Value Determinates Value Criteria Land Value Approaches Relationship between the Approaches 44

46 Lesson Learning Objectives By the end of this lesson, you should be able to: Apply value theories to arrive at purchase prices of real estate. Characterize a favorable market for real estate sales. List and explain the different types of influences on real estate value. List and explain the four elements of value. Explain how combining characteristics and determinants establish value. Describe the three approaches to value. Explain adjustments in the market value approach. Explain the different types of value using the cost or replacement approach to value. Explain how future income creates value. Explain how capitalization rates are determined. Introduction A market defines a place for buying and selling commodities; for our purposes, the commodity is real estate and the market refers to the local real estate market. Please note, however, that, although we consider the market locally, no real estate transaction occurs in a vacuum. There are local as well as national (and, especially for large developments, some international) implications to consider. Market characteristics influence value. These characteristics fall under one of the following categories: economic, social, governmental, or physical. In turn, these characteristics, when applied to our value criterions, influence value in set ways. There are four value criterions: demand, utility, scarcity, and transferability. This lesson explains market characteristics first, followed by value determinates. The Combining Market Characteristics with Value Determinates section clarifies how market characteristics and value criterions relate. 45

47 This lesson also covers three approaches to appraising a property: the cost approach, the sales comparison approach, and the income capitalization approach. These approaches are not mutually exclusive. Often an appraiser uses them in conjunction with one another. The last part of this lesson covers the process an appraiser uses to combine data from these different approaches. It should be noted that the information contained within this lesson may become dated and the student may need to update his or her knowledge on the issues presented here. Market Influences Consumers are often unaware of what causes and affects real estate value. In fact, many economic, social, and legal areas, such as the job market, city planning, and the cost of credit, affect real estate value. All of these property and market characteristics fall under one of the following categories which appraisers use to collect data, and then apply their findings to. Physical The location of the property, its age, its condition, and the climate in which it is located all affect value. An appraiser must gather information relating to all of these factors before he or she can make an accurate statement concerning value. Physical characteristics can include: 1. Proximity to shopping, schools, places of worship, public transportation, etc. 2. Climatic conditions 3. Physical hazards or natural hazards 4. Character in soil farmland 5. Size width, depth, and shape of lot 46

48 6. Action of the sun retail shoppers walk on the shady side of the street, so south or west sides of commercial streets are often preferred for business locations 7. Topography varying from level land to hillside property Social This area may seem a little broader than the physical market characteristics. Social conditions that affect property value relate to the local populations: mainly their ages, preferences, family sizes, etc. Social conditions can also include: Marriage/divorce rates Birth/death rates Social atmosphere Quality of school system, parks, cultural centers Attitudes toward law and order Social comparison people with comparable interests, similar social and economic status Governmental Governmental controls influence property use and distribution. Consequently, such controls also influence property value. These controls include property taxes, zoning laws, and rent controls. Many jurisdictions may apply to a single location. It is important that the appraiser consider all applicable local, state, and national controls. Political or governmental influences can also include: Building codes Mass transportation system Adequate fire and police protections Legislation with attention to solution of community problems 47

49 Economic Economic characteristics include the local median income, interest rates, and the availability of financing. Many of these factors extend beyond the local real estate market. In real estate, one of the most important economic characteristics is the cost of credit. Economic factors may also include the following: Job opportunities in the area Salary/wage levels Inflation Elements that Create Value The previous information relates to the data that an appraiser collects on a property. As with property, though, the value of the data is not just in having, but also in attaining it and how it is used afterward. The following information deals with how the appraiser applies the collected data to the following value criterions: demand, utility, scarcity, and transferability. Demand: The desire and capability to purchase a commodity. For a commodity to be valuable, it must be in demand. Demand is an economic concept that implies not only the presence of a need but also the existence of monetary power to fill that need. Wishful-Buyer thinking or necessity, alone, no matter how strong does not constitute demand. To bring about demand, the purchasing power must be available to satisfy the perceived need. Utility: A commodity's actual or perceived purpose. For a commodity to be valuable, it must fulfill some purpose. It is the power of a good to render a service or fill a need. Utility must be present for a good or service to be of value. Scarcity: The unavailability of a desired commodity. Valuable commodities are often in limited supply. 48

50 Scarcity is a relative term and must be considered in relation to demand or supply and the alternate uses, present or prospective, to which the good or service may be put. For example, Christmas trees may be scarce the day before Christmas and most abundant the week after. The value will fluctuate accordingly. Transferability: A commodity's ability to change hands. For a commodity to be valuable, it must be transferable. Even if the characteristics of utility, scarcity and demand are present, if the good or thing cannot be transferred in whole or in part, market value cannot exist. For example, the moon may have utility, it is scarce with only one, and there might be a demand for it if ownership and use of it could be controlled. The lack of transferability, however, keeps the moon a greed good marketwise. Transferability does not necessarily mean physical mobility it means rather the possession and control of all the rights which constitute ownership of property. An appraiser must establish the presence of all four of these features and the relationship between them in order to establish value. Demand and scarcity are not unlike supply and demand on a local level. If in a neighborhood there are only three given houses of a particularly popular style, then those three homes are worth more than if there were many homes of that style. Generally, a home is a useful commodity; however, a poor design or the presence of obsolete features lowers the value of any property. In real estate, transferability refers to title. A property with an easily transferable title is more valuable. If there are many limitations to a potential buyer's ownership rights or an outstanding lien, then a home is worth less. One might say that the most scarce, useful, desirable properties with the easiest title to transfer are the most valuable. 49

51 Combining Market Characteristics with Value Determinates Demand, utility, scarcity, and transferability determine value, but how do these determinates relate to the previously discussed social, political, and economic market characteristics? Market characteristics influence demand, utility, scarcity, and transferability, which in turn have an effect on value. The following scenes contain a series of exercises to better acquaint you with the relationship between market characteristics, value determinates, and actual property value. Relationship Charts Although the market characteristics are complex, please consider the following chart as a simple demonstration of value relationship: Market Characteristic Value Determinates Affected Physical: Property Location Demand/Scarcity Value Increases Near a park with a lake There is a high demand and scarce supply of lake properties An appraiser notes that the property in question is near a lake. She or he then applies the idea to the four value determinates. The above illustrates how the physical characteristic relates to the criteria s scarcity and demand. Generally, lake properties are scarce and in high demand. According to our criteria, this increases value. The student may note how other ideas, such as consumer preference and even substitution, relate to the above ideas. There are many interwoven relationships to consider; the above illustrates one. 50

52 Similarly the following chart is another demonstration of value relationship. Market Characteristic Value Determinate Affected Governmental: Liens Transferability Value Decreases Two outstanding liens A title with outstanding encumbrances complicates transferability To be valuable, a commodity must be able to exchange hands. Limited title prevents this, a negative characteristic met by two liens. Two liens limit the transferability of title, and, consequently, decrease the property's value. Market Reading Given the following market description, consider the effect on the four value determinates. Again, although actual markets are much more complex, this demonstration keeps the relationships simple for the sake of time and educational illustration. Market Description Pleasant Town is a new development springing up around a manufacturing plant an hour's drive from an established urban center. Although the new development has a strong, adequately growing infrastructure, there are few established public amenities and neither a park nor a library. In addition, the nearest school is within the neighboring, older city. The house in question is standard for the area, welldesigned and brand new, with no outstanding liens. Value Criteria Most of the description above relates to physical characteristics. A real market would have many other characteristics to consider. Here we will apply just the previous information to our four value criterions. 51

53 Characteristics Relevant to Demand: The property s location provides employment opportunities. The property's nearby infrastructure continues to grow. There are no public amenities. The home is new and well-designed. There are a multitude of relevant characteristics. For now, just consider these. Effects: There is a demand for housing. While it will change over time (possibly in connection with the factory's economic health), for now value increases because demand is high. Note the close connection between the factory and the source of demand. Without public amenities or other incentives, the factory is our principle source of demand. Characteristics Relevant to Utility: The home meets contemporary standards and functional preferences. The neighborhood has a strong infrastructure. Effects: A functional, new house is useful. The home meets our utility requirement. Value exists or increases. Characteristics Relevant to Scarcity: This determinate closely ties into demand. Real property is scarce and, therefore, generally valuable; however, here we must consider the property's local scarcity. A standard house is not particularly scarce. Effects: Since it is common, the house is not scarce. Consequently, value decreases. Characteristics Relevant to Transferability: Title is clear. There are no outstanding liens. Effects: A clean new title meets transferability requirements. Value increases. 52

54 Property Value Summation Scarcity within the neighborhood for the home in question is average and nearby employment opportunity drives the increase in demand. (Information on factory output, expansion, etc., may be useful in determining value and the likelihood of retaining value.) The utility of the home is high because it is new and well-designed. This, coupled with the easily conveyed title, increases the property's value. Land Value Approaches The following scenes outline three of the most common approaches to valuation: sales comparison, cost, and income capitalization. Sales Comparison Approach The sales comparison approach to appraisal utilizes two value principles that the student may recall from Lesson 2: contribution and substitution. The value principle of substitution states that a person will only pay as much for a property as he or she must pay to acquire a comparable property. The principle of contribution states that an improvement to a home is only worth as much as it adds to the property s market value and does not relate to the improvement's actual cost. With this in mind, the sales comparison approach, also called the market data approach, requires an appraiser to collect the recent purchase prices of properties similar to the property she or he is appraising. The appraiser then notes the differences between these homes, called comparable and his or her assignment, called the subject property. The appraiser adds or subtracts the contributing value of these differences, called adjustments, and takes the remainder as the subject property's value. Please look at the equation below: Comparable Property Purchase price ± Adjustments = Subject Property Value 53

55 Appraisers rely heavily on this approach for appraising residential properties and vacant land. For our purposes, be sure to remember that all adjustments are made to the comparable purchase price, not the subject property. That is to say, if the subject property has a swimming pool and the comparable does not, then the appraiser adds the contributing value of the pool to the purchase price of the comparable. If the comparable has a swimming pool and the subject property does not, then the appraiser subtracts the pool's contributing value from the comparable property's purchase price. Types of Adjustments There are many factors for which an appraiser may adjust the comparable's purchase price. We group these factors into three categories: on-site features, offsite features, and sale conditions. On-site features that necessitate adjustment relate to the physical differences between two properties, including our previous example with the swimming pool. An appraiser adjusts for any property differences, such as the number of bedrooms or bathrooms, fireplaces, pools, covered decks, carpet type, windows, etc. In essence, any physical inconstancy with a contributing value. Off-site differences relate to location. These characteristics may include a closer proximity to public amenities, a noisy street or railroad tracks. A sale condition may also necessitate adjustment. For example, creative financing may have influenced the comparable's purchase price. The appraiser would adjust for all these conditions. Adjustment Examples Complete the following exercises using the sales comparison approach to appraisal. 54

56 On-Site Differences Appraiser A wants to find the value for Home B. He finds out that Home C recently sold up the street for $120,000. The houses are very similar except that Home C has an extra half-bath with a contributing value of $500. Home B Home C Question 1: Which home is the subject property? Question 2: Which home is the comparable property? Question 3: Using the sales comparison approach to appraisal, fill in the appropriate home in the appropriate spot. $120,000 ( ) $500 (contributing value) = $119,500 ( ) 1: The subject property is the home the appraiser is currently appraising (Home B). 2: A similar, recently sold home that an appraiser uses to estimate the value of the subject property (Home C). 3: The comparable (Home C) has a bath with a contributing value of $500. Subtract this amount from the purchase price to compensate for the difference and arrive at the subject property (Home B)'s value. Off-Site Differences Appraiser B is currently appraising several homes within a five-mile radius around a park. She wants to establish the contributing value of park proximity, so she takes two otherwise identical homes: Home A, within a mile radius, and Home B five miles away from the park. Home A sold for $100,000. Home B sold for $95,000. What is the park s contributing value? 55

57 Answer: Take the difference between the two homes. $100,000 X = $95,000. So the contributing value is $5,000. Sale Condition Differences Subject Property W is 10 years old. Appraiser Y finds a comparable property that is also 10 years old, which sold for $80,000 six months prior. She knows that changes in the market affect purchase price and determines that, for various reasons, property values increased 5% over the six months. Using the sales comparison approach to appraisal, what is the value of Subject Property W? Answer First, multiply $80,000 by.05. This results in $4,000. If you add that to the comparable value, the subject property s value is $84,000. Appraising Vacant Land Appraisers usually use the sales comparison approach to value to appraise vacant lots as well. An appraiser will find similar parcels and adjust for any on-site, off-site, or sale condition differences. Such differences might include soil integrity, terrain, size and/or shape, zoning ordinances, favorable location, and the presence of utilities. Arm's-Length Transaction Although the appraiser adjusts for subtle differences in a property, she or he must carefully examine the condition of sale. If the appraiser finds that the sale did not occur at an arm's-length, then he or she should pick a different property. An arm'slength transaction refers to a transaction in which neither the seller nor buyer act under undue duress. Only an experienced appraiser can absolutely separate those sales conditions that she or he can adjust from and those that provide undue duress; however, consider the following exercise illustrating those transactions that pose undue duress. 56

58 Select those conditions that may prevent an arm's-length sale. 1. The seller's company transferred her to a new city and she must move immediately. Yes No 2. The home is put up for sale for tax delinquency. Yes No 3. The city recently zoned a landfill nearby the home. Yes No 4. The seller failed to disclose the untreated mold growth in the bathroom. Yes No 5. The buyer is the seller's son-in-law. Yes No Feedback: Numbers 1, 2, 4, and 5 are not conducted at an arm's-length. In the first sale, the seller needs to sell the home as quickly as possible. This means that the home may not remain on the market long enough to fetch the property's market price. In this case, the appraiser should probably choose another property. In example 2, time is also a key factor. Without adequate marketing time, the sale condition is not at an arm's-length. In example 4, the seller failed to disclose pertinent information and this pushed undue stress onto the buyer. The fifth example may be the simplest example of an arm's-length complication. When there is a direct relationship between a buyer and a seller other than the terms of sales, the sale is probably not at an arm's-length. 57

59 When trying to decide if a transaction is at an arm's-length, keep these general rules in mind: Forced sales (foreclosure, tax sale, estate liquidation, etc.) do not constitute a sale at an arm's-length. If the principals know each other outside the sales transaction, then it is not at an arm's-length. Extremely creative financing and/or little or no down payment will compromise an arm's-length sale. Cost Approach Using the cost approach to appraisal, an appraiser estimates the value of a property by separating out the land value and value of all the present improvements. To approximate the value of the improvements, the appraiser estimates their replacement or reproduction cost: the price of such an improvement, new, at current prices. The appraiser then subtracts any depreciation on the actual improvements to calculate the current value of the improvements. The appraiser adds this amount to the estimated site value, usually found through the sales comparison approach. Consider the following equation: Reproduction Cost of Improvements - Improvement's Depreciation + Site Value = Property Value Depreciation All commodities depreciate and real property is no exception. Two causes of depreciation: deterioration and obsolescence. Deterioration occurs through wear and tear or exposure to the elements. Changing laws and tastes most commonly cause obsolescence, which we separate into functional obsolescence and external obsolescence. Functional obsolescence is due to an outdated layout or design. 58

60 Often, zoning laws, supply and demand, or a changing highest and best use cause external obsolescence. Steps in the Cost Approach to Appraisal The cost approach to appraisal requires several steps. Initially, consider the list below. Afterwards, an example will illustrate each step. Note that to establish the value of land, an appraiser uses the sales comparison approach. An appraiser calculates the value of the building and the value of the land independently. 1. Establish the improvements reproduction cost. 2. Find the depreciation in dollars on the existing building. 3. Establish the value of a comparable land parcel. 4. Make the necessary adjustments to the comparable parcel. 5. Combine the figures from the previous steps into the cost approach formula. 6. State the value of the subject property. Cost Approach Examples Complete the following exercise using the cost approach to appraisal. Appraiser Y wants to find the value of Office Building A. Office Building A would cost $400,000 to construct today. In light of this, Appraiser Y concludes that the building has depreciated by 20%. In addition, he finds a vacant and nearly identical parcel nearby that sold for $100,000 early that year. The comparable land has a small hill, which makes it more valuable than the subject property. Appraiser Y estimates this difference at $1,000. What is the value of the subject property, Office Building A? For the answer, complete the following steps: This problem has two parts, the sales comparison steps for the land valuation and the cost steps for the improvement valuation. Let us begin with the cost. 59

61 Step 1: Cost approach steps 1. Establish the reproduction cost of Office Building A. 2. Find the depreciation in dollars. x = Step 2: Establish the site value using the sales comparison approach. 1. Establish the value of the comparable parcel. 2. Subtract the adjustment to establish site value. = Step 3: Combine the information above in the cost approach equation. + = 2. What is the property value of Office Building A? Answer Key: Step 1: 1. $400,000 (cost to construct today) 2. $400,000 (reproduction cost) x 20% (depreciation extent) = $80,000 (depreciation loss) 60

62 Step 2: 1. $100,000 (comparable parcel cost) 2. $100,000 (comparable) - $1,000 (contributing value) = $99,000 (site value) Step 3: 1. $400,000 - $80,000 + $99,000 = property value 2. $419,000 Income Capitalization Approach The income capitalization approach calculates property value in relation to the profit that an owner expects from a property over the course of his or her investment. Value then equals the net income a property will produce over its remaining economic life or the profit the property will generate before it diminishes due to obsolescence or deterioration. Before continuing on the income capitalization approach, please review the following terms: 1. Net Operating Income: An annual representation of realized profit (gross income minus operating expenses). 2. Effective Gross Income: All the sources of income, including rent, minus vacancy and collection expenses (i.e., non-payment, late payment, etc.). 3. Operating Expenses: All the costs associated with maintaining and running the property. 4. Potential Gross Income: A property's maximum profit opportunity providing for no vacancies or collection losses. 5. Rate of Return: An investor's percentage yield based off a property's income. 61

63 With these terms in mind, the value of the property equals the net operating income or the difference between the effective gross income and all operating expenses divided by the rate of return. To arrive at an adequate net operating income, an appraiser must utilize a thorough calculation of income and expenses. In essence, there are four steps to calculating value using the income capitalization approach: Estimate the potential gross income, which is the profit assuming no vacancies or collection losses. Establish the effective gross income by subtracting vacancies and collection losses from the potential gross income. Determine the annual net operating income by subtracting all annual operating expenses from the effective gross income. Divide the net operating income by the rate of return, also called the capitalization rate. Once an appraiser has the potential gross income, she or he utilizes the following equations, which illustrate the steps. Equation 1: Effective Gross Income Potential Gross Income - Vacancies and Collection Losses = Effective Gross Income Equation 2: Net Operating Income Effective Gross Income - Operating Expenses = Net Operating Income Equation 3: Property Value Net Operating Income Capitalization Rate = Property Value 62

64 Income Capitalization Approach Examples Complete the following exercise using the income capitalization approach to appraisal. Investment Property X yields a net annual rental income of $50,000. The investors expect a 20% return on their various investments. The investors wish to sell Investment Property X. What should their asking price be (what is the market value of Investment Property X)? Answer $50,000 (Rental Income) = 20% (Return on Investments) $250,000 (Market Value) Uses for Income Capitalization Approach The cost approach and the sales comparison approach to appraisal have their relative uses in valuing of single-family residencies; however, appraisers only use the income capitalization approach for income-producing properties (i.e., commercial properties or investment properties). Because single-family residencies are not usually income-producing properties and because the cumbersome income capitalization techniques often fail to produce a figure representative of the home's actual purchase price, appraisers do not typically choose this method for evaluating single-family homes. Relationship between the Approaches The three approaches for appraisal are intertwined. Consider the use of the sales comparison approach within the cost approach equation. 63

65 Following texts outline how an appraiser decides on which of the appraisal approaches to use and the relationships between them. Choosing an Approach All three approaches to appraisal require different information. For example, to use the cost approach, the appraiser must receive construction costs. To use the sales comparison approach, an appraiser must have access to the purchase prices of comparable properties. To use the income capitalization approach, an appraiser must know a property's investment return and figures relating to personal investment amounts. Depending on the particular job, sometimes this information might be unavailable. The availability of information influences which appraisal approach an appraiser uses. A property's use also influences this decision. Previously the lesson explained that the income capitalization approach is overly complex and often inaccurate when applied to single-family residential homes. An appraiser considers the nature and use of a particular property before deciding upon a particular approach over another. In general, appraisers ask themselves the following questions. After reviewing the questions, we provide a series of answers. Depending upon the answer and given the information within this lesson, choose the most appropriate approach to appraisal. Is the property a commercial property? Is the property a single-family residence? Is there access to information on the purchase prices of comparable properties? What information is the appraiser unable to access? A building's use is the single most important factor to consider when deciding which approach to use. In light of this, think about the following situations. Which approach would formulate the basis of your appraisal if you were the appraiser? 64

66 1. The property in question is a residential home near a similar home that sold for $100,000 earlier the same month. Which approach to appraisal is an appraiser likely to use? Answer Sales Comparison: The sales comparison approach to appraisal is most commonly used for residential homes. Provided that the appraiser has access to comparable properties, it will almost always formulate the basis of his or her value estimate. 2. The property in question is a large office building downtown with an investment return of 10%. Which approach to appraisal is an appraiser likely to use? Answer: Income Capitalization: More than likely an appraiser will calculate the purchase price relative to the profit the building will yield as an investment over the course of its economic life. Given the previous information and exercises, you may have arrived at the following beliefs, which most appraisers hold. (Although these rules formulate the basis for an appraisal, an appraiser often combines approaches within a single job and some properties, introduced on subsequent pages, do not fall neatly into the given groupings.) Nevertheless, in general: The sales comparison approach is most reliable for single-family homes. The cost approach is usually most reliable for non-income-producing properties other than single-family residences. The income capitalization approach is most reliable for commercial or income-producing properties. 65

67 Combining Approaches Even with the previous rules, an appraiser usually combines approaches, especially if she or he needs to separate the improvement's value from the land value. For example, if an appraiser uses the cost approach to appraise an improvement, he or she must separate it out from the land's value. If an appraiser completes a tax valuation, the appraiser must also separate out the value of the improvements from the value of the land. Complicated Building Uses Single-family residential homes rely on the sales comparison approach. Investment properties rely on the income capitalization approach. These divisions may seem clear, but what about the properties which do not fall neatly into one of these two groupings? Consider schools, hospitals, and government-owned buildings. These examples are neither single-family residencies nor traditional income producing properties. An experienced appraiser must consider these types of properties on a case-bycase basis. Examine the following example, which illustrates how an appraiser might handle appraising a schoolhouse, which would constitute a complicated building use valuation. If a 30-year-old schoolhouse were sold, which of the appraisal approaches would be used? Which of the approaches discussed would best form the basis of the valuation? Schoolhouses are sold very rarely. Due to this, there will probably be no comparable properties. Without any comparable properties, the sales comparison approach does not work. The income capitalization approach might work, if the schoolhouse could easily convert into offices or another standard commercial use. 66

68 Without these important pieces of information, however, the cost approach would likely be the most useful way to form the basis of this particular appraisal. More than likely, the high cost of reproducing such a building today would constitute the building's major selling point. Lesson Summary This lesson introduces the idea of a market, which is a place for buying and selling commodities; for our purposes, the commodity is real estate and the market refers to the local real estate market. The value principles described in the previous lesson play out in any number of ways within this market. This lesson introduces two market characteristics and value criterions. An appraiser gathers information on market characteristics or conditions. These characteristics represent one of four types: social, physical, economic, or governmental. Social characteristics relate to the local real estate market's demographics: its population, average age, family size, consumer preference, etc. The physical characteristics relate to the area's climate and the property's age, size, and condition. Economic characteristics include the cost of credit, the availability of financing and interest rates. Governmental controls also influence value. These controls include all applicable taxation and zoning laws. An appraiser applies these characteristics to the four value criterions: demand, utility, scarcity, and transferability, to discover how they affect value. For example, if a home were located near a lake, then the appraiser would note this physical characteristic. He or she would then apply this to the value criterion of demand. Properties near lakes are in high demand, thus, they have increased value. The appraiser could then apply the characteristic to scarcity. Generally, lake properties are scarce. Consequently, value increases. 67

69 This lesson also covers the three most common approaches to property valuation: the cost approach, the sales comparison approach, and the income capitalization approach. These appraisal methods are not mutually exclusive. Often, an appraiser uses more than one technique on a single project. In particular, the cost approach to appraisal necessitates the use of the sales comparison approach to appraisal, as illustrated below. Using the sales comparison approach, an appraiser equates the subject property's value to the purchase price of a comparable property plus or minus adjustments for the contributing value of on-site, off-site, or sale condition differences. This method is used almost exclusively for single-family residences, vacant lots, and site valuation in the cost approach. It uses the following equation: Comparables Purchase Price ± Adjustments = Property Value Using the cost approach, the appraiser estimates value equal to an improvement's reproduction cost at current market prices minus depreciation. The appraiser adds this amount to the estimated site value, usually found through the sales comparison approach. The cost approach is most commonly used to appraise nonincome-producing properties that are not single-family homes. It uses the following equation: Reproduction Cost of Improvements - Improvement's Depreciation + Site Value = Property Value 68

70 Using the income capitalization approach, appraisers estimate the value of a property by the amount of income it can be expected to produce over the course of its economic life. The value of the property is equal to the net operating income or the difference between the effective gross income and all operating expenses divided by the rate of return. This is used exclusively for income producing properties and utilizes the following equation. Net Operating Income Return (Capitalization) Rate = Property Value 69

71 Lesson 4: The Appraisal Process & Real Estate Appraisal Practice Lesson Topics This lesson focuses on the following topics: Introduction Eight Steps of the Appraisal Process Completing a Residential Appraisal Field Applications of Appraisal 70