MODULE 7-A: APPRAISALS, BPOS AND USPAP

MODULE 7-A: APPRAISALS, BPOS AND USPAP LEARNING OBJECTIVES One of the most challenging aspects of the real estate business is the development of prices or values of the rights to real estate. Buyers and sellers need guidance from experts before setting listing prices or preparing offers, as do any professionals involved in the real estate decision-making process. Appraising is a specialty in the real estate business requiring professional qualifications. Regardless of the reason for the appraisal, it is necessary to follow the steps in the appraisal process to consider all social, political, and legal aspects that affect the income-producing characteristics of the real estate. LECTURE OUTLINE I. Licensing of Fee Appraisers (in Indiana) A. Any fee appraiser must be a licensed or certified appraiser or broker to charge to appraise. B. Employees of mortgage loan institutions are now required to be licensed if making an appraisal for lending purposes. C. Education: The current Appraiser Qualifications Board (AQB) minimum education criteria are outlined in the table below. In addition to required education hours, there is also a uniform state licensing/certification examination and a college degree requirement for the certified levels. Minimum Criteria for Appraisal Education Hours Level Hours Appraiser Trainee 75 Licensed Residential Real Property Appraiser 150 Certified General Real Property Appraiser 300 Two hundred classroom hours, 2,500 hours of experience and passing a state examination are required to become a licensed residential appraiser to do primarily residential mortgage appraisals. Other licenses include the trainee license until the initial experience is gained, the certified residential license, and general certified license that allows the appraiser to appraise any type of property. Each additional license requires additional education, experience, and testing. RECP Broker Transition Course Manual - Student Class 7-A, Page 175

II. Appraisal: An Estimate of Value A. An estimate of value in writing; B. Of specific rights in real property; C. As of a specific date; D. For a specific purpose. III. Reason for an Appraisal: Provides a Basis for Real Estate Decisions A. Decision to sell by the present owner(s). B. Provide guidance to purchase in making offers. For the purchase of a previously occupied home. In today s market, changing building costs have a major effect on the value of existing property. C. Governmental reasons might include: 1. Tax assessment. For property and special assessments. 2. Condemnation proceedings. Due to the necessary acquisition of property. D. Necessary for mortgage lending decisions. A mortgage lender needs information to aid in making a decision on the advisability of making a mortgage loan. Most banks and savings and loans are regulated and require appraisals to be made by competent appraisers. E. Insurance. An insurance company may make an estimate of value to assist a client in determining the amount of coverage. F. Definition of Value: Value for what purpose? There may be several values for the same property at any one given time. 1. Property assessment for tax purposes. 2. Insurance value. 3. Loan value. 4. Condemnation value. 5. Federal estate tax value. 6. Liquidation value. IV. Market Value The most probable selling price of a property, based upon the three evaluation techniques: A. B. C. RECP Pre-License Broker Course Manual - Student Class 7-A, Page 176

V. Cost Versus Price A. Price What a particular purchaser agreed to pay and a particular seller agreed to accept in their transaction. Thus: Sales price. B. Cost The total dollar expenditure for the property. It includes not only the price but all the additional items such as closing costs or other expenses related to acquiring the property. Sometimes cost and price will be equal, but many times not. VI. Factors Influencing Value A. Internal Factors Influencing Value Include: 1. Location Can be the greatest single contribution to market value of any particular property. 2. Utility The highest and best use of the property must be studied when considering the capacity of the property to produce income. 3. Scarcity The supply of the type of real estate will add or subtract value. 4. Effective Demand The desire backed by the ability to satisfy the desire. 5. Leases on the subject property Are the rents collected above or below the market value? B. External Causes of Change in Property Values 1. Governmental regulations have a great effect on the valuation of property, such as FHA appraisal standards for the valuation of property. 2. Social and economic changes. a. Neighborhood changes Mix between single and family owner occupied and rental property. b. Changes in surrounding properties From residential to commercial and the resulting changes in use. 3. Physical factors Can be both external and internal. External would include services provided to the property. Internal would be the effects of depreciation. C. Other Economic Factors Affecting the Value of Real Estate 1. Highest and best use The legally permissible use that will generate, when capitalized, the greatest net present value of income. 2. Substitution The concept that the value of a property is equal to the cost of acquiring an equally desirable substitute. 3. Conformity The property must be used in such a way as to conform to surrounding land uses if the maximum value is to be obtained. Zoning and deed restrictions are often implemented to maintain conformity. 4. Competition Based on the results of supply and demand for a property. RECP Pre-License Broker Course Manual - Student Class 7-A, Page 177

5. Contribution The value of a component part of a piece of property that is equal to what the component part adds to the total value. The net contribution is the result after deducting the cost. 6. Change in uses, etc., will affect value. 7. Anticipation Value will change with the expectation of the occurrence of some future benefit or detriment affecting the property. 8. Determination of land use: a. Zoning determines how land may be used or improved. b. Market forces and prices of the property compared to economic returns. 9. Assemblage and plottage. Increased value received for putting two or more parcels together, thus getting greater utility. VII. Depreciation Several types of depreciation exist and may include one or all of those listed below: A. Physical Deterioration Physical deterioration causes physical depreciation to occur, thus causing a loss in value to the property. It is an internal force causing a decrease in value. B. Functional Obsolescence A loss in property value because of a loss in the ability of the physical property to provide services as compared with alternatives. Example: Poor floor plan. C. Economic or Locational Obsolescence. A loss in property value from external forces that unfavorably affects the income of the property. Example: Chemical plant that emits fumes near the subject property. D. Curability 1. Curable An item causing depreciation may be replaced or repaired. 2. Incurable An item causing depreciation that cannot be feasibly replaced for an economic reason or simply because of the impracticality of it. The cost to fix exceeds the value created by the improvement. Examples: a. Physical curable. b. Physical incurable. c. Functional curable. d. Functional incurable. E. Estimating Depreciation It is important to recognize the methods; however, the calculation of depreciation based on the different methods must be left for study at a later time. Several methods of depreciation exist to represent the loss in value from a cost to build a like structure today. The methods include: 1. Straight line Divide the economic life into 100% to get the rate. Multiply the effective age by the rate to get the percent of depreciation. Multiply the percent of depreciation times the cost new to get dollar amount of depreciation. RECP Pre-License Broker Course Manual - Student Class 7-A, Page 178

2. Capitalization Capitalizing the loss in income by the causes of depreciation. 3. Market Using an amount derived from market information. 4. Breakdown Itemized list of causes and costs to correct. VIII. The Appraisal Process In arriving at an opinion of value as of a specified date, the appraiser must go through a certain process. This procedure, called the appraisal process, is as follows: A. Define the Problem 1. Identify property to be appraised. Street address and legal description. 2. State objective of appraisal. 3. Define value involved. 4. Set date appraisal estimate is desired. Also, discuss the effective date that is the date the value is placed on the property (not necessarily the date of the report). The effective date may be past or present as instructed by the client. B. Preliminary Survey and Appraisal Plan 1. Estimate of highest and best use of property. 2. Estimate a. Data needed. b. Time required. c. Costs involved. 3. Fix fee to be charged. Fee is predetermined by figuring costs, time, overhead and profit. 4. Get written commitment from client. C. Plan Appraisal 1. Preliminary outline for report. 2. Outline work required. 3. Data collection and analysis. One of the most important aspects of the appraisal process is that of collecting and analyzing the data of the property. It can be broken down into major categories. a. General. Includes the areas of economic base studies, money markets and general market analysis of all geographical areas affecting the property (all locational and economic factors). b. Specific subject property data. Includes physical characteristics, title data and analysis of highest and best use of the land. Such information would include access site dimensions, size of land and elevation. RECP Pre-License Broker Course Manual - Student Class 7-A, Page 179

D. Apply Three Methods or Approaches to Value 1. Cost Approach a. Application (1) Estimate market value of land by comparative land sales as if vacant. (2) Cost of new improvements. a) Replacement cost most commonly used. ii) Quantity survey. Cost per square foot. iii) Unit in place. iv) Index if historic cost is available. b) Reproduction cost. Cost of creating an exact duplicate. (3) Adjust for accrued depreciation (i.e., less depreciation). a) Physical Curable and incurable. b) Functional Curable and Incurable. c) Economic Usually only incurable. (4) Add land value to depreciated value of building to get value. b. Critique of Cost Approach. Not always used, but especially helpful when appraising new construction or special use properties. May be the only way to appraise certain types of unique buildings that do not sell very often or have income streams. The greatest problem is that it is difficult to measure depreciation if the property is older and suffers from a lot of depreciation; difficult to discern properties that are not at highest and best use. Example: Cost Approach Problem A four-plex has 5,000 square feet of building area and would cost $47 a square foot to replace today. The property had an economic life of 50 years and an effective age of eight years. The lot has been valued at $26,000 by a market comparison. The appraiser would value the property in the following way: 5,000 sq. ft. x $47 = $235,000 cost to replace 50 year life = 2% per year straight-line depreciation 8 years x 2% = 16% depreciation $235,000 x.16 = $37,600 accrued depreciation $235,000 Cost to replace -37,600 Accrued Depreciation $197,400 Present value of building + 26,000 Land value $223,400 Total value of the property RECP Pre-License Broker Course Manual - Student Class 7-A, Page 180

2. Income Approach a. Application (1) Determine income (rental schedules, etc.). a) Gross possible income (as if 100% occupied). b) Less an allowance for vacancy and collection loss. c) Effective gross income. (2) Determine expenses. a) Fixed. b) Operating variable expenses based on occupancy. c) Reserve for replacements of equipment such as furnace or a roof. (3) Estimate remaining useful life. (4) Apply appropriate capitalization rate to net income. Capitalization rate is a percentage. Capitalization is the mathematical process for converting current net income into indication of value. I = Net Annual Income R = Capitalization Rate V = Value I = RV R = I/V V = I/R a) The gross annual income is derived by deducting an allowance for vacancy and collection loss from the gross possible income. b) The net annual income is derived by deducting total operating expenses from the gross effective income of the property. c) Select an appropriate capitalization rate. This step is the most essential and the rate should be calculated most carefully so as to reflect accurately all risks involved. d) Divide the net annual income by the capitalization rate to arrive at the appraised value. Example: Income Approach Problem The same four-plex used in the cost approach example rents for $650 per month per unit. The operating expenses are 30% of the effective gross income. The vacancy rate is 5%. The capitalization rate of 10% to be used consists of a 2% recapture rate and 8% risk rate. The appraiser would value the property in the following manner: RECP Pre-License Broker Course Manual - Student Class 7-A, Page 181

$650 x 4 units x 12 months = $31,200 potential gross income $31,200 x.05 vacancy rate = $1,560 vacancy loss $31,200 Potential gross income -1.560 Less vacancy loss $29,640 Effective gross income $29,640 x.30 expenses = $8,892 expenses $29,640 Effective gross income -8,892 Less: operating expenses $20,748 Net operating income Value = net income / capitalization rate $207,480 = $20,748 / 0.10 b. Critique of Income Approach. Used where income data on subject property is readily available, i.e., apartment building. Suits incomeproducing properties; adheres to technical definition of value as it relates to income; if calculated properly, indicates the amount of risk involved in the property from the standpoint of the purpose of the appraisal. Depends on the availability of comparable rental information and having access to historical expenses. 3. Development of the Gross Rent Multiplier a. Definition: A unit of comparison derived from comparable sales. Value is determined by multiplying the factor (multiplier) by the gross income of the subject property to arrive at market value. b. Development. The multiplier is developed as follows: (1) Sales and income data are gathered on comparable properties. (2) The multiplier for each comparable is calculated by dividing its sales price by its gross income. Example: Gross Rent Multiplier Problem Using the four-plex used in the previous examples. The resulting multipliers are utilized to arrive at the gross rent multiplier (GRM). Some multipliers are computed annually. Sales Price Gross Monthly Rent Multiplier $200,000.00 $2,000.00 100 $196,300.00 $2,200.00 88 $225,000.00 $2,500.00 90 $204,250.00 $2,150.00 95 With certain market data shown above, we might conclude properties in a certain neighborhood are selling for 90 times their gross monthly rent. RECP Pre-License Broker Course Manual - Student Class 7-A, Page 182

If your subject property is renting for $2,600, then $2,600 time 90 equals $234,000.00, the estimated value using the GRM. 4. Sales Comparison (Market Data Approach) The property value is derived by considering the recent sales of similar properties and adjusting for differences between the subject and the comparable sales. a. Application (1) Analyze subject property. (2) Select comparable properties. (3) Analyze information on comparable properties. (4) Compare subject with comparables. Comparisons are made with respect to at least four elements of comparison including: time of sale; physical factors including both land and building; location; and conditions of the sale, including financing. The adjusted sales price of the comp reflects the price if they are comparable, a positive adjustment means the subject is better than the comp, and negative means not as good. E. Critique of Market Data Approach. Used in active markets where recent information on sales is readily available on comparable properties. Also used for raw land or other improved properties where there are sales that are similar. With use of data plans, relatively simple in concept for the salesperson, broker, or investor. Disadvantages include errors in adjustment or trouble finding good comparable properties and sale information. Correlation of the three approaches and final estimate of value. 1. Reconsider purpose of appraisal. 2. Carefully review the three approaches to see if the range between high and low figures can be narrowed. 3. Adjust to reflect adequacy and reliability of available data and arrive at final estimate of value. F. Write report 1. Letter appraisal A brief estimate and explanation. 2. Form appraisal For lending purposes or relocation purposes, etc. 3. Narrative Very complete formal appraisal. RECP Pre-License Broker Course Manual - Student Class 7-A, Page 183

IX. Estimating Price for Listings Competitive Market Analysis We have seen how an appraisal is made and have gone through the appraisal process. A real estate agent is often called on to render an estimate of value for purposes of obtaining a listing. It is not unusual for several real estate agents to go through a property, make their individual estimate of value, and compare notes before suggesting a listing price to the owner. This estimate of value is not to be confused with making an appraisal (rendering a professional opinion of value usually in writing after applying the usual techniques and for which he/she receives a fee). Estimating value for listing purposes may employ some of the customer appraisal techniques, particularly in the market approach to value, but this practice does not constitute an appraisal because: A. It is usually in writing. B. The entire appraisal process is not applied (usually, only a market comparison). C. No fee is charged by a listing salesperson; under Indiana law, only a broker may charge an appraisal fee. D. The real estate professional is not completely unbiased nor can he/she be totally objective as the salesperson or broker wants the listing. He/she, therefore, cannot certify as does the professional appraiser, that he/she has no present or future interest in the real estate appraised. E. Emphasis is also given for comparable properties currently on the market. X. Introduction to USPAP A. Objectives 1. Help you comply with Indiana Law regarding valuations you conduct. 2. Expose you to standards for developing more accurate and professional valuations. 3. Introduce you to standards for communicating your valuations. The objective of this lesson is to help you comply with Indiana Law when you conduct property valuations. This lesson will also expose you to standards that can assist you by increasing your accuracy and professionalism when developing valuations. B. Key Terms 1. Appraisal The estimate of the value of something 2. Broker Price Opinion (BPO) A real estate broker who performs an appraisal for a fee. 3. CMA Comparison of the prices of recently sold homes to homes on the market. RECP Pre-License Broker Course Manual - Student Class 7-A, Page 184

C. USPAP: An Overview 1. The Uniform Standards of Professional Appraisal Practice (USPAP) are the generally accepted standards for professional appraisal practice in North America. USPAP contains standards for all types of appraisal services. Standards are included for real estate, personal property, business and mass appraisal. 2. The purpose of USPAP is to promote and maintain a high level of public trust in appraisal practice by establishing requirements for appraisers. It is essential that appraisers develop and communicate their analyses, opinions, and conclusions to intended users of their services in a manner that is meaningful and not misleading. 3. Who Creates the Requirements Established in USPAP? The Appraisal Standards Board of the Appraisal Foundation creates the requirements established in USPAP. D. How USPAP Applies to Real Estate Professionals 1. Who Must Comply with USPAP? Any broker who appraises real estate in Indiana must comply with the Uniform Standards of Professional Appraisal Practice (876 IAC 1-1-43). Compliance with USPAP is required when either the service or the appraiser is obligated to comply by law or regulation, or by agreement with the client or intended users. Under federal law, USPAP must be followed by anyone conducting a real estate appraisal used in connection with federally related transactions. 2. Indiana law goes further than federal law. Indiana law states that any licensed broker who conducts an appraisal for a fee (BPO) must comply with USPAP. The services you are providing might actually qualify as appraisals even if you do not call them appraisals. E. USPAP Definition of Appraisal The USPAP definition of, Appraisal includes: the act or process of developing an opinion of value; or an opinion of value. F. Does a BPO need to comply with USPAP? YES! BPOs must comply with USPAP. A BPO stands for Broker Price Opinion. BPOs are not permitted for valuations concerning federally related transactions. Although federal law does not require a BPO to comply with USPAP, Indiana law does. Because a BPO is an opinion of value, it must comply with USPAP. G. Does a CMA need to comply with USPAP? No: Not if it is provided without a fee. CMA stands for Comparative Market Analysis. So long as a CMA is provided free of charge, it need not comply with USPAP. RECP Pre-License Broker Course Manual - Student Class 7-A, Page 185

H. USPAP Standards: -- The Appraisal Foundation offers a link to a flip book of the standards at: http://www.uspap.org/. Below is a very cursory glimpse of relevant USPAP Standards. These are not the full or verbatim standards. When using USPAP Standards, rely on the Standards as published by The Appraisal Foundation: Standard 1: REAL PROPERTY APPRAISAL, DEVELOPMENT: Directed toward the substantive aspects of developing a credible appraisal of real property. Follows the appraisal development process in the order of topics addressed and can be used by appraisers and the users of appraisal services as a checklist. Rule 1-1: Know and use recognized techniques and methods; Do not commit substantial error or leave out important information; and Do not render services negligently. Rule 1-2: identify the client, other users, and intended use; identify the type and definition of value and most probably price; identify the effective date, and characteristics of the property; identify extraordinary assumptions; identify hypothetical conditions; determine scope of work necessary for credible results. Rule 1-3: Identify and analyze; Opinion of highest and best use Rule 1-4: Collect, Verify, and Analyze all information necessary for credibility. Rule 1-5: Requirements when developing a market value opinion Rule 1-6: Reconciliation of data and approaches Standard 2: REAL PROPERTY APPRAISAL, REPORTING: In reporting the results of a real property appraisal, an appraiser must communicate each analysis, opinion, and conclusion in a manner that is not misleading. Addresses the content and level of information required in a report that communicates the results of a real property appraisal. Does not dictate the form, format, or style of real property appraisal reports. They are functions of the needs of intended users and appraisers. The substantive content of a report determines its compliance. Rule 2-1: Written or Oral real property reports Rule 2-2: Type of Appraisal Report must be stated: Self Contained; Summary; Restricted Use RECP Pre-License Broker Course Manual - Student Class 7-A, Page 186

Rule 2-3: Signed Certification content Rule 2-4: Substantive Matters for Oral real property report. Standard 3: APPRAISAL REVIEW, DEVELOPMENT, AND REPORTING: An appraiser acting as a reviewer must Identify the problem; determine scope of work necessary to solve; correctly complete research and analyses necessary for a credible appraisal review. The results of an appraisal review must be communicated in a manner that is not misleading. Directed toward the substantive aspects of developing a credible opinion of another appraiser s work. Addresses the content and level of information in a report. Does not dictate the form, format, or style of Appraisal Review Reports. Rule 3-1: Know and use recognized techniques and methods; Do not commit substantial error or leave out important information; and Do not render services negligently. Rule 3-2: identify the client, other users, and intended use; identify the purpose, effective date, characteristics of the property, extraordinary assumptions, hypothetical conditions; determine scope of work necessary for credible results. Rule 3-3: Reviewer must apply necessary methods and techniques. Rule 3-4: Review Report must be separate from the work under review; not be misleading; be understandable to users; disclose assumptions and hypotheticals. Rule 3-5: Content Consistency Requirements Rule 3-6: Signed Certification content Rule 3-7: Substantive Matters that must be addressed by Oral Review Report Standard 4: REAL PROPERTY APPRAISAL CONSULTING, DEVELOPMENT Appraiser must identify the problem; determine the scope of work necessary to solve the problem; correctly complete the research and analyses necessary for credible results. Purpose under this standard is to develop, without advocacy, an anlaysis, recommendation, or opinion where at least one opinion of value is a componenet of the analysis leading to the assignment results. RECP Pre-License Broker Course Manual - Student Class 7-A, Page 187

Rule 4-1: Know and use recognized techniques and methods; Do not commit substantial error or leave out important information; and Do not render services negligently. Rule 4-2: identify the client, other users, and intended use; identify the analyses or recommendation or opinion, type and definition of value, effective date, characteristics of the property, extraordinary assumptions, hypothetical conditions; determine scope of work necessary for credible results. Standard 5: REAL PROPERTY APPRAISAL CONSULTING, REPORTING Communicate each analysis, opinion, and conclusion in a manner that is not misleading. Rule 5-1: be clear and do not be misleading; contain sufficient information to be understandable by intended users; disclose all assumptions, hypotheticals and limiting conditions Rule 5-2: Content Consistency requirements Rule 5-3: Signed Certification content Rule 5-4: Substantive matters that must be addressed by Oral real property appraisal consulting report I. The NAR Code of Ethics NAR addresses the area of appraisal in Article 11, by saying: The services which REALTORS provide to their clients and customers shall conform to the standards of practice and competence which are reasonably expected in the specific real estate disciplines in which they engage; specifically, residential real estate brokerage, real property management, commercial and industrial real estate brokerage, land brokerage, real estate appraisal, real estate counseling, real estate syndication, real estate auction, and international real estate. REALTORS shall not undertake to provide specialized professional services concerning a type of property or service that is outside their field of competence unless they engage the assistance of one who is competent on such types of property or service, or unless the facts are fully disclosed to the client. Any persons engaged to provide such assistance shall be so identified to the client and their contribution to the assignment should be set forth. (Amended 1/10) RECP Pre-License Broker Course Manual - Student Class 7-A, Page 188

J. Standard of Practice 11-1 When REALTORS prepare opinions of real property value or price, other than in pursuit of a listing or to assist a potential purchaser in formulating a purchase offer, such opinions shall include the following unless the party requesting the opinion requires a specific type of report or different data set: 1. Identification of the subject property. 2. Date prepared. 3. Defined value or price. 4. Limiting conditions, including statements of purpose(s) and intended user(s). 5. Any present or contemplated interest, including the possibility of representing the seller/landlord or buyers/tenants. 6. Basis for the opinion, including applicable market data. 7. If the opinion is not an appraisal, a statement to that effect (Amended 1/10). K. Standard of Practice 11-2 The obligations of the Code of Ethics in respect of real estate disciplines other than appraisal shall be interpreted and applied in accordance with the standards of competence and practice which clients and the public reasonably require to protect their rights and interests considering the complexity of the transaction, the availability of expert assistance, and, where the REALTOR is an agent or subagent, the obligations of a fiduciary. (Adopted 1/95) RECP Pre-License Broker Course Manual - Student Class 7-A, Page 189

REVIEW QUESTIONS 1. A house has a present value of $53,000. If it was depreciated at 2.5% a year for the last 5 years, what was its original cost? Calculation: 2. Mrs. Benson was looking for an investment property that would yield a 14% return and would cost $75,000 with less than $2,400 in annual expenses. What net monthly income would the property have to generate to meet these criteria? Calculation: 3. The cost of a building new was $75,000. The building had an estimated life of 40 years. It was depreciated using the straight line method and has a value of $60,000 today. a. What was the annual rate of depreciation? b. How many years are left in the estimated life of the building? 4. A property has an annual gross income of $9,600 with monthly expenses of $600. The owner desires a 10% capitalization rate including an 8% return on his money. Using the income approach, what is the estimated value of the building? a. $96,000 b. $120,000 c. $10,000 d. $24,000 Calculation: 5. If the annual gross income from a building is $12,500, the sales price was $100,000 and the net operating income was $5,000, what is the GRM for the property? a. 5 b. 12.5 c. 40 d. 8 Calculation: Calculation: RECP Pre-License Broker Course Manual - Student Class 7-A, Page 190