Chapter 13 The Market Approach to Value 11/22/2005 FIN4777 - Special Topics in Real Estate - Professor Rui Yao 1 Introduction Definition: An approach to estimating market value of a subject property by means of examining the transaction prices of recent sales of properties similar to the subject property in the same or similar real estate asset market The Market Approach is the most fundamental and important of the three traditional approaches to valuation Formally known as the sales comparison or market comparison method Directly based on the property asset market itself Most theoretically sound for the estimation of a property s market value 11/22/2005 FIN4777 - Special Topics in Real Estate - Professor Rui Yao 2 1
Introduction (Contd.) Steps in the Market Approach process: - Define the submarket of comparable properties - Screen and select the comparable properties - Adjust the comps towards the subject property - Develop a conclusion of value History is the demon of the market approach to value Price information becomes stale Hard to project into future Thin markets with few transactions require an appraiser to go back further in time Result is a less confident conclusion of value 11/22/2005 FIN4777 - Special Topics in Real Estate - Professor Rui Yao 3 Traditional Methods of Defining the Submarket Prior to selecting comparable properties the analyst must define the relevant submarket A set of properties that would be considered substitutes in the mind of the typical buyer of such property On the supply side, submarket is typically defined by geographic boundaries and size ranges as well as price and quality ranges Geographic boundaries Waterfronts; Major roads; School districts Similar zoning; Similar local government Similar access to employment or shopping or entertainment 11/22/2005 FIN4777 - Special Topics in Real Estate - Professor Rui Yao 4 2
Submarket (Contd.) 11/22/2005 FIN4777 - Special Topics in Real Estate - Professor Rui Yao 5 Newer Methods for Defining Residential Submarkets Expert systems can be developed to select the geographic area considered as a submarket The typical process is to start with the block group where the subject property is located and then to add blocks in all directions that satisfy certain criteria - The average price of the homes on the adjacent block are within 20% of the average selling price of the subject property block - The average household incomes on the adjacent block are within 30% of the subject property block - The age of the homes on the adjacent block are within 20% of the subject property block 11/22/2005 FIN4777 - Special Topics in Real Estate - Professor Rui Yao 6 3
Submarket Definition (Contd.) If one cannot generate reasonable number of comparable properties, criteria must be relaxed to expand the area 11/22/2005 FIN4777 - Special Topics in Real Estate - Professor Rui Yao 7 Selecting Comps Comps must be arms length The buyer and seller are not related in any way that could influence price The sales must not be unusual in any way Financing should be within the typical range of loan to value and interest rates for such property The time on the market should not be unusual If it appears to be too good a deal then it is not a valid comp Comps should be as physically similar as possible to the subject property in size, age, quality, location and features 11/22/2005 FIN4777 - Special Topics in Real Estate - Professor Rui Yao 8 4
Selecting Comps (Contd.) The minimum number of comps is 3 on a form report but 5 to 10 would be better If a multiple regression statistical model is used as a method of estimating selling price (the dependent variable) then the minimum sample size would be 30 11/22/2005 FIN4777 - Special Topics in Real Estate - Professor Rui Yao 9 Adjusting the Comps The analyst is trying to answer the following question: What would the comp sell for if it were identical to the subject property? The types of adjustments may include: Time Size Quality Features and Lot Size Location Financing 11/22/2005 FIN4777 - Special Topics in Real Estate - Professor Rui Yao 10 5
Adjusting the Comps (Contd.) Time adjustments should be made prior to feature adjustments, especially if the objective of the valuation is to derive current market value 11/22/2005 FIN4777 - Special Topics in Real Estate - Professor Rui Yao 11 Size Adjustments If the comp is bigger we must lower the price to adjust towards the subject property. If the comp is smaller we must add to the price to adjust towards the subject property. 11/22/2005 FIN4777 - Special Topics in Real Estate - Professor Rui Yao 12 6
Adjusting the Comps (Contd.) Size adjustments are based on the units of comparison The adjustment for size is usually linear thus this is the single most important adjustment A homogenous sample of comps size will explain 85% of the variation in selling price 11/22/2005 FIN4777 - Special Topics in Real Estate - Professor Rui Yao 13 Adjusting the Comps (Contd.) Feature adjustments are based on significant different features between the subject property and the comp property Method 1: Percentage of current cost, based upon how important the feature is to the typical buyers of such property Current cost * percentage of property with the feature It requires that the analyst contacts contractors and estimates the cost of the single feature Method 2: A better method then using the percentage of current cost approach is to determine the value of a feature based on paired sales analysis 11/22/2005 FIN4777 - Special Topics in Real Estate - Professor Rui Yao 14 7
An Example of Feature Adjustments Using Percentage of Current Cost 11/22/2005 FIN4777 - Special Topics in Real Estate - Professor Rui Yao 15 Adjusting the Comps (Contd.) Quality adjustments relate to the condition of the improvements Location and Views may require adjustments ideally a paired sales analysis is used to make such adjustments 11/22/2005 FIN4777 - Special Topics in Real Estate - Professor Rui Yao 16 8
Adjusting the Comps (Contd.) Adjustments for differences in financing these are becoming rare Financing may require an adjustment when financing distorts the selling price of a property When a home sells using FHA (Federal Housing Administration) or VA (Veterans Administration) financing whereby the seller has agreed to pay the points on the loan at closing in behalf of the buyer the seller provides below market financing as part of the terms of the sale 11/22/2005 FIN4777 - Special Topics in Real Estate - Professor Rui Yao 17 A Simple Example of the Market Approach using Paired Sales Analysis The appraiser has identified four factors or criteria that could influence the market value of houses similar to the subject house: Date of the transaction Age of the house Number of bedrooms in the house Size of the garage The appraiser has also obtained information on six recently completed sales of homes similar to the subject house The appraiser arranges all this market information in the market data grid 11/22/2005 FIN4777 - Special Topics in Real Estate - Professor Rui Yao 18 9
Simple Example (Contd.) A market analysis "grid" or chart lists the subject property and comps along one dimension, and their value/price-influencing factors along the other In the comparative analysis grid, the comps prices are always adjusted toward the subject property 11/22/2005 FIN4777 - Special Topics in Real Estate - Professor Rui Yao 19 11/22/2005 FIN4777 - Special Topics in Real Estate - Professor Rui Yao 20 10
Comps (Contd.) Reconciliation of Market Value: After adjusting the comps and deriving the indications of value for the subject property the appraiser needs to weigh the evidence and derive a final conclusion of value 11/22/2005 FIN4777 - Special Topics in Real Estate - Professor Rui Yao 21 Confidence in the Conclusion of Market Value Two major reasons for dispersion in the estimation of market value: Omitted variables It isn t likely that the appraiser will be able to perfectly identify and quantify all value-influencing factors for all of the comparable sales transactions Random error or noise Transaction prices are not generally exactly equal to the "market value" of each property in each transaction, but rather differ from market value by a random "error" or "noise" component 11/22/2005 FIN4777 - Special Topics in Real Estate - Professor Rui Yao 22 11
Multiple Regression and Mass Appraisal Multiple regression method aims at solving for selling price as the dependent variable, and property features as independent variables Assume the following model is based on a large sample of sales in your city: Selling price = $85(Sq. ft) + $2500 (Bedrooms) + $1200 (Baths) + + error Regression R 2 tells how reliable the model is how much of the total price variation in the selling process is explained by the feature variables A property with 2,500 square feet and 3 baths and 4 bedrooms will result in a Value Estimate of: Y = $85(2,500) + $2,500(4) + $1,200(3) = $226,100 11/22/2005 FIN4777 - Special Topics in Real Estate - Professor Rui Yao 23 ValueSure AVM Fidelity National Information Solutions (FNIS) offers a product called ValueSure that does on-line automated appraisal Aimed at mortgage lenders Generates a comprehensive four page report a predicted market value for a subject property a series of unique charts and data which show price trends and sales distributions for the surrounding market The value model FNIS uses includes multiple regression analysis, repeat sales trends and assessor information 11/22/2005 FIN4777 - Special Topics in Real Estate - Professor Rui Yao 24 12
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