Valuing Property Learning Objectives Upon completion of this section you should: Define market, supply and demand; in addition, be able to identify factors that affect supply and demand. Explain why the value of real property does not remain the same. Define and explain the differences between market value, market price and cost. Define the concepts of an appraisal. Define the three approaches to value and give examples of the general use of each: Market data, Cost, Income. Explain the difference between reproduction cost and replacement cost. Explain the concept of highest and best use. Explain the primary purpose for state license law requirements for licensed and certified appraisers. Explain the differences between an appraisal and a market analysis (CMA). Identify and explain types of construction, e.g., modular construction, frame built construction, manufactured home, etc.
Valuing Property The real estate market in the most basic terminology is the exchange of real estate. For example, the market for residential real estate is the buying and selling of homes, while the property management market is the exchange of the use of property. These are simplifications of a complex system that make up the real estate market. In order to understand the value of real estate within the market it helps to first establish what are the key drivers. From an economics perspective, the drivers of value are established by supply and demand. Supply and demand each have multiple factors which influence them, but together they determine value. Supply is the quantity available in the market and demand is the quantity desired by buyers at various prices. Demand for Real Estate Demand changes if the price of the real estate changes. As prices change up or down by a certain percentage, demand for real estate also changes by a percentage. The severity of the change in demand when prices move illustrates how sensitive demand is to the effects of price. When price changes cause a greater shift in demand by percentage, demand is seen as sensitive to price. Conversely, if price changes cause a smaller shift in demand by percentage, demand is relatively insensitive to price. 1. Demand sensitivity to price: 5% change in price causes a 7% change in the quantity demanded. 2. Demand insensitivity to price: 5% change in price causes a 3% change in the quantity demanded. In economic terms, demand sensitivity would mean it is elastic and demand insensitivity would mean it is inelastic. This concept is the first step in understanding what causes real estate booms and busts. Demand for real estate is relatively inelastic (insensitive) to price. This inelasticity allows real estate prices to rise quickly without changing the quantity demanded by an equal percentage. A common representation of demand can be demonstrated graphically. You ll notice in the graph the slope of the line is steep, not flat, which shows as price increases and decreases the effect on the quantity demanded is not as severe.
Price is not the only factor which affects demand. Demand is driven by a number of factors but can be summarized into four major areas: 1. Population size and growth 2. Income 3. Price of substitutes 4. Price expectations Population size and growth changes affect the number of market participants creating more demand in the area for real estate. If we think about real estate as a game of musical chairs where you buy the right to sit in the chair, the more participants playing the higher the demand for chairs since everyone who is playing wants one. If there are 20 chairs and 2 participants, the demand for chairs would be low, however if there were 30 participants and still only 20 chairs the quantity of chairs demanded would be higher, eventually driving prices to increase until some seeking to buy a chair choose to move to another room to seek a chair further away. Income changes the demand for real estate by altering the funds available to purchase, which changes the number people who are able to afford a particular property assuming constant prices. More folks being able to afford real estate and increasing incomes will in reality have an effect on the price of real estate over time. It would be as if the incomes of some of the participants increased in our game of musical chairs, creating more people who could afford to buy a chair. This would increase the demand for chairs until the prices rose enough to again drive some to seek chairs elsewhere.
Prices for substitutes sounds technical, but only means the price of alternatives such as renting. If the price of renting is relatively affordable compared to purchasing, this will affect the number of participants in the market to own. It would be as if our musical chairs options would also offer chairs to rent in addition to the 20 available to own. If the price to rent the chairs is relatively cheap people may be enticed to choose the rental versus buying. The availability of substitutes can be different in subsections of the market. Middle class homes are much more numerous and therefore more substitutes exist with the greater supply, whereas luxury homes are more rare and therefore fewer substitutes exist. Price expectations impact the demand for real estate because perceptions of the market in the future can affect the number of participants. When there is an expectation that prices will rise for the foreseeable future people who were going to delay their participation may choose to jump in, thereby increasing demand. In the mid-2000s we saw what expectations of price increases can do, when there was a rapid rise until 2007, or when the technology stock bubble increased until 2000. The expectation of future prices drove and continues to drive decisions for those choosing to enter or exit the market. Supply of Real Estate The supply of real estate is the number of units (residential) or space available (commercial) at different prices. Supply is best discussed by differentiating the short run and long run. The short run refers to the present, and doesn t capture what is happening 3 years in the future, as supply changes. Long run is an aggregate of supply over long periods of time. Let s look at a graphical representation of short run supply. Short run supply references what is available at any given time, and as a result is fixed.
Since it is a fixed quantity in the short run, the present moment, price changes have no effect on the supply of real estate. The supply or real estate does however, move and is not fixed as time goes by. Adding to supply happens through new construction. New construction doesn t happen right away, so even if the prices increase today, there are already a finite number of properties being finished that will come available in the next few months. Construction lag is the time between conception and completion of a project. It typically takes a minimum of 6-12 months for a new residential construction project to be finished, which affects overall supply. Commercial buildings take even longer. Because of the time lag, it makes it very difficult for developers and builders to adjust the supply when the quantity needed in the market changes. The lag is caused by required planning, engineering, permitting, and construction. It s quite different to a company producing soda as they can scale back production tomorrow to lower output, or ramp up production to meet additional quantities demanded. The lag in the real estate market and the soda company would be similar if the company had reached capacity at all of its factories and had to build an additional factory to meet the supply requirements. New construction supply looks over the the long run like this:
If you look closely you will notice the line isn t a perfect 1 to 1 slope. It is flatter, which represents the elasticity of supply. In contrast to demand being relatively price inelastic, the supply of new construction is relatively elastic (sensitive), which means responsive to changes in price. Practically, increases in prices of real estate typically lead to a greater percentage quantity being produced than the percentage price increase. For example, supply elasticity can result in a 3% increase in price creating a 5% increase in the supply of new construction. The over responsiveness of construction supply and the relatively inelastic nature of demand drive much of the boom and bust cycles we see in real estate. As prices increase, they can accelerate because in the short run, supply is fixed and even new construction begun immediately can t impact the supply of housing for at least 6 months. The inelastic (insensitive) nature of demand will not greatly change the number of participants as prices rise since it is relatively inelastic, meaning the demand won t shift proportionally. Prices rise, demand remains and can even strengthen as price expectations pull more participants into the market, and the sensitive nature of new construction will lead eventually to overbuilding. All of the numerous factors involved in the supply and demand of real estate are complex and typically local because each area has different economic prospects. If the oil industry is doing well, then Houston is prospering since jobs are plentiful. Meanwhile, tech industry growth helps San Francisco and Seattle. It is important when discerning the growth factors in your area to consider the local economy as well as the national or
global economy. For example, a company such as Boeing is affected by the global aviation industry, not just what is happening where they produce planes. The supply of land available for construction is affected by the government through zoning. Zoning designates the density and use of property. By allowing greater density the government can increase potential supply. In areas where density is the best option to increase the supply due to the land being used for other purposes, it limits how rapidly an area can increase the supply. It s easier to build on land that is vacant. The availability of land is another factor which influences the new construction supply that makes it to market. Most builders and developers use financing to pay for the properties they build. Therefore, the availability of loans affects the supply of housing. If banks are not lending to builders, there will be a corresponding impact on the amount of new construction. Cost, Value and Price The amount of money needed to build a structure including the cost of acquiring the land is defined as the cost. Price is different from cost. It doesn t refer to how much money was needed to create a property or how much money may be needed to replace it. Price refers to the what a buyer pays for the property (sales price) or the amount of money the seller is asking for (listing price). Market value is the expected price a willing buyer and seller would agree upon. The sales price is the actual number it is sold at, known as its market price, not it s expected price. These may differ due to inefficiencies in the market. Market value assumes all conditions are perfectly normal, which is rarely the case. Buyer s sometimes pay over market value and other times pay under market value for many reasons, which can be because of financing or personal motivations of the parties involved. Appraisal Properly valuing real estate is important for brokers. One of the most common questions clients have is the value of their properties. Since there isn t a helpful ticker symbol with prices constantly adjusting like the stock market, there is a bit of mystery in the general
public regarding the value of homes. Each home is unique and therefore, needs to be properly evaluated before giving an estimate of value. To be able to provide informed and accurate valuations it is important to learn the basics concepts of appraisal. Appraisal is an opinion of value for property. An official appraisal is performed by a professional specializing in providing estimates of value, the appraiser. An appraiser s opinion of the value of property is meant to be an objective value, based on evidence gathered from other properties. It has to be backed by facts and figures. Appraisals are used in many situations, including verifying value for a lender, tax value, condemnation, insurance, divorce, wills, or transferring ownership. Loans are the most common reason for an appraisal. The lender requires an appraisal before approving most loans. An appraisal provides the lender a third party opinion of value to assure them the value of the property is enough collateral for the loan. While a borrower is required to pay for the appraisal, it s the lender who is using it to verify the value. Washington state has clear licensing requirements for appraisers much like real estate professionals have licensing requirements and laws they must follow. The purpose of these laws is to protect the public and to provide clear guidelines to those in the profession. The laws also serve to ensure professional appraisers meet minimum standards of competence. How Appraiser's Value Properties Appraisers go through a systematic process to determine the value of a property. It includes identifying the problem, determining what to do to solve the problem, collecting and analyzing data, valuing the land only (excluding any buildings), applying the approaches to value and then reconciling them to come up with a final value. Basically the job of an appraiser is to break the problem down to its component parts and gather and analyze reliable data to determine a final value. The specificity with which they accomplish their assignment is one of the key differences between a real estate broker valuing property and an appraiser. The factors discussed earlier that affect the desirability of property (e.g. economic prospects) is something the appraiser has to pay attention to. An appraiser must determine if a property is in a growing, desirable area, whereby a higher value may be justifiable, or if it is in a neighborhood which is losing it s appeal, thereby lowering its value. Coupled with the overall economic prospects of the region it can help the appraiser adjust the price to fit the trends.
Principles of Value Principle of Conformity Property is valued at it s highest when it s use is compatible to the surrounding area. Compatibility also includes the design of the building. Government's help to accomplish conformity and compatibility through land use and zoning regulations. Principle of Change Neighborhoods and cities change over time, including individual properties. An appraiser has to keep up with current trends to be able to incorporate any changes in the value of property. Even economic and governmental changes can alter the value of real estate. Principle of Substitution The major principle of appraisal, the principle of substitution holds the price of an equal substitute will determine the value of a property. Real property is worth no more than what an equivalent substitute can be acquired for assuming it can be done without delay. If it is a free market, there should be a meeting of a buyer and seller at the price where an equal substitute could be bought or sold. If a property is listed at $850,000 and a substitute could be found at $825,000 the property is worth approximately $825,000. Principle of Supply and Demand The principle of supply and demand states that price changes with changes in supply and demand. Demand changes price, not necessarily equivalently, and the same holds for supply changes. Increasing demand and reducing supply will raise real estate values, and vice versa. Principle of Highest and Best Use Highest and best use is the most efficient, highest value way a property can be used. It is the best financial return a property can produce when it is at the highest and best use. For example, a property currently being used as a 4 unit apartment complex in the downtown area, may have a highest and best use of a 10 story office building because it would produce the best return. The highest and best use can change over time as the local real estate market changes. While it may be a 10 story office building currently in our example, in 4 years, it could be a 30 unit apartment complex. The competition in the
area can affect the highest and best use as well as any zoning changes which allow for higher density. The appraiser's job is to determine the highest and best use at the time of the appraisal. The use must meet 4 criteria to be considered a possible highest use: Legally permissible Physically possible Most productive use Economically feasible Principle of Progression The principle of progression asserts being near other higher valued properties affects the value of a property. Basically, lower valued properties have their value increase from being in the neighborhood of higher valued properties. Principle of Regression The exact opposite of the principle of progression. The principle of regression holds higher valued properties are negatively affected by being in the neighborhood of lower valued properties. Principle of Contribution Each part of a property has a value proportional to its contribution to overall value. Essentially, the whole is the sum of its parts. Principle of Anticipation Principle of anticipation means future benefits of a property have value. Appraisers use the future income a property can produce as well as any future sales value to produce an estimate of present value. Greater future benefits would indicate greater present value. Past information is used to help project future income. Principle of Competition Whenever there are large profits to be made due to undersupply there will be increasing competition. For example, if there is a high demand for townhomes which has led to increasing profits for builders, competitors will enter the market to increase supply leading to lower returns in the future. Principle of Balance Maintaining value is accomplished when development uses are in balance, with contrasting and complementary uses being present. It adds to value when balance is
obtained, whereas, over development or underdevelopment of one property type decreases value. Principle of Four-Stage Life Cycle Structures don t last forever, and are constantly in a state of decay or decline and therefore need to be replaced or redone. The life cycle properties go through are four stages: growth, stability, decline, and revitalization. This concept applies not only to individual properties, but entire neighborhoods. When properties in a neighborhood reach a state of decline, there is a revitalization because of the lower values, leading to investment and restoration. Factors Influencing Value Directional Growth As appraisers determine value, consideration needs to be made for the direction the city is growing. If a property is in the path of revitalization or growth it will have an impact, increasing the value. Special attention needs to be paid if the revitalization or growth is happening quickly. Location Location is a major factor in the value of real property. It affects the demand for property and therefore influences its value. Utility Utility is a properties usefulness, financially speaking, it s ability to generate income. Usefulness is based on the assumption of highest and best use. There is of course a judgement call as to the highest and best use which affects the usefulness of the property. Cities and counties can affect the usefulness of property through land use controls. Size The size of a property affects it s available uses and therefore its utility and options for highest and best use. Corner Influence Properties on the corner fronting two streets are influenced by the traffic and exposure. For commercial sites this is often a positive since more traffic, easy access, and more
potential customers add to value. However, there are downsides, such as setbacks from both roads which can decrease the available building area, and noise from the street can negatively impact value. It is typically a positive for commercial properties and a negative for residential properties. Shape Odd shaped properties usually decrease the available options of a property. Once setbacks, parking, access, and other critical elements are accounted for, it is usually a disadvantage to have an irregularly shaped lot. Even if a property is large in size, it may not be useful if the lot shape is very narrow and therefore unbuildable. Thoroughfare Conditions Quality of streets, including the amount of traffic affects the value of properties which border the street as well as those in the neighborhood. High traffic can be a large positive of a commercial property, however, if the road is in poor condition, it will negatively affect the perception and value of the properties it borders. Residential homes almost always are negatively affected by increased traffic. Exposure Businesses benefit from the side of the street they are located on because people seek the shady side of the street when it s hot out. This makes the south and west side of the streets more valuable. It not only helps to have the additional foot traffic in front of stores, but the lack of sun into the store helps preserve merchandise. Newer design concepts are helping to offset any gains or losses in value due to street location. Plottage or Assemblage Plottage and assemblage have the same meaning, the gathering of smaller adjacent properties under one owner. Assemblage can add value by allowing for a higher and better use than would be possible if they were separate. For example, an apartment complex requires parking, open space, and setbacks. A larger parcel of land can increase the number of units that can be built due to the flexibility of more space. Topography and Character of Soil Hills and slopes can affect the value of property either by increasing the views or increasing construction costs. Also, soil which is soft requires more foundation engineering and material while hard soil will support the weight of construction. Drainage and landscaping are also affected by the soil.
Obsolescence Obsolescence is when a building isn t desirable while it s still working just fine. In real estate, there are two types of obsolescence that affect value, functional and external. Functional obsolescence is when a property has a feature that is either inadequate or over improved. Inadequacy would include no air conditioning, when adding air conditioning would increase the value of the property more than the cost of the air conditioner. Over improvements happen when a tennis court is built for $50,000 and the value to the home is only $10,000. External obsolescence, also known as economic obsolescence, is when the factors outside of the property itself are inadequate, such as: a neighborhood that has many foreclosures, the immediate neighbors have loud animals, or the property is on a busy street. External obsolescence isn t something that can be fixed. Building Restrictions and Zones Building and zoning codes can have a positive or negative effect on value. It can restrict the uses of a property, depressing the value, or it can change to add more allowable uses, increasing the property value. Depreciation Depreciation is the loss of value over time. It may be a result of external obsolescence, functional obsolescence or it may be due to physical deterioration, the aging of the physical structures. Physical deterioration and functional obsolescence have two types of depreciation, curable depreciation and incurable depreciation. As the name indicates, curable depreciation can be changed if it is financially practical to make those changes (it s cost is less than value added). Incurable depreciation is impractical to fix financially (it s cost is more than value added), such as foundation replacement, structural framing and any other major replacement expense. Over time, the IRS allows owners of rental properties to depreciate their real estate. The reduction in value is calculated from the cost the owner originally paid for the asset, not it s current value. The depreciation or reduction in value is allowed until the entire value of the asset is effectively zero. Reductions in the value of the asset have to be consistent each year. Depreciation cannot be applied to the value of the land, only to the value of the buildings (improvements). Land does not depreciate, buildings do. Therefore the cost basis which the owner paid for the property isn t the entire purchase price, but the value assigned to the structures. Typically, the tax assessor will value the land and the improvements separately. This can be used as a reference point to
determine the value of the buildings. Traditional Approaches to Value In order to value property, appraiser s use three separate techniques. Appraisers will use all three to come up with values, and each has some element of comparison involved. An appraisal will attempt to use all three approaches to value, however, often only two, and occasionally only one may be completed due to the type of appraisal being done. The approaches to value have to be calculated independent of one another. They are: 1. Market Data (or Sales Comparison) Approach 2. Cost Approach 3. Income Approach Each property is unique, and has different options and potential. Property uses can vary widely which can cause logical differences in estimates of value. Some of the use differences include commercial, residential, both for use or investment. Even the purpose of the appraisal varies from obtaining a loan, insuring the property, to paying taxes. All of these factors play a part in the methods of appraisal. The available information can influence the approaches to value. For example there may not be other properties that are similar which are being used for the same purpose, as an investment, making the income approach to value difficult to complete. An appraiser will choose to find out what the purpose of the appraisal is as well. After gathering all of the data and using all three approaches to value, the appraiser will provide a conclusion to what the value should be given all of the information, known as reconciliation. Sales Comparison Approach The sales comparison approach, also referred to as the market data approach, uses similar nearby properties that have recently sold to come to an estimate of value. The sales comparison approach is the method for determining value most closely related to what real estate brokers use and is the most popular approach when valuing residential real estate. It is particularly useful when there are many similar properties and sales. Primarily based on the principle of substitution, the value of the property should be equivalent to the price paid for a substitute.
It s important to point out the language used in the sales comparison approach and the other approaches regarding the properties selected to compare with the appraised property. The similar properties to the one being appraised are known as a comparables and the property being appraised is the subject. Any adjustments up or down made when comparing properties are done to the comparables, not the subject. The sales comparison approach seeks to find properties that have sold as closely as possible in time to when the appraisal is done. When a comparable is further away in time to the appraisal date, there has to be adjustment for the markets growth or contraction during the intervening time. It s best to find properties sold as recent as possible. Location is another major factor and proximity to the property affects the quality of the comparable. If the property is far away, it is influenced by a different neighborhood, potentially different economic prospects, and even different building styles. Closer is better. Also of major consequence to the valuation is the use of the characteristics of the property including size, square footage, neighborhood, location, bedrooms and bathrooms, age, style, and financing terms. Once the appraiser has selected comparable properties, they will use a table to assemble all of data in one place. Even with the comparable properties it is important the appraiser consider anything that may have influenced the price, including foreclosure. The reason for considering influences outside of the statistical comparison data is an appraisal is based on the assumption the seller is not influenced by outside factors and also doesn t need to rush a sale giving the property proper exposure to the market. In a best case scenario, all of the properties would be viewed by the appraiser to aid in determining value. Units and elements of comparison When comparing properties an appraiser uses certain characteristics including lot size, square footage, and bedrooms and bathrooms. Essentially it s a list of the elements of a property that most directly contribute to value. Because properties are all unique, any differences between the comparable and the subject need to be reconciled so the estimate of value adjusts for differences. To do this reconciliation, the comparable property's value is adjusted either up or down by a specific dollar amount to account for the differences between the comparable and subject. For example, if a comparable property has another 300 square feet of space, the price would be adjusted down to make it more like the subject. The appraiser assigns a dollar value to the additional square footage and then subtracts that amount from the value of the comparable to
make sure they are like properties. There is an element of judgement by the appraiser, the process attempts to focus those judgments into clear values. Example: Assume that the house to be appraised is a 2,400 square foot, 5-year old, single-family tract home located two blocks from the beach, with a fair view, stucco, 10 rooms, 4 bedrooms, 3 baths, 3 car garage. It is in good condition. Prices have been increasing at 1% a month. The appraiser has selected from the neighborhood comparables which are equal in most of their financing and physical characteristics, except as shown on the rating chart. The value or sales price for the subject property is determined as shown on the chart below. Next is a figure representing a basic appraisal worksheet format filled out to value a residential property: Elements/Units Comparables Subject Data 1 Data 2 Data 3 Sales Price $664,000 $676,000 $698,000? Financing Terms Normal Normal Normal Normal Conditions of Sale Normal Normal Normal Normal Time (Sale Date) Jan 20XX March 20XX April 20XX June 20XX Adjustment 1%/mo $33,200 $20,280 $12,960 Garage Equal Equal Equal Equal Age Equal Equal Equal Equal Rooms Equal Equal Equal Equal Bathrooms Equal Equal Equal Equal View None Some Fine Fair Adjustment *(inferior) +12,000 *(inferior) +8,000 *(superior) -12,000 Square Footage 2,400 2,430 2,390 2,400
Adjustment 0 0 0 Net Adjustments +45,200 +28,280 +$960 Adjusted Sale Price 709,200 712,280 698,960 Indicated Value $699,000 * Inferior means the comparable is inferior to the subject property in this regard. Superior means the opposite. Subtract the adjustment if the comparable is superior to the subject property. Add the adjustment if the comparable is inferior to the subject property. Reconciliation: Data 2 is close to the subject property in size, and view although not as good as the subject. Data 1 is close to the subject, but is oldest and there is a difference in the quality of the view. Data 3 is nicer than the subject in the quality of the view, but due to the proximity in sale date, is the best representation of value, leading us to an indicated value of $699,000. Notice there is a judgement made as to the best comparable to give it a greater weight in the valuation process. Cost Approach The cost approach is a lot like it sounds, figuring out the costs to rebuild the property, and then taking away any loss of value the current building has suffered due to aging. It s based on the same concept as the sales comparison method, the principle of substitution. The value of a property is equal to a substitute. It s similar because the cost approach is looking at how much to replace the current property less depreciation (loss of value). That s just another way of comparing the cost, or price of a similar property, a replacement being the exact substitute on the exact same site. Besides the cost to replace the building, a value must be assigned to acquire the land, assuming it were vacant. Once a property is valued using the cost approach and before the depreciation is factored into the value, it is the value of the same property (more or less) new. An important note to remember is the land is never depreciated. Since this is the price that would be assigned to a brand new home, it s typically used as the highest value possible for the property. The property cannot be reasonably valued if the value is higher than the cost to replace it with a new structure.
The Procedure in Brief The following are the steps involved in completing an appraisal using the cost approach: 1. Estimate the land value assuming it is vacant and available. 2. Estimate the replacement or reproduction cost of the current building(s). 3. Estimate the amount of total depreciation to the building(s). 4. Subtract the total depreciation from the replacement cost. 5. Add the adjusted value to the value of the land. The result is the cost approach value. In the steps to completing the appraisal, reproduction cost and replacement cost are mentioned. Let s take a moment to define each. Reproduction cost is the total cost of building the same building, an actual replica of the current building including materials. It helps to determine the actual cost of the same building since it s equivalent, however building materials and construction processes change all the time and constructing the exact same building can become impractical. Reproduction is best used on recently built and unique properties. Replacement cost is different than reproduction cost because it doesn t use exactly the same materials and construction processes, but instead estimates the cost to as closely as possible replace the same building using current materials and methods. It is easier for an appraiser to accurately estimate the costs of construction using current materials and methods, but requires a number of judgements to be made regarding replacement materials and design. Given it s more practical nature, replacement cost is most commonly used in the cost approach. Income (Capitalization) Approach The income approach focuses on the financial benefits the property can provide in the future. Another term for finding the present value based on its future income is capitalization. After projecting the income, the flows of money are discounted to the present. Discounted to the present is due to the financial concept of time value of money, which states future money is worth more than money in the present. Why is that? By forgoing money in the present, a person or company is missing out on current enjoyment or opportunity. In order to be persuaded to postpone the use and enjoyment of the money, the individual or company will need to be given compensation for waiting. The payment for delaying the use of financial resources is one of the basic principles of our financial system, which is charged in the form of interest.
Income property investors expect the money they invested, plus a return on that money. Property investors use a term for the concept of requiring return for their money, it s yield. Yield is the percentage of return they require for the use of their money. It works much like interest, requiring a percentage payback for their investment, but usually higher than a lender since an investor is in line after any debts, if the property is sold. There are two methods of income capitalization, direct income capitalization and yield capitalization. Direct capitalization determines the property value by using one annual net income amount to determine the properties value. Yield capitalization determines the present value of future income by discounting the future income by the required return (yield). When using the direct capitalization method, a single year net operating income is divided by a capitalization rate (CAP rate) to determine the value. A CAP rate is a percentage ratio between the property s net income and it s sales price. It gives a basic percentage of the total cost of a property versus its acquisition cost. A logical question is where does the CAP rate come from that an appraiser will use for a property? The cap rate is determined by using comparable properties and their CAP rates. In order to make sure the rate the appraiser chose is proper, the appraiser will check the comparables in relation to the subject property based on age, location, physical condition, income, expenses and risk factors. Yield capitalization focuses on discounting each cash flow to a present value. As mentioned, the value of money in the present is greater than money in the future, so projected future income needs to get discounted at the appropriate return rate. The mechanics of calculating net present value of future income is beyond the scope of this course. Gross Income Multiplier Appraisers need to value some properties based on the capitalization approach even though they are not typically used that way (e.g. single family homes). To value these properties appraisers can use a method called the gross income multiplier (GIM) or
gross rent multiplier method, which determines value based on the multiple derived from dividing the sales price of the property by the rental income it produces. It s not a percentage, but a multiplier. It s not a sophisticated method of determining value, which is why it s only used for properties not typically used as an investment (e.g. rented residential homes). The appraiser will seek to find comparable properties and see what they sold for and the their monthly rent or annual rent figures. By doing that they can find the gross income multiplier for each property and then apply it to the subject. Once an appraiser has determined the gross income multiplier of the comparables they can use the multiplier to estimate the value of the subject property by reworking the equation. Let s take a look at how an appraiser would apply this to 3 comparable properties. Example: Property Price Monthly Rent GIM A $750,000 $3,300 227.3 B $775,000 $3,500 221.4 C $740,000 $3,200 231.3 Using the data gathered and gross income multipliers calculated, an appraiser may choose to use the median GIM of 227.3 to calculate the subjects estimated value. The appraiser would use the estimated rent they determined, let s say $3,275, and then use the GIM to come up with an estimated value: Example: $3,275 (Rent) x 227.3 (GIM) = $744,408 (Estimated Value) The calculations in the previous examples was done using monthly rent calculations. It could just as well have been done on an annual basis, the key is it s the same throughout the calculations.
Note: Always check to make sure the calculations used to determine the Gross Income Multiplier are in the same units. If the calculation was done in months or years, make sure all other calculations are either converted to that measure or are in that measure to begin with. Calculating Net Operating Income Regardless of the method chosen when using the income approach, there is a need to determine the net operating income. The net operating income gives a picture of the total income produced after accounting for expenses of operation. It s important because a property can have extremely high income but if the expenses are just as high, the income derived from ownership may be small. The first step in calculating net operating income is to determine the gross income of the property. Gross income is the income produced by the property. There are two terms used when referring to gross income, potential gross income and effective gross income. The difference is potential gross income refers to what the income of the property would be if it were fully rented at 100% occupancy and effective gross income accounts for vacancies and nonpayment that happen in the normal course of operations. Potential gross income is the optimistic view that the property is fully leased 100% of the time with no loss of income due to nonpayment by any tenant. It is rather simple to determine this figure since it only involves adding up the rent amounts per month for each unit/space and then multiplying by 12 for a yearly figure. Potential gross income is inclusive of all other income such as parking, laundry, vending machines, and storage space. Since it is almost never as wonderful as the potential gross income indicates, we need to factor in the losses that are to be expected due to nonpayment, and vacancy, which is what effective gross income provides. To calculate the effective gross income any vacancy and collection loss is subtracted from the potential gross income. The vacancy and collection losses are typically represented as a percentage and known as a vacancy factor. This is different slightly from loss only due to vacancy which is called the vacancy rate, also stated in percentage terms. Vacancy rate is a percentage of the available units in a property which are unoccupied at any given time. Vacancy rate gives a portrayal of loss due to vacancy only where vacancy factor includes vacancy and loss due to nonpayment.
Appraisers make calculations based off assumptions, not necessarily what the current financials of a building are. Even though a building is leased with a high vacancy rate, the appraiser will use what should be the market vacancy rate if there is a discrepancy. Making the adjustment factors is management skill and random chance. The same is true for the amount of rent charged. A building may not be charging what is considered market rate for its units. Market rent or market rate is the rent charged by landlords for the equivalent type of space in the area. It may differ from the contract rent or scheduled rent, which is the amount of rent currently being charged and collected. Expenses of operating the building need to be subtracted from the potential gross income to arrive at net operating income. Expenses can be fixed, variable, or reserves. Fixed expenses are unaffected by changes in the occupancy of the building. For example, property taxes are going to remain the same regardless if the building has a vacancy rate of 50% or 5%. Variable expenses change with number of occupants in the building such as utilities, or management costs. Reserves are money set aside for future replacements that don t need to be replaced every year. An example is reserves may be used to replace a refrigerator or even something larger like a roof. Potential gross income - Vacancy loss (vacancy factor * potential gross income) + Additional income Effective gross income (total) - Fixed expenses - Variable expenses - Reserves Net operating income (total) The Role of an Appraiser Compared to Real Estate Brokers While both the appraiser and the real estate professional will generate opinions of value, the appraiser has more specific training regarding valuation and supports their valuation with industry standard methods. This is why a broker will often give an opinion of value, but should not claim to be as accurate or not defer to an appraisal when determining value. Example: Harlen, a licensed real estate broker in Washington State, meets the Smiths at a party. Upon finding out that Harlen is a real estate agent, the Smiths ask Harlen to do an appraisal on their home so that they can refinance. While
Harlen can perform a market analysis on their home and estimate the sales price, he cannot perform an appraisal (which is a more detailed opinion of value and can only be performed by a licensed appraiser). Harlen should refer the Smiths to a certified appraiser. An appraisal is an estimate of value at a given time and reflects the appraiser s opinion of value, while a real estate professional will use something called a comparative market analysis, or CMA. A comparative market analysis uses current, pending, and recently sold properties that are close in as many characteristics as possible to the subject property to determine value. Comparative market analysis sounds a lot like one of the techniques used by appraisers. It is. The market analysis is much like the Market Data (Sales Comparison) approach used by appraisers. Appraisers use the other two methods but a real estate professional will typically focus on the Market Data approach. An important distinction between a CMA and an appraisal is the use of actively available (not yet sold) properties as well as those pending sale (under contract) in addition to the sold properties to help determine value. Appraisers don t use active properties or those under contract because they have not closed yet and therefore can t be used as quantitatively established values. Actively available properties in a CMA help a real estate broker and their client determine what the competition for similar properties may be. If there are two properties available that are essentially the same, yet one is offered for less, logic dictates the lower priced properties will sell first.
Valuing Property Key Terms Demand - Demand changes if the price of the real estate changes. As prices change up or down by a certain percentage, demand for real estate also changes by a percentage. Elastic - demand sensitivity would mean it is elastic. Inelastic - demand insensitivity would mean it is inelastic. Construction Lag - is the time between conception and completion of a project. Cost - The amount of money needed to build a structure including the cost of acquiring the land. Price - refers to the what a buyer pays for the property (sales price) or the amount of money the seller is asking for (listing price). Market Value - is the expected price a willing buyer and seller would agree upon. Appraisal - is an opinion of value for property. Appraiser - An official appraisal is performed by a professional specializing in providing estimates of value, known as the appraiser. Principle of Conformity - Property is valued at it s highest when it s use is compatible to the surrounding area. Compatibility also includes the design of the building. Government's help to accomplish conformity and compatibility through land use and zoning regulations. Principle of Change - Neighborhoods and cities change over time, including individual properties. An appraiser has to keep up with current trends to be able to incorporate any changes in the value of property. Principle of Substitution - The major principle of appraisal, the principle of substitution holds the price of an equal substitute will determine the value of a property.
Principle of Supply and Demand - The principle of supply and demand states that price changes with changes in supply and demand. Demand changes price, not necessarily equivalently, and the same holds for supply changes. Increasing demand and reducing supply will raise real estate values, and vice versa Principle of Highest and Best Use - Highest and best use is the most efficient, highest value way a property can be used. It is the best financial return a property can produce when it is at the highest and best use. Principle of Progression - The principle of progression asserts being near other higher valued properties affects the value of a property. Principle of Regression - The exact opposite of the principle of progression. The principle of regression holds higher valued properties are negatively affected by being in the neighborhood of lower valued properties. Principle of Contribution - Each part of a property has a value proportional to its contribution to overall value. Essentially, the whole is the sum of its parts. Principle of Anticipation - Principle of anticipation means future benefits of a property have value. Principle of Competition - Whenever there are large profits to be made due to undersupply there will be increasing competition. Principle of Balance - Maintaining value is accomplished when development uses are in balance, with contrasting and complementary uses being present. Depreciation - is the loss of value over time. Physical Deterioration - is the aging of the physical structures. Physical deterioration and functional obsolescence have two types of depreciation, curable depreciation and incurable depreciation. Curable Depreciation - As the name indicates, curable depreciation can be changed if it is financially practical to make those changes (it s cost is less than value added).
Incurable Depreciation - is impractical to fix financially (it s cost is more than value added), such as foundation replacement, structural framing and any other major replacement expense. Reconciliation - is when the appraiser will provide a conclusion to what the value should be based on all of the information, after gathering all of the data and using all three approaches to value. Sales Comparison Approach - The sales comparison approach, also referred to as the market data approach, uses similar nearby properties that have recently sold to come to an estimate of value. Comparables - this is the similar properties to the one being appraised. Any adjustments up or down made when comparing properties are done to the comparables. Subject - this is the property being appraised. Cost Approach - The cost approach is a lot like it sounds, figuring out the costs to rebuild the property, and then taking away any loss of value the current building has suffered due to aging. Reproduction Cost - is the total cost of building the same building, an actual replica of the current building including materials. Replacement Cost - is different than reproduction cost because it doesn t use exactly the same materials and construction processes, but instead estimates the cost to as closely as possible replace the same building using current materials and methods. Income (Capitalization) Approach - The income approach focuses on the financial benefits the property can provide in the future. Yield - is the percentage of return they require for the use of their money. Gross Income - is the income produced by the property. Potential Gross Income - refers to what the income of the property would be if it were fully rented at 100% occupancy.