Real Estate Principles of Appraisal

1
Real Estate Principles of Appraisal

• Real Estate Brokers Program
• Barbara Grodaes

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Introduction

• Main responsibility of agent is to protect the
  interests of their clients.
• Agent must have the knowledge and ability to form
  objective opinions and provide unbiased estimates
  of real value.
• Agent is expected to be able to estimate the
  market value and projected revenue of real estate
  offered for sale with reasonable skill.
• Agent must have a basic understanding of methods
  of evaluation and be able to form, express and
  defend opinion of value.

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Fundamentals Theory/Principles

• Appraisal definition is an estimate of value
  based on current market happenings.
• 3 Levels of appraisal knowledge.

Professional Appraiser THIRD level of appraisal
knowledge
Members of real estate related fields SECOND
level of appraisal knowledge
GENERAL PUBLIC (bought/sold/owned/has owned Real
Estate) FIRST level of appraisal knowledge
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Purpose and Function of Appraisal

• An appraiser considers historical data in order
  to forecast future probabilities (estimate value)
  does not set value.
• An appraiser studies the market and the
  historical data and attempts to predict the
  probable selling price of a property.
• Appraisers are often asked to estimate market
  value (price property will sell under average
  sale circumstances).
• Purpose is for specific type of value and
  function is what use the appraisal is for.

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Average Sale Circumstances

• An informed buyer and seller (access to
  reasonable market information, rather than
  absolute knowledge).
• Rational or prudent behaviour by both buyer and
  seller (acting in own self-interest).
• No undue pressure on either party (neither under
  compulsion or abnormal pressures).
• A reasonable time is allowed to find a buyer
  (property exposed in market for a set time).

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Objective Versus Subjective

• Objective concept of value means the cost of
  creation is the measure of its value (no personal
  attachment - is basis for cost approach to value
  but not the dominant concept in appraisal).
• Subjective concept of value means the value is
  created and exists in the mind of the individual
  (subjective value predominates in the buyers
  mind personal value).

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Elements of Value

• Utility must be useful and efficient.
• Scarcity supply must be relatively scarce.
• Effective Demand must be an ability to
  purchase, not merely a desire to own.
• Transferability must have the capability of
  being transferred or exchanged for money.For
  real estate property to have value, it must
  possess the features known these elements.

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Forces That Influence Value

• Subjective value of property is influenced by
  these forces which can create, maintain, modify
  or destroy value. They are
• Social Forces population growth, family sizes,
  cultural backgrounds, education.
• Political (Governmental) Forces zoning or land
  use controls, building codes, rent controls,
  interest rate controls (federal/provincial/municip
  al)
• Economic Forces levels of interest rates,
  employment trends, wage levels, availability of
  mortgage money, supply and demand.
• Physical Forces climate, topography, soils,
  flood plains, frost belts.

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Market Value, Price and Cost

• Market value expected price that should result
  under specific market conditions.
• Price historical It is the amount for which a
  property actually sold.
• Cost the expenditure required to create a
  property.At certain times, market value can be
  the same as price or cost or both, but are not
  interchangeable terms.Study the basic Principles
  of Real Property Value.

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Principles of Value

• Principle of Anticipation expectation of future
  benefits.
• Principle of Change value only valid at a
  specified date.
• Principle of Supply Demand price
  varies(residential real estate, price can lag or
  inflate more extremely than other commodities).
• Principle of Substitution when property is
  replaceable (this principle underlies all the
  valuation approaches).
• Principle of Balance value is created and
  sustained when there is proper equilibrium in the
  amount and location of essential types of real
  estate.

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Principles of Value, continued

• Principle of Surplus Productivity net income
  that remains after the proper costs of labour,
  co-coordinating expenses and capital have been
  paid. The remaining net income is attributed to
  the land and tends to fix land value.This
  principle is the basis for estimating highest and
  best use of undeveloped property.

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Principles of Value, continued

• Principle of Increasing and Decreasing Returns
  increases in the factors of production will
  produce increased returns, up to a certain point
  only. After that, any additional expenditure will
  not produce a return commensurate with the
  additional investments.
• Principle of Competition profits create
  competition and excessive profits breed
  competition that tends to destroy those profits.

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Principles of Value, continued

• Principle of Conformity maximum value is
  created and maintained where there is a
  reasonable degree of uniformity or homogeneity of
  use.
• Principle of Highest and Best Use that use, at
  the time of appraisal, that will most likely
  produce the highest net return over a given
  period of time.This principle is the basic
  premise of value.

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Nature of Property

• Land ground, soil and everything that is
  attached to it, beneath it and above it.
• Property physical thing and rights of ownership
  of the thing.
• Real Estate physical land and improvements to
  and on the land (tangible).
• Real Property physical real estate plus the
  rights that go with ownership (tangibles/intangibl
  es).Owner has the right to use the property, to
  sell it, to lease it, to enter it, to give it
  away, or not to do any of these.

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Four Powers of Government

• Power of Taxation.
• Power of Eminent Domain (expropriation) right to
  take private property for public use upon payment
  of compensation to the owner.
• Police Power right to regulate property by
  zoning bylaws, health, building and fire codes
  and so on.
• Escheat right to have titular ownership of a
  property revert to it if the owner dies and
  leaves no will or known heirs.

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Restrictions on Ownership

• Other restrictions on ownership rights include
  Restrictive Covenants limit use of property.
• Personal property (movable items not part of
  the real estate) take care in distinguishing
  which items are personal property and which are a
  part of the real estate.
• Market value of real property actually means the
  ownership of that parcel of real estate and the
  rights that go with ownership.

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Appraisal Process
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Define the Problem

• After establishing clients objectives, identify
  the property both municipally and legally (survey
  plan helpful).
• Specify the property rights involved and identify
  the rights of ownership.
• Identify the purpose and function purpose is
  type of value and function is the use that will
  be made of the value estimate.
• Define type of value and state effective date.
• Ascertain scope of appraisal in respect of the
  extent of data collected.
• Obtain commitment from the client to avoid later
  problems establish precise terms of reference.

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Preliminary Survey Appraisal Plan

• First phase of field work windshield
  inspection of neighbourhood and property.
• Determine type of data (general or specific).
  Depending on purpose and function.
• Determine if additional help is required
  (engineer/lawyer/specialist of any kind).
• Determine the approach to be used (cost, income
  or direct comparison).
• Create an Appraisal Plan will expedite the
  efficient handling of the assignment.

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Data Collection Analysis

• General Data includes the following forces
• Economic (interest rates, lenders attitude,
  average prices, ownership trends, stability,
  etc.)
• Social (population, amenities, locations, etc.)
• Political (local government, attitudes towards
  taxes, assessments, planning and zoning).
• Physical (location of city, location of
  neighbour-hood, street layouts and subdivision
  system, transportation, physical features,
  existence of undesirable elements, etc.)

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Study of Trends

• Consider the forces which influence both property
  values and their changes.
• Trend is defined as a series of related changes
  brought about by a chain of cause and effect.
  These are studied in order to measure historical
  trend which then forms basis for forecasting a
  future trend.
• A trend has 4 features necessary to analyze
  possible future effect on property values 1.
  Time 3. Cause 2. Direction 4. Effect

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Data Collection Analysis, cont

• Specific Data includes the following
• Details about the property being appraised.
• Details on comparable sales and local market
  characteristics.This information is used in
  determining highest and best use and to make
  comparisons necessary to estimate market value.
  The character of the subject property provided
  helps appraiser collect comparable data about
  land sales, building sales and rents necessary to
  complete.

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Site Analysis

• A comprehensive site analysis is basic to the
  valuation of any property. Five factors which
  must be analyzed separately are
• Physical Factors.
• Locations Factors.
• Legal/Governmental Factors.
• Economic Factors.
• Environmental Factors.

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Physical Factors

• Site Dimensions, Depth, Width, Shape, Area, Soils
  and Topography, Services and Utilities, Road and
  Street Patterns, Landscaping.
• The analysis of the above, the physical factors,
  deals with forces affecting the physical utility
  of the site.
• Accessibility, prominence, suitable/unsuitable
  development as well as all physical factors may
  have an influence on value.

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Locational Factors

• Most significant single characteristic of any
  site is its fixed location.
• Location is expressed in terms of the
  relationship of the site to the surrounding and
  nearby facilities and nuisances.
• Land Use Pattern, Access to Facilities, Corner
  Influence, Hazards and Nuisances all may have an
  influence on value.

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Legal-Governmental Factors

• Legal factors deal with the permitted and
  restrictive uses of the site.
• These include
• Legal Description
• Title Data
• Zoning
• Taxes and Assessment
• Easements
• Title Restrictions.

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Other Factors

• Economic Factors operating at the neighbourhood
  or market area level, including tax burden,
  utility costs and servicing costs.
• Environmental Factors problems or toxic
  contamination can be found in many rural and
  urban properties and can have a varying impact on
  value. Appraisers are not experts and will
  request copies of reports prepared by experts.

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Building Inspection Analysis

• Inspection of Improvements importance cannot be
  overemphasized.
• Usually divided into two types
• Site Improvements such as fencing, landscaping,
  paved driveway, swimming pool, parking area,
  outside lights, etc.
• Building Improvements dealing with four areas
  general data, construction data, equipment data,
  functional data.

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Comparable Sales Data

• Detailed data is required on market sales of
  comparable properties.
• Itemization of key features serve as a basis for
  the application of valuation techniques
  estimating value of the site, building
  construction cost, value of property directly,
  all by comparison, and, deriving a gross rent
  multiplier or a capitalization rate.
• The required information includes date, sales
  price, location, land-use controls, physical
  characteristics, functional utility and
  condition, income and expense information, terms
  of financing and conditions of sale.

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Compare and Adjust

• Make comparables transform to the subject
  remember the subject never moves.
• Compare each comparable independently.
• Key to Remember (Singleton thing!)
• If Comparable is superior SUBTRACT
• If Comparable is inferior ADD
• Two Rules of Thumb1. Look for high number
  adjustment 2. Look for many adjustments Margin
  error is higher for these.

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Highest Best Use

• Cornerstone of any appraisal. Use which will
  support the highest value and will produce the
  greatest net return over a period of time.
• Definition The reasonably probable and legal
  use of vacant land or an improved property, which
  is physically possible, appropriately supported,
  financially feasible, and that results in the
  highest value.

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Criteria for Highest Best Use

• Four criteria need to be met to determine
• Legally permissible both current potential.
• Physically possible concerning uses.
• Financially feasible anticipate earnings to
  generate a fair and competitive return on its
  cost of acquisition or development.
• Maximally productive of the range of profitable
  uses of land, those uses which provide the
  highest return or are maximally productive will
  represent the highest and best use.

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Highest Best Use of Land as if Vacant

• Assumes parcel of land is either vacant or can be
  made vacant by demolition of existing buildings.
• Key questions What uses should be made of the
  land? What type of buildings should be
  constructed? When?
• When reasonable forecast of a change in future
  use has been made, then the existing use is known
  as an interim use.

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Highest Best Use of Property as Improved

• Typically it is its existing use. Evaluation is
  made in light of the existing improvements.
• Key questions Do those improvements represent
  the most profitable use of the land? Should old
  building be maintain as is, or should it be
  renovated to modern standards? Is land more
  valuable for redevelopment to alternative uses?
  Should the structure be demolished?
• If appraiser believes existing use is not highest
  and best use, then existing use must be ignored
  in appraisal.

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Direct Comparison Approach

• This is based primarily on principle of
  substitution informed buyer will pay no more
  for a property than cost of obtaining comparable,
  competitive property with the same utility, on
  the open market.
• Optimum results are obtained when good and truly
  comparable properties are used least amount of
  adjustments needed.
• Reduce selling price to a proper unit of
  comparison, adjust to the sale price per unit,
  motivation, time, location, physical, and all
  other adjustments, and select an estimate within
  a value range.
• Process tends to be judgmental, not scientific.

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Units of Comparison

• Price/Sq. Ft.
• Price/Unit
• Gross Income Multiplier Price/Gross
  Income
• Price Earning Multiplier NOI/Price (NOInet
  operating income)
• Monthly Rental Factor Price/Monthly Rent
• Rule of Thumb add up income for building and
  multiply by Gross Income Multiplier.

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Cost Approach

• Also based on the principle of substitution.
• Simplistically divide the property into vacant
  land value plus depreciated cost of improvements.
  The reproduction cost new is adjusted for
  physical, functional and locational depreciation.
  The sum of vacant land value depreciated
  improve-ments together provide an estimate of
  value.
• Also based on the objective concept of value
  (cost to create as the main criterion).

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4 Steps in Applying Cost Approach

• Estimate the value of the site.
• Estimate the cost of reproducing or replacing the
  existing improvements as though they were new on
  the effective date of appraisal.
• Estimate the accrued depreciation suffered by the
  improvements from all causes.
• Estimate value.For properties where there is no
  market or not an income stream, this method is
  most valid to estimate market value.

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Site (Land) Valuation 4 Methods

• Direct Comparison Method easily understood.
• Land Residual Method (principle of surplus
  productivity) used to find value estimate of a
  site which is readily adaptable for use as the
  location for an income-producing property.
• Land Development Method for raw acreage
  designated for subdivision or development.
• Abstraction Method seldom used as a single
  tool, however, in the absence of good
  comparables, can be valid and invaluable.

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Cost Estimates

• Choose an approach that would most accurately
  reflect a true market value estimate
  reproduction cost or replacement cost
• Reproduction cost cost of exact reproducing.
• Replacement cost cost of replacing same size
  and utility using current technology, materials
  and equipment.

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Methods to Estimate Reproduction

• Quantity Survey Method most accurate, detailed
  and complex, usually done by professionals and
  time-consuming.
• Unit-In-Place Method less detailed, reasonably
  accurate, however still requires expertise and
  time-consuming.
• Comparative Method most commonly used done by
  direct comparison approach broken down into
  cost/sq.M variance needs good comparables.
• Cost Services up-to-date information in forms
  one can readily apply (quick and easy if manuals
  kept up to date).

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Depreciation

• To complete cost approach to value, estimate any
  losses in value due to the passage of time or the
  resultant wearing away or changes in utility of
  the building.
• Definition loss in value due to any cause.
• Accrued Depreciation is the difference between
  the reproduction cost or the replacement cost of
  the improvement and the market value of the
  improvement, both measured as at the date of
  appraisal.

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Physical Depreciation

• Loss due to wear and tear, decay and structural
  defects. There are 2 kinds
• Repairs items that a buyer would anticipate
  fixing immediately after buying (e.g..
  short-lived items such as floor coverings,
  furnace, hot water tank, plumbing fixtures,
  painting, decorating, broken windows/doors).
• Incurable Physical Deterioration items not
  economically feasible to fix (e.g. long-lived
  items such as floor joists, structure, or dry rot
  or termite damage).

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Functional Depreciation

• Loss in value to a building because of an
  inability of the structure to perform its proper
  function efficiently. This is divided into 2
• Curable Functional Depreciation cost of
  replacing item is justified by the increase in
  building utility and value (replace old furnace).
• Incurable Functional Depreciation cost of
  replacing item is greater than the anticipated
  increase in utility and thus, value not a sound
  undertaking (outmoded floor plan).

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External Depreciation

• Loss in value to a building arising from sources
  outside of the property itself. Owner has no
  direct control.
• Example of this type of depreciation would be a
  house located next to a busy truck stop or
  fast-food restaurant, depending on the proximity
  to the subject.
• Has been referred to as external obsolescence or
  locational obsolescence.

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Measurement Age-Life Depreciation

• Age-Life Method refers to effective age and
  life refers to economic life.
• Effective Age is the indicate age based on use
  and care which may be lt or gt than the
  chronological age.
• Economic Life is the period of time over which a
  structure may reasonably be expected to be
  competitive in the market in the use for which it
  was intended (note not physical remaining
  standing).

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Age-Life Method, continued

• Remaining Economic Life is the period from the
  date of appraisal to the end of the economic
  life. It is the difference between economic life
  and effective age.
• Depreciation Effective Age x
  Reproduction Economic Life Cost
• This method applies only to physical
  deterioration it does not measure functional or
  external forms of obsolescence.
• Also, it assumes components depreciate at same
  rate, on a straight-line basis.

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Engineering Breakdown Method

• Another method of estimating or measuring accrued
  depreciation.
• This is to depreciation what quantity survey is
  to cost. Extremely detailed, piece-by-piece
  breakdown of each and every part with a separate
  depreciation measurement on each.
• Not often used by appraisers, because of its
  complexity of the measurements and items required.

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Market or Sales Method

• Another method of estimating or measuring accrued
  depreciation.
• This compares the building being appraised to
  others of a similar kind and quality, but
  different age, that have recently been sold. That
  portion of the price that represents the building
  only is determined and then compared to the
  estimate of the reproduction cost of the building
  being appraised (accrued depreciation).
• Weak in that land must be valued and good
  comparable sales data must be available.

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Observed Condition Method

• Another method of estimating or measuring accrued
  depreciation.
• Seldom used in its entirety but essential to
  understand to be able to properly apply the other
  methods. Application requires observations of
  depreciation be categorized, measured and
  deducted from the reproduction cost.
• Method breaks down depreciation into physical,
  functional and external depreciation.

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Physical (Repairs and Incurable)

• Repairs measured by cost to cure.
• Estimating cost to cure requires measurement of
  the reproduction cost of the depreciated item
  that is included in the reproduction cost of the
  whole structure.
• Be careful not to double depreciate section of
  the report.
• Incurable measured by taking the ratio of
  effective age to economic life and deducting that
  ratio from the reproduction cost. This applies to
  short- and long-lived items.

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Measurement Methods, continued...

• Curable functional depreciation measure by the
  cost to cure.
• Incurable functional depreciation measure by
  taking the estimated or actual rental loss
  arising from the deficiency and multiplying it by
  the gross rent multiplier (GRM) if it is an
  income property. (The GRM is the relationship
  between the annual gross rent and the sale
  price).
• External depreciation measure by multiplying
  rent loss resulting from this locational
  obsolescence by the GRM of an income property.
  The result will be the value loss to both land
  and building.

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Estimate Market Value

• Final step is calculationReproduction Cost
  Accrued Depreciation Value of Building
• Value of site and value of other outside
  improvements (if any) are added to the value of
  the building to arrive at the value of the
  property.

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Income Approach

• Based on the theory that the value of a property
  is the present worth of the future income which
  this property is capable of producing.
• Technique involves an estimation of the gross
  income capability.
• Gross income is reduced by vacancy allowance and
  operating expenses to a stabilized net income
  estimate.
• Net income is capitalized at an appropriate rate
  into an indication of market value.

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Application of Income Approach

• Estimate the potential annual gross income (AGI)
  less likely vacancies and bad debts.
• Estimate the total annual operating expenses.
• Calculate the net operating income.
• Select the appropriate capitalization rate.
• Capitalize the net income into value.
• Effective Gross Income Gross Income Allowance
  for Vacancy Collection Losses

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Capitalization

• A capitalization rate is NOT a statement of a
  rate return. It is merely a ratio, expressed as a
  percentage used to convert current net operating
  income into an expression of market value or
  probably selling price.
• Overall capitalization is made of 2 rates
• The rate of return on the invested capital.
• The rate of return of the capital (recapture
  rate). Overall capitalization
  VI/R

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Capitalize Net Income into Value

• Using Direct Capitalization method
• Note 1. mortgage payments NOT operating
  expenses 2. Low risk low cap rate
  high value
• Use Allans garage formula (Allans Insulated
  roof is over his Recreational Vehicle)
• (income over capitalization rate and value)
• Gross Rent Multiplier (GRM) is the ratio of the
  sale price to the annual gross income at the date
  of the sale.

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Final Reconciliation Value Estimate

• Reconciliation is process which the appraiser
  reaches a single value estimate based on an
  evaluation and selection from among two or more
  alternative conclusions.
• Review the reliability of the data and weigh the
  relevance to the property.
• Use the best and most reliable to get your final
  estimate of value.
• Note not simply averaging the estimates.

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Appraisal Report

• Written presentation of the general and specific
  data considered and analyzed, the method used and
  the technique employed together with a
  reconciliation that leads to final estimate of
  value.
• Three basic types of reports
• Form Report.
• Letter of Opinion.
• Full Narrative Report.