Chapter 10: REAL ESTATE APPRAISAL

CHAPTER 10: REAL ESTATE APPRAISAL Chapter Highlights

1. What does an appraiser do?

A professional appraiser is trained in estimating real property value.

2. How is an appraisal beneficial?

Several parties may desire estimates of real property value. The value judgment an appraiser renders may provide prospective purchasers or investors with some assurance that they are not paying too much for a property. Current owners, contemplating the sale, exchange, or refinancing of their real property, may be interested in an independent estimate of their property’s worth. The value of real property is also important to insurance companies, which must know the value of insured property—both at the time the policy originates and at the time of any loss—in order to calculate premium amounts and claims on policies. Most mortgage lenders need to know the value of real property pledged as collateral for a loan because they must comply with regulatory restrictions regarding the maximum loan amount as a percentage of the property’s value. Governmental units also require estimates of property value to determine compensation amounts in condemnation proceedings, and in assessing property taxes.

3. What is an appraisal?

An appraisal is an unbiased written estimate of the fair market value of a property at a particular time. The appraisal report is the document the appraiser submits to the client, which, if prepared properly, should enable the client to understand the appraiser’s estimate of value. The report contains the appraiser’s final estimate of value, the data on which the estimate is based, and the calculations the appraiser used to arrive at the estimate.

4. What should a residential appraisal report include?

Residential appraisal reports should include a location map that shows comparables used in the appraisal, a floor plan showing rooms with doorways, an exterior sketch of the dwelling with measurements, and two sets of original 35- millimeter photos showing the property front, rear, and street scene.

5. What does the FIRREA provide?

Parts of the Financial Reform, Recovery, and Enforcement Act of 1989 (FIRREA), popularly known as the savings and loan bail-out bill, directly address the quality control problem in the appraisal industry. As with real estate brokers, the licensing of real estate appraisers is done at the state level, and before passage of FIRREA, not all states required appraisers to be licensed. To improve the overall quality of the appraisal industry, FIRREA specifies minimum quality standards for appraisers, requires that an appraisal be conducted for all federally related mortgage loans, and requires that a qualified appraiser conduct these appraisals. FIRREA provides minimum standards for two classes of appraisers: licensed appraisers and certified appraisers.

6. What does it require?

FIRREA requires a licensed appraiser to have at least two years of appraisal experience (using a standard of 1,000 hours per year), and 75 hours of education (most states require that 15 of the hours cover professional appraisal practice and ethics). In addition, appraisers must pass a uniform state examination in order to be licensed. FIRREA also requires appraisers to take a minimum of ten classroom hours of continuing education for license renewal. FIRREA allows certified appraisers to appraise all types of real estate. Because these can include more complex transactions than those in which a licensed appraiser may be involved, minimum certification standards are more stringent than licensing requirements. In addition to two years of appraisal experience, FIRREA mandates that a

Larsen • REAL ESTATE PRINCIPLES AND PRACTICES HIGHLIGHTS • CHAPTER 10  2 certified appraiser have at least one year of the experience in nonresidential appraisal practice. The minimum education requirement for certification is 165 hours (under certain circumstances, a college degree may substitute for the 165 hours). FIRREA also requires appraisers to pass a uniform state examination for certification. Although the certification examination is more rigorous than the licensing examination, both exams cover: appraisal topics, real estate instruments, real estate law, real estate financing, and an appraisal code of ethics. Minimum continuing education requirements, identical to those for a licensed appraiser, are also required for certification renewal. All states have enacted legislation that meets FIRREA minimums and some have enacted legislation that extends coverage to transactions not covered by FIRREA such as for insurance or estate purposes.

7. What is market value?

The most probable price that a property should bring in a competitive open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus.

8. What is market price?

Market price is the price for which the property actually sells.

9. Explain the substitution principle.

In most real estate markets, one property may provide similar income or utility compared to another property. This fact is captured in the substitution principle, which holds that the maximum value of a property is equal to the cost of acquiring an equally desirable substitute property, assuming one would not encounter costly delays in acquiring the substitute. In essence, the substitution principle recognizes that real estate consumers have options, and that a prudent party will pay no more for a property than would be paid for an existing substitute, or the cost of building a like structure. The substitutability of real estate is an important element in analyzing market data and in estimating market value. In fact, substitutability gives appraisers another way in which to define a particular market. Assuming that prices reflect differences in utility accurately, if buyers are not willing to substitute one property for the other, then the properties are in different submarkets.

10. What is the principle of anticipation?

The principle of anticipation holds that the current market value of a property is based on the present value of the future benefits of ownership. This principle is especially important in valuing income property, where the value of the property is determined by discounting the future cash flows the property is expected to generate by an appropriate rate to arrive at the present value of those cash flows. Of course, the value that individuals attach to a particular property may vary, either because the individuals estimate different benefits, discount future benefits at different rates, or because they would put the property to different uses.

11. Define highest and best use.

A thorough appraisal will include an estimate of value based on the current use and an estimate based on the highest and best use if it differs from the current use. The highest and best use can be defined as the use that results in the highest present value of the property. In an efficient market all property is put to its highest and best use. Recognizing that real estate markets are not perfectly efficient, however, the Uniform Standards state: two separate highest and best uses exist: one for the site as though vacant, and one for the site as though improved. The first looks through the building as though it did not exist and estimates the best use of the site as though it were vacant. The second estimates the best use of the site and building(s) with all improvements together.

12. What is the principle of contribution?

Appraisers must be skilled in estimating how much the buildings or other improvements contribute to a property’s market value. In making such evaluations, appraisers follow the principle of contribution that holds that the component parts of real property assume value according to how much they contribute to the market value of the entire property. The value of a component is not necessarily equal to its cost. An addition may increase the value of

Larsen • REAL ESTATE PRINCIPLES AND PRACTICES HIGHLIGHTS • CHAPTER 10  3 the property by an amount equal to or greater than its cost, but in many cases the value added by an addition is less than its cost. It is possible that an addition may even reduce property value. 13. Explain the principle of diminishing returns.

Related to the principle of contribution is the principle of diminishing returns, which recognizes that, after a certain point, additional improvements to a property will increase the value of the property by smaller and smaller amounts.

14. What is the principle of competition?

The principle of competition recognizes the fact that, over time, competitive forces tend to reduce abnormally high profits. The principle of competition applies to all competitive markets, including real estate markets. Competition takes place at two levels—existing properties compete with each other, and existing properties compete with newly developed properties. If a particular type of property earns unusually high profits, these profits will attract new entries into the market, thereby increasing the supply, and driving profits down to equilibrium levels. New constructions will include the features currently desired by consumers and may incorporate state-of-the-art technology that tends to put older properties at a disadvantage. In estimating the value of new or existing properties, appraisers must recognize this fact and adjust for unusually high temporary profits. Appraisers should, however, support such adjustments by evidence of market trends.

15. Explain the principle of proportionality.

The principle of proportionality, sometimes called the principle of balance, states that for each property there is an optimum combination of improvements and land that maximizes value. The value of a particular property may suffer because the owner does not follow this principle. In essence, real estate can be under- or over-improved. The principle of proportionality suggests that there is some optimum proportion of elements that meets consumer preferences in land use and building design. In estimating the value of a property, the appraiser must make judgments on the ideal use of the property.

16. What is the principle of conformity?

Related to the principle of proportionality is the principle of conformity, which holds that the value of a property is positively related to the degree of harmony between it and surrounding properties.

17. Explain the principle of change.

The principle of change recognizes that real estate values are subject to supply and demand factors that are in a continual state of evolution. Like most assets, the value of real estate is positively related to the level of demand for it, and negatively related to its supply. The demand for real estate for a particular use depends on factors such as: population, income, employment, family size, age of head of household, savings levels, and real property prices. The supply of real property is also affected by numerous factors, including: the number and size of the existing units, the number of similar (or substitute) units being constructed, zoning ordinances, building codes, the type and availability of financing, and real property prices. Appraisers must estimate both the direction and degree of any change in such factors, and the impact of these changes on market value. To accomplish this, appraisers must conduct, or update, a market analysis.

18. How does an appraiser plan an appraisal?

To plan the appraisal, the appraiser must identify several factors: the reason for the appraisal, the character of the subject property (the particular property being appraised), the character of the market in which the subject property is located, and the data that will be needed to complete the appraisal. In addition, the appraiser should estimate the time and expense required to complete the appraisal. An appraiser requires a clear statement of the type of value being sought because this may affect the value estimate. The character of the property includes not only the type of property and the use to which it is put, but also the property rights to which the owner is entitled. Identifying the character of the market requires the appraiser to identify both the submarket in which the subject property belongs, and the relevant economic, environmental, and social factors mentioned earlier.

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19. Explain a physical inspection.

A physical inspection of the property enables the appraiser to verify the number and quality of various characteristics (e.g., number of rooms, type of building materials, and condition of the property) present in the subject property.

20. Where does an appraiser obtain market data?

Market data may be secured from a number of sources, including: public records, real estate agents, other appraisers, mortgage lenders, the local chamber of commerce, planning and zoning authorities, and suppliers of building materials and equipment.

21. How does an appraiser estimate value?

Real estate appraisers use three basic approaches to estimate value: the sales comparison approach, the cost approach, and the income approach. The Uniform Standards dictate that appraisers use at least two of the three approaches to support their final value estimate. The value estimate the appraiser derives from each approach is based on unique information. The approaches are similar, however, in that the information used in each is market- derived. With the cost approach, current market costs of the components comprising the property are a key element. Under the sales comparison approach, the value estimate stems from the value of similar properties as determined by recent market transactions. The “income” used in the income approach is based on the market demand for the product or service provided by the real property as reflected by current or potential market rents.

22. What are the steps involved in the sales comparison approach?

First, the appraiser identifies several (at least three for residential appraisals) recently sold properties that are similar in character and utility to the subject property. These are referred to as comparables, or “comps.” Appraisers frequently identify comparables using data they obtain from individual real estate brokers or multiple listing services, but a number of other sources are also available. Next, the appraiser adjusts the sale price of each comparable to account for differences between it and the subject property. If a comparable has a more desirable feature than the subject property, such as an extra room or a fireplace, the appraiser adjusts the comparable sale price downward by the value of the feature. If the subject property has a more desirable feature than the comparable, the appraiser increases the comparable sale price by the value of the feature. Finally, the appraiser uses the adjusted sale prices of the comparables as a guide to estimate the value of the subject property.

23. What are sale prices regressed against?

Specifically, sale prices are regressed against various property characteristics, such as: lot size, living area, number of rooms, structure design, construction materials, number of garage stalls, fireplaces, and location.

24. Explain the cost approach.

Under the cost approach, the appraiser must determine the total cost required to produce a property that provides the same utility as the subject property. This does not necessarily mean reproduction of an exact replica of the existing structure. For older structures it may not be feasible to reproduce a property. The materials and design used in many older buildings may be more costly and/or less efficient than what is available or required today. There are four basic steps involved in the cost approach. First, the appraiser must estimate the value of the land. Second, the appraiser must estimate the current cost to produce the improvements on the land. In calculating these costs, the appraiser must include both direct costs, such as labor, supplies, and profits, and indirect costs such as fees, financing costs, and taxes. Third, the appraiser must determine any loss in value, or depreciation, of the subject property and subtract it from the current production cost. Finally, the appraiser determines the appraised value of the subject property by adding the value of the land to the adjusted production cost.

25. How do appraisers estimate production costs?

Appraisers may select from a number of methods to estimate production costs, including quantity survey, unit-in- place, comparative unit, construction-cost manuals, and cost indexing. The appraiser selects a particular method based on the value and type of property, common practice in the area, or the client’s preference. Those clients with a preference should express it before the appraisal begins.

26. Explain the quantity survey method.

With this method, the appraiser bases the cost estimate on a list of prices for materials and their cost, labor cost, and the contractor’s overhead and profit. Contractors use this method extensively to prepare bids for proposed construction projects. The quantity survey does, however, require a great deal of skill, and the expense involved in generating the estimate is not justified for most appraisal assignments.

27. What is the unit-in-place method?

The unit-in-place method, also known as the segregated cost method, requires less time, detail, and expense compared to the quantity survey. Under this method, the appraiser classifies the subject property into components, such as parking areas, floors, walls, roofs, electrical systems, and plumbing systems. Next, the appraiser calculates the unit price for each component on either a square, linear, or cubic footage basis. The appraiser then estimates total production cost by multiplying the quantity of each component in the subject property by its unit price.

28. Explain the comparative unit method.

A third method, the comparative unit method, provides reasonably accurate production cost estimates, and requires less technical knowledge of construction practices compared with the methods discussed previously. For these reasons, the comparative unit method is the most widely used by appraisers. Under this method, an appraiser estimates production cost by determining the cost (or, keeping the principle of substitution in mind, the sale price) of recently constructed buildings, similar in nature, and located in the same market as the subject, expressed as a unit cost such as cost per square foot.

29. How do appraisers use cost manuals?

They use cost manuals frequently to estimate costs for complex, special-purpose buildings for which comparable properties are scarce or nonexistent. Appraisers also use the data in the manuals to verify the reasonableness of cost estimates derived by another method. Finally, the information contained in a construction cost manual may assist the appraiser in using the cost indexing method of estimating reproduction costs.

30. Explain the cost indexing method.

Under this method, the appraiser estimates current production cost by multiplying the original construction costs by a cost index reflecting the change in construction costs since the original construction occurred.

31. What are the types of depreciation for which an appraiser must adjust production costs downward?

Physical depreciation is a reduction in property value due to an impairment of the physical condition of the property. Such depreciation may be caused by ordinary wear and tear, by the action of physical elements such as wind and rain, or by a catastrophic event. Functional depreciation describes decreases in property value that may be caused by changes in technology, design, or consumer preferences. External depreciation, also known as economic depreciation, environmental obsolescence, or locational obsolescence, is a loss of value caused by factors outside of the property itself.

Physical and functional depreciation can be further classified into one of two categories: curable and incurable. Curable depreciation describes any loss in value that can be corrected at a reasonable cost. If depreciation is curable, appraisers usually use the cost of curing it as their estimate of depreciation. Incurable depreciation is the deterioration or functional obsolescence of an improvement that is economically infeasible to repair. The amount of incurable depreciation is calculated by the present value of the loss in rental income due to the incurable item.

Because a property owner may have little, or no, control over nearby negative influences on the value of the subject property, external depreciation is almost always incurable.

32. What are the weaknesses of the cost approach?

The major weakness of the cost approach is the fact that cost does not necessarily equal value. Another weakness of the cost approach concerns the estimation of depreciation. Because the estimation is subjective and estimation of the replacement cost of older structures may be difficult, the cost approach is best suited for the appraisal of relatively new buildings.

33. Explain the income approach.

The income approach is based on the idea that a property’s worth is largely a function of the present value of any future income the property generates. The income approach is most appropriate for properties that can, or do, produce predictable annual income, such as apartment complexes, office buildings, and shopping centers.

34. What are the steps involved in the income approach?

Several basic steps are involved in the income approach. First, the appraiser must estimate annual potential gross income. Depending on conditions, the estimate may not be the same as present or past annual gross income, and the appraiser must adjust the estimate to account for estimated vacancies. Second, the appraiser must estimate annual operating expenses. Again, this estimate may be different from past or present expenses. Third, the appraiser subtracts expenses from income to determine net operating income. Finally, the appraiser converts estimated net operating income into an estimate of property value through a process known as capitalization.

35. Explain the methods an appraiser can use to determine the cap rate.

Some of the more popular methods to determine the cap rate are: band-of-investment, market comparison, and the debt coverage ratio. Using the band-of-investment method, the capitalization rate is a weighted average of the yield earned by all suppliers of funds used to acquire the property. The equity holder’s yield is based on the return a prudent investor would require given the risk associated with the investment. The investor is only entitled to the residual cash flows after he or she makes payments to the lender. Finally, each capital supplier’s yield is multiplied by the appropriate weight, and the combination of the weighted yields results in the overall capitalization rate of 11.324 percent. Note that this capitalization rate is independent of the dollar amount borrowed, and could be used to capitalize any property’s NOI as long as it is being financed with an 80 percent loan-to-value, thirty-year, 9 percent interest rate loan.

Using the market comparison method, the appraiser first identifies recently sold properties that are similar to the subject property with regard to location, property characteristics, and net operating income generated. The appraiser can then calculate the capitalization rate to be used in valuing the subject property by dividing the sale price of the comparable by the comparable’s net operating income.

Under the debt coverage ratio method, the capitalization rate shows the relationship of net operating income to annual debt service. The debt coverage ratio is derived by dividing net operating income by the debt service.

36. Explain reconciliation of value.

The appraiser’s final task in estimating property value is to consolidate the estimated values derived under the sales comparison, cost, and income approaches into a single number. This process, known as reconciliation of value, or correlation of value, is not a simple mathematical exercise; it involves the exercise of judgment and analysis. In most cases, the estimates of value derived by the three approaches should be similar. If substantial differences exist, the appraiser must review the data gathering method and analysis for each approach. If the estimates remain widely divergent, the appraiser must consider the purpose of the appraisal.

Larsen • REAL ESTATE PRINCIPLES AND PRACTICES