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Washington Real Estate FundamentalsLesson 12: Real Estate Appraisal © 2011 Rockwell Publishing
Appraisal Basics Appraisal: Estimate or opinion of a property’s value, made by professional appraiser and set forth in written appraisal report. Sometimes called a valuation. Not a scientific conclusion. Competent appraisers may disagree about a property’s value. © 2011 Rockwell Publishing
Appraisal Basics How appraisals are usedSeller sometimes obtains appraisal before listing property, to help set price. Buyer sometimes obtains appraisal to find out how much to offer. Most often, buyer’s lender orders appraisal. Uses appraisal to determine if property is adequate security for proposed loan. Maximum loan amount tied to property’s value. © 2011 Rockwell Publishing
Appraisal Basics How appraisals are usedIn each of these cases, seller, buyer, or buyer’s lender would hire fee appraiser. Fee appraiser: Independent appraiser hired to value particular property for a fee. Most appraisers are fee appraisers. May be self-employed or work for appraisal firm. © 2011 Rockwell Publishing
Appraisal Basics How appraisals are usedOther functions of real estate appraisals: property management (setting rental rates) land development (highest and best use) property tax assessments probate of estates corporate mergers and acquisitions bankruptcies condemnation proceedings © 2011 Rockwell Publishing
Appraisal Basics Appraiser/client relationshipWhoever hires appraiser is the client. Appraiser is client’s agent. Example: Lender orders independent appraisal for buyer’s loan application. Lender, not buyer, is appraiser’s client. Appraiser is lender’s agent, owes fiduciary duties to lender. © 2011 Rockwell Publishing
Appraisal Basics Appraiser’s feeAppraiser’s fee set in advance, based on: expected difficulty of assignment how much time it’s likely to take Fee can’t be: percentage of appraised value based on client’s satisfaction with results © 2011 Rockwell Publishing
Appraisal Basics Appraiser independence rulesIn most home loan transactions, mortgage loan originator (MLO) barred from substantive communication with appraiser. MLO must arrange for appraisal through: appraisal management company separate department in lender’s organization Also, real estate agent may not select or compensate appraiser. © 2011 Rockwell Publishing
Appraisal Basics Appraiser independence rulesUnder federal and state law, illegal for anyone with interest in transaction to attempt to improperly influence appraiser. Coercion, extortion, bribery. Not illegal to ask appraiser to: consider additional property information explain basis of value estimate more fully correct errors in appraisal report © 2011 Rockwell Publishing
Appraisal Basics State licensing and certificationIn Washington, all appraisers must be state-certified, state-licensed, or registered trainees. For federally related loans (most real estate loans), appraisal must be prepared: by state-certified or state-licensed appraiser in accordance with Uniform Standards of Profession Appraisal Practice (USPAP) Exemption: loans of $250,000 or less © 2011 Rockwell Publishing
Summary Appraisal BasicsFee appraiser Federally related loan Mortgage loan originator (MLO) State-certified appraiser State-licensed appraiser Registered appraiser trainee Uniform Standards of Professional Appraisal Practice (USPAP) © 2011 Rockwell Publishing
Value Value: Present worth of future benefits of property ownership.Usually measured in terms of money. © 2011 Rockwell Publishing
Value Types of value Value in use: How much a property is worth to a particular person. Also called subjective value, utility value. Value in exchange: How much a property is worth to the average person who might buy it. Also called objective value. Most commonly called market value. © 2011 Rockwell Publishing
Market Value Elements of valueTo have market value, an item must have four characteristics: utility scarcity transferability demand These are sometimes called the elements of value. © 2011 Rockwell Publishing
Market Value Definition from USPAP“The most probable price which a property should bring in a competitive and 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.” Most probable price, not highest price. Price property should bring, not will bring. © 2011 Rockwell Publishing
Market Value Market value vs. priceThus, market value is the price that should be paid under all conditions requisite to a fair sale: competitive and open market prudent, informed, and unrelated parties no undue stimulus (unusual pressure to buy or sell) In contrast, market price (or sales price) is the price actually paid, regardless of the conditions of sale. © 2011 Rockwell Publishing
Summary Value Value Value in use Value in exchange Market valueElements of value Conditions requisite to a fair sale © 2011 Rockwell Publishing
Value Principles of valueValue is created and changed by major forces: social ideals and standards economic fluctuations government regulations Principles of value: Body of precepts that take these forces into account and guide appraiser during valuation process. Apply no matter which method of appraisal the appraiser is using. © 2011 Rockwell Publishing
Value Principles of valueHighest and best use Change Anticipation Supply and demand Substitution Conformity Progression and regression Contribution Competition © 2011 Rockwell Publishing
Principles of Value Principle of highest and best useHighest and best use: Use of the property that would bring owner greatest net return. Important in appraisal of income- producing property. Highest and best use must be a legal use; can’t violate zoning or CC&Rs. © 2011 Rockwell Publishing
Principles of Value Principle of changePrinciple of change: A property’s value will increase or decrease over time. Changes in value occur: in response to external forces as the property itself improves or deteriorates Therefore appraisal always tied to specific point in time: effective date. © 2011 Rockwell Publishing
Principles of Value Principle of changeProperty’s four-phase life cycle: integration equilibrium disintegration rejuvenation Property’s value depends on where it is in its life cycle. © 2011 Rockwell Publishing
Principles of Value Principle of changeProperty has: physical life cycle economic life cycle Economic life usually ends first. Improvements become obsolete before they actually fall apart. © 2011 Rockwell Publishing
Principles of Value Principle of anticipationPrinciple of anticipation: Anticipated future benefits of owning a property affect its value. If property’s value expected to increase in future, that anticipation increases its current value. If property’s value expected to decrease, that anticipation decreases current value. © 2011 Rockwell Publishing
Principles of Value Principle of supply and demandIf demand for a product exceeds available supply, value will increase. If supply exceeds demand, value will decrease. © 2011 Rockwell Publishing
Principles of Value Principle of supply and demandIn real estate context, if demand for housing in a location increases, prices will rise. Developers will respond to increased demand by building more houses. As supply increases, demand will be met and prices will fall. © 2011 Rockwell Publishing
Principles of Value Principle of substitutionPrinciple of substitution: Property’s value limited by cost of obtaining equally desirable substitute, if substitute can be obtained without undue delay. If two equally desirable properties available, the one that costs less will be purchased first. Principle is theoretical basis for all three methods of appraisal (discussed later). © 2011 Rockwell Publishing
Principles of Value Principle of conformityPrinciple of conformity: Maximum value of land is achieved when there is an acceptable degree of social and economic conformity in the area. Homes should be roughly similar in age, size, style, and quality. Great disparity within a neighborhood may decrease values. © 2011 Rockwell Publishing
Principles of Value Progression and regressionValue of a property is affected by value of surrounding properties. Principle of progression: Inexpensive home more valuable in neighborhood of expensive homes than it would be in neighborhood of similar homes. Principle of regression: Expensive home less valuable in neighborhood of smaller or rundown homes. © 2011 Rockwell Publishing
Principles of Value Principle of contributionPrinciple of contribution: An improvement may contribute more or less to the property’s value than the improvement cost to make. Example: Finished basement Construction cost: $7,000 Contribution to value of home: $2,000 © 2011 Rockwell Publishing
Principles of Value Principle of competitionPrinciple of competition: Value of property, especially income-producing property, is affected by competing properties. Example: Income from (and therefore value of) gas station reduced if second gas station built across the street. © 2011 Rockwell Publishing
Summary Principles of ValueHighest and best use Change Anticipation Supply and demand Substitution Conformity Progression and regression Contribution Competition © 2011 Rockwell Publishing
The Appraisal Process 7 StepsDefine problem. Determine data needed and where to find it. Gather and verify general data. Gather and verify specific data. Select and apply valuation methods. Reconcile value indicators for final value estimate. Issue appraisal report. © 2011 Rockwell Publishing
The Appraisal Process Step 1: Define the problemTo define problem, appraiser must: identify subject property determine function of appraisal © 2011 Rockwell Publishing
The Appraisal Process Step 2: Determine data neededAppraiser decides what data is needed based on: type of property function of appraisal Two main categories of data: general specific © 2011 Rockwell Publishing
The Appraisal Process Step 3: Gather & verify general dataGeneral data: Information pertinent to subject property’s value that does not concern the property itself. Population trends Economic conditions Condition and quality of neighborhood © 2011 Rockwell Publishing
The Appraisal Process Step 4: Gather & verify specific dataSpecific data: Data concerning subject property itself. To collect specific data, appraiser performs: site analysis building analysis © 2011 Rockwell Publishing
The Appraisal Process Step 5: Apply valuation methodsAppraiser chooses appropriate valuation method(s), given type of property being appraised. Three methods of appraisal: sales comparison approach cost approach income approach For particular assignment, may use only one method, or two, or all three. © 2011 Rockwell Publishing
The Appraisal Process Step 6: ReconciliationValue indicator: Estimate of what subject property is worth based on application of a single valuation method. Each method applied results in a different value indicator. Value indicators must be reconciled to arrive at final value estimate. Appraiser puts most emphasis on approach best suited to type of property. © 2011 Rockwell Publishing
The Appraisal Process Step 7: Issue appraisal reportFinal step is to prepare appraisal report and present report to client. Appraisal report gives: final value estimate explanatory information about how estimate was arrived at © 2011 Rockwell Publishing
Gathering Data Now we’ll take a closer look at steps 3 and 4, gathering general and specific data. Appraiser first gathers, verifies, and analyzes general data: economic trends and conditions (especially local conditions) neighborhood analysis © 2011 Rockwell Publishing
General Data Neighborhood analysisConsiderations in neighborhood analysis: percentage of home ownership vacant homes and lots, land use changes conformity of homes land contours and streets utilities and public services nuisances proximity to schools, employment, shopping prestige of area government influences: zoning, taxes © 2011 Rockwell Publishing
Gathering Data Specific dataNext, appraiser gathers, verifies, and analyzes specific data, data about the subject property itself: site analysis (land and utilities) building analysis (improvements) © 2011 Rockwell Publishing
Specific Data Site analysisObjective of site analysis: to determine property’s highest and best use. Appraiser considers: lot size and shape (area, width, depth) frontage topography utilities site in relation to surrounding area other factors that affect use or title © 2011 Rockwell Publishing
Site Analysis FrontageFrontage: Length of lot boundary that abuts street, body of water, or some other amenity. Important consideration for: retail property residential property beside a lake or other desirable feature © 2011 Rockwell Publishing
Site Analysis PlottagePlottage: Increase in value that may occur when two or more properties are combined into single property. Single large lot often worth more than sum of the values of the smaller lots that were joined together. Plottage is a factor in industrial or commercial development, where large lots are often necessary. © 2011 Rockwell Publishing
Site Analysis UtilitiesAppraiser considers availability and cost of utility connections. For property in remote area, cost may be prohibitive, decreasing property’s value. For septic system, soil must be suitable. Percolation test: Measures how well soil absorbs water, to determine whether septic system can be used. © 2011 Rockwell Publishing
Specific Data Building analysisAppraiser examining improvements considers: construction quality age and current condition of structures size of structures (square footage) interior layout number & size of rooms (bedrooms, baths) energy efficiency and equipment garage or carport, basement orientation of structures on site (views, etc.) © 2011 Rockwell Publishing
Specific Data Building analysisSquare footage refers to improved living area. Excludes garage, basement, porches. Also, appraiser will not count square footage of addition made without appropriate permits. © 2011 Rockwell Publishing
Summary The Appraisal Process7 steps in appraisal process General data Specific data Value indicators Reconciliation Neighborhood analysis Site analysis Building analysis © 2011 Rockwell Publishing
Methods of Appraisal Three main methods of appraising real property, called the three approaches to value: Sales comparison approach Cost approach Income approach All are methods of estimating market value. Which method appraiser relies on most depends on type of property in question. © 2011 Rockwell Publishing
Methods of Appraisal Sales comparison approach to valueSales comparison approach: Uses recent sales of similar properties in local market as basis for estimate of subject property’s value. Also called market data approach. Application of principle of substitution: Buyers won’t pay more for subject than market price for identical property. Best method for appraising single-family homes, vacant land. © 2011 Rockwell Publishing
Sales Comparison Approach Comparable salesAppraiser applying sales comparison method must locate at least 3 comparable sales. Comparable sale: Property similar to the subject property that was recently sold. Also called a comparable or a comp. Appraiser adjusts sales price of each comparable to reflect differences between it and subject property. © 2011 Rockwell Publishing
Sales Comparison Approach Primary elements of comparisonAppraiser decides whether a property would be a good comparable using the primary elements of comparison: date of sale location physical characteristics terms of sale conditions of sale © 2011 Rockwell Publishing
Primary Elements of Comparison Date of saleDate of sale: Date buyer and seller agreed on a price. Important because property values are constantly changing. © 2011 Rockwell Publishing
Primary Elements of Comparison Date of saleAppraiser should use most recent sales available. In volatile market, sales should be from last three months. In ordinary market, from last six months. In inactive market, may use older sales and adjust for inflation, other trends. Should not use sales that are more than a year old, however. © 2011 Rockwell Publishing
Primary Elements of Comparison LocationLocation is the factor that has the greatest impact on a property’s value. Appraiser looks for comparables in same neighborhood as subject property. If necessary, may use sale of property in comparable neighborhood. © 2011 Rockwell Publishing
Primary Elements of Comparison Physical characteristicsComparables should be similar to subject property in: architectural style construction quality overall condition features and amenities Appraiser will make adjustments to account for differences in physical characteristics. © 2011 Rockwell Publishing
Primary Elements of Comparison Terms of saleA sale that involved seller financing or other special terms generally isn’t a good comparable. Buyer may have been willing to pay more because of special financing terms. Difficult to judge effect on sales price. Appraiser looks for comparables sold on terms that are cash equivalent. © 2011 Rockwell Publishing
Primary Elements of Comparison Conditions of saleTo be used as a comparable, sale must have taken place under normal conditions: parties were unrelated (“arm’s length transaction”) buyer and seller acted prudently and knowledgeably no unusual pressure on either party property was offered in a competitive and open market for a reasonable time © 2011 Rockwell Publishing
Sales Comparison Approach Making adjustmentsTo take into account physical differences between a comparable and the subject, appraiser adjusts sales price of comparable. It’s always the comparable’s price, not the subject’s value, that is adjusted. © 2011 Rockwell Publishing
Sales Comparison Approach Making adjustmentsSubject property has a feature the comp lacks: value of feature added to comp’s sales price Subject property lacks a feature the comp has: value of feature subtracted from comp’s sales price © 2011 Rockwell Publishing
Sales Comparison Approach Estimating subject property’s valueAppraiser estimates subject property’s value based on adjusted prices of at least three comparables. Never simply averages the adjusted prices. More weight given to the comparable(s) to which fewer adjustments were made. © 2011 Rockwell Publishing
Summary Sales Comparison ApproachComparable Primary elements of comparison Date of sale Location Physical characteristics Terms of sale Conditions of sale Making adjustments © 2011 Rockwell Publishing
Methods of Appraisal Cost approach to valueCost approach: Bases estimate of subject property’s value on how much it would cost to build a replacement of the improvements. Also called summation method, because it involves adding separate estimates of the improvements and land together. © 2011 Rockwell Publishing
Cost Approach to Value Sets ceiling on valueCost approach usually provides ceiling for subject property’s value. Another application of principle of substitution: Buyers won’t pay more for a used property than the cost of building a new property of equal desirability. © 2011 Rockwell Publishing
Cost Approach to Value 3 StepsSteps in cost approach: Estimate cost of replacing improvements. Estimate and deduct any depreciation. Add value of land. © 2011 Rockwell Publishing
Cost Approach to Value Step 1: Estimating replacement costReplacement cost: Current cost of building improvements with equivalent utility, using modern materials and construction methods. Reproduction cost: Current cost of building exact replica, using materials and methods identical to those originally used. Replacement cost much better indicator of property’s market value. © 2011 Rockwell Publishing
Estimating Replacement Cost 3 Methods1. Square-foot (comparative unit) method Easiest and most widely used. Square footage × Construction cost per sq. ft. 2. Unit-in-place method Estimate cost of replacing each building component (roof, flooring, plumbing, etc.). 3. Quantity survey method Detailed, time-consuming estimate of quantities and prices of materials and labor. © 2011 Rockwell Publishing
Cost Approach to Value Step 2: Deducting depreciationDepreciation: Loss in value due to any cause. Three categories of depreciation: physical deterioration functional obsolescence external obsolescence © 2011 Rockwell Publishing
Categories of Depreciation Physical deteriorationPhysical deterioration: Loss in value due to wear and tear, damage, or structural defects. Easiest type of depreciation to identify and measure. This type may be either curable or incurable. © 2011 Rockwell Publishing
Categories of Depreciation Curable or incurable depreciationCurable depreciation: Cost of correcting it can be recovered in sales price when property sold. Incurable depreciation: Can’t be corrected, or cost would be too high. Physical deterioration usually curable, unless especially severe. Curable physical deterioration commonly called deferred maintenance. © 2011 Rockwell Publishing
Categories of Depreciation Functional obsolescenceFunctional obsolescence: Loss in value due to functional inadequacies, often caused by age or poor design. Examples: bad floor plan, too few bath- rooms, outdated fixtures, unattractive style. May be curable or incurable. If problem is inside property lines and it’s not physical deterioration, then it’s functional obsolescence. © 2011 Rockwell Publishing
Categories of Depreciation External obsolescenceExternal obsolescence: Loss in value due to factors outside of property itself. Also called economic obsolescence. Examples: adverse zoning changes undesirable neighborhood traffic congestion proximity to nuisance Always incurable – outside owner’s control. © 2011 Rockwell Publishing
Cost Approach to Value Step 3: Adding land valueFinal step in cost approach is to add value of subject property’s lot or site to depreciated replacement cost of improvements. Value of land estimated by sales comparison method. Land is not depreciated. To appraiser, land is indestructible and does not lose value. © 2011 Rockwell Publishing
Summary Cost Approach Cost approach Replacement cost Reproduction costDepreciation Physical deterioration Deferred maintenance Functional obsolescence External obsolescence Curable and incurable depreciation © 2011 Rockwell Publishing
Methods of Appraisal Income approach to valueIncome approach: Uses the income that the subject property generates to estimate its value to potential investors. Also called capitalization method. Used to appraise income-producing properties such as office buildings and apartment buildings. © 2011 Rockwell Publishing
Income Approach to Value 5 StepsCalculate property’s potential gross income. Deduct bad debt and vacancy factor to calculate effective gross income. Subtract operating expenses to calculate net income. Select appropriate capitalization rate. Capitalize property’s net income to estimate its value. © 2011 Rockwell Publishing
Income Approach to Value 1. Calculating potential gross incomePotential gross income: How much the property would rent for in current rental market. Also called economic rent, in contrast to contract rent. Contract rent: How much the property currently rents for under an existing lease. © 2011 Rockwell Publishing
Income Approach to Value 2. Calculating effective gross incomeEffective gross income: Potential gross income minus a bad debt and vacancy factor. Bad debt and vacancy factor: Percentage deducted from potential gross income to allow for unpaid rents and vacancies. All units won’t be rented 100% of time. Tenants won’t always pay rent owed. © 2011 Rockwell Publishing
Income Approach to Value 3. Calculating net incomeNet income: Effective gross income minus operating expenses. Operating expenses: Costs associated with operating income-producing property. Three main categories: fixed expenses maintenance expenses reserves for replacement © 2011 Rockwell Publishing
Calculating Net Income Operating expensesFixed expenses: property taxes hazard insurance © 2011 Rockwell Publishing
Calculating Net Income Operating expensesMaintenance expenses: tenant services utilities supplies cleaning repairs administrative costs building employee wages © 2011 Rockwell Publishing
Calculating Net Income Operating expensesReserves for replacement: Funds set aside for eventual replacement of structures and equipment that will wear out. © 2011 Rockwell Publishing
Calculating Net Income Other expensesExpenses connected with property ownership that are not operating expenses for appraisal purposes: mortgage payments (debt service) income tax paid on property’s earnings depreciation reserves These are not deducted from effective gross income in calculating net income. © 2011 Rockwell Publishing
Income Approach to Value 4. Selecting a capitalization rateCapitalization: Process of converting subject property’s net income into estimate of value. Expressed as mathematical formula: Income ÷ Rate = Value Rate in formula is capitalization rate. Represents desired rate of return for investor (potential purchaser). © 2011 Rockwell Publishing
Selecting a Capitalization Rate Rate reflects investment riskIf property is risky investment, investors: require a greater return choose a higher capitalization rate A higher capitalization rate translates into a lower value for the property. In other words, investors would be willing to pay less for the property. © 2011 Rockwell Publishing
Selecting a Capitalization Rate Selection methodsAppraisers have various methods for selecting appropriate capitalization rate. Example: Direct comparison method Appraiser analyzes recent sales of comparable income properties to determine their capitalization rates. Investors likely to want about the same capitalization rate for subject property. © 2011 Rockwell Publishing
Income Approach to Value 5. Capitalizing net incomeFinal step is to capitalize subject property’s annual net income to arrive at estimate of value. In other words, divide net income by chosen capitalization rate to calculate value estimate. Income ÷ Rate = Value © 2011 Rockwell Publishing
Income Approach to Value Gross income multiplier methodGross income multiplier method: Simplified version of income approach for appraising single-family home used as rental property. Also called gross rent multiplier method. © 2011 Rockwell Publishing
Gross Income Multiplier Method Comparable rental homesAppraiser locates comparables: rental homes similar to subject property that sold recently. For each comparable, appraiser calculates a gross income multiplier. Divides comparable’s sales price by its rental income. May use either monthly or annual rent (appraiser’s choice). © 2011 Rockwell Publishing
Gross Income Multiplier Method Using gross income multipliersNext, appraiser uses gross income multipliers of comparables to choose multiplier for subject property. Finally, appraiser multiplies chosen gross income multiplier by subject property’s rent to find its value. If possible, appraiser should use subject’s economic rent. © 2011 Rockwell Publishing
Gross Income Multiplier Method Rough estimateGross income multiplier method provides only rough estimate of value. Based on gross income. Doesn’t take into account operating expenses or vacancies. © 2011 Rockwell Publishing
Reconciliation and Final EstimateReconciliation: Last step in appraisal process, when appraiser assembles and interprets all relevant data. Reconciles value indicators from the different methods of appraisal applied. Gives greatest weight to most relevant method for type of property. Experience and judgment play critical role. © 2011 Rockwell Publishing
Reconciliation and Final EstimateFinal estimate of value: Figure that best represents appraiser’s expert opinion of subject property’s value. Appraiser presents final estimate of value to client in appraisal report. © 2011 Rockwell Publishing
Reconciliation and Final Estimate Appraisal reportForm report: Uniform Residential Appraisal Report form, used for most residential appraisals. Presents only key data and conclusions. Narrative report: For a more complicated appraisal, report includes detailed presentation of data and reasoning. © 2011 Rockwell Publishing
Summary Income Approach and ReconciliationPotential gross income Effective gross income Net income Operating expenses Capitalization rate Gross income multiplier method Reconciliation Final estimate of value Appraisal report © 2011 Rockwell Publishing
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