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Washington Real Estate Fundamentals Lesson 12: Real Estate Appraisal © 2011 Rockwell Publishing
Appraisal Basics Appraisal: Estimate or opinion of a propertys 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 propertys value. © 2011 Rockwell Publishing
Appraisal Basics How appraisals are used Seller sometimes obtains appraisal before listing property, to help set price. Buyer sometimes obtains appraisal to find out how much to offer. Most often, buyers lender orders appraisal. Uses appraisal to determine if property is adequate security for proposed loan. Maximum loan amount tied to propertys value. © 2011 Rockwell Publishing
Appraisal Basics How appraisals are used In each of these cases, seller, buyer, or buyers 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 used Other 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 relationship Whoever hires appraiser is the client. Appraiser is clients agent. Example: Lender orders independent appraisal for buyers loan application. Lender, not buyer, is appraisers client. Appraiser is lenders agent, owes fiduciary duties to lender. © 2011 Rockwell Publishing
Appraisal Basics Appraisers fee Appraisers fee set in advance, based on: expected difficulty of assignment how much time its likely to take Fee cant be: percentage of appraised value based on clients satisfaction with results © 2011 Rockwell Publishing
Appraisal Basics Appraiser independence rules In 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 lenders organization Also, real estate agent may not select or compensate appraiser. © 2011 Rockwell Publishing
Appraisal Basics Appraiser independence rules Under 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 certification In 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 Basics Appraisal Fee 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 value To 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. price Thus, 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 value Elements of value Conditions requisite to a fair sale © 2011 Rockwell Publishing
Value Principles of value Value 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 value Highest 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 use Highest 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; cant violate zoning or CC&Rs. © 2011 Rockwell Publishing
Principles of Value Principle of change Principle of change: A propertys 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 change Propertys four-phase life cycle: integration equilibrium disintegration rejuvenation Propertys value depends on where it is in its life cycle. © 2011 Rockwell Publishing
Principles of Value Principle of change Property 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 anticipation Principle of anticipation: Anticipated future benefits of owning a property affect its value. If propertys value expected to increase in future, that anticipation increases its current value. If propertys value expected to decrease, that anticipation decreases current value. © 2011 Rockwell Publishing
Principles of Value Principle of supply and demand Principle of supply and demand: If 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 demand In 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 substitution Principle of substitution: Propertys 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 conformity Principle 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 regression Value 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 contribution Principle of contribution: An improvement may contribute more or less to the propertys 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 competition Principle 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 Value Highest and best use Change Anticipation Supply and demand Substitution Conformity Progression and regression Contribution Competition © 2011 Rockwell Publishing
The Appraisal Process 7 Steps 1.Define problem. 2.Determine data needed and where to find it. 3.Gather and verify general data. 4.Gather and verify specific data. 5.Select and apply valuation methods. 6.Reconcile value indicators for final value estimate. 7.Issue appraisal report. © 2011 Rockwell Publishing
The Appraisal Process Step 1: Define the problem To define problem, appraiser must: identify subject property determine function of appraisal © 2011 Rockwell Publishing
The Appraisal Process Step 2: Determine data needed Appraiser 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 data General data: Information pertinent to subject propertys 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 data Specific 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 methods Appraiser 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: Reconciliation Value 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 report Final 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 well 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 analysis Considerations 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 data Next, 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 analysis Objective of site analysis: to determine propertys 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 Frontage Frontage: 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 Plottage Plottage: 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 Utilities Appraiser considers availability and cost of utility connections. For property in remote area, cost may be prohibitive, decreasing propertys 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 analysis Appraiser 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 analysis Square 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 Process 7 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 value Sales comparison approach: Uses recent sales of similar properties in local market as basis for estimate of subject propertys value. Also called market data approach. Application of principle of substitution: Buyers wont 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 sales Appraiser 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 comparison Appraiser 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 sale Date 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 sale Appraiser 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 Location Location is the factor that has the greatest impact on a propertys 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 characteristics Comparables 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 sale A sale that involved seller financing or other special terms generally isnt 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 sale To be used as a comparable, sale must have taken place under normal conditions: parties were unrelated (arms 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 adjustments To take into account physical differences between a comparable and the subject, appraiser adjusts sales price of comparable. Its always the comparables price, not the subjects value, that is adjusted. © 2011 Rockwell Publishing
Sales Comparison Approach Making adjustments Subject property has a feature the comp lacks: value of feature added to comps sales price Subject property lacks a feature the comp has: value of feature subtracted from comps sales price © 2011 Rockwell Publishing
Sales Comparison Approach Estimating subject propertys value Appraiser estimates subject propertys 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 Approach Sales comparison approach Comparable 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 value Cost approach: Bases estimate of subject propertys 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 value Cost approach usually provides ceiling for subject propertys value. Another application of principle of substitution: Buyers wont 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 Steps Steps in cost approach: 1.Estimate cost of replacing improvements. 2.Estimate and deduct any depreciation. 3.Add value of land. © 2011 Rockwell Publishing
Cost Approach to Value Step 1: Estimating replacement cost Replacement 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 propertys market value. © 2011 Rockwell Publishing
Estimating Replacement Cost 3 Methods 1. 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 depreciation Depreciation: Loss in value due to any cause. Three categories of depreciation: physical deterioration functional obsolescence external obsolescence © 2011 Rockwell Publishing
Categories of Depreciation Physical deterioration Physical 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 depreciation Curable depreciation: Cost of correcting it can be recovered in sales price when property sold. Incurable depreciation: Cant 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 obsolescence Functional 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 its not physical deterioration, then its functional obsolescence. © 2011 Rockwell Publishing
Categories of Depreciation External obsolescence External 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 owners control. © 2011 Rockwell Publishing
Cost Approach to Value Step 3: Adding land value Final step in cost approach is to add value of subject propertys 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 cost Depreciation Physical deterioration Deferred maintenance Functional obsolescence External obsolescence Curable and incurable depreciation © 2011 Rockwell Publishing
Methods of Appraisal Income approach to value Income 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 Steps 1.Calculate propertys potential gross income. 2.Deduct bad debt and vacancy factor to calculate effective gross income. 3.Subtract operating expenses to calculate net income. 4.Select appropriate capitalization rate. 5.Capitalize propertys net income to estimate its value. © 2011 Rockwell Publishing
Income Approach to Value 1. Calculating potential gross income Potential 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 income Effective 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 wont be rented 100% of time. Tenants wont always pay rent owed. © 2011 Rockwell Publishing
Income Approach to Value 3. Calculating net income Net 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 expenses Fixed expenses: property taxes hazard insurance © 2011 Rockwell Publishing
Calculating Net Income Operating expenses Maintenance expenses: tenant services utilities supplies cleaning repairs administrative costs building employee wages © 2011 Rockwell Publishing
Calculating Net Income Operating expenses Reserves for replacement: Funds set aside for eventual replacement of structures and equipment that will wear out. © 2011 Rockwell Publishing
Calculating Net Income Other expenses Expenses connected with property ownership that are not operating expenses for appraisal purposes: mortgage payments (debt service) income tax paid on propertys 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 rate Capitalization: Process of converting subject propertys 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 risk If 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 methods Appraisers 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 income Final step is to capitalize subject propertys 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 method Gross 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 homes Appraiser locates comparables: rental homes similar to subject property that sold recently. For each comparable, appraiser calculates a gross income multiplier. Divides comparables sales price by its rental income. May use either monthly or annual rent (appraisers choice). © 2011 Rockwell Publishing
Gross Income Multiplier Method Using gross income multipliers Next, appraiser uses gross income multipliers of comparables to choose multiplier for subject property. Finally, appraiser multiplies chosen gross income multiplier by subject propertys rent to find its value. If possible, appraiser should use subjects economic rent. © 2011 Rockwell Publishing
Gross Income Multiplier Method Rough estimate Gross income multiplier method provides only rough estimate of value. Based on gross income. Doesnt take into account operating expenses or vacancies. © 2011 Rockwell Publishing
Reconciliation and Final Estimate Reconciliation: 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 Estimate Final estimate of value: Figure that best represents appraisers expert opinion of subject propertys value. Appraiser presents final estimate of value to client in appraisal report. © 2011 Rockwell Publishing
Reconciliation and Final Estimate Appraisal report Form 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 Reconciliation Income approach Potential 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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