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Real Estate Principles of Appraisal Real Estate Brokers’ Program Barbara Grodaes.

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1 Real Estate Principles of Appraisal Real Estate Brokers’ Program Barbara Grodaes

2 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.

3 Fundamentals Theory/Principles  Appraisal definition is an estimate of value based on current market happenings.  3 Levels of appraisal knowledge. GENERAL PUBLIC (bought/sold/owned/has owned Real Estate) FIRST level of appraisal knowledge Members of real estate & related fields SECOND level of appraisal knowledge Professional Appraiser THIRD level of appraisal knowledge

4 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.

5 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).

6 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 buyer’s mind – personal value).

7 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.

8 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/municipal)  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.

9 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.

10 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.

11 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.

12 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.

13 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.

14 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/intangibles). 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.

15 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.

16 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.

17 Appraisal Process Preliminary Survey And Appraisal Plan Data Collection and Analysis Define the Problem OK Establish Value Conclusion Highest and Best Use Problem Reconciliation Decide on one or More approaches Cost ApproachDirect Comparison Approach Income Approach

18 Define the Problem  After establishing client’s 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.

19 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.

20 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.)

21 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. Time3. Cause 2. Direction4. Effect

22 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.

23 Site Analysis  A comprehensive site analysis is basic to the valuation of any property. Five factors which must be analyzed separately are: 1. Physical Factors. 2. Locations Factors. 3. Legal/Governmental Factors. 4. Economic Factors. 5. Environmental Factors.

24 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.

25 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.

26 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.

27 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.

28 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.

29 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.

30 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 Thumb 1. Look for high number adjustment 2. Look for many adjustments Margin error is higher for these.

31 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.

32 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.

33 Highest & Best Use of Land as if V acant  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.

34 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.

35 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.

36 Units of Comparison  Price/Sq. Ft.  Price/Unit  Gross Income Multiplier = Price/Gross Income  Price Earning Multiplier= NOI/Price (NOI=net operating income)  Monthly Rental Factor = Price/Monthly Rent  Rule of Thumb – add up income for building and multiply by Gross Income Multiplier.

37 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).

38 4 Steps in Applying Cost Approach 1. Estimate the value of the site. 2. Estimate the cost of reproducing or replacing the existing improvements as though they were new on the effective date of appraisal. 3. Estimate the accrued depreciation suffered by the improvements from all causes. 4. Estimate value. For properties where there is no market or not an income stream, this method is most valid to estimate market value.

39 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.

40 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.

41 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).

42 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.

43 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).

44 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).

45 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.

46 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 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).

47 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.

48 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.

49 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.

50 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.

51 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.

52 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.

53 Estimate Market Value  Final step is calculation: Reproduction 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.

54 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.

55 Application of Income Approach 1. Estimate the potential annual gross income (AGI) less likely vacancies and bad debts. 2. Estimate the total annual operating expenses. 3. Calculate the net operating income. 4. Select the appropriate capitalization rate. 5. Capitalize the net income into value.  Effective Gross Income = Gross Income – Allowance for Vacancy – Collection Losses

56 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: 1. The rate of return on the invested capital. 2. The rate of return of the capital (recapture rate). Overall capitalization: V=I/R

57 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 Allan’s garage formula (Allan’s 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. I RV

58 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.

59 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.


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