The Appraisal of Real Estate

What is appraisal? Simply put, appraisal is the act or process of estimating value. More precisely: “The term appraisal means a written statement independently and impartially prepared by a qualified appraiser setting forth an opinion of defined value of adequately described property as of a specific date, supported by the presentation and analysis of relevant market information” - Real Estate Valuation, Lusht, 1997

What is value? Value is the worth of an item. Human behavior determines value because no item has inherent value. Value in exchange is the quantity of one thing that can be obtained in exchange for another good. This relationship is determined by the market. Value is subjective due to personal preferences, but market value is objective due to market behavior.

Market Value "The most probably selling price in terms of money which a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buy and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus.” - Appraising Real Property Boyce & Kinnard, 1984

Market Price “The amount actually paid, or to be paid, for a property in a particular transaction, which differs from market value in that it is an accomplished or historic fact, whereas market value is and remains an estimate……” - Appraising Real Property Boyce & Kinnard, 1984

Market Value vs. Market Price (the skinny) Value and price are identical in a theoretical, perfectly competitive market. We live in a real world! Market value is the “most probably selling price” under typical market conditions. Price is an agreed upon amount or a historical figure.

Typical Market Conditions It depends! Open and competitive market Prudent buyer and seller Typical motivation for buyer and seller Adequate marketing effort Cash equivalency

Other Types Investment value Use value Book value Rental value Salvage value Assessed value

Fundament Theory of Appraisal Supply and demand Anticipation/Change Competition reduces economic rents Substitution Opportunity cost Contribution Externalities/linkages

Value - Why do we care? Ownership transfer Financing Litigation Taxes Consulting Rents, feasibility, zoning board, insurers, etc.

The Appraisal Process Step 1: Problem Definition Real estate identification Property rights Use of appraisal Value definition Date

The Appraisal Process Step 2: Preliminary Analysis & Data Plan of attack Information General – trends Specific – property and comparable Supply & Demand – future changes

The Appraisal Process Step 3: Highest and Best Use Analysis “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” Vacant vs. improved Vacant may be highest and best use. Identify use with highest overall return Helps identify comparable properties

The Appraisal Process Step 4: Land Value Estimate Sales comparison Allocation (ratio) Extraction (less improvements) Subdivision & development Land residual technique (NOIland)

The Appraisal Process Step 5: Application of Three Approaches Sales Comparison (VSC) Cost (VC) Income (VI)

The Appraisal Process Step 6: Reconciliation Using various estimates of value under a number of methods determine one estimate of value. How?

The Appraisal Process Step 7: Report of Defined Value Conclusion communicating the final value estimate written. It presents the data, assumptions, and analyses in a manner so that an intelligent reader should comprehend the logical process and come up with a similar answer to the problem. It should also explain how and why particular steps were taken.

The Income Approach Should look familiar! GI=GO (DCF model)

The Income Approach Gross income multipliers Potential or effective gross income

The Sales Comparison Approach Underlying economic theory: Similar goods sell for similar prices. Applicable to all property types but works best for property types with frequent transactions. Data, data, data..

Sales Comparison Procedure: Research market/gather data Verify information Select units of comparison (ft^2, apt. unit, etc) Develop comparable analysis Compare comps to subject with respect to elements of comparison & make adjustments Reconcile

Sales Comparison Sequence of adjustments: Financing terms Conditions of sale Market conditions Location Physical characteristics

Sales Comparison A(n) _________ adjustment will be made to the comparable price when the comparable property is superior to the subject property. Net adjustments lead to the adjusted sales price.

Sales Comparison Uses and limitations: Good data = good results An easy “amateur” appraisal Financing advantage No data = no use

The Cost Approach Underlying economic theory: No prudent buyer would pay more than it would cost to purchase the land and develop. Applicable to all property types but does not have the ease of sales comparison. Data, data, data..

Cost Approach Procedure: Estimate site value Estimate hard and soft costs of improvements including reasonable profit Estimate accrued depreciation in the structure Add site value to improvement depreciated cost

Cost Approach Site Value (previously discussed) Reproduction vs. replacement cost Reproduction is exact replica Replacement is a “newer” building of equal utility (modern materials, designs, and layout)

Cost Approach Direct (hard) costs Building permits Labor Materials Equipment Security Contractors profit

Cost Approach Indirect (soft) costs: Consulting Engineering and architecture Cost of carry (fees, points, interest, lease-up) Selling expenses Leasing commissions

Cost Approach Cost Data Collection Marshall & Swift MEANS

Cost Approach Comparative Unit Method: Determine (find) estimate of cost per unit of area Aggregate cost per unit Size matters Use of benchmark building Adjust for size, finish quality, time, etc.

Cost Approach Unit in Place Method: Each category (section) of the building’s cost is estimated. Foundation, sprinkler, roof, framing, on a square foot cost basis

Cost Approach Quantity Survey Method Most complex and time consuming No aggregation of data according to size Number of labor hours, direct cost supplies are estimated and the cost of each is applied. Rarely used.

Cost Approach Depreciation: Non-accounting sense Three major types: Physical deterioration Functional obsolescence External obsolescence Economic life, effective (actual) age, remaining economic life

Cost Approach Market Extraction Method (depreciation): Transaction prices of similar properties with respect to age/depreciation Sale price minus land = depreciable cost (1) Estimate the replacement cost (2) (2)-(1) = total depreciation

Cost Approach Age-Life Method (depreciation) Estimate total economic life of similar properties Estimate effective age Compute ratio of effective age (subject) to total economic life Apply ratio to development cost

Cost Approach Breakdown Method (depreciation): Most complex and least used Usually used with another method of estimating depreciation Each form of depreciation is estimated separately

Cost Approach In summary: Useful when there is not an active market for the subject property type

Reconciliation We have 3 (or more) estimates of value.

Appraisal Method Summary Comparable sales Like goods sell for like prices Requires transaction data on “similar” properties Income approach Value is PV(future benefits) Most relevant for income producing real estate Cost approach Buyers will not pay more than the cost Utilizes industry cost estimators

Conclusion A real estate appraisal is a professional opinion of value as of a particular date based on systematic analysis and market data.