Chapter 4–Valuation and Market Analysis

ABC Real Estate School 3st ed National Workbook August 2010 45

Chapter 4–Valuation and Market Analysis

Learning Goals: • Define appraisal, value, and market value.

tices.

.

me

Differentiate between market price and market value. • Explain a force that impacts value. • Explain why the value of real property does not remain constant. • Define the su

• Cite the licensing requirements for real estate appraisers in your jurisdiction and the legislation that affects appraisal prac

• Differentiate between an appraisal and a competitive market analysis. • Outline the appraisal process. • List the four characteristics of value in the real estate market. • Differentiate between market value and market price and between cost and

value. • Define and give examples of the principles of value used when appraising real

estate. • List and describe the steps involved in the sales comparison approach to value• List and describe the steps involved in the cost approach to value. • Distinguish between reproduction cost and replacement cost. • Describe the three types of depreciation and the difference between curable and

incurable depreciation. • List and describe the steps involved in the income approach to value. • State the formulas for determining a gross rent multiplier and a gross inco

multiplier and how they are used in appraising. • Describe the process of reconciliation. •

pply and demand model.

VOCABULARY

Competitive Market Analysis (also called a CMA): A licensee looks at comparable, recently-sold properties in an attempt to determine the future estimated sales price of a property that will be listed (offered for sale) by the licensee.

ABC Real Estate School 3st ed National Workbook August 2010 Page 146

Characteristics Which Indicate Value:

A licensee is not an appraiser, but he/she does need to be able to estimate value n e value of t estimate to assist buyers in dete

How does a licensee nder?

nged.

nd able’ buyer is it

r the or as an owner-occupied

tial property, sitting on a street that has been newly zoned commeits c r s it a unique property? Is it a brick church built in the early 1800’s or is it a

track home in a residential neighborhood? How many similar properties are available? How may similar properties are for sale? How may similar properties have sold recently? How many foreclosures are there in the area? A scarce item will have g will be more challenging to price.

he

ransfer?

i his job. He uses that estimate to enlighten a seller’s opinion about th his/her real property. He also uses tha

rmining a price to offer for the seller’s real property. How does a licensee estimate the value of a property?

find value to create a broker price opinion (BPO) of a foreclosure for a leThe 4 major characteristics of value haven’t changed much over the years. The criteria used to evaluate these indicators have changed as our economic environment has cha Is there demand for the property? What will a ‘ready, willing, apay for the property, under what terms? Is the neighborhood in demand, ordeteriorating? What is the ‘highest and best use’ (also know a utility or usefulness) foproperty? Will the property be used as a rental, property? What is its zoning and current land use? Is its land use contradictory to its zoning? For example, is it presently being used as a residen

rcial; or does it’s current use match ur ent zoning?

I

reater value and Is the property transferable? Can the buyer obtain financing to purchase the property or does it need to be a cash sale? How much of a down payment will thebuyer need to purchase the property? Are there any legal problems with tt


1. Demand

• The need backed up by the ability to pay.

2. Highest and Best Use/Utility

• The usefulness of the property.

3. Scarcity/uniqueness

• A limited supply of the item of value.

4. Transferability

• Ability to transfer the property legally and easily.

Licensees are NOT appraisers!

A licensee’s appraisal is: An estimate or opinion of value

Made by a professional appraiser Only good for a specific amount of time

Real estate agents prepare appraisals (estimate of value) for their clients, but they do not have the expertise or

credentials to be an appraiser.


Principles Which Impact Value perts believe that the most important of those principles is location, location, location. What would be the

on the Las Vegas strip, or 1 acre on N Virginia in Reno versus 1 acre 100 miles from a city, in tween the two cities.

a) The most important principle of value.

c) What is its proximity to other businesses, homes, and local landmarks such as highways, rivers and tourist attractions.

d) What type of view does the property have? Demand

a) Demand is need supported by the ability to pay. b) Is there a list of people waiting to purchase in the area? c) Is it is ‘stable’ residential area? d) How many properties are for sale or for lease in the area?

3. Supply a) How many properties are available? b) ey all occupied?

4. Utilia) How useful is the property? b) Is the lot bc) How muc ng? d) Does the) What

. Scarcity

b

Certain principles impact value. Most ex

difference in value of 1 acre the desert be

1. Location

b) What is the address of the property?

2.

Are there vacant, deserted properties; or are thty

uildable? h revenue is the property generati

e l t ha are the dimensions of the property?

o ve utilities?

5a) How many comparable properties exist? ) How many comparable properties are available?


6. Transferability a) Is it legal to for the owner to sell the property? b) Is there financing money at good terms to purchase the

property? c) H nd the loan? d) A he property?

.

ntal forces effect the the property?

etition? t is a business, will it have a lot of competition in the future?

all mmercial?

sidential property….does it have ‘track home fixtures’ or does

he cost of e and valuable property as a

much would it cost to duplicate the property? build new?

ow much is the down-payment required to fure there any legal restrictions to transfer t

7 Future Benefit/Anticipation a) What will be the future revenue resulting from the property

purchase? b) What are the expectations of future value?

8. Change a) How will economic, social, and governme

value of the property and revenue from9. Competition

a) How many comparable properties exist? b) If it is a business, does it have a lot of compc) If i

10. Conformity a) Is the architecture unique and/or consistent?

11. Consistent Use a) Is the neighborhood land use consistent? All residential or

co12. Extras

a) Does the property have ‘upgrades’? For example, if it is a reit have ‘high-end’ fixtures?

13. Substitution a) The market value of a property is affected by t

obtaining an equally desirablsubstitute.31

b) Howc) Is it cheaper to buy an existing product or

31 http://pinalcountyaz.gov/Departments/Assessor/Appraisal/Pages/Principles.aspx January 28, 2010.


Supply v Demand The sup and demand model describes how prices vary as a result othe balance between product availability and the number of products

ply f

that consumers are willing and able to purchase.

Price and demand in a given market are inversely related. In other words, the higher the price of a product, the less of it people would be able and willing to buy. As the price of a produ relatively ct rises, overall purchasing power decreases and consumers move towardless expensive goods. Other factors can also affect demand; for example an increase or decrease in relative income may also impact demand.

Supply is the relationship between the price of a good and the quantity available for sale from suppliers at that price. Producers attempt to produce the amount of goods that will bring them the highest profit. Other things unchanged, supply is typically represented as a directly proportional relation between price and quantity supplied.

In other words, the higher the price at which the good can be sold, the more of it producers will supply. The higher price makes it profitable to increase production. At a price below break even, there is a shortage of quantity supplied compared to quantity demanded. This pulls the pr a surplus of quantity supplied ice up. At a price above equilibrium, there is compared to quantity demanded. This pushes the price down. The model of supply and demand predicts that for given supply and demand curves, price and quantity will stabilize at the price that makes quantity supplied equal to quantity demanded. This is at the intersec

Demand goes up ⇒ Price goes up.

.

Supply goes down ⇒ Demand goes up ⇒ Price goes up.

tion of the two curves in the graph above, market equilibrium.32

If and then

Supply goes up ⇒ Demand is constant ⇒ Price goes down. Supply goes down ⇒ Demand is constant ⇒ Price goes up. Supply is constant ⇒

Supply is constant ⇒ Demand goes down ⇒ Price goes down Supply goes up ⇒ Demand goes down ⇒ Price goes down. Supply goes up ⇒ Demand goes up faster ⇒ Price goes up.

32 http://en.wikipedia.org/wiki/Economics#Supply_and_demand Accessed Jan 27, 2010.

http://pinalcountyaz.gov/Departments/Assessor/Appraisal/Pages/Principles.aspx


How does this relate to houses?

Nevada history teaches us supply and demand. During the year 2004, there was a

constant supply of houses for sale. Lenders became very generous with funding, causing an increase in demand for houses for sale. Because supply was constant and demand went up, prices increased. Builders increased supply, but demand still exceeded supply, because of the supply of loans. Prices continued to rise.

Starting in approximately 2007, the supply of loans decreased, decreasing demand; but the supply of real property for sale stayed constant. In addition to the decrease in the supply of loans, income started to decrease, decreasing demand. In both of these cases, supply stayed constant and demand decreased, causing a decrease in home prices.

esNevada newspapers and industry insiders talk about a ‘shadow inventory’ of foreclosurthat exist in areas such as Clark County. These are properties that have been repossessed by lenders. According to industry sources, the foreclosures are being kept out of inventory for sale to help keep the supply of homes for sale constant. Why would the lenders hold onto the homes and not try to liquidate its assets? A huge increase in supply, with demand and sources of lending funds constant, would cause a decrease in prices. This would ‘de-value’ the lender’s existing assets.

How does this relate to commercial units for lease?

25%. the prices?

In 2010, vacancy of commercial office units in Clark County is approachingSupply continues to increase, demand continues to decrease. What is happening to Prices continue to decrease.


Location, Location, Location Most real estate cteristics that impact value of real pr

Physical features effect value. The most important of these is location. The Site charact

r

and would have found success less challenging in a better l

om

insiders would agree that the three most important charaoperty are location, location and location.

eristic location may dictate success or failure for a business; and quiet, security, andhappiness or chaos, insecurity and unhappiness for a home-owner. How many time have youseen restaurants come and go from a specific location? Sure, sometimes a business with stellamarketing skills eventually may take over the location and make it work; but that business probably would have succeeded anywhere,

ocation. What is the ‘protected’ view? Who are the property’s neighbors? What is the access?

What is the crime rate? What is the traffic count? These are all important factors that stem frthe property’s location.

What else impacts value?

There are external and internal forces that impact property values. In addition to supply, demand, and location; other characteristics that impact value include utility, scarcity, transferability, anticipation, change, competition, conformity, consistent use, contribution, substitution, surplus productivity, balance and variable proportions.

Utility How useful is the property? What is the ning? What is the land use? Who was the previous owner or resident of the location? What is the access to utilities? Is the land pristine, or is the land contaminated. For example, a commercial corner lot may have previously been

zo


inhabited by an established gas station, or dry cleaner. If so, were the gas tanked removed from beneath the ground, or are they still there contaminating the ground?

A house in a highly desired residential area can be very useful. What about an abandoned, obsolete, c ld you give a large parcel of

nd without access to . A building cannot be built ontaminated factory? How much value wou any utilities that can only be used for huntingla

on the property. Without usefulness, the property’s value decreases.

Scarcity

The next characteristic that impacts value is scarcity. This is similar to supply, but is in

property. What about ski resort properties, waterfront properties or view properties? Because these highly desirable properties are scarce, their per unit value will be greater than a tract home in large supply.

There is a limited supply of land. Each piece of land has a unique location. The more scarce an item, the greater the demand, the more valuable the item. Scarcity is related to supply and demand theory.

dependent because it implies that there may be a limit to the availability of a product. Scarcity is what makes commercial property more valuable than residential property. It is less available than residential

Transf

Transferability is also an important indicator of value. Sometimes the product cannot be

to it; or if the person who has possession of the personal property does not actually own the title. A defeasible deed could exist because of a restriction on the deed. For example, the deed connected to a property may require the land be used for a specific purpose, such as a park, sanctuary or church. If the property is used for another purpose, ownership may revert to someone else.

Another possible situation that would cause a title or deed to become unmarketable could be a physical p as a property that was built over the property line on to someone

erability

sold because of flaws on the legal ownership document; such as an personal property item that didn’t have clear title or a piece of real property that came with a defeatable (defeasible) deed.

A title is not clear when there are liens (secured loans) attached

roblem, suchelse’s property, encroaching on the property. If uncovered in a survey, and because it negates the actual physical description of the property, it may make the property unmarketable and untransferable.


Anticipation

, causes prices of goods to increase.

he stock will increase. It is a ‘self fulfilling prophesy’. Anticipation will influence the value of a property. What is consumer sentiment? Do

buyers feel that the price of the property will decrease over time or do buyers feel that the price of the property will increase? What is the public perception of the future economic climate?

Anticipation alone, substantiated or unsubstantiated, can cause price increases. Most often though, the anticipation is based on advanced knowledge of future events. Maybe an investor purch ks will someday become a desired piece of commercial property on a busy highway. Maybe a family purchases a home in a new development that they think w

Anticipation can be the most underrated characteristic of value. Anticipation was the source of a frenzy, causing a run-up in real property prices in some markets, in the mid 2000’s. A homeowner discovered the sales price of the house next door, so he put his home on the market. Demand exceeded supply of available homes and loans were plentiful, so the prices continued to rise. Anticipation can cause unrealistic, unsupportable demand; and with a stable supply or at least supply less than demand

This also happens with stocks listed on the stock markets. Purchasers buy stocks in anticipation of a higher future value, and if enough purchaser buy the same stock that is in stable supply, the price of t

ases property that he thin

ill someday become a stable, high-end area. Most people purchase instead of rent their homes because of anticipation that the property value will increase, enabling them to sell the large investment someday, adding to their financial portfolio before retirement.

Change Change or the anticipation of change is also a characteristic of value. The continuing effects

g, a ates offered to large institutional financial institutions, a change in the land-

se of a neighbo ng property, even a change in reserve requirements (the percentage of money

of economic, social, and governmental forces on the property location and it’s environment, may result in a change in market value.

Commercial land is usually more valuable than residential land. Residential land is usually more valuable than industrial land. A change in zoning, a change in access to fundinchange in interest r

riu


that must be kept on hand at a federally insured financial institution), all can cause a change in the value of a property.

For example, a large metropolitan area just announced that a freeway will be extended through a residential piece of property, and the neighboring homeowner now owns commercial freeway frontage. Did the value of the neighbor’s property change? Did the neighbor’s property just increase or decrease? Is the home still the most valuable asset on the land, or is the home now a nonessential piece of the property’s value?

Competition

Competition is the tendency of a highly profitable product to be duplicated by othersan excess supply of similar goods and services reduces profitability, and thus value. In other words, when an industry is profitable, word gets out. When the demand for new homes exceedssupply, new developers come and build more developments. The new developm

until

ents are built

more e

ors come when

again m

fficiently, and advertising increases. Competition also comes when real estate offices become profitable. As real estate

businesses expand, sometimes they lose sight of their client’s needs. Competitthey see opportunity, and eventually the market gets saturated. Eventually, the supply of businesses exceeds the supply of customers. Advertising again increases, the price of services decreases, and businesses start to drop out of the market. Competition decreases until supply

atches demand, and the cycle begins again.

Conformity Conformity creates maximum market value through a reasonable degree of similarity of

property use, appearance, and owner demographics. This is the reason that master plan communities, such a Hills in Reno and Sun City Summerlin in Las Vegas and

es, lti-

homes are

s CottonwoodMesquite, require consistent building styles, similar colors, consistent billboards and signs sizand legally enforced zoning and land use. Similar property values are combined together. Mumillion dollar properties are built next to other multi-million dollar properties. Familykept near other family homes. Conformity perpetuates added-value.

A lower-quality property in an area has a higher value because it benefits from the higher-quality properties in the neighborhood. A higher-quality property in an area has a lower value because it is disadvantaged from the lower-quality properties in the neighborhood.


Consistent Use In addition to conformity, land-use should also be consistent in order to reap the greatest value from real property. Residential property should locate next to other residential property. Industrial property should locate next to other industrial property. Commercial property should locate next to other residential property. The exceptions to this are city lofts, downtown housing, and high-rise condos. A resident’s needs change as he or she ages and develops priorities. Lofts near bus incorporated into a master communities plans.

iness areas are usually

Contribution How much value will a new kitchen add? 80-90%? How much value will a homeowner

earn by swapping white tiles and beige tiles. 0% Does is the cost of the improvement the only variable? No. The cost of the improvement matters, but the added value to the next purchaser imost important variable.

s

Substitution The market value of a property is affected by the cost of obtaining an equally desirable and valuable property as a substitute. In other words, is it cheaper to purchase an existing property or build a brand new prope pares to the existing property? The cost of labor, materials, and real e in substitution.

rty that directly com property play a rol

Example: Mr. Lee is looking for a home to purchase on Mt. Charleston, outside of LaVegas. He is deciding between purchasing a vacant half acre parcel and an existing home on a half acre.

The Parkers, the sellers of the existing home, purchased their l

s

ot at the peak of the market ause in 2006 for $275,000. They scrambled for contractors to finish the project, and bec

of the low supply of workers and the high demand for those workers; the project went


$75,000 over budget. The asking price for the existing property is $450,000, which is their investment.

The vacant parcel is owned by a bank. The asking price for the parcel is $125,000.

Contractors and workers are plentiful, because of the lack of supply of jobs. A contractor has given the Lee’s a bid of $175,000 to build a new home on the vacant lot, comparable to the size of the P akes the substitution cost of the existing property $300,000

arker’s property. That m.

Which is the better deal for Mr. Lee? Hopefully you chose the 2nd example…the vacant parcel.

Highest and best use

“Highest and bes in real estate appraisal. It states that the value o

Test of highest and best use In order to b e Highest and Best Use of a property, any potential use must pass The exact definition of Highest and Best Use

•

• financially feasible •

owable

,

t use is a conceptf a property is directly related to the use of that property; the highest and

best use is the reasonably probable use that produces the highest property value.This use, the Highest and Best Use, may or may not be the current use of the property.

e considered as th a series of tests.

varies, but generally the use must be:

• legally allowable physically possible

maximally productive

Legally all

Only those uses that are, or may be, legally allowed are potential highest and best uses. This may exclude uses that are not, and unlikely to become, allowed by zoning


are ver, some such uses may not be reproduced if the legally

hysically possible

Any potential use must be physically possible given the size, shape, topography, and other characteristics of the site. For example a 40,000-square-foot (3,700 m2) single story warehouse would not fit on a 10,000-square-foot (930 m2) site, therefore that use would fail the physical possibility test.

sibility

ial is somewhat irrelevant. In the case of an improved property with limited

remaining economic life, the question of financial feasibility becomes a question of the maximally productive use of the site. If the value of the land As Vacant

ting improvements that do not represent the highest net value of the site is considered to be financially unfeasible.

e the highest net return (profit) to the developer. A veloped with residential, commercial or

ent might only have one of those uses as its highest and best use. These three hypothetical development scenarios follow to illustrate the test

Price of Site: $100,000 (remains unchanged in all three examples)

uses forbidden by government regulations, and uses prohibited by deed restrictions or covenants.

Properties with a use that predates existing zoning regulations may be legally nonconforming. Such grandfathered uses are generally legal even though they do not meet current zoning regulations. Since their use predates the zoning, they "grandfathered in". Howenonconforming improvement is destroyed or damaged beyond a certain point.

P

Financial fea

The highest and best use of a property must be financially feasible. This meansthat the proposed use of a property must generate adequate revenue to justify the costs of construction plus a profit for the developer. In the case of an improved property, with obvious remaining economic life, the question of financfeasibility

exceeds the value of the property As Improved less reversion/demolition costs, then redevelopment of the site becomes the maximally productive use of the property and continued use of the exis

Maximally productive use

Finally the use must generatproperty that could hypothetically be deindustrial developm

of maximally productive use.


Cost to construct 10,000 sq ft (930 m2) industrial warehouse: $750,000

P

Profit for retail development: 15%

Cost to construct 10,000 sq ft (930 m2) of residential condominiums: $1,200,000

As the examples illustrate, even though the retail development results in the t value for the development, the residential development

e

ial. A

similar "House B" in a commercially zoned area may have a highest and best use as nd highest and best use as improved as a single family

residence.

B" has a value as a house of $200,000, and a site value as a commercial lot of $250,000 with a cost to demolish the house and

is to demolish

_____

Market Value of 10,000 sq ft (930 m2) industrial warehouse: $910,000 rofit for industrial development: 7%

____ Cost to construct 10,000 sq ft (930 m2) retail strip center: $1,500,000 Market Value of 10,000 sq ft (930 m2) retail strip center: $1,840,000

_____

Market Value of 10,000 sq ft (930 m2) of residential condominiums: $1,534,000 Profit for residential development: 18% _____

overall highest markescenario results in the highest net return to the developer and this makes it themaximally productive use.

Vacant and improved

The Test of Highest and Best Use is applied to an improved properties both as improved and as if vacant. Vacant properties are generally only given the as vacant test. The Highest and Best Use as vacant may be the same or different as thHighest and Best use as improved.

For example, "House A" in a residentially zoned area may have a highest and bestuse as vacant and a highest and best use as improved that are both resident

vacant as a commercial lot a

If the value of the commercial lot as vacant in "House B" exceeds the value of house as a residence as improved plus demolition costs, the overall highest and best use of this property would be the as vacant value of the commercial lot. For example, assume that "House

prepare the site at $25,000. The Highest and Best Use of the site


the hous

ighest and best use • The most profitable use of a property given:

• Legal constraints • Financial const

e and sell the site as a commercial lot. The market value would be $225,000 ($250,000 site value minus $25,000 demolition cost). However if the

existing ould not

e.

is contrary as a

t Use is the commercial lot use. The market the property is driven by this hypothetical conversion, even if it never

ic theory

se

e same utility while a seller would accept no less that a seller of a comparable property. That is true to the neighborhood.”33

H

raints

demolition costs rose to $55,000, the Highest and Best Use would be theresidential use, because the value as a commercial lot (now $195,000) wexceed the existing value as a residenc

This would be the Highest and Best Use of the property, even though it to what actually exists. Even if the house is not razed and the site soldcommercial lot, the Highest and Besvalue oftakes place due to the utility that this potential conversion would bring to a purchaser.

Econom

The economic concepts of utility and substitution drive the highest and best uanalysis. The highest and best use of a property determines its utility to a potential purchaser. The purchaser of such a property would pay no more than a competing property with th

• Physical possibility • Maximum productivity

33 http://en.wikipedia.org/wiki/Highest_and_best_use Accessed June 25, 2010.


Market Cycles Real estate market cycles are an important investment concept. Every investor wants to

?

ut oincide

les, cycle prediction is a useful real estate concept.

buy real estate at the bottom of the market, and sell it at the peak of the market. A buyer wants to know, “Is it a good time to sell”? and a seller wants to know, “Is it a good time to buy”Everyone wants to maximize their profits and minimize their losses. As with any investment opportunity, the real estate market is always changing. It expands rapidly, slows down, levels out, and even contracts. The large swings are obvious, bthe peaks and valleys are hard to predict until after they happen. Because price changes cwith these cyc

Expansion

Expansion slows

Stable


Market Price v. Market Value Market v the highest and best use of the subject property. It is an alue must be based on

opinion of value based on the analysis of an appraiser. Often it is also the most probable price negotiated by well-informed parties not under duress, within a specific time frame.

It is important to distinguish between market value and market price. Market price is the price actually paid by the buyer for the property. A price obtained for a specific property in a specific transaction may or may not represent that property's market value. Special considerations may have been present, such as a special relationship between the buyer and the seller. The transaction may have been part of a larger set of transactions. A buyer may have been willing to pay a premium over and above the market value, if his perception of the property value was higher than the market value of the property; such as the purchase of a property that connects a property already owned by the buyer. The property may have been a distressed property, a foreclosure.

An example of this would be the owner of a neighboring property who, by combining his own property with the subject pr rty, could obtain economies l rationale for ope -of-scale. The usuathis valuation w of the whole is greater than the parts', since full ould be that the 'sum sum of theownership of the larger parcel entails special privileges for which a potential purchaser would be willing to pay,34

Another example would be the sale of a property by a seller with limited time to live, the sale of a property due to a divorce or the sale of a property by someone who inherited the property. Regardless of the value of the p er may decide to unload the property roperty, the sellfor a reduced price.

Maybe a buyer ‘anticipates’ a surge in property values. The buyer suspects that the value of the property will increase and is willing to ‘overpay’ for the property. The market price may be greater or less than the market value, depending on the circumstances and or market cycle.

arket Value: M * Opinion of value based on analysis * The most probable price the property will sell for * With well-informed parties * Within a reasonable time * Without duress * By normal consideration

34 http://en.wikipedia.org/wiki/Real_estate_appraisal#Price_versus_value Feb 2, 2010.

Chapter 4–Valuation and Market Analysis

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Transcript of Chapter 4–Valuation and Market Analysis