Washington Real Estate Fundamentals Lesson 12: Real Estate Appraisal © 2011 Rockwell Publishing.

Washington Real Estate Fundamentals

Lesson 12:

Real Estate Appraisal

© 2011 Rockwell Publishing

Appraisal Basics

Appraisal: Estimate or opinion of a property’s value, made by professional appraiser and set forth in written appraisal report.

Sometimes called a valuation.Not a scientific conclusion.

Competent appraisers may disagree about a property’s value.


Appraisal BasicsHow 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, buyer’s lender orders appraisal. Uses appraisal to determine if property is

adequate security for proposed loan. Maximum loan amount tied to property’s

value.© 2011 Rockwell Publishing


In each of these cases, seller, buyer, or buyer’s lender would hire fee appraiser. Fee appraiser: Independent appraiser hired

to value particular property for a fee. Most appraisers are fee appraisers. May be self-employed or work for

appraisal firm.



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


Appraisal BasicsAppraiser/client relationship

Whoever hires appraiser is the client.Appraiser is client’s agent.Example: Lender orders independent

appraisal for buyer’s loan application.Lender, not buyer, is appraiser’s client.Appraiser is lender’s agent, owes

fiduciary duties to lender.


Appraisal BasicsAppraiser’s fee

Appraiser’s fee set in advance, based on:expected difficulty of assignmenthow much time it’s likely to take

Fee can’t be:percentage of appraised valuebased on client’s satisfaction with results


Appraisal BasicsAppraiser 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 companyseparate department in lender’s

organizationAlso, real estate agent may not select or

compensate appraiser.© 2011 Rockwell Publishing

Appraisal BasicsAppraiser 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 informationexplain basis of value estimate more fullycorrect errors in appraisal report


Appraisal BasicsState 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 appraiserin accordance with Uniform Standards of

Profession Appraisal Practice (USPAP) Exemption: loans of $250,000 or less


SummaryAppraisal 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)


Value

Value: Present worth of future benefits of property ownership.

Usually measured in terms of money.


ValueTypes 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.


Market ValueElements of value

To have market value, an item must have four characteristics:

utilityscarcitytransferabilitydemand

These are sometimes called the elements of value.


Market ValueDefinition 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.


Market ValueMarket value vs. price

Thus, market value is the price that should be paid under all conditions requisite to a fair sale:

competitive and open marketprudent, informed, and unrelated partiesno 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.


SummaryValue

• Value• Value in use• Value in exchange• Market value• Elements of value• Conditions requisite to a fair sale


ValuePrinciples of value

Value is created and changed by major forces:social ideals and standardseconomic fluctuationsgovernment 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.


ValuePrinciples of value

Highest and best useChangeAnticipationSupply and demandSubstitutionConformityProgression and regressionContributionCompetition


Principles of ValuePrinciple 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; can’t violate zoning or CC&Rs.


Principles of ValuePrinciple of change

Principle of change: A property’s value will increase or decrease over time.

Changes in value occur:in response to external forcesas the property itself improves or

deteriorates

Therefore appraisal always tied to specific point in time: effective date.



Property’s four-phase life cycle:integrationequilibriumdisintegrationrejuvenation

Property’s value depends on where it is in its life cycle.



Property has:physical life cycleeconomic life cycle

Economic life usually ends first.Improvements become obsolete before

they actually fall apart.


Principles of ValuePrinciple of anticipation

Principle of anticipation: Anticipated future benefits of owning a property affect its value.

If property’s value expected to increase in future, that anticipation increases its current value.

If property’s value expected to decrease, that anticipation decreases current value.


Principles of ValuePrinciple 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.


Principles of ValuePrinciple 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.


Principles of ValuePrinciple of substitution

Principle of substitution: Property’s value limited by cost of obtaining equally desirable substitute, if substitute can be obtained without undue delay.

If two equally desirable properties available, the one that costs less will be purchased first.

Principle is theoretical basis for all three methods of appraisal (discussed later).


Principles of ValuePrinciple 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.


Principles of ValueProgression 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.


Principles of ValuePrinciple of contribution

Principle of contribution: An improvement may contribute more or less to the property’s value than the improvement cost to make.

Example: Finished basementConstruction cost: $7,000Contribution to value of home: $2,000


Principles of ValuePrinciple 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.


SummaryPrinciples of Value

• Highest and best use• Change• Anticipation• Supply and demand• Substitution• Conformity• Progression and regression• Contribution• Competition


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.


The Appraisal ProcessStep 1: Define the problem

To define problem, appraiser must:identify subject propertydetermine function of appraisal


The Appraisal ProcessStep 2: Determine data needed

Appraiser decides what data is needed based on:

type of propertyfunction of appraisal

Two main categories of data:generalspecific


The Appraisal ProcessStep 3: Gather & verify general data

General data: Information pertinent to subject property’s value that does not concern the property itself.

Population trendsEconomic conditionsCondition and quality of neighborhood


The Appraisal ProcessStep 4: Gather & verify specific data

Specific data: Data concerning subject property itself.

To collect specific data, appraiser performs:site analysisbuilding analysis


The Appraisal ProcessStep 5: Apply valuation methods

Appraiser chooses appropriate valuation method(s), given type of property being appraised.

Three methods of appraisal:sales comparison approachcost approachincome approach

For particular assignment, may use only one method, or two, or all three.


The Appraisal ProcessStep 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.


The Appraisal ProcessStep 7: Issue appraisal report

Final step is to prepare appraisal report and present report to client.

Appraisal report gives:final value estimateexplanatory information about how

estimate was arrived at


Gathering Data

Now we’ll take a closer look at steps 3 and 4, gathering general and specific data.

Appraiser first gathers, verifies, and analyzes general data:

economic trends and conditions (especially local conditions)

neighborhood analysis


General DataNeighborhood 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


Gathering DataSpecific data

Next, appraiser gathers, verifies, and analyzes specific data, data about the subject property itself:

site analysis (land and utilities)building analysis (improvements)


Specific DataSite analysis

Objective of site analysis: to determine property’s highest and best use.

Appraiser considers:lot size and shape (area, width, depth)frontagetopographyutilitiessite in relation to surrounding areaother factors that affect use or title


Site AnalysisFrontage

Frontage: Length of lot boundary that abuts street, body of water, or some other amenity.

Important consideration for:retail propertyresidential property beside a lake or

other desirable feature


Site AnalysisPlottage

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.


Site AnalysisUtilities

Appraiser considers availability and cost of utility connections.

For property in remote area, cost may be prohibitive, decreasing property’s value.

For septic system, soil must be suitable.Percolation test: Measures how well

soil absorbs water, to determine whether septic system can be used.


Specific DataBuilding 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.)


Specific DataBuilding 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.


SummaryThe Appraisal Process

• 7 steps in appraisal process• General data• Specific data• Value indicators• Reconciliation• Neighborhood analysis• Site analysis• Building analysis


Methods of Appraisal

Three main methods of appraising real property, called the three approaches to value:

Sales comparison approachCost approach Income approach

All are methods of estimating market value.

Which method appraiser relies on most depends on type of property in question.


Methods of AppraisalSales comparison approach to value

Sales comparison approach: Uses recent sales of similar properties in local market as basis for estimate of subject property’s value.

Also called market data approach.

Application of principle of substitution: Buyers won’t pay more for subject than

market price for identical property.

Best method for appraising single-family homes, vacant land.


Sales Comparison ApproachComparable 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.


Sales Comparison ApproachPrimary elements of comparison

Appraiser decides whether a property would be a good comparable using the primary elements of comparison:

date of salelocationphysical characteristicsterms of saleconditions of sale


Primary Elements of ComparisonDate of sale

Date of sale: Date buyer and seller agreed on a price.

Important because property values are constantly changing.


Primary Elements of ComparisonDate 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.


Primary Elements of ComparisonLocation

Location is the factor that has the greatest impact on a property’s value.

Appraiser looks for comparables in same neighborhood as subject property.

If necessary, may use sale of property in comparable neighborhood.


Primary Elements of ComparisonPhysical characteristics

Comparables should be similar to subject property in:

architectural styleconstruction qualityoverall conditionfeatures and amenities

Appraiser will make adjustments to account for differences in physical characteristics.


Primary Elements of ComparisonTerms of sale

A sale that involved seller financing or other special terms generally isn’t a good comparable.

Buyer may have been willing to pay more because of special financing terms.

Difficult to judge effect on sales price.

Appraiser looks for comparables sold on terms that are cash equivalent.


Primary Elements of ComparisonConditions of sale

To be used as a comparable, sale must have taken place under normal conditions:

parties were unrelated (“arm’s length transaction”)

buyer and seller acted prudently and knowledgeably

no unusual pressure on either partyproperty was offered in a competitive and

open market for a reasonable time


Sales Comparison ApproachMaking adjustments

To take into account physical differences between a comparable and the subject, appraiser adjusts sales price of comparable.

It’s always the comparable’s price, not the subject’s value, that is adjusted.


Sales Comparison ApproachMaking adjustments

Subject property has a feature the comp lacks:value of feature added to comp’s sales

price

Subject property lacks a feature the comp has:value of feature subtracted from comp’s

sales price


Sales Comparison ApproachEstimating subject property’s value

Appraiser estimates subject property’s value based on adjusted prices of at least three comparables.

Never simply averages the adjusted prices.

More weight given to the comparable(s) to which fewer adjustments were made.


SummarySales Comparison Approach

• Sales comparison approach• Comparable• Primary elements of comparison• Date of sale• Location• Physical characteristics• Terms of sale• Conditions of sale• Making adjustments


Methods of AppraisalCost approach to value

Cost approach: Bases estimate of subject property’s value on how much it would cost to build a replacement of the improvements.

Also called summation method, because it involves adding separate estimates of the improvements and land together.


Cost Approach to ValueSets ceiling on value

Cost approach usually provides ceiling for subject property’s value.

Another application of principle of substitution:Buyers won’t pay more for a used

property than the cost of building a new property of equal desirability.


Cost Approach to Value3 Steps

Steps in cost approach:

1. Estimate cost of replacing improvements.

2. Estimate and deduct any depreciation.

3. Add value of land.


Cost Approach to ValueStep 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 property’s market value.


Estimating Replacement Cost3 Methods

1. Square-foot (comparative unit) methodEasiest and most widely used.Square footage × Construction cost per sq. ft.

2. Unit-in-place methodEstimate cost of replacing each building

component (roof, flooring, plumbing, etc.).

3. Quantity survey methodDetailed, time-consuming estimate of

quantities and prices of materials and labor.© 2011 Rockwell Publishing

Cost Approach to ValueStep 2: Deducting depreciation

Depreciation: Loss in value due to any cause.

Three categories of depreciation: physical deterioration functional obsolescence external obsolescence


Categories of DepreciationPhysical 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.


Categories of DepreciationCurable or incurable depreciation

Curable depreciation: Cost of correcting it can be recovered in sales price when property sold.

Incurable depreciation: Can’t be corrected, or cost would be too high.

Physical deterioration usually curable, unless especially severe.Curable physical deterioration commonly

called deferred maintenance.


Categories of DepreciationFunctional 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 it’s not physical deterioration, then it’s functional obsolescence.


Categories of DepreciationExternal obsolescence

External obsolescence: Loss in value due to factors outside of property itself. Also called economic obsolescence.

Examples:adverse zoning changesundesirable neighborhoodtraffic congestionproximity to nuisance

Always incurable – outside owner’s control.© 2011 Rockwell Publishing

Cost Approach to ValueStep 3: Adding land value

Final step in cost approach is to add value of subject property’s lot or site to depreciated replacement cost of improvements.

Value of land estimated by sales comparison method.

Land is not depreciated.To appraiser, land is indestructible and

does not lose value.


SummaryCost Approach

• Cost approach• Replacement cost• Reproduction cost• Depreciation• Physical deterioration• Deferred maintenance• Functional obsolescence• External obsolescence• Curable and incurable depreciation


Methods of AppraisalIncome 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.


Income Approach to Value5 Steps

1. Calculate property’s 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 property’s net income to estimate its value.


Income Approach to Value1. 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.


Income Approach to Value2. 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 won’t be rented 100% of time.Tenants won’t always pay rent owed.


Income Approach to Value3. Calculating net income

Net income: Effective gross income minus operating expenses.

Operating expenses: Costs associated with operating income-producing property.

Three main categories:fixed expensesmaintenance expensesreserves for replacement


Calculating Net IncomeOperating expenses

Fixed expenses:property taxeshazard insurance



Maintenance expenses:tenant servicesutilitiessuppliescleaningrepairsadministrative costsbuilding employee wages



Reserves for replacement: Funds set aside for eventual replacement of structures and equipment that will wear out.


Calculating Net IncomeOther expenses

Expenses connected with property ownership that are not operating expenses for appraisal purposes:

mortgage payments (debt service)income tax paid on property’s earningsdepreciation reserves

These are not deducted from effective gross income in calculating net income.


Income Approach to Value4. Selecting a capitalization rate

Capitalization: Process of converting subject property’s net income into estimate of value.

Expressed as mathematical formula:

Income ÷ Rate = Value

Rate in formula is capitalization rate.Represents desired rate of return for

investor (potential purchaser).


Selecting a Capitalization RateRate reflects investment risk

If property is risky investment, investors:require a greater returnchoose 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.


Selecting a Capitalization RateSelection methods

Appraisers have various methods for selecting appropriate capitalization rate.

Example: Direct comparison methodAppraiser analyzes recent sales of

comparable income properties to determine their capitalization rates.

Investors likely to want about the same capitalization rate for subject property.


Income Approach to Value5. Capitalizing net income

Final step is to capitalize subject property’s annual net income to arrive at estimate of value.

In other words, divide net income by chosen capitalization rate to calculate value estimate.

Income ÷ Rate = Value


Income Approach to ValueGross 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.


Gross Income Multiplier MethodComparable rental homes

Appraiser locates comparables: rental homes similar to subject property that sold recently.

For each comparable, appraiser calculates a gross income multiplier.

Divides comparable’s sales price by its rental income.

May use either monthly or annual rent (appraiser’s choice).


Gross Income Multiplier MethodUsing 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 property’s rent to find its value.

If possible, appraiser should use subject’s economic rent.


Gross Income Multiplier MethodRough estimate

Gross income multiplier method provides only rough estimate of value.

Based on gross income.Doesn’t take into account operating

expenses or vacancies.


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.


Reconciliation and Final Estimate

Final estimate of value: Figure that best represents appraiser’s expert opinion of subject property’s value.

Appraiser presents final estimate of value to client in appraisal report.


Reconciliation and Final EstimateAppraisal 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.


SummaryIncome 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


Washington Real Estate Fundamentals Lesson 12: Real Estate Appraisal © 2011 Rockwell Publishing.

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Transcript of Washington Real Estate Fundamentals Lesson 12: Real Estate Appraisal © 2011 Rockwell Publishing.