Rea 100 Chapter 18

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Appraisal

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To estimate the value of something. Appraisals are also used to set prices on property listed for sale and to set premiums on fire insurance policies; they are used by government to acquire and manage public property tax levels for taxpayers.

To appraise means to estimate it's value.

-Appraisals are made as of a specific date. Not as a certificate of value that is good forever until used.

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Informal appraisal

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simply an estimate of value

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Formal appraisal

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"an independently and impartially prepared written statement expressing an opinion of a defined value of an adequately described property as of a specific date , that is supported by the presentation and analysis of relevant market information."

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Uniform Standards of Professional Appraisal Practice (USPAP) uses the valuation process (step-by-step procedure that appraisers use to conduct their work) which involves the following steps:

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1.) define the appraisal problem
2.) conduct preliminary analysis, formulate an appraisal plan, and collect the data
3.) estimate the highest and best use of the land as if vacant, and the property as improved
4.) estimate land value
5.) estimate the improved property value thought the appropriate value approaches
6.) reconcile the results to arrive at a defined value estimate
7.) report the conclusion of value

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What are the three value approaches in making an estimate?

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1.) Market approach
2.) Cost Approach
3.) Income approach

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Market approach (also called the market data approach or market comparison approach)

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A method of valuing property based on the prices of recent sales of similar properties and use them as benchmarks in estimating the value of the property you are appraising.

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Cost approach

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Add together the cost of the individual components that make up the property being appraised. Therefore, it starts with the cost of a similar parcel of vacant land and adds the cost of lumber, concrete, plumbing, wiring, labor and so on necessary to build a similar building. Depreciation is then subtracted.

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Income approach

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A method of valuing a property based on the monetary returns/ net income it can be expected to produce for its owner plus any anticipated price increase or decrease.

Being able to estimate the value of a property is an essential part of taking a listing and conducting negotiations.

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Market value (fair market value)

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The most probable price that a property should bring in a competitive and open market under all conditions requisite to a fair sale, each acting prudently, knowledgeably and assuming the price is not affected by undue stimulus.

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Market value is defined as the consummation (finalized completion) of a sale at a specified date and the passing of title from seller to buyer under conditions whereby:

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1.) buyer and seller are typically motivated
2.) both parties are well informed or well advised and each is acting in what he or she considers his or her best interest
3.) a reasonable time is allowed for exposure in the open market
4.) payment is made in terms of cash in U.S. dollars or in terms of of financial arrangements comparable thereto
5.) the price represents the normal consideration for the property sold, unaffected by special or creative financing or sale concessions granted by anyone associated with the sale.

*Market value is at the heart of nearly all real estate transactions

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subject property

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the property that is being appraised

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Comparables or "comps"

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Properties similar to the subject property that have sold recently. Therefore after the subject property, the next step in the market approach is to locate houses with similar physical features and amenities that have sold recently under market value conditions.

The more similar they are to the subject property, the fewer and smaller the adjustments made in comparison process, and hence less room for error.

- It is best to use comparable sales no more than six months old. During periods of relatively stable prices, this can be extended to one year. However, during periods of rapidly changing prices, even a sale six months old may be out of date.

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To apply market comparison approach, the following information must be collected for each comparable sale:

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-date of sale
-sales price
- financing terms
-location of the property
- description of it's physical characteristics and amenities

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Although deeds seldom states the purchase price, nearly all states levy (impose) a deed transfer or conveyance tax which is shown on recorded deed. This is turn can

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provide a clue as to the purchase price

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Adjustments

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Corrections made for price changes since each comparable was sold, as well as for differences in physical features, amenities and financial terms. The result indicates the market value of the subject property.

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When using market comparison approach, all adjustments are made to the

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comparable properties, not to the subject property. This is because we cannot adjust the value of something for which we do not yet know the value.

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Adjusted market price

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The dollar value of each comparable sale after it has gone through an adjustment process to make it the same as the subject property. Adjustments for each comparable are totaled and either added or subtracted from its sales price.

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Competitive market analysis (CMA)

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This popular method with agents who list and sell residential property is based on the principle that value can be estimated not only by looking at similar homes that have sold recently, but also by taking into account homes presently on the market value plus homes that were listed for sale but did not sell.

The CMA is a listing tool that sales agent prepares in order to show a seller what the home is likely to sell for and the CMA helps the agent decide whether to accept the listing.

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To apply the market comparison approach, the following information must be collected:

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Date of sale, sales price, financing terms, location of the property, and a description of its physical characteristics and amenities.

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Gross Rent Multiplier (GRM)

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A popular method because it is simple to apply and an economic comparison factor that relates the gross rent a property can produce to its purchase price. -- A number that is multiplied by a property's gross rents to produce an estimate of the property's worth.

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For apartment buildings, commercial and industrial properties, the GRM is computed by

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dividing the sales price of the property by its gross annual rent.

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A property with low operating expenses and a long expected economic life span can have a GRM score of

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7 or more. Whereas a property with high operating expenses or a shorter expected life span would be valued using a GRM of 6 or less.

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In order to choose a method of estimating construction costs,

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one must decide whether cost will be approached on a reproduction basis or on a replacement basis.

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Reproduction cost

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the cost at today's prices of constructing an exact replica of the subject improvements using the same or very similar materials.

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Replacement cost

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The cost at today's prices and using today's methods of construction, for an improvement having the same or equivalent usefulness as the subject property.

Replacement cost is the more practical choice of the two as it eliminates nonessential or obsolete (no longer produced or used; replacing with something new) features and takes full advantage of current construction materials and techniques.

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Square-foot method

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A method for estimating construction costs that is based on the cost per square foot to build a structure.

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In making an estimate, we use three kinds of depreciation methods which are:

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Physical deterioration- wear and tear

Functional obsolescence- outmoded equipment (old-fashioned plumbing fixtures), overly adequate structures, or improper designations for today's needs.

Economic obsolescence- loss of value due to external forces or events. (air noise pollution, etc)

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Curable depreciation

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Can be fixed at a reasonable cost. (worn carpeting, leaky roof, etc)

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Incurable depreciation

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Cannot be reasonably fixed and must simply be lived with ( illogical room layout)

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Capitalize

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To convert future income to current value.

Basic Principle of capitalization is: Income divided by Rate equals Value.

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Scheduled Gross (Projected gross)

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The estimated rent a fully occupied property can be expected to produce on an annual basis. This is derived from historical data blends with current operating experience of similar building by looking at past records. This helps determine what the future will bring.

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Operating expenses

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Expenditures necessary to maintain the production of income.

--Improvements are not classified as expenses because they increase the usefulness of the property, which increases property value.

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Reserves for replacement

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established items that do not require an expenditure of cash each year but perhaps only once in a lifetime.

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Net Operating Income (NOI)

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Gross income less operating expenses, vacancies and collection losses.

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Operating expense ratio

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Operating expense- Expenditures necessary to maintain the production of income.

The operating expense ratio can be calculated by dividing the total operating expenses by the effective gross income.

If the resulting ratio is out of step compared to similar properties, it signals the need for further investigation.

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Fictional depreciation

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method in which the U.S. Treasury allows income property owners to deduct as an expense when calculating income taxes. It was chosen by Congress to create an incentive to invest in real estate, not as an accurate gage of a property's life.

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The Appraisal Foundation

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Private organization whose purpose is to establish and approve.
1.) Uniform appraisal standards
2.) Appropriate criteria for the certification and recertification of qualified appraisers
3.) Appropriate systems for the certification and recertification of qualified appraisers.

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The Appraisal Foundation has established two subcommittees:

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Appraiser Qualifications Board (establishes criteria for appraisers) and the Appraisal Standards Board ( sets standards for the appraisal to be performed).

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FIRREA (Title XI Financial Institution's Reform, Recovery and Enforcement Act of 1989)

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Congress enacted this act along with the Appraisal Subcommittee of the Federal Financial Institution's Examination Council which establishes standards that will have a far-reaching impact on the appraisal industry

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USPAP (The Uniform Standards of Professional Appraisal Practice)

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Mandatory requirements that the appraiser must be aware of, understand and correctly employ those methods and techniques that are necessary.

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Complete Appraisal (Derived from the USPAP definition section)

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The first type of appraisal which is defined as the act or process of estimating value without invoking the Departure Provision. A Complete appraisal report may not depart from Specific USPAP Guidelines.

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Limited Appraisal (Derived from the USPAP definition section)

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The second and last type of appraisal defined as the act or process or estimating value performed under and resulting from invoking the Departure Provision

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Self-contained appraisal report

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The most detailed report attributable to the length and descriptive detail. Fully supports the conclusions of the appraiser as a self-contained format.

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Summary report

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less detailed than a self-contained report since it is only a summarization of the report rather than in detail.

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Restricted report

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The least detailed out of the three reporting options. There is only minimal presentation of info intended for use only by the client. This kind of report must have restrictions that limits the reliance on the report to the client and warns the client that additional info is needed.

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What are the reporting standards for self-contained appraisal reports set forth by USPAP?

See page 315

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1.) Identify and describe the real estate being appraised
2.) State the real property interest being appraised.
3.) State the purpose and intended use of the appraisal
4.) Define the value to be estimated
5.) State the effective date of the appraisal and the date of the report.
6.) State the extent of the process of collecting, confirming, and reporting data.
7.) State all assumptions and limiting conditions that affect the analyses, opinions and conclusions.
8.) Describe the information considered, the appraisal procedures followed and the reasoning that supports the analyses, opinions and conclusions.
9.) Describe the appraiser's opinion of the highest and best use of the real estate , when such an opinion us necessary and appropriate.
10.) Explain and support the exclusion of any of the usual valuation approaches
11.) Describe any additional information that may be appropriate to show compliance with or clearly identify and explain permitted departures from specific guidelines
12.) Include a signed certification

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The three traditional formats of Appraisal Reports are

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LETTER REPORT- least formal report. Contains conditions of the assignment , a summary of the nature and scope of the appraiser's investigation and an opinion of value. Used most often when the client is familiar with the property.

FORM REPORT- Most common type of report for real estate loan appraisals made on preprinted form usually containing a checklist for describing/rating property characteristics.

NARRATIVE REPORT- longest and most formal report of appraisal. Step-by-step presentation of facts used by the appraiser to arrive at a value. Preferred for self-contained appraisal reports.

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In order for a good service to have value in the marketplace, it must possess

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Demand, Utility, Scarcity and Transferability

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Principle of anticipation

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what a person will pay for a property depends on the expected benefits from the property in the future for ANTICIPATION of future income

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Principle of substitution

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Acts as an upper limit on prices; the lower priced of two similar properties will usually sell first.

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Highest and best use

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the use that will give the property its greatest current value.

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Principle of Competition

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recognizes that where substantial profits are being made, competition will be encouraged ie. when owners of apartment buildings are making substantial profit off of increased rent then builders and investors are encouraged to build more apartment buildings.

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Principle of conformity

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holds that maximum value is realized when there is a reasonable degree of homogeneity in a neighborhood. ie. a $200,000 would be out of place in a neighborhood of $90,000 houses

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Principle of diminishing marginal returns (principle of contribution)

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refers to the relationship between added cost and the value it returns. ie. we should invest dollars whenever they will return to us more than $1 of value for each $1 invested and we should stop when each dollar invested returns less than $1 in value.

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Assessed value

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Value given to a property by the country tax assessor for purposes of property taxation.

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Estate tax value

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value that federal and state taxation authorities establish for a deceased person's property; it is used to calculate the amount of estate taxes that must be paid.

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Insurance value

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concerned with the cost of replacing damaged property.

1.) value of land is not included as it is presumed only the structures are destructible.
2.) the amount of coverage is based on the replacement cost of the structures

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assemblage

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When two or more parcels are combined into a single large parcel

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plottage value

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Increased value of the large parcel over and above the sum of the smaller parcels

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Replacement value

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value measured by current cost of building a structure of equivalent utility.

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Salvage value

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what a structure is worth if it has to be removed and taken elsewhere, either whole or dismantled for parts. Since salvage operations require much labor, the salvage value of most buildings is usually very low.

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Buyer's market

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whenever supply and demand are unbalanced because of excess supply, this market forms where there are few buyers and many sellers which allows the buyer the option to negotiate prices and terms more in their favor.

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Seller's market

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When demand exceeds supply, sellers are able to negotiate prices and terms more to their liking.

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Broad market

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Many buyers and sellers are in the market at the same time making it easier to establish price of a property

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Thin market

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when there are only a few buyers and a few sellers in the market at the same time. It is often difficult to appraise a property in this kind of market because there are so few sales to use as comparables.

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When making a market comparison appraisal, how many comparable properties should be used?

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Enough to reasonably estimate market value but not so many as to involve more time and expense than is gained in added information. For a single family home, 3-5 good comparables are usually adequate

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How useful are asking prices and offers to buy when making a market comparison appraisal?

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Asking prices are useful in that they set an upper limit on value. Offering prices are useful in that they set a lower limit on value.

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In the market approach, are the adjustments made to the subject property or to the comparables? Why?

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Adjustments are made to the comparable properties. This is because it is impossible to adjust the value of something for which one does not yet know the value.

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Explain the use of gross rent multipliers in valuing real properties. What are the strengths and the weaknesses of this method?

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Gross rent times gross multiplier equals indicated property value. The strength of this approach is in its simplicity. Its weakness is also in its simplicity as it overlooks anything other than gross rents.

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What are the five steps used in valuing an improved property by the cost approach?

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1.) Estimate land value as though vacant
2.) Estimate new construction cost of a similar building
3.)Subtract estimated depreciation from construction cost to obtain -->>
4.) The indicated value of the structure, and
5.) add this to the land value

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Briefly explain the concept of the income approach to valuing real property,

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The income approach values a property based on its expected monetary returns in light of current rates of return being demanded by investors.

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Explain how the competitive market analysis method differs from the standard market approach method. Which method is better? For what?

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In the standard market comparison approach, a specific dollar adjustment is made for each item of difference between the comparables and the subject property. With competitive market analysis, adjustments are made in a generalized fashion in the minds of the agent and the seller. The CMA approach is usually preferred for listing homes for sale because there is less room for disagreement. The standard market approach is preferred for appraisal reports as it shows exactly how the appraiser valued for adjustments.

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What precaution does the principle of diminishing marginal returns suggest to a real estate owner?

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The principle of diminishing marginal returns warns against investing more than the capitalized value of the anticipated net returns.

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With regard to appraising a single-family house, what type of appraisal format would most likely be requested by the lender? A prospective buyer? An executor of an estate? A highway department?

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All of them would require a formal appraisal report

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In order to determine the market value of a parcel of real property, the appraiser assumes that

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Payment will be made in cash or equivalent along with reasonable time that must be allowed for market exposure, both purchaser and seller will be fully informed and neither buyer nor seller should be under abnormal pressure to buy or sell

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Using the market comparison approach to value determination, a real estate appraiser looks for data on sales of comparable properties which have occurred within the last

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six months

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Should an appraiser personally inspect each property used as a comparable sale in making an appraisal by the market comparison approach?

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Yes, to avoid making errors

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When there are more comparable properties than an appraiser needs, he should

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choose those that require the fewest adjustments.

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In a residential appraisal using the market approach, the appraiser would NOT make any adjustments for

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Improvements made to a comparable after it was sold.

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In temperate climate not subject to extreme weather conditions, is any adjustment necessary in appraising a house which has a two-car garage as compared to a similar house with a two-car carport?

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Yes, if buyers will pay more for a garage, appraisers must consider this.

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Adjustments for advantageous financing would be made in the

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market comparison approach to appraisal

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In completing an appraisal by the market comparison approach, the process by which comparables are weighted according to similarity to the subject property is known as

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correlation process

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The value of vacant land is commonly stated in

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Square foot, front foot and acre. Never square yard.

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Two vacant, adjacent lots are being appraised. They each have the same street frontage, but one is twice the depth of the other. The lot with the greater depth will be appraised

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as worth more than the other, but less than twice as much.

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A competitive market analysis (CMA) does not provide a listing agent with an

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appraisal to a lender because lenders do not accept CMAs

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Seller motivation is considered most in the

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competitive market analysis method

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Which of the following approaches is most likely to provide only a rough estimate of the value of a rental property?

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Gross rent multiplier because it considers only the gross income without considering expenses

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An appraisal by the cost approach does not include

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land because it is not depreciated in an appraisal

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In appraising a historically significant residence built in the Victorian era using the cost approach, an appraiser will probably appraise it on the basis of its

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reproduction cost because the building is historic

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A home in a residential neighborhood is in excellent condition, but which has a poorly designed floor plan, is suffering from

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incurable depreciation (functional obsolescence)

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A real estate appraisal is an _________ of value.

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estimate

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Four students are in an appraisal course. In completing a problem using the income approach, each student used a different cap rate: 8.5%, 9%, 9.5% and 10%. Which cap rate will produce the highest indicated value for the property?

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8.5% because the lower the capitalization rate used by the appraiser, the higher the indicated value of the property.

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The rents that a property can be expected to produce on an annual basis may be referred to as the scheduled gross or

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projected gross income.

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To project the gross income and expenses of a building, the best starting point is

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the actual record of income and expenses for the past three to five years for projecting future gross income and expenses.

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In income and expense forecasts, a small error in income projections results in

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a larger error in the market value of the property

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A projected annual operating statement for a rented building would NOT include

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capital improvements

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Replacement reserves are set up for items in a building that must be replaced

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more than once in the building's life, but not annually.

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The operating expense ratio of a building is determined by dividing the total operating expenses by the

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effective gross income

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Market comparison approach should be used for

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residential properties

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Income approach should be used for

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apartment buildings

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Special-purpose buildings are usually best appraised by the

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cost approach

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The actual selling price of a property is determined by the

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buyer and seller

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The Appraisal Foundation is a

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private organization

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The new FIRREA legislation requires that appraisal reports the

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amount of the fee paid for the appraisal

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Standards for review appraisals and reporting were developed by

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FIRREA (Financial Institution's Reform, Recovery and Enforcement Act)

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A real estate analysis is

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a process of providing information on diversified problems, recommendations and conclusions in real estate

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The use of a property which will give it its greatest current value is its

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highest and best use

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The principle stating that the maximum value of a property tends to be set by the cost of acquiring another equally desirable property is known as the principle of

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substitution

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A real estate salesperson gave an owner an off-hand estimate of the value of his home. Relying on this information, the owner listed with the salesperson's broker and contracted to sell the home at the salesperson's estimated value. The property was later appraised by a qualified appraiser for a substantially larger amount. The broker would

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be liable for civil damages to the property owner and would be subject to disciplinary action by the real estate department for unprofessional conduct.

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The principle which holds that maximum value is realized when a reasonable degree of homogeneity is present in a neighborhood is known as the principle of

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conformity

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May a property have different values if the purpose of the appraisal from two or more appraisals are not the same?

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Yes, because value is affected by the PURPOSE of the appraisal