Chapter 15

CONCEPTS or APPRAISING

A real estate appraisal is merely an estimate (or opinion) of value. It is usually presented in the form of a written or narrative report, which states the estimate of the value of a property as of a specified date, and is supported by the statement and analysis of factual and relevant data. An appraisal does not establish, create, or determine value. It is only an opinion of value. The accuracy of an appraisal depends upon the experience and skill of the appraiser and the availability of pertinent data.

Appraising is not an exact science, for no two people may agree on the same estimate of value. However, it is considered an "art" which can be learned and developed by training, experience, judgment and knowledge. In most real estate transactions, the broker is not called upon to make a formal appraisal. Appraising is a job for a professional who has the proper training and skill to be recognized as an expert.

VALUE

MARKET VALUE. The purpose of all appraisals is to estimate market value. Market value is defined as the most probable price a buyer, acting freely, would pay and the lowest price a seller, acting freely, would accept, assuming both are fully informed and the property has been on the market for a reasonable time. Note: "Market value" is best indicated by recent sales of comparable properties.

CHARACTERISTICS OF VALUE. Value is not a characteristic inherent in the object itself. The value of property has been defined as the relationship between something desired and a potential purchaser. The value of real estate is related to the need for shelter and income. As need increases and supply decreases, values go up. Personal factors, such as the desire for a particular location or type of home, also contribute to value.

FOUR ELEMENTS OF VALUE. There are four elements of value:

1. Utility. Utility is the ability to arouse desire for its possession or use.

2. Scarcity. The object must be relatively scarce to satisfy the demand.

3. Demand. There must be a need and ability to purchase.

4. Transferability. It must be possible to transfer good title with ease.

FORCES WHICH CREATE VALUE. Real property value is totally dependent upon four great forces, which motivate human activity. These forces create, maintain, modify or destroy value. The four forces are:

1. Social. Social forces include population growth and decline, shifts in population density and changes in family sizes.

2. Economic. Economic forces consist of natural resources, commercial and industrial trends, employment trends and wage levels, availability of money and credit, price leveIs, interest rates and tax burdens.

3. Political or Government. Zoning laws, building codes, police and fire regulation and rent controls affect the value of real estate.

4. Physical. Physical forces include climate and topography, soil fertility, mineral resources transportation schools, churches, parks and flood control.

The interplay of these forces has an impact upon value and must be considered in estimating the value of real estate. They are the basis for making an appraisal.

TYPES OF VALUE. The purpose of most appraisals is to estimate market value. However, property may also be appraised to determine other types of value such as insurable value, assessed value, salvage value, loan value, rental value and condemnation value. Note: For appraisal purposes, the assessed value of a property always has the greatest influence on a property's value.

VALUE AS DISTINGUISHED FROM COST AND MARKET PRICE. Cost is a measure of past expenditures. A house, which sold for $190,000, may have been sold for more or less than the market value, depending upon the circumstances of the sale. For example, a home, which cost $200,000, to build may be valued at $300,000 because of a superior location.

Market price is the amount paid for a property. It is what a seller gets for the sale of property or what a buyer pays under current market conditions. Price can be taken as an indicator of value only after considering all the factors that made up the sale, such as location, financing and forces influencing the sale.

ECONOMIC PRINCIPLES THAT AFFECT VALUE. The value of property is affected by certain economic principles. The most important of these principles are as follows:

1. Highest and Best Use. Highest and best use is that use of property, which at the time of appraisal is most likely to produce the greatest net return to. it the land over a given period of time. "Net return" doesn't always refer to return of money, but can take the form of amenities. For example, a private dwelling may render a "net return" in the form of agreeable living far outweighing a monetary net rental yield. On the other hand, the presence of a single family dwelling on a lot zoned for business use, may not be utilizing the land for its highest and best use. The land might be more valuable for use as a parking lot. It is the best use of property, which creates its greatest value. Therefore, its current use at the time of the appraisal may not be considered in determining highest and best use.

2. Supply and Demand. Scarcity of a commodity influences its value by creating a greater demand for the item. For example, as oceanfront property diminishes, its value increases to meet the demand. Demand is also affected by desire. If there is an over-supply of apartments in a given area, the desire for them will diminish, and values or rents will go down.

3. Substitution. The value of property tends to be set at the cost of acquiring an equally desirable substitute property. In theory, no one should pay more for a property than what it would cost to obtain a site by purchase and sale and the construct a building of equal desirability and utility. Substitution is the basis for the comparison or market data approach to appraising. Note: The "market data approach" is most often used in evaluating residential property.

4. Balance. Balance refer to the relationship between cost, added cost and the value it returns. For each dollar invested, the value should increase by more than one dollar.

5. Conformity. A property will tend to hold its value when other properties in the area are similar in style and quality (homogeneity), and will decline in value when they are not. For example, a $300,000 house would be out of place in a neighborhood of $180,000- houses. Conformity is the basis for zoning laws, since it assures a uniformity of structures and uses which enhances value.

6. Contribution. The value of an improvement to property is measured by its contribution to the net return of the property rather than its actual cost. For example, a single-family homeowner installs a swimming pool at a cost of $15,000, but the value of the home may only increase by $5,000, On the other hand, a swimming pool installed at a cost of $50,000 in an apartment building, might increase the property value by more than its cost, due to the potential increase in rents.

7. Increasing and Decreasing Returns. This theory states that the more money spent in the production of a project, the greater will be its return, up to a certain point (the law of increasing returns), and that any additional expenditures beyond this point will not produce a sufficient return to justify the additional investments (the law of decreasing returns). In estimating value, the appraiser must make a hypothetical projection as to what improvements would return the greatest net yield to the land.

8. Anticipation. The value of property is affected by anticipated, future benefits or deficits. For example, in estimating the value of an apartment building, the appraiser must examine the past income experience in order to determine whether the building will continue to produce at the same or a decreased level in the future. An appraiser must anticipate, as best as possible, what forces and factors will create or influence future benefits.

9. Competition. This principle states that competition will be encouraged in an area where substantial profits are being made. For example, if a developer is making substantial profits on the sale of condominiums in a resort area, other builders will be encouraged to build more condominiums. For the developer, the danger of competition is that over-building may result in a reduction of value.

10. Plottage. Plottage is the merging of two or more adjoining lots to produce a larger lot having greater value than the original lots had separately. For example, two lots valued at $20,000 each may be worth a total of $60,000 when combined to form one lot. The process of combining two lots into one is known as assemblage.

11. Change. Everything is in a constant state of change, which is characterized by three stages: (1) Growth, (2) Stability and (3) Decline. Property value in a given neighborhood will fluctuate and be influenced by these stages. The ability to anticipate and identify changes will produce a more accurate estimate of value.

THREE APPROACHES TO ESTIMATING VALUE

The three basic methods or approaches to appraising real estate are: (1) Market Data, (2) Cost and (3) Income (Capitalization). While each method works best for a particular type of property, all three are used in most appraisals. The appraiser determines how much weight is to be given to each approach.

MARKET DATA APPROACH TO APPRAISING

The market data approach (comparison method) is considered the most reliable, especially in appraising residential property where the amenities and intangible benefits are so difficult to measure. By using the principle of substitution, the appraiser compares the property being appraised with recent sales and offerings of similar properties in the neighborhood. The prices of the comparable sales are adjusted for the difference in ages, conditions, size, style, location and physical characteristics. The appraiser selects the most comparable sales and estimates the value of the subject property in relation to the ones selected. The appraiser prepares a rating chart, as illustrated in Figure 15:1, in which prices of the comparable sales are adjusted to match the subject property.

SOURCES OF DATA. In using the market data approach, the appraiser must find enough comparable houses in the neighborhood that have changed hands recently. Three is usually the minimum requirement for most bank appraisals. Five is most desirable. Information regarding recent sales can be obtained from such sources as: office files, public records, deed tax stamps, assessor's office, newspapers, trade journals, classified ads, word of mouth, other brokers, friends, sellers, buyers, tradesmen in the area and county recording offices.

COST APPROACH TO APPRAISING

The cost approach is based upon the cost of replacing the property to be appraised (subject property). Note: The "cost approach" to value is best used on a unique, older public building, such as a school or a library. The property's value is assumed to be equal to its replacement cost less depreciation. The appraiser estimates the value of the land and adds this to the reproduction cost of the improvement less an allowance for depreciation. The three steps to the cost approach are:

1. Estimate the value of the land as if vacant.

2. Estimate the current cost of reproducing the existing improvements.

3. Estimate and deduct depreciation from all causes.

VALUE OF THE LAND. Land value is estimated by referring to recent sales of comparable property in the neighborhood and by checking with the local tax assessor's office to determine what portion of the purchase price can be allocated to the land. Adjustments are made for significant differences, such as lot shape, presence of sewer lines, and utilities.

The value of the improvement may be estimated by using either the replacement cost or the reproduction cost. Reproduction cost is what it would cost, at current prices, to duplicate the building using the same materials and construction methods. Replacement cost is the cost of constructing the same general style of building using modern construction practices and designs. Most appraisals use the replacement cost method.

DETERMINING REPLACEMENT COST. There are three methods of determining replacement cost: (1) Quantity survey, (2) Unit-In-Place and (3) Square footage.

Quantity Survey. This method is used mostly by experienced cost estimators for pricing contract bidding. Under this method, a detailed cost estimate is made for each major labor and material construction item, from cost of groundbreaking to final decorating and cleaning up. Since the average appraiser is neither technically trained nor qualified to undertake this minute and detailed cost study, other quicker methods are used.

Unit-In-Place. This is a simpler and quicker method of appraising cost, preferred by architects and builders. Under this method, the costs of structural units installed or in place are itemized and summarized. For example, the number of cubic yards of concrete poured is multiplied by the units in place. The same is done for the number of square feet units of flooring, roofing, siding, and plastering. Although fairly accurate, this method is time consuming and costly for the average appraiser.

Square Footage. Under this method, the: applicable unit cost per square foot of a building is determined by dividing the total building costs of similar structures recently completed, by the building's total interior square footage. The unit cost thus obtained is then multiplied by the total square feet of the building to be appraised. For example, a two story brick colonial might cost $90 per square foot to build. A two-story brick colonial with a floor area of 1,800 square feet would then cost $162,000. This is fairly accurate, provided the unit cost is obtained from a similar building constructed. within the last six months.

DEPRECIATION. Depreciation is the loss of value from any cause. To arrive at value, the estimated cost of reproducing an improvement must be adjusted for depreciation. There are three categories of depreciation: (1) Physical deterioration, (2) Functional obsolescence and (3) Economic obsolescence. Physical deterioration and functional obsolescence may be further subdivided according to curability. The third class, economic depreciation, is rarely curable. Note: Depreciation of the value of investment property is commonly claimed as a tax deduction.

Physical Deterioration. Deterioration resulting from deferred maintenance, such as wear and tear on the roof; the heating and plumbing systems and the paintwork can usually be cured at a reasonable cost. Deterioration caused by the ravages of time, such as settling, a cracked foundation or a leaky basement, problems, which cannot be repaired at a reasonable cost, is incurable.

Functional Obsolescence. Functional obsolescence consists of physical or design features, which are no longer desirable, such as outmoded plumbing, old kitchens and baths, poor room arrangement and lack of closets. Most of these can be easily corrected, although at some expense. Physical or design features which are too costly to correct, such as a house with no basement or a four bedroom house with only one bathroom, are incurable. However, other factors, such as the scarcity of land or a desirable location, may make such items economically curable.

Economic Obsolescence. Economic or locational obsolescence relates to loss of value from external causes and is incurable. Population changes, zoning changes, nearness to construction of new apartment or office buildings, nearness to factories, highways, airports, noise, etc., all affect the desirability of the location.

METHODS FOR DETERMINING DEPRECIATION ALLOWANCE. In doing a cost approach estimate of value, there are two methods of determining the deduction for depreciation: (1) The Breakdown Method and (2) The Straight Line Age-Life Method.

The Breakdown Method. Using the breakdown method, the appraiser determines the total depreciation by observing and assigning a dollar value to the three kinds of depreciation and subtracting this from the replacement cost. Although more complicated, this method is more accurate than the straight line age-life method.

The Straight Line Age-Life Method. Using the straight-line method, the appraiser determines a building's economic life when new and then determines its actual remaining life at the time of the appraisal. The actual remaining life is subtracted from to arrive at the effective life. The accrued depreciation is deducted from the replacement cost. Note: "Economic life" refers to the period during which a property may be profitably utilized.

Figure 15:2

EXAMPLE OF COST APPROACH APPRAISAL

CAPITALIZATION RATE. The most difficult part of using the income approach is to determine the appropriate capitalization rate. The rate should be one which investors in that type and class of property require as a condition for making their purchases of such properties. The rate varies depending upon the type of investment and risk involved. Generally, the greater the risk, the higher the rate of return. By analogy, an investor will expect a higher rate of return on a speculative stock than for government bonds because of the difference in the risk. Likewise, a real estate investor will expect a greater rate of return from an older apartment building in a marginal location than from a newly constructed garden apartment building in a prime location. The following formulas are useful in doing capitalization problems:

STEPS IN THE INCOME APPROACH. In applying the income approach, the appraiser first determines the gross annual rents. If the appraiser feels that the actual rents are too low, they may be estimated. An allowance of approximately 5% for vacancies and legal expenses is deducted from gross rents to arrive at effective gross rents. Annual operating expenses are then deducted from the effective gross rents to arrive at the annual net operating income. The value of the property is estimated by dividing the annual net operating income by the appropriate capitalization rate.

Example of Appraisal by The Income Approach

GROSS INCOME MULTIPLIER (GIM). The gross income multiplier is a factor or number, which is multiplied by the annual gross income to arrive at a value estimate. For example, if a duplex with an annual gross income of $30,000 is sold for $150,000, its price is five times the annual gross income. The use of a gross income multiplier is not an acceptable appraisal method. It is used as a method of comparison. For example, suppose apartment buildings in a particular area are producing an annual gross income of 1/6th of the price at which they are selling. The value of a subject property being appraised in the same area could be said to be worth at least six times its annual gross income.

GROSS RENT MULTIPLIER (GRM). The GPM is used for evaluating one family residences or duplexes, which are owned for rental income. Value is determined by multiplying the monthly rent by a number or factor developed from comparable sales. The GIM and GRM are not reliable methods of appraising property. They are used as a substitute for a more elaborate income capitalization analysis.

STEPS IN THE APPRAISAL PROCESS

The appraisal process consists of a number of orderly steps, which lead to the appraiser's estimate of value contained in an appraisal report. These steps are as follows: Note: An appraiser checks a property's zoning to determine the legally permissible uses for the site and uses the market data approach to determine land value.

1. Define the Problem. Determine the purpose of the appraisal; define the value to be estimated.

2. Determine Highest and Best Use. Make a preliminary survey of the market forces, competition and potential uses of the property to determine its most profitable use.

3. Establish a Data Program. List the types of data needed and the sources to be consulted. There are two principal classes of data: (1) General and (2) Specific. General data indicates facts about and conditions in the region, the city and the neighborhood. Specific data comprises information about the title, the building and the site.

4. Select the Appropriate Approach. In most appraisals, all three approaches are used although the appraiser may believe the value indication from one approach is more significant than the others.

5. Gather the Data for the Approaches To Be Used.

6. Estimate the Value of the Property Using. All Three Approaches. This is the process of interpreting the data into a value estimate.

7. Reconcile the Estimated Values. The appraiser reviews all three approaches and determines how much weight to give to each one in order to arrive at a final value estimate. This process is also known as correlation, and is more fully explained later in this chapter.

8. Prepare an Appraisal Report. An appraisal report is a formal, written presentation of the data considered and analyzed, the methods used, and the opinions and conclusions reached in formulating the appraiser's final estimate of value.

9. Note: (Cost) The cost of an appraisal is based primarily on the amount of time and work put into the report.

CORRELATION. In correlating the three value approaches, the appraiser takes into account the purpose of the appraisal, the type of property, and the adequacy of the data processed in each approach. This will determine how much weight will be given to each approach. For example, in the case of a single-family residence, more weight would be given to the market data approach. If the appraisal were being made for insurance purposes, more weight would be given to the cost approach. In the case of a twenty-unit apartment building, the appraiser would rely more upon the capitalization approach.

The appraiser does not average the results of the three approaches to arrive at a value estimate. By placing more emphasis on the approach, which appears to be the most reliable, the appraiser may make a judgement as to what degree of reliance to place on the other two indicators of value.

APPRAISAL OF LEASE INTERESTS

When real estate is leased, the owner gives up or transfers one right of ownership, i.e. possession. To the owner, the right that has been given up is known as a leased fee. The person (lessee) receiving the right to use the property has a leasehold interest.

Leased Fee. A leased fee is the owner's interest in property leased to another. A leased fee entitles the owner to rents plus the reversion of the property at the termination of the lease, plus any benefits according to the terms of the lease. In appraising a leased fee, the appraiser usually capitalizes the present value of the income received by the lessor and adds the reversionary value of the land and/or building.

Leasehold Interest. A leasehold interest consists of use and occupancy of the property, plus or minus the difference between the actual or contract rent paid and the economic rent. Economic rent is what should be paid under normal market conditions. The value of a lease is determined by the difference between the contract rent and the economic rent, and how long the lease has to run. For example, a five-year lease with three years remaining has a contract rent of $600 per month. The current rental value of the premises is now $800 per month. If the lease is assignable, the fact that it offers a $200 per month savings for three years makes it more valuable.

COMPETITIVE MARKET ANALYSIS

Real estate brokers who list and sell residences use the competitive market analysis (CMA) method to estimate the value of the listing. CMA is a variation of the market comparison approach and is based on the principle that value can be estimated, not only by looking at recent sales of similar homes, but also by taking into account homes presently on the market, plus homes that were listed for sale but did not sell. CMA is a tool used by brokers to show the seller what the home will likely sell for and to determine whether or not to accept the listing.

KEY WORDS AND PHRASES