Real Estate Appraisal

Appraisal Concepts and Process

Key Appraisal Terms

• Accrued Depreciation
• Anticipation
• Appraiser
• Appraiser Independent Requirements
• Assemblage
• Broker's Price Opinion (BPO)
• Capitalization Rate
• Change
• Competition
• Conformity
• Contribution
• Cost Approach
• Depreciation
• Economic Life
• External Obsolescence
• Functional Obsolescence
• Highest and Best Use
• Income Approach
• Law of Diminishing Returns
• Law of Increasing Returns
• Market Data Approach
• Market Value
• Net Operating Income
• Physical Deterioration
• Plotage
• Progression
• Property Inspection Waiver
• Reconciliation
• Regression
• Sales Comparison Approach
• Sales Price
• Substitution
• Supply and Demand
• Uniform Standards of Professional Appraisal Practice (USPAP)
• Value

Appraisal Overview

• Appraisal is a specialized area within real estate.
• Most transactions require an appraisal by a licensed appraiser.
• Real estate professionals need to understand appraisal principles for accurate Comparative Market Analysis (CMA).
• Broker's Price Opinion (BPO) is less expensive than an appraisal and may be used for refinancing.
• Knowledge of the appraisal process helps recognize questionable appraisals.

Definition of Appraisal

• An appraisal is an opinion of value based on supportable evidence and approved methods.
• An appraisal report provides an opinion of market value to a lender or client.
• It includes an analysis of market conditions, property features, and comparable properties.
• Considers recent sales, listings, land value, and construction costs.

Appraiser Independence

• Appraisers are independent professionals providing unbiased opinions of value.
• Appraising is a professional service performed for a fee, not a commission based on the appraised value.
• Accurate appraisals are crucial for real estate transactions and safeguard against fraud.
• The Dodd-Frank Act addressed coercion and influence on appraisals to prevent fraud, separating lenders and appraisers.
• Fannie Mae issued appraiser independence requirements effective October 2010.
• Appraisal activities are regulated, requiring licensing and continuing education.

Federally Related Transactions

• Involve a federal financial or regulatory agency.
• Include the sale, lease, purchase, investment, or exchange of property.
• Also, include using real property as security for a loan or investment.

Appraisal Waivers

• Fannie Mae may not require a new appraisal for limited cash-out refinancing if the borrower and lender are the same and the transaction occurred less than 12 months ago.

Appraiser Qualifications

• Appraisers require continued education, certifications, and designations.

Comparative Market Analysis (CMA)

• Used by real estate professionals to suggest a listing price to sellers.
• Based on recently closed and active properties, as well as expired listings.
• Includes a disclosure stating that the CMA is not an appraisal.

Broker's Price Opinion (BPO)

• Similar to a CMA but with specific questions for the licensee to answer after a drive-by inspection.
• Lenders use BPOs for refinancing, short sales, and foreclosures.
• It's an opportunity for real estate professionals to earn income.

Appraisal Process

• An orderly set of procedures to collect and analyze data for a justifiable opinion of value.
• The value sought is often market value, but appraisals can determine insurance, salvage, or assessment value (property taxes).

Data Needed for Appraisal

1. General Data:
   • Everything that may have an impact on value.
   • Includes national, regional, city, neighborhood, and local influences (physical, economic, social, and political).
2. Specific Data:
   • Relates only to the property being appraised.
   • Includes square footage, number of bathrooms and bedrooms, etc.

Steps in the Appraisal Process

1. Define the problem (determine the value).
2. Determine the scope of work.
3. Gather general data (nation, region, city, neighborhood).
4. Analyze the property itself (specific data).
5. Determine the appropriate appraisal approach based on property type.

Appraisal Report

• Identifies the real estate and property interest (e.g., fee simple).
• States the purpose and intended use of the appraisal.
• Defines the value sought (e.g., sales price).
• States the effective date of the value.
• Outlines the extent of data collection, confirmation, and reporting.
• Lists assumptions and limiting conditions.
• Describes information considered and supports the report's conclusion.
• Includes the appraiser's opinion of the highest and best use.
• Confirms compliance with rules, regulations, and laws.
• Features a signed certification.

Independence in Valuation

• Value is not determined by the seller, buyer, or real estate professional.
• The appraiser relies on experience and expertise to develop an objective report.
• The lender relies on the appraisal to make loan decisions, especially in case of loan default.

Sections of an Appraisal Report

• Property information: address, occupancy, real estate taxes, fee simple, PUD/HOA details.
• Contract information: contract price, date, seller's ownership, financial assistance, concessions.
• Neighborhood description: location, built-up percentage, growth rate, marketing time, housing trends, property values, supply and demand.
• Site details: lot dimensions, area, shape, zoning specification, zoning compliance, and highest and best use.
• Utilities: list of utilities, flood hazard area, FEMA details.
• Improvements: number of units, type (detached, attached), design, year built, foundation, attic, heating.
• Subject property and comparable properties.

Value

• Value, in real estate, has the following characteristics (DUST):
  • Demand: Need or desire for possession, backed by financial means.
  • Utility: Usefulness for its intended purpose.
  • Scarcity: Limited supply.
  • Transferability: Ability to transfer ownership.

Market Value

• The most probable price a property should bring in a competitive and open market.
• Assumes informed and prudent buyers and sellers acting without undue pressure.
• Requires that:
  • Buyers and sellers are unrelated.
  • Both are well-informed about the property.
  • A reasonable time is allowed for market exposure.
  • Payment is made in cash or equivalent.
  • The price is unaffected by special financing.

Market Price

• Market price is a property's actual sales price, while market value is an opinion of what the property should sell for under fair conditions.

Cost

• Cost does not always equal market value.
• Cost and value may be the same for new improvements.
• Additional improvements may not add equal value (e.g., a $30,000 swimming pool may not increase the property's value by $30,000).

Basic Principles of Value

• Anticipation: Value is created by the expectation of future events.
• Change: Physical and economic conditions are not constant.
• Competition: Interaction of supply and demand creates competition.
• Conformity: Maximum value is created when a property is in harmony with its surroundings.
• Contribution: The value of a property part is measured by its effect on the value of the whole.
• Highest and Best Use: Most profitable single use of a property that is physically possible, legally permitted, economically feasible, and the most productive.
• Increasing and Diminishing Returns: Improvements increase the property's value only to a certain point.
  • Law of increasing returns applies when improvements increase income or value.
  • Law of diminishing returns applies when additional improvements do not increase income or value.

Plattage and Assemblage

• Plattage: The increase in value that results from consolidating adjacent lots into a single larger one.
• Assemblage: The process of merging separately owned lots under one owner.

Regression and Progression

• Regression: The worth of a better-quality property is affected adversely by the presence of a lesser-quality property.
• Progression: The value of a smaller house increases when located among larger, more expensive houses.

Substitution

• The maximum value of a property tends to be set by the cost of purchasing an equally desirable and valuable substitute property.

Supply and Demand

• Value depends on supply and demand.
• Values decrease when the supply of similar properties increases.
• Values increase when the demand for properties increases.

Three Approaches to Value

1. Sales Comparison Approach (Market Data Approach)
2. Cost Approach
3. Income Approach

1. Sales Comparison Approach

• Value is obtained by comparing the property with recently sold comparables (similar properties in location and features).
• Adjustments are made to the sales price of comparables to account for differences.
• This approach is an example of the principle of substitution.
• Considered the most reliable approach for single-family homes.

2. Cost Approach

• Based on the principle of substitution. Consists of five steps:
  1. Estimate the land value.
  2. Determine construction cost of improvements (materials and labor).
  3. Estimate accrued depreciation.
  4. Subtract depreciation from construction cost.
  5. Add land value to the depreciated cost of improvements.

Depreciation (Cost Approach)

• Loss in value for any reason.
• Affects improvements, not land.
• Classified as curable or incurable, depending on whether it can be corrected economically.
• Three classes:
  1. Physical Deterioration
  2. Functional Obsolescence
  3. External Obsolescence

1. Physical Deterioration

• Curable items are repairs that will increase value equal to the cost of the repair (e.g., painting).
• Incurable items are defects caused by physical wear and tear where the cost of correction is not economically feasible (e.g., extensive crack in the foundation).

2. Functional Obsolescence

• Loss in value from outdated or unacceptable physical design features.
• Curable if they can be replaced or redesigned at a cost offset by the increase in value (e.g., outmoded plumbing).
• Incurable if the cost of the cure is greater than the resulting increase in value (e.g., a four-bedroom home with only one bathroom).

3. External Obsolescence

• Loss in value caused by factors outside the property (environmental, social, economic forces).
• Always incurable (e.g., proximity to a polluting factory).

Straight-Line Method (Economic Age-Life Method) to Determine Depreciation

• Depreciation is assumed to occur at an even rate over a structure's economic life.

• The Economic life is the period during which it is expected to remain useful for its original intended purposes.

  • Property's cost is divided by the number of years of its expected economic life to derive the amount of annual depreciation.

• The cost approach is most useful for newer or special-purpose buildings (schools, churches, public buildings) where there are no comparable sales.

3. Income Approach

• Based on the present value of the right to future income.
• Assumes that the income generated by a property will determine its value.
• Used for income-producing properties (apartment buildings, office buildings, retail stores).
• Estimates (5 steps):
  1. Estimate the property's annual potential gross income.
  2. Deduct allowance for vacancy.
  3. Deduct operating costs.
  4. Estimate the rate of return (cap rate) that an investor will demand for the investment.
  5. Apply the cap rate to the property's annual net operating income to estimate value

Cap Rate

• The cap rate is determined by comparing the relationship of the net operating income with the sales price of similar properties that are sold.

  • Cap Rate = {Annual Net Income \over Sales Price}
  • Value = {Annual Income \over Cap Rate}
  • Cap Rate = {Income \over Value}
  • Income = Value * Cap Rate

• Formula:

  • Value = {Annual Income \over Cap Rate}

• Note: a lower cap rate indicates less risk and a higher value.