Unit 16: Key Points

These are the most important points for you to remember in this unit.

Regulation of Appraising – FIRREA

• Appraisal Foundation—the source of appraisal standards and appraiser qualifications.
• Federally-Related Transaction— any real estate-related financial transaction which a federal regulatory agency regulates that requires the services of an appraiser.
• To prepare an appraisal that will be used in a federally related transaction, a person must be a state-certified appraiser.
  • State-certified residential appraisers are qualified to appraise one to four residential units without regard to value or complexity.
  • State-certified general appraisers are qualified to appraise all types of real property.
• The Uniform Standards of Professional Appraisal Practice (USPAP) sets the standards and requirements for the valuation of real property.
• The Ethics Rule of USPAP is to promote and preserve public trust, and requires that appraisers
  • perform assignments with impartiality, objectivity, and independence, and without accommodation of personal interest, and
  • must not accept an assignment that is contingent on the value of the property. 
• Real estate licensees may perform appraisals for a fee. There are several requirements for real estate licensees performing appraisals, including
  • the appraisal may not involve a federally related transaction,
  • licensees may not represent themselves as certified or licensed appraisers unless they are licensed or certified under Chapter 475, Part II, and
  • licensees who prepare appraisals must comply with the USPAP.
• Sales associates should not prepare appraisals without the express consent and supervision of the broker. Fees for preparing appraisals can be collected only by a broker.
• The Comparative Market Analysis (CMA) helps sellers to set listing prices and buyers to decide on the amount to offer for a property.
  • The CMA may not be called an appraisal. It is an opinion of value.
  • Licensees are permitted to charge a fee for preparation of a CMA. The fee must be paid to the broker.
  • Licensees need not conform to USPAP when preparing a CMA.
  • Broker Price Opinion (BPO)
• The BPO cannot be called an appraisal.
  • The licensee may charge a fee for preparing a BPO. The fee must be paid to the broker.
  • The licensee need not comply with the USPAP when preparing a BPO.

Concept of Value

• Value is the most probable price that a property should bring in the  market in a fair sale.
• Price is the consideration paid from a buyer to a seller in an actual transaction.
• Cost is the amount of money required to improve a parcel of real estate.
• Appraisers may be asked to estimate:
  • Assessed value—used for property tax purposes. County property appraisers regularly appraise property to be used as the basis for taxes.
  • Insurance value—generally an estimate using the cost approach that insurance companies may use to measure replacement cost.
  • Going-concern value—the value of a business that is profitable.
  • Liquidation value—assumes a quicker than normal sale. The liquidation value of a business that has failed is usually lower.           
  • Investment value—the amount an income property is worth to a particular investor based on that investor’s required rate of return. It is a subjective value and not considered as market value. 
  • Salvage value—the value of an improvement at the end of its useful life.
  • Market value—the value most often sought by an appraiser.
  • Market Value is “the most probable price that 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, knowledgeably and assuming the price is not affected by undue stimulus.”
• Characteristics of Value—there are four essential factors for a parcel or real estate to have value.
  • Demand – Desire along with the economic means to purchase.
  • Utility – Must be useful and able to fill a need.
  • Scarcity – If there is excess supply on the market, the value falls.
  • Transferability – The legal ability to convey title.

Principles of Value

• Principle of substitution–establishes that the value of a property is set by the cost to obtain another property that is comparable, either by purchasing it or by building it.
• Highest and best use of a parcel of land is the use which produces the greatest return to the land.
• Increasing returns—demonstrates that improving a property may add more value than it costs to improve it.
• Decreasing returns—demonstrates that improving a property may cost more than the value added, also called an over-improvement.
• Progression and Regression—related to increasing and decreasing returns.
  • Progression says that the value of a modest home in a neighborhood of larger, expensive homes will be higher than if the home were in an area of more modest homes.
  • Regression says, “Don’t build your fancy, large home in a neighborhood of smaller homes.” Its value will be less than if you built it in a more prestigious neighborhood.
• The principle of conformity says that improvements that are dissimilar to other properties in the area will have less contributory value than the typical house in the area.
• Assemblage and Plottage:
  • Assemblage involves combining two or more parcels of land in order to increase the overall value.
  • Plottage is the increased value of the property after assemblage.

Introduction to the Three Approaches to Value

• There are three principal methods used in estimating real property value:
  • sales comparison approach,
  • cost approach, and
  • income approach.

Sales Comparison Approach

• This approach is based on the theory of substitution. If a buyer can purchase a similar property for a lower price, the buyer will buy that property.
• The approach used by the appraiser is to value the subject property based on recent sales of similar (comparable) properties in the neighborhood.
• Differences in the sold properties from the subject property are accounted for by adjusting the sale price of the comparable property, not to the subject property.
• Adjust the comparable using the acronyms “CIA / CBS.”
  • If the Comparable is Inferior, Add, If the Comparable is Better, Subtract.
• The sales comparison approach to value lets the market tell the appraiser what prices buyers are paying in the market for similar homes.
• Steps in the approach:
  • Locate the most recent sales in the neighborhood.
  • Review each sale to determine that it is like the subject.
  • The age of the comparable should be roughly the same as the subject property.
  • A 30-year-old home is not like the subject property if it is two years old.
  • Prepare an adjustment grid, listing each of the properties on the grid.
  • Adjust each of the comparable sales so that they reflect that characteristic of the subject property.
  • Adjustments are made to the comparable property only, never to the subject property.    
• The types of property best suited for this approach are in an active market with several recent sales.

Cost-Depreciation Approach

• The cost-depreciation approach is based on the premise that the value of a property can be estimated by the land value and the investment required to reproduce the building new, less depreciation.
  • It is used as a check on the other approaches, and is used as the primary approach for special-purpose buildings, such as hospitals, or schools.
• Steps in the Approach
  • Estimate the current cost to reproduce the building new.
  • Estimate the total depreciation of the building and subtract it from the cost to reproduce the building.
  • Estimate the value of the land as if the land were vacant.
  • Add the value of the land to the depreciated value of the structures.
• Reproduction vs. replacement cost
  • Reproduction cost is the cost to exactly reproduce the improvements as of the date of the appraisal.
  • Replacement cost is the cost required to build a substitute property having the same use as the subject property using modern, updated materials.

Steps in the Cost Approach

• Step 1: Estimate the current cost to reproduce the building new.
  • Quantity survey method is a detailed inventory of every item in the building, plus the labor, financing, and builder’s profit.
  • Unit-in-place method is the cost of each item plus the labor cost to install the item.
  • Comparative square foot method, also called the “unit comparison method” is the most used.
  • Cost estimating manuals show typical costs of reproduction for many types of structures.
  • Index method: find the original cost of building the subject property and apply an index to that cost.
• Step 2: Estimate loss from depreciation—an estimate of the loss of value from all causes.
  • Land is not depreciated. Only the improvements are depreciated.
  • Depreciation can be classified as either curable or incurable. 
    • Curable depreciation is a loss of value that can be corrected at a cost less than the resulting increase in property value.
    • Incurable depreciation either cannot be corrected or would cost more than the increase in property value.
  • The three types of depreciation are:
    • Physical deterioration -ordinary wear and tear and physical damage.
      • It is curable depreciation if fixing the defect will add at least as much value as it costs.
      • It is incurable depreciation if fixing a defect will not add at least as much value as it costs.
    • Functional obsolescence is anything which is inferior to a new structure of the same type. It may be curable or incurable.
    • External obsolescence is a loss in value which is caused by problems outside the property. The loss is usually incurable.
• Step 3: Estimate the value of the land as if vacant
  • The value of the land is normally estimated using the comparable sales approach.
• Step 4: Add the value of the land to the depreciated value of the structure.
• Application of approach
  • Most appropriate for properties that are not typically sold or rented, such as schools, libraries, and town halls.
  • The value estimated by the cost approach sets the maximum value for a property.

Income approach-There are six steps in the approach.

• Step 1: Estimate potential gross income (PGI)—the amount of income the owner would receive if the property were 100% rented.
• Step 2: Estimate effective gross income (EGI)—the typical amount a property would bring in from rentals, less vacancies and collection losses.
  • Vacancies mean that an apartment is ready for rent, but is vacant.
  • Collection losses occur when the apartment is occupied, but the owner can’t collect the rent.

• Step 3: Estimate property expenses—three types:
  • Fixed expenses are those costs that don’t vary based on the occupancy rate. Property taxes and insurance are fixed expenses.
  • Variable expenses fluctuate with the rises and falls in the occupancy rate. Examples would be management expense (part of this is commissions on rentals), supplies, maintenance, and garbage collection.
  • Reserves for replacement is an amount charged against the income (but not usually set up in a reserve bank account). It is for component parts of the improvements like the roof, HVAC (heating, ventilation, and cooling), and carpeting which wear out faster than the structure itself.
• Step 4: Find net operating income by subtracting expenses from the effective gross income.         
• Step 5: Estimate the appropriate capitalization rate.
  • Dividing the net operating income of similar income properties that have sold recently by the sale price results in a capitalization rate that can be applied to the subject property’s net income.
• Step 6: Find value by dividing the NOI by the capitalization rate.
• To estimate value with this approach, use the basic formula:

I = Income (annual net operating income)
R = Rate (of interest). The capitalization rate represents the relationship  between   net income and sale price
V = Value (of property)

     To find the formula you need, cover the item you are solving for.

• Gross rent multiplier (GRM) is a multiple of the potential gross rent of a property.
  • GRM is derived from the comparable sales approach, using sales of similar rental properties.
• Gross income multiplier (GIM) is used to estimate the value of larger income properties. It is based on the annual income of the property. 

Preparing a Comparative Market Analysis (CMA)

• Most real estate licensees use a comparative market analysis to help show a seller the best offering price for a property.
• Buyers also make use of the CMA to help set the offering price when preparing an offer.
• Find comparable properties that are currently listed, have sold recently, or the listing has expired.
• Recently sold—the properties that have sold recently help to show what value buyers and sellers agree on. The adjusted value is the best estimate of what an appraisal will show. 
• Currently on the market—the properties currently on the market show the competition to the seller’s property.
• Recently expired listings—show the market’s resistance to overpriced listings.