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

2. 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.
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3. Appraisal Basics How 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.
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4. Appraisal Basics How appraisals are used
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.
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5. Appraisal Basics How appraisals are used
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
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6. Appraisal Basics Appraiser/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.
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7. Appraisal Basics Appraiser’s fee
Appraiser’s fee set in advance, based on:
expected difficulty of assignment
how much time it’s likely to take
Fee can’t be:
percentage of appraised value
based on client’s satisfaction with results
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8. Appraisal Basics Appraiser 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 company
separate department in lender’s organization
Also, real estate agent may not select or compensate appraiser.
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9. Appraisal Basics Appraiser 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 information
explain basis of value estimate more fully
correct errors in appraisal report
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10. Appraisal Basics State 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 appraiser
in accordance with Uniform Standards of Profession Appraisal Practice (USPAP)
Exemption: loans of $250,000 or less
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11. Summary Appraisal Basics
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)
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12. Value Value: Present worth of future benefits of property ownership.
Usually measured in terms of money.
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13. Value Types 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.
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14. Market Value Elements of value
To have market value, an item must have four characteristics:
utility
scarcity
transferability
demand
These are sometimes called the elements of value.
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15. Market Value Definition 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.
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16. Market Value Market value vs. price
Thus, market value is the price that should be paid under all conditions requisite to a fair sale:
competitive and open market
prudent, informed, and unrelated parties
no 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.
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17. Summary Value Value Value in use Value in exchange Market value
Elements of value
Conditions requisite to a fair sale
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18. Value Principles of value
Value is created and changed by major forces:
social ideals and standards
economic fluctuations
government 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.
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19. Value Principles of value
Highest and best use
Change
Anticipation
Supply and demand
Substitution
Conformity
Progression and regression
Contribution
Competition
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20. Principles of Value Principle 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.
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21. Principles of Value Principle of change
Principle of change: A property’s value will increase or decrease over time.
Changes in value occur:
in response to external forces
as the property itself improves or deteriorates
Therefore appraisal always tied to specific point in time: effective date.
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22. Principles of Value Principle of change
Property’s four-phase life cycle:
integration
equilibrium
disintegration
rejuvenation
Property’s value depends on where it is in its life cycle.
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23. Principles of Value Principle of change
Property has:
physical life cycle
economic life cycle
Economic life usually ends first.
Improvements become obsolete before they actually fall apart.
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24. Principles of Value Principle 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.
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25. Principles of Value Principle of supply and demand
If demand for a product exceeds available supply, value will increase.
If supply exceeds demand, value will decrease.
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26. Principles of Value Principle 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.
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27. Principles of Value Principle 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).
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28. Principles of Value Principle 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.
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29. Principles of Value Progression 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.
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30. Principles of Value Principle 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 basement
Construction cost: $7,000
Contribution to value of home: $2,000
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31. Principles of Value Principle 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.
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32. Summary Principles of Value
Highest and best use
Change
Anticipation
Supply and demand
Substitution
Conformity
Progression and regression
Contribution
Competition
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33. The Appraisal Process 7 Steps
Define problem.
Determine data needed and where to find it.
Gather and verify general data.
Gather and verify specific data.
Select and apply valuation methods.
Reconcile value indicators for final value estimate.
Issue appraisal report.
© 2011 Rockwell Publishing

34. The Appraisal Process Step 1: Define the problem
To define problem, appraiser must:
identify subject property
determine function of appraisal
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35. The Appraisal Process Step 2: Determine data needed
Appraiser decides what data is needed based on:
type of property
function of appraisal
Two main categories of data:
general
specific
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36. The Appraisal Process Step 3: Gather & verify general data
General data: Information pertinent to subject property’s value that does not concern the property itself.
Population trends
Economic conditions
Condition and quality of neighborhood
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37. The Appraisal Process Step 4: Gather & verify specific data
Specific data: Data concerning subject property itself.
To collect specific data, appraiser performs:
site analysis
building analysis
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38. The Appraisal Process Step 5: Apply valuation methods
Appraiser chooses appropriate valuation method(s), given type of property being appraised.
Three methods of appraisal:
sales comparison approach
cost approach
income approach
For particular assignment, may use only one method, or two, or all three.
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39. The Appraisal Process Step 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.
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40. The Appraisal Process Step 7: Issue appraisal report
Final step is to prepare appraisal report and present report to client.
Appraisal report gives:
final value estimate
explanatory information about how estimate was arrived at
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41. 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
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42. General Data Neighborhood 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
© 2011 Rockwell Publishing

43. Gathering Data Specific data
Next, appraiser gathers, verifies, and analyzes specific data, data about the subject property itself:
site analysis (land and utilities)
building analysis (improvements)
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44. Specific Data Site analysis
Objective of site analysis: to determine property’s highest and best use.
Appraiser considers:
lot size and shape (area, width, depth)
frontage
topography
utilities
site in relation to surrounding area
other factors that affect use or title
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45. Site Analysis Frontage
Frontage: Length of lot boundary that abuts street, body of water, or some other amenity.
Important consideration for:
retail property
residential property beside a lake or other desirable feature
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46. Site Analysis Plottage
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.
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47. Site Analysis Utilities
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.
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48. Specific Data Building 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.)
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49. Specific Data Building 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.
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50. Summary The Appraisal Process
7 steps in appraisal process
General data
Specific data
Value indicators
Reconciliation
Neighborhood analysis
Site analysis
Building analysis
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51. Methods of Appraisal
Three main methods of appraising real property, called the three approaches to value:
Sales comparison approach
Cost approach
Income approach
All are methods of estimating market value.
Which method appraiser relies on most depends on type of property in question.
© 2011 Rockwell Publishing

52. Methods of Appraisal Sales 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.
© 2011 Rockwell Publishing

53. Sales Comparison Approach Comparable 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.
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54. Sales Comparison Approach Primary elements of comparison
Appraiser decides whether a property would be a good comparable using the primary elements of comparison:
date of sale
location
physical characteristics
terms of sale
conditions of sale
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55. Primary Elements of Comparison Date of sale
Date of sale: Date buyer and seller agreed on a price.
Important because property values are constantly changing.
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56. Primary Elements of Comparison Date 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.
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57. Primary Elements of Comparison Location
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.
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58. Primary Elements of Comparison Physical characteristics
Comparables should be similar to subject property in:
architectural style
construction quality
overall condition
features and amenities
Appraiser will make adjustments to account for differences in physical characteristics.
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59. Primary Elements of Comparison Terms 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.
© 2011 Rockwell Publishing

60. Primary Elements of Comparison Conditions 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 party
property was offered in a competitive and open market for a reasonable time
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61. Sales Comparison Approach Making 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.
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62. Sales Comparison Approach Making 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
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63. Sales Comparison Approach Estimating 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.
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64. Summary Sales Comparison Approach
Comparable
Primary elements of comparison
Date of sale
Location
Physical characteristics
Terms of sale
Conditions of sale
Making adjustments
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65. Methods of Appraisal Cost 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.
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66. Cost Approach to Value Sets 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.
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67. Cost Approach to Value 3 Steps
Steps in cost approach:
Estimate cost of replacing improvements.
Estimate and deduct any depreciation.
Add value of land.
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68. Cost Approach to Value Step 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.
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69. Estimating Replacement Cost 3 Methods
1. Square-foot (comparative unit) method
Easiest and most widely used.
Square footage × Construction cost per sq. ft.
2. Unit-in-place method
Estimate cost of replacing each building component (roof, flooring, plumbing, etc.).
3. Quantity survey method
Detailed, time-consuming estimate of quantities and prices of materials and labor.
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70. Cost Approach to Value Step 2: Deducting depreciation
Depreciation: Loss in value due to any cause.
Three categories of depreciation:
physical deterioration
functional obsolescence
external obsolescence
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71. Categories of Depreciation Physical 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.
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72. Categories of Depreciation Curable 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.
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73. Categories of Depreciation Functional 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.
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74. Categories of Depreciation External obsolescence
External obsolescence: Loss in value due to factors outside of property itself. Also called economic obsolescence.
Examples:
adverse zoning changes
undesirable neighborhood
traffic congestion
proximity to nuisance
Always incurable – outside owner’s control.
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75. Cost Approach to Value Step 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.
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76. Summary Cost Approach Cost approach Replacement cost Reproduction cost
Depreciation
Physical deterioration
Deferred maintenance
Functional obsolescence
External obsolescence
Curable and incurable depreciation
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77. Methods of Appraisal Income 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.
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78. Income Approach to Value 5 Steps
Calculate property’s potential gross income.
Deduct bad debt and vacancy factor to calculate effective gross income.
Subtract operating expenses to calculate net income.
Select appropriate capitalization rate.
Capitalize property’s net income to estimate its value.
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79. Income Approach to Value 1. 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.
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80. Income Approach to Value 2. 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.
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81. Income Approach to Value 3. Calculating net income
Net income: Effective gross income minus operating expenses.
Operating expenses: Costs associated with operating income-producing property.
Three main categories:
fixed expenses
maintenance expenses
reserves for replacement
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82. Calculating Net Income Operating expenses
Fixed expenses:
property taxes
hazard insurance
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83. Calculating Net Income Operating expenses
Maintenance expenses:
tenant services
utilities
supplies
cleaning
repairs
administrative costs
building employee wages
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84. Calculating Net Income Operating expenses
Reserves for replacement: Funds set aside for eventual replacement of structures and equipment that will wear out.
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85. Calculating Net Income Other expenses
Expenses connected with property ownership that are not operating expenses for appraisal purposes:
mortgage payments (debt service)
income tax paid on property’s earnings
depreciation reserves
These are not deducted from effective gross income in calculating net income.
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86. Income Approach to Value 4. 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).
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87. Selecting a Capitalization Rate Rate reflects investment risk
If property is risky investment, investors:
require a greater return
choose 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.
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88. Selecting a Capitalization Rate Selection methods
Appraisers have various methods for selecting appropriate capitalization rate.
Example: Direct comparison method
Appraiser analyzes recent sales of comparable income properties to determine their capitalization rates.
Investors likely to want about the same capitalization rate for subject property.
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89. Income Approach to Value 5. 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
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90. Income Approach to Value Gross 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.
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91. Gross Income Multiplier Method Comparable 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).
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92. Gross Income Multiplier Method Using 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.
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93. Gross Income Multiplier Method Rough estimate
Gross income multiplier method provides only rough estimate of value.
Based on gross income.
Doesn’t take into account operating expenses or vacancies.
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94. 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.
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95. 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.
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96. Reconciliation and Final Estimate Appraisal 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.
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97. Summary Income Approach and Reconciliation
Potential gross income
Effective gross income
Net income
Operating expenses
Capitalization rate
Gross income multiplier method
Reconciliation
Final estimate of value
Appraisal report
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