1. © 2010 Rockwell Publishing Lesson 11: Real Estate Appraisal Principles of California Real Estate

2. © 2010 Rockwell Publishing Introduction to Appraisal Appraisal: Estimate of property’s value, made by professional appraiser and set forth in written appraisal report. Opinion, not scientific conclusion. Competent appraisers may disagree about value of a property.

3. © 2010 Rockwell Publishing Introduction to Appraisal Purpose and function Purpose: To estimate property’s value. Function: Reason appraisal is being done, or how appraisal will be used.

4. © 2010 Rockwell Publishing Introduction to Appraisal Appraiser/client relationship Appraisers may be self-employed or work for: banks or savings and loans mortgage companies private corporations involved in real estate government agencies Fee appraiser: Self-employed appraiser, hired by client to appraise property for a fee.

5. © 2010 Rockwell Publishing Introduction to Appraisal Appraiser/client relationship To improve impartiality, appraisers in federally related transactions may not have substantive communications with loan originators. Appraisals must be arranged by independent management company or separate department within lender’s organization.

6. © 2010 Rockwell Publishing Introduction to Appraisal Appraiser/client relationship Appraiser is agent and has fiduciary duty to client. Appraiser has duty of confidentiality and should disclose results of appraisal to client only. Appraiser must also disclose if he has any interest in property being appraised.

7. © 2010 Rockwell Publishing Introduction to Appraisal USPAP Uniform Standards of Professional Appraisal Practice (USPAP): Govern the appraisal profession. It is a felony for appraiser to fail to abide by USPAP in order to defraud a federally insured lender.

8. © 2010 Rockwell Publishing Introduction to Appraisal Licensing and certification Appraisals for federally related loans must be prepared by state-licensed or state-certified appraisers. Exemption: loans of $250,000 or less. California law doesn’t require all appraisers to be licensed or certified. Offers licensing so appraisers can do appraisals for federally related loans.

9. © 2010 Rockwell Publishing Introduction to Appraisal Licensing and certification Four levels of California appraisal licenses: trainee license residential license certified residential real estate appraiser certified general real estate appraiser Certified general real estate appraiser is highest level of certification.

10. © 2010 Rockwell Publishing Introduction to Appraisal Licensing and certification California’s definition of appraisal does not include opinions of value given by real estate licensees in course of business. Competitive market analysis is not an appraisal (and should not be referred to in that way).

11. © 2010 Rockwell Publishing Value Common definitions of value: present worth of future benefits ability of item or service to command other items or services in exchange relationship between desired thing and person who desires it

12. © 2010 Rockwell Publishing Elements of Value For property to have value it must have certain characteristics, called elements of value: utility scarcity demand transferability

13. © 2010 Rockwell Publishing Types of Value Value in use: Subjective value placed on property by particular person. Value in exchange: Value as viewed by average person; also known as market value.

14. © 2010 Rockwell Publishing Market Value Definition of market value 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.

15. © 2010 Rockwell Publishing Market Value Market price vs. market value Market price: Price that someone actually paid for property in a transaction; also called sales price. Market value: Price that should be paid for the property under normal conditions. “Most probable price property should bring.” Matter of likelihood, not certainty. Market value ≠ Market price

16. © 2010 Rockwell Publishing Market Value Sale conditions Sale is generally considered to have taken place under normal market conditions if: arm’s length transaction (unrelated parties) competitive and open market prudent and informed parties no undue stimulus

17. © 2010 Rockwell Publishing Market Value Marketability and acceptability To have market value, property must have marketability and acceptability.

18. © 2010 Rockwell Publishing Summary Introduction to Appraisal Appraisal State licenses Value Value in use Value in exchange Market value Market price Elements of value Sale conditions

19. © 2010 Rockwell Publishing Principles of Value Value is created, supported, or eroded by external forces that affect attitudes and behavior: social ideals and standards economic fluctuations government regulations physical and environmental factors

20. © 2010 Rockwell Publishing Principles of Value External forces Social forces: Changes in family size, number of cars, energy efficiency, affect home values (demand for certain features). Economic forces: Employment levels and interest rates affect purchasing power. Government forces: Zoning, building codes, and property taxes also affect home values. Environmental forces: Earthquakes, floods, pollution, climate also have big impact.

21. © 2010 Rockwell Publishing Principles of Value External forces When property’s value increases due to any external forces (beyond owner’s control), increase is referred to as an unearned increment.

22. © 2010 Rockwell Publishing Principles of Value List of values Principles of value include: highest and best use change anticipation supply and demand substitution conformity contribution balance

23. © 2010 Rockwell Publishing Principles of Value Highest and best use Highest and best use: Use of property that would bring owner the greatest net return over time. (Could include net income as well as enjoyment.) Important in appraisal of income- producing property. Highest and best use must be legal; it can’t violate zoning or CC&Rs.

24. © 2010 Rockwell Publishing Principles of Value Change Principle of change: Property’s value will increase or decrease over time. Changes in value occur: in response to external forces as property improves or deteriorates

25. © 2010 Rockwell Publishing Principles of Value Change Because value is always subject to change, estimate of value is only good on given date, called the effective date.

26. © 2010 Rockwell Publishing Principles of Value Change A property’s value depends on where it is in its life cycle. A property has four phases in its life cycle: integration (growth/development) equilibrium (stability) disintegration (decline) rejuvenation (renewal, remodeling)

27. © 2010 Rockwell Publishing Property also has: physical life cycle, and economic life cycle. Economic (or useful) life usually ends before the physical life. Improvements usually become obsolete before they actually fall apart. Principles of Value Change

28. © 2010 Rockwell Publishing Principles of Value Supply and demand Principle of supply and demand: If demand for product exceeds available supply, its value will increase. If supply of product exceeds demand, its value will decrease.

29. © 2010 Rockwell Publishing Principles of Value Supply and demand In real estate, supply and demand affects housing supply and purchase prices, and apartment vacancies and rents.

30. © 2010 Rockwell Publishing Principles of Value Substitution Principle of substitution: Value of product is limited by cost of obtaining an equally desirable substitute, if substitute can be obtained without undue delay.

31. © 2010 Rockwell Publishing If two equally desirable properties are available, one that costs less will be purchased first. Example: House is listed for $250,000, but comparable properties are available nearby for $210,000 to $220,000. An informed buyer would choose one of the lower-priced houses. Principles of Value Substitution

32. © 2010 Rockwell Publishing Principle of substitution is theoretical basis for all three methods of appraisal (discussed later). Principles of Value Substitution

33. © 2010 Rockwell Publishing Principles of Value Conformity Principle of conformity: Maximum value of property is achieved when there is reasonable degree of conformity in the area. In residential neighborhood, some conformity (but not too much) among properties has positive effect on value.

34. © 2010 Rockwell Publishing Principles of Value Conformity Property’s value is also affected by value of surrounding properties. Progression: An inexpensive home is more valuable when surrounded by more expensive homes. Regression: An expensive home is less valuable when surrounded by smaller or rundown homes.

35. © 2010 Rockwell Publishing Principles of Value Contribution Principle of contribution: Improvement may contribute more or less to property’s value than the improvement cost to make.

36. © 2010 Rockwell Publishing Principles of Value Balance Principle of balance: Value of a property is maximized when agents of production are in balance with each other. Four agents of production: labor coordination capital land

37. © 2010 Rockwell Publishing Summary Principles of Value Highest and best use Change Supply and demand Substitution Conformity Progression and regression Contribution Balance

38. © 2010 Rockwell Publishing The Appraisal Process 1. Define the problem. 2. Determine data needed and where to find it. 3. Gather and verify general data. 4. Gather and verify specific data. 5. Select and apply appraisal methods. 6. Reconcile value indicators for final value estimate. 7. Issue appraisal report.

39. © 2010 Rockwell Publishing The Appraisal Process Define the problem To define problem, appraiser must: identify subject property determine function of the appraisal

40. © 2010 Rockwell Publishing The Appraisal Process Determine data needed Appraiser decides what data she will need based on: type of property function of appraisal Categories of data include: general data specific data

41. © 2010 Rockwell Publishing The Appraisal Process Gather and verify general data General data: Information about matters outside subject property that affect value. Includes information about: economic trends community issues like zoning, proximity to amenities, transportation, schools condition of neighborhood

42. © 2010 Rockwell Publishing The Appraisal Process Gather and verify general data Neighborhood factors include: ● percentage of home ownership (owner- occupied properties are preferred) ● vacant homes and lots (indicates low interest) ● conformity (reasonable similarity preferred)

43. © 2010 Rockwell Publishing The Appraisal Process Gather and verify general data Factors (cont’d): ● contour of land (mild, rolling topography preferred) ● streets (wide, gently curving streets and cul-de-sacs preferred) ● government influences (e.g., high property taxes may discourage new construction)

44. © 2010 Rockwell Publishing Specific data: Data concerning subject property itself. To collect specific data, appraiser performs: site analysis building analysis The Appraisal Process Gather and verify specific data

45. © 2010 Rockwell Publishing Feasibility study: Appraisers often perform feasibility studies for developers. Appraiser would not gather specific data until it has been decided that particular project would be economically feasible. Gathering Specific Data Feasibility study

46. © 2010 Rockwell Publishing Gathering Specific Data Site analysis Goal of site analysis is determining property’s highest and best use. Appraiser examines site’s physical characteristics, such as: lot size lot shape topography

47. © 2010 Rockwell Publishing Frontage: Length of lot boundary that abuts street, body of water, or some other amenity. Important consideration for: commercial property, which is usually valued in terms of frontage residential property beside lake or other desirable feature Site Analysis Frontage

48. © 2010 Rockwell Publishing Area: Size of lot. Residential land is usually measured in square feet or acres. Newly subdivided land may be measured in commercial acres (amount not used for streets and other public amenities). Industrial land is measured in square feet or acreage. Site Analysis Area

49. © 2010 Rockwell Publishing Depth: Distance between site’s front boundary and its rear boundary. A depth table may be used to evaluate how lot’s depth affects its value. Depth tables are most commonly used in appraising commercial land. Site Analysis Depth

50. © 2010 Rockwell Publishing Plottage: Increase in value that occurs when two or more properties are combined. May occur in industrial or commercial development, where large lots are necessary. Single lot often worth more than sum of the values of the smaller lots that were joined together. Site Analysis Plottage

51. © 2010 Rockwell Publishing Location has different effect on value for different types of properties. Retail store is worth more if located on a corner due to corner influence (exposure to two different streets). Residential corner lots are less valuable due to traffic. Lots near center of subdivision are more valuable if distant from busy streets. Site Analysis Location and value

52. © 2010 Rockwell Publishing Gathering Specific Data Building analysis When examining subject property’s improvements, appraiser considers: construction quality current condition of structures size of structures (square footage) interior layout number and size of rooms orientation (placement of structures on site in relation to views and privacy)

53. © 2010 Rockwell Publishing The Appraisal Process Selecting appraisal methods Appraiser must choose appropriate appraisal method(s), given the type of property being appraised. May choose to use one, two, or all three methods.

54. © 2010 Rockwell Publishing Selecting Appraisal Methods Three methods of appraising property: sales comparison approach cost approach income approach Appraisers will consider type of property to be appraised when choosing method.

55. © 2010 Rockwell Publishing For certain types of property, only one or two approaches is appropriate. If more than one approach is applied, appraiser gives more weight to most relevant approach during reconciliation process. Selecting Appraisal Methods

56. © 2010 Rockwell Publishing Summary The Appraisal Process Steps in appraisal process General data Specific data Appraisal methods Neighborhood analysis Site analysis Building analysis

57. © 2010 Rockwell Publishing Methods of Appraisal Sales comparison approach Sales comparison approach: Compares subject property to similar properties that have recently sold, which are referred to as comparable sales or comps. Also called market data approach. Best method for appraising: single-family homes vacant land

58. © 2010 Rockwell Publishing Methods of Appraisal Sales comparison approach Appraiser must locate at least 3 comparable properties. Appraiser adjusts sales price of each comparable to reflect differences between it and subject property.

59. © 2010 Rockwell Publishing Sales Comparison Approach Elements of comparison Appraiser decides if property is good comp by using primary elements of comparison: date of sale location of property physical characteristics terms of sale conditions of sale

60. © 2010 Rockwell Publishing Sales Comparison Approach Elements of comparison Date of sale: Date buyer and seller agreed on a price. Important because property values are constantly changing.

61. © 2010 Rockwell Publishing Should always use most recent sales available. Preferably within last 6 months (less if market rapidly changing). If market has been inactive, may use older sales and adjust for inflation and other trends. Never use sales that are more than 1 year old. Sales Comparison Approach Elements of comparison

62. © 2010 Rockwell Publishing Sales Comparison Approach Elements of comparison Location: Factor that has greatest effect on property’s value. Appraiser looks for comparables in same neighborhood as subject property.

63. © 2010 Rockwell Publishing Sales Comparison Approach Elements of comparison Physical characteristics: Comparables should be similar to subject property in: architectural style construction quality overall condition amenities

64. © 2010 Rockwell Publishing Sales Comparison Approach Elements of comparison Terms of sale: Sale that involved seller financing or other special terms often isn’t good comparable. Buyer may have been willing to pay more because of special terms. Difficult to judge effect on sales price. Appraiser generally looks for comparables sold on terms that are cash equivalent.

65. © 2010 Rockwell Publishing Sales Comparison Approach Elements of comparison Conditions of sale: Appraisers must determine circumstances of comparable sales to see if they took place under normal conditions: Property offered in competitive and open market for reasonable time. Buyer and seller acted prudently and are unrelated (arm’s length transaction). No undue pressure on either party.

66. © 2010 Rockwell Publishing Sales Comparison Approach Elements of comparison Original price of the property or cost of building the improvements is not a consideration in sales comparison approach.

67. © 2010 Rockwell Publishing Sales Comparison Approach Making adjustments To account for differences between comparable and subject property, an appraiser adjusts the sales price of the comparable. It’s always comparable’s price, not subject’s, that is adjusted.

68. © 2010 Rockwell Publishing Sales Comparison Approach Making adjustments If subject property has feature comparable lacks, appraiser adds value of feature to comparable’s sales price. If subject property lacks feature comparable has, appraiser subtracts value of feature from comparable’s sales price. If too many differences, property is not comparable and shouldn’t be used.

69. © 2010 Rockwell Publishing Sales Comparison Approach Making adjustments Appraiser estimates subject property’s value based on adjusted prices of at least 3 comparables. Never simply averages adjusted prices. More weight given to comparables which are most similar (fewer adjustments).

70. © 2010 Rockwell Publishing Sales Comparison Approach Use of listings When comparable sales are limited (for example when market is coming out of dormant or volatile period), appraiser may compare subject property to current listings. Must remember listing prices tend to be high (ceiling of market value range). Assessed values (for taxes) are never used for comparable sales.

71. © 2010 Rockwell Publishing Summary Sales Comparison Approach Sales comparison approach Elements of comparison Comparable Adjustments

72. © 2010 Rockwell Publishing Cost Approach to Value Cost approach: Appraisal method that bases estimate of subject property’s value on cost of replacing it.

73. © 2010 Rockwell Publishing Cost Approach to Value Cost approach provides ceiling for subject property’s value. Buyers won’t pay more for used property than for new property of equal desirability. This is principle of substitution.

74. © 2010 Rockwell Publishing Cost Approach to Value Three steps Steps in cost approach: estimate cost of replacing improvements deduct any depreciation add value of land

75. © 2010 Rockwell Publishing Cost Approach to Value Step 1: Estimating replacement cost Replacement cost: Current cost of constructing building that can be used in same way as subject property. Replacement cost is better indicator of property’s current market value. Reproduction cost: Current cost of building exact replica of building, using identical materials and methods.

76. © 2010 Rockwell Publishing Estimating Replacement Cost Three methods 1. Square-foot method: Easiest and most widely used. Square footage × Construction cost per square foot 2. Unit-in-place method Estimate cost of replacing building components (roof, floors, plumbing, etc.). 3. Quantity survey method Detailed, time-consuming estimate of materials and labor.

77. © 2010 Rockwell Publishing Cost Approach to Value Step 2: Deduct depreciation Depreciation: Loss in value due to any cause. Only improvements depreciate; land does not. Three categories of depreciation: physical deterioration functional obsolescence external obsolescence

78. © 2010 Rockwell Publishing Cost Approach to Value Appraiser’s approach to depreciation While accountant is concerned with book depreciation for tax purposes, appraiser is only concerned with actual losses in value of real property.

79. © 2010 Rockwell Publishing Categories of Depreciation Physical deterioration Physical deterioration: Loss in value due to wear and tear, deterioration, damage or structural defects. Easiest form of depreciation to identify and measure.

80. © 2010 Rockwell Publishing Categories of Depreciation Physical deterioration Physical deterioration may be curable or incurable: Curable: Cost of correcting issue could be recovered in sale price when property is sold. Also known as deferred maintenance. Incurable: Issue can’t be fixed or cost of doing so is impractically high.

81. © 2010 Rockwell Publishing Categories of Depreciation Functional obsolescence Functional obsolescence: Loss in value due to functional inadequacies, often caused by age or poor design. Examples: inconvenient floor plan, outdated fixtures, too few bathrooms for bedrooms. If a problem is inside property lines and it’s not physical deterioration, then it’s functional obsolescence.

82. © 2010 Rockwell Publishing Categories of Depreciation External obsolescence External obsolescence: Loss in value caused by factors outside of property lines, external to property itself. Also called economic obsolescence. Examples: adverse zoning changes undesirable neighborhood traffic congestion proximity to a nuisance

83. © 2010 Rockwell Publishing Physical deterioration: Usually curable, unless particularly severe. Functional obsolescence: May be curable, depending on the cost of modifications. External obsolescence: Virtually always incurable, because it’s out of the property owner’s control. Depreciation Curable or incurable

84. © 2010 Rockwell Publishing Depreciation Estimating depreciation Methods of estimating depreciation fall into two categories: indirect methods capitalization method market data method direct methods straight-line method engineering method

85. © 2010 Rockwell Publishing Estimating Depreciation Indirect methods Indirect methods are considered more accurate than direct methods, since they’re based on market data.

86. © 2010 Rockwell Publishing Estimating Depreciation Direct methods Straight-line method: Concerned with property’s effective age, rather than its actual chronological age. Effective age: How long building will be useful in its present use. Sometimes called age-life method.

87. © 2010 Rockwell Publishing Cost Approach to Value Step 3: Adding land value Last step in cost approach to value is to add value of land to depreciated value of improvements. Value of land is usually estimated by sales comparison method.

88. © 2010 Rockwell Publishing Summary Cost Approach Replacement cost Reproduction cost Depreciation Physical deterioration Functional obsolescence External obsolescence Estimating depreciation Land value

89. © 2010 Rockwell Publishing Income Approach to Value Income approach: Method used to appraise present value of property’s income-producing capabilities. Also called capitalization method. Appraiser uses property’s income to estimate its value to investor. Often used for commercial properties and residential rental properties.

90. © 2010 Rockwell Publishing Income Approach to Value Five steps Calculate property’s potential gross income. Deduct bad debt and vacancy factor to estimate effective gross income. Subtract operating expenses to determine net income. Select appropriate capitalization rate. Capitalize property’s net income to estimate its value.

91. © 2010 Rockwell Publishing Income Approach to Value Gross income: Estimate of what property would earn if it were available for lease in today’s market. Economic rent: Rent property would earn on open market if fully occupied and all rents collected. Also called potential gross income. Contract rent refers to what property is earning now, under present terms.

92. © 2010 Rockwell Publishing Effective gross income: Potential gross income (economic rent) minus bad debt and vacancy factor. Bad debt and vacancy factor: Percentage of potential gross income deducted to allow for unpaid rents and vacancies. Income Approach to Value Effective gross income

93. © 2010 Rockwell Publishing Income Approach to Value Net income Net income: Effective gross income minus operating expenses. Three types of operating expenses: fixed expenses maintenance expenses reserves for replacement

94. © 2010 Rockwell Publishing Operating Expenses Fixed expenses Fixed expenses: real estate taxes hazard insurance

95. © 2010 Rockwell Publishing Maintenance expenses: tenant services utilities supplies cleaning repairs administrative and managerial costs Operating Expenses Maintenance expenses

96. © 2010 Rockwell Publishing Reserves for replacement: Funds set aside for eventual replacement of structures and equipment that will wear out. Operating Expenses Reserves for replacement

97. © 2010 Rockwell Publishing Property expenses not considered operating expenses (for appraisal purposes) include: mortgage payments (debt service) owner’s income taxes depreciation reserves Operating Expenses Other expenses

98. © 2010 Rockwell Publishing Income Approach to Value Selecting capitalization rate Capitalization: Process of converting net income estimate into estimate of property’s present value. Expressed as mathematical formula: Annual Net Income ÷ Cap Rate = Value

99. © 2010 Rockwell Publishing If property is risky investment, investor usually requires greater rate of return on investment (chooses higher capitalization rate). Higher capitalization rate will result in lower value for property. Selecting Capitalization Rate

100. © 2010 Rockwell Publishing To select appropriate capitalization rate, appraiser must account for both: return OF the investment (ability to recapture the original sum invested) return ON the investment (the investor’s profit) Selecting Capitalization Rate Return of / return on investment

101. © 2010 Rockwell Publishing Appraisers use three methods for selecting an appropriate capitalization rate: direct comparison method band of investment method summation method Selecting Capitalization Rate

102. © 2010 Rockwell Publishing After calculating annual net income and choosing capitalization rate, final step is to capitalize annual net income. This produces estimate of value for the property. Income Approach to Value Capitalizing net income

103. © 2010 Rockwell Publishing Instead of using one capitalization rate, appraiser may value land and building separately using one of two techniques: building residual technique (used to determine building value) land residual technique (used to determine land value) Capitalizing Net Income

104. © 2010 Rockwell Publishing Income Approach to Value Gross multiplier method Gross multiplier method: Simplified version of income approach, to appraise residence used as rental property. Annual or monthly income may be used, depending on appraiser’s preference.

105. © 2010 Rockwell Publishing Gross Multiplier Method Comparable rental homes Appraiser locates comparable rental properties and calculates gross multiplier for each property. Multiplier indicates relationship between comparable’s sales price and rental rate. Appraiser uses comparables to select appropriate multiplier for subject property, adjusting for similarities and differences.

106. © 2010 Rockwell Publishing Site Valuation Appraiser uses site valuation techniques to: appraise vacant land, value land separately from its improvements (as in property tax assessment), or value land with building that will be torn down

107. © 2010 Rockwell Publishing Site Valuation Methods of site valuation include: sales comparison method land residual method abstraction method development method

108. © 2010 Rockwell Publishing Site Valuation Sales comparison method is most widely used. Recent sales of comparable sites are used to estimate value of subject site. Land residual method is site valuation by income approach. Appraiser calculates value of land by capitalizing its income.

109. © 2010 Rockwell Publishing Site Valuation Improved property: Sometimes, appraiser will need to appraise site with building that’s going to be torn down. Appraiser evaluates site according to highest and best use, then deducts cost of removing structure.

110. © 2010 Rockwell Publishing Reconciliation and Final Estimate Reconciliation: Interpreting value indicators resulting from each method of appraisal to arrive at final value estimate for subject property. Reconciliation and issuance of appraisal report are final steps in appraisal process.

111. © 2010 Rockwell Publishing Reconciliation Appraiser does not simply average value indicators. Appraiser gives more weight to most relevant method. For example: appraising single-family home: sales comparison approach most relevant appraising apartment building: income approach most relevant

112. © 2010 Rockwell Publishing Appraisal Report Appraiser presents conclusions to client in appraisal report. Form report: Uniform Residential Appraisal Report form used for most residential appraisals. Narrative report: For more complicated appraisal, appraiser provides detailed presentation of data and reasoning. (Property value usually in purpose section.)

113. © 2010 Rockwell Publishing Summary Income Approach/Reconciliation/Final Estimate Income approach Potential gross income Effective gross income Net income Capitalization Gross multiplier method Reconciliation Form report Narrative report