Appraisal

An appraisal is an unbiased or objective opinion of value, or the most likely price that a probable buyer will pay for a property in an open market sale. In an open market sale, the buyer doesn’t have to buy, the seller doesn’t have to sell, and both are competent parties.


Appraisal Principles
   

The art of appraising follows some basic principles.


Principle of Highest and Best Use

Principle of Highest and Best Use, ask the question what is the best use for the property?  This the first step for Vacant land.  You would want to figure out how much of a net return you can get by building on the property.  This would be done by conducting a site analysis. If the use is temporary, it would then be considered the Interim use


Principle of Substitution

Principle of Substitution states that no prudent person would pay one million dollars when there is another one readily available that has the same use, design and income for five hundred thousand dollars, the lowest price one is preferred.


Principle of Conformity

The principle of Conformity states that conformity to land use objectives contributes the most to economic stability in a residential community.  This is why homes are built in the same style as the other properties in that same area, because the values will go up.


Principle of Contribution

The Principle of Contribution, How much does an item contribute to the net income of a property?  For example, if a swimming pool was built on a 16 unit apartment building in Yuma Arizona it would contribute more to the net income if it was built on a 16 unit apartment building in Minneapolis Minnesota.

Principle of change

The principle of change realizes the economic and social forces that affect value. A diligent appraiser asks: ‘Is this community experiencing growth, stability, decline or restoration?’ in other words, the area the property is in will effect the value more than the property itself.


The principle of regression states that the value of a more expensive home placed in a neighborhood of less expensive homes will drop in value. Generally, a $1 million home placed in a neighborhood where homes sell for $500,000 will not appraise for $1 million due to the principle of regression.


Progression states that the value of less expensive properties will increase when placed in the area of more expensive properties.



Market Value


Market Value is the present worth of one commodity to draw on the open market.  The original cost of an item has no relevance to its value. Cost is defined as the actual dollars spent to produce an asset.


The Four Essential Elements of value are:

    Scarcity, how much of there is it?

    Transferability, it be sold?

    Utility, can it be used?

    Demand, does anybody want it?

Just think of the acronym “stud”


Market price is the actual selling price of the property. Market value, cost, and market price could be the same, but they seldom are.

For example, using the market data approach, an appraiser has determined that the market value of a property is $175,000. But under the cost approach, it would cost $190,000 to rebuild the property. The property sold for $200,000 which makes the price $200,000, because that is what somebody is willing to pay.


The appraiser is hired to determine the market value for the property, not the price of the property.


Two ways to increase value is through assemblage and plottage.  Assemblage is the combining of two or more parcels, usually but not necessarily contiguous, into one ownership or use.  Plottage is an increment of value arising as a result of combining two or more sites to develop one site having a greater utility than each when separately considered.



An appraiser is paid according to the time involved not the percentage of the sale price of the property.   Remember the appraiser must be neutral.


Steps in the appraisal


. The steps in the appraisal process are:


- State the purpose

- List the data needed and its sources

- Gather, record and verify the data

- Gather, record and verify the specific data such as site development

- Gather, and record and verify the data for each approach

- Analyze and interpret the data

- Reconcile data for final estimate

- Prepare an appraisal report


The type of value being estimated would be found in the Statement of Purpose Section of the Report


An appraisers report will not have the buyer’s financial condition because how you pay for the property has nothing to do with the value of the property itself.


Appraisal methodology


The three approaches to appraising are:

Market data approach

Income approach

Cost approach.


Market data approach

Market Data Approach, which is also know as the Comparison approach is the process of estimating the value of property through the examination and comparison of actual sales of comparable properties.

This Approach is best used to find values of houses and vacant lots.


When comparing two properties you need to deduct for features of the comparable.    For example, if one property has a pool and the other does not, you need to account for the value of the pool


This is the most difficult aspect of this Approach.  Adjustments are necessary because while some properties are similar, two properties are rarely similar concerning everything.


This approach utilizes Entire property as the unit of comparison.   The basis of the Market Data is the Principal of substitution.   Market Data is usually used to establish Rent Schedules.  How much do you want to charge somebody for rent? Just ask the tenants next door how much they are paying.


Market Data becomes less reliable during times of rapid economic change or instability, or in an inactive market, simply because there is nothing to compare it too.


Capitalization (income) Approach

Income Capitalization is a valuation method appraisers and real estate investors use to estimate the value of income producing real estate. It is based upon the premise of anticipation i.e., the expectation of future benefits. This method of valuation relates value to two things: [1] the "market rent" that a property can be expected to earn and, [2] the "reversion" (resale) when a property is sold. 


Capitalization (income) Approach, converts Income into value. A property that can prove to bring in more income will increase the value.  Capitalization Approach would be most appropriate for a shopping center.


Cap Rate

The hardest part of the Capitalization Approach is determining the Cap Rate.

Methods use to Determine the Capitalization Rate are the Market Comparison Method, the Band of Investment Method, or the Summation Method.

The cap rate is directly related to risk


A Post Office building would have a lower capitalization rate because it is a lower risk.  As compared to a Hardware store which would have a high cap rate because it is a higher risk.

Capitalization rate (or "cap rate") is a measure of the ratio between the net operating income produced by an asset (usually real estate) and its capital cost (the original price paid to buy the asset) or alternatively its current market value. The rate is calculated in a simple fashion as follows:


For example, if a building is purchased for $1,000,000 sale price and it produces $100,000 in positive net operating income (the amount left over after fixed costs and variable costs are subtracted from gross lease income) during one year, then:

  1. $100,000 / $1,000,000 = 0.10 = 10%

The asset's capitalization rate is ten percent.

Capitalization rates are an indirect measure of how fast an investment will pay for itself. In the example above, the purchased building will be fully capitalized (pay for itself) after ten years (100% divided by 10%). If the capitalization rate were 5%, the payback period would be twenty years. Note that a real estate appraisal in the U.S. uses net operating income. Cash Flow equals net operating income minus debt service. Where sufficiently detailed information is not available, the capitalization rate will be derived or estimated from net operating income to determine cost, value or required annual income.

Cost (replacement) approach

Cost (replacement) approach is the process of estimating the value of a property by adding to the estimated land value the appraiser's estimate of the replacement cost of the building, less depreciation.


Basically, how much would it cost for a brand new replacement?


This is most commonly used to appraise special purpose properties such as Libraries, Schools and police stations


Cost approach sets the upper limits of value.  This approach is most appropriate for the appraisal of new property, not old.


If you had to appraise a property from 1910 you would be using the current cost of reproduction, the Cost it took to build it in 1910 would not be a factor.


The Replacement Cost of Improvements is the cost to replace an improvement with another improvement having the same utility.


The Methods for estimating the cost of Construction are:

Unit-in-Place Method

- Unit-in-place calculates the added cost of single units installed;

Square Footage Method

- Square Footage method utilizes exterior dimensions to calculate the cost per square foot

Quantity Survey Method

- Quanity survey calculates the cost of labor and materials to construct each component of a building, it is very accurate but time consuming


Gross Rent Multipliers

Gross Rent Multiplier is the ratio of the price of a real estate investment to its annual rental income before expenses such as property taxes, insurance, and even utilities for vacation rental properties. Other expenses could include the cost of hiring a property management company. To sum up Gross Rent Multiplier, it is the number of years the property would take to pay for itself in gross received rent. For the investor, a higher GRM (perhaps over 20) is a poorer opportunity, whereas a lower one (perhaps under 15) is better.


The GRM is calculated with the following formula as long as you are aware of the two variables Price and Rent, as the GRM will be the quotient of the two variables: PURCHASE PRICE/GROSS ANNUAL RENTAL INCOME =GRM; $180,000/$15,000 = 12.

The GRM is useful for comparing and selecting investment properties where depreciation effects, periodic costs (such as property taxes and insurance) and costs to the investor incurred by a potential renter (such as utilities and repairs) can be expected to be uniform across the properties (either as uniform values or uniform fractions of the gross rental income) or insignificant in comparison to gross rental income. As these costs are also often more difficult to predict than market rental return, the GRM serves as an alternative to a measure of net investment return where such a measure would be difficult to determine.

The common measure of rental real estate value based on net return rather than gross rental income is the Capitalization Rate (CAP RATE). In contrast to the GRM, the Cap Rate is not a multiplier but a rate of annual return. A similar multiplier to the GRM derived from net return would be the multiplicative inverse of the Cap Rate.

Gross Rent Multipliers are found by dividing the price of the property by its rent.

    - $100,000 property divided by $10,000 annually in rent would give you an annual Gross rent multiplier of 10

    - $100,000 property divided by $1,000 monthly in rent would give you a monthly Gross rent multiplier of 100

    - If you are given a monthly rent amount and an annually GRM then multiply that monthly number by 12, because you always want to use annual figures when possible.



 

Introduction

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Cluster housing   

Liens   

Appraisal   

Appraisal Principles   

Principle of Highest and Best Use   

Principle of Substitution   

Principle of Conformity   

Principle of Contribution   

Principle of change   

Market Value   

Steps in the appraisal   

Appraisal methodology   

Market data approach   

Capitalization (income) Approach   

Cap Rate   

Cost (replacement) approach   

Gross Rent Multipliers   

Depreciation   

Physical Deterioration   

Functional Obsolescence   

Economic Obsolescence   

Financing   

Lenders   

Primary mortgage   

FHA   

VA   

Types of Loans   

Loans clauses   

Investing   

Construction Terms   

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