The Appraisal of Real Estate

What is appraisal?Simply put, appraisal is the act or process of estimating value.More precisely: “The term appraisal means a written statement independently and impartially prepared by a qualified appraiser setting forth an opinion of defined value of adequately described property as of a specific date, supported by the presentation and analysis of relevant market information”

- Real Estate Valuation, Lusht, 1997

What is value?

Value is the worth of an item.Human behavior determines value because no item has inherent value.Value in exchange is the quantity of one thing that can be obtained in exchange for another good. This relationship is determined by the market.Value is subjective due to personal preferences, but market value is objective due to market behavior.

Market Value

"The most probably selling price in terms of money which a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buy and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus.”

- Appraising Real Property Boyce & Kinnard, 1984

Market Price

“The amount actually paid, or to be paid, for a property in a particular transaction, which differs from market value in that it is an accomplished or historic fact, whereas market value is and remains an estimate……”

- Appraising Real Property Boyce & Kinnard, 1984

Market Value vs. Market Price(the skinny)

Value and price are identical in a theoretical, perfectly competitive market.We live in a real world! Market value is the “most probably selling price” under typical market conditions.Price is an agreed upon amount or a historical figure.

Typical Market Conditions

It depends!Open and competitive marketPrudent buyer and sellerTypical motivation for buyer and sellerAdequate marketing effortCash equivalency

Other Types

Investment valueUse valueBook valueRental valueSalvage valueAssessed value

Fundament Theory of Appraisal

Supply and demandAnticipation/ChangeCompetition reduces economic rentsSubstitutionOpportunity costContributionExternalities/linkages

Value - Why do we care?

Ownership transferFinancingLitigationTaxesConsulting Rents, feasibility, zoning board,

insurers, etc.

The Appraisal Process

Step 1: Problem Definition Real estate identification Property rights Use of appraisal Value definition Date

The Appraisal Process

Step 2: Preliminary Analysis & Data Plan of attack Information

General – trends Specific – property and comparable Supply & Demand – future changes

The Appraisal Process

Step 3: Highest and Best Use Analysis“the reasonably probable and legal use of vacant land or an improved property, which is physically possible, appropriately supported, financially feasible, and that results in the highest value”

Vacant vs. improved Vacant may be highest and best use.1. Identify use with highest overall return2. Helps identify comparable properties

The Appraisal Process

Step 4: Land Value Estimate Sales comparison Allocation (ratio) Extraction (less improvements) Subdivision & development Land residual technique (NOIland)

The Appraisal Process

Step 5: Application of Three Approaches Sales Comparison (VSC) Cost (VC) Income (VI)

The Appraisal Process

Step 6: Reconciliation Using various estimates of value

under a number of methods determine one estimate of value.

How?

The Appraisal Process

Step 7: Report of Defined Value Conclusion communicating the final value

estimate written. It presents the data, assumptions, and

analyses in a manner so that an intelligent reader should comprehend the logical process and come up with a similar answer to the problem.

It should also explain how and why particular steps were taken.

The Income Approach

Should look familiar!GI=GO (DCF model)

01

0

1 1

Nt Nt N

t

NOI NSPV

y y

NOIV

R

The Income Approach

Gross income multipliers

Potential or effective gross income

*

SPIM

GI

The Sales Comparison Approach

Underlying economic theory: Similar goods sell for similar prices.Applicable to all property types but works best for property types with frequent transactions.Data, data, data..

Sales Comparison

Procedure: Research market/gather data Verify information Select units of comparison (ft^2, apt. unit,

etc) Develop comparable analysis Compare comps to subject with respect to

elements of comparison & make adjustments

Reconcile

Sales Comparison

Sequence of adjustments: Financing terms Conditions of sale Market conditions Location Physical characteristics

Sales Comparison

A(n) _________ adjustment will be made to the comparable price when the comparable property is superior to the subject property.Net adjustments lead to the adjusted sales price.

Sales Comparison

Uses and limitations: Good data = good results An easy “amateur” appraisal Financing advantage No data = no use

The Cost Approach

Underlying economic theory: No prudent buyer would pay more than it would cost to purchase the land and develop.Applicable to all property types but does not have the ease of sales comparison.Data, data, data..

Cost Approach

Procedure: Estimate site value Estimate hard and soft costs of

improvements including reasonable profit

Estimate accrued depreciation in the structure

Add site value to improvement depreciated cost

Cost Approach

Site Value (previously discussed)Reproduction vs. replacement cost Reproduction is exact replica Replacement is a “newer” building of

equal utility (modern materials, designs, and layout)

Cost Approach

Direct (hard) costs Building permits Labor Materials Equipment Security Contractors profit

Cost Approach

Indirect (soft) costs: Consulting Engineering and architecture Cost of carry (fees, points, interest,

lease-up) Selling expenses Leasing commissions

Cost Approach

Cost Data Collection Marshall & Swift MEANS

Cost Approach

Comparative Unit Method: Determine (find) estimate of cost per

unit of area Aggregate cost per unit Size matters Use of benchmark building

Adjust for size, finish quality, time, etc.

Cost Approach

Unit in Place Method: Each category (section) of the

building’s cost is estimated. Foundation, sprinkler, roof, framing,

on a square foot cost basis

Cost Approach

Quantity Survey Method Most complex and time consuming No aggregation of data according to

size Number of labor hours, direct cost

supplies are estimated and the cost of each is applied.

Rarely used.

Cost Approach

Depreciation: Non-accounting sense Three major types:

Physical deterioration Functional obsolescence External obsolescence

Economic life, effective (actual) age, remaining economic life

Cost Approach

Market Extraction Method (depreciation): Transaction prices of similar properties

with respect to age/depreciation Sale price minus land = depreciable

cost (1) Estimate the replacement cost (2) (2)-(1) = total depreciation

Cost Approach

Age-Life Method (depreciation) Estimate total economic life of similar

properties Estimate effective age Compute ratio of effective age

(subject) to total economic life Apply ratio to development cost

Cost Approach

Breakdown Method (depreciation): Most complex and least used Usually used with another method of

estimating depreciation Each form of depreciation is

estimated separately

Cost Approach

In summary:

Useful when there is not an active market for the subject property type

0 landV V Development Cost Accrued Depreciation

Reconciliation

We have 3 (or more) estimates of value.

,

1

SC SC C C I I

SC C I

V V V V

where

Appraisal Method Summary

Comparable sales Like goods sell for like prices Requires transaction data on “similar”

properties

Income approach Value is PV(future benefits) Most relevant for income producing real estate

Cost approach Buyers will not pay more than the cost Utilizes industry cost estimators

Conclusion

A real estate appraisal is a professional opinion of value as of a particular date based on systematic analysis and market data.