Chapter 17: Real Property Valuation - Art Poling CE and...

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1 © Dearborn Real Estate Education, 2012 Chapter 17: Real Property Valuation © Dearborn Real Estate Education, 2012 Appraising • Estimate or opinion of value • Only valid for the day conducted • Appraisal may only be conducted by a licensed appraiser • Regulated by NC Appraisal Board • Broker does a CMA to find “probable sales price,” not an appraisal (or BPO) for “market value” Value Characteristics of value Demand – the need or desire for possession or ownership backed by the financial means to satisfy that need Utility – the capacity to satisfy human needs and desires Scarcity – a finite or limited supply Transferability – the relative ease with which ownership rights can be transferred

Transcript of Chapter 17: Real Property Valuation - Art Poling CE and...

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© Dearborn Real Estate Education, 2012

Chapter 17: Real Property Valuation

© Dearborn Real Estate Education, 2012

Appraising

• Estimate or opinion of value

• Only valid for the day conducted

• Appraisal may only be conducted by a licensed appraiser

• Regulated by NC Appraisal Board

• Broker does a CMA to find “probable sales price,” not an appraisal (or BPO) for “market value”

Value

� Characteristics of value

– Demand – the need or desire for possession or ownership backed by the financial means to satisfy that need

– Utility – the capacity to satisfy human needs and desires

– Scarcity – a finite or limited supply

– Transferability – the relative ease with which ownership rights can be transferred

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© Dearborn Real Estate Education, 2012

Value

• Characteristics of Value

–Demand

–Utility

–Scarcity

–Transferability

© Dearborn Real Estate Education, 2012

Market Value

The most probable price a property will bring in a competitive and open market under all conditions requisite to a fair sale; the buyer and the seller are each acting prudently, knowledgeably, and without undue influence.

Value

� Market value Definition– The most probable price a property will bring– In a competitive and open market– Under all conditions requisite to a fair sale– The buyer and seller are each acting prudently,

knowledgeably and without undue influence– The buyer and seller must be unrelated and acting

without undue pressure� A reasonable length of time must be allowed for the

property to be exposed in the open market� Both the buyer and the seller must be well informed of the

property's use and potential, including its assets and defects

– Consideration paid in cash or its equivalent

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Value

• Market value vs. market price

• Market value vs. cost

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Forces and Factors Influencing Value

• Social forces

• Economic forces

• Political forces

• Physical forces

Social forces

� “We’re likelier to own homes than our parents or grandparents were.” 1

� According to the US Census Bureau, the home ownership rate was 55 percent in 1950; 64 percent in 1980; an 69 percent in 2005. The homeownership rate fell to 64.7 percent in the 2nd quarter of 2014, the lowest level since 1995.

1 Quoted from HOME: The Blueprints of Our Lives from Harper Collins

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Social forces� The Evolution of Home, Sweet Home

The average house in 1950 was 1,100 square feet. IN 1980- it was 1,740. By 2005, it grew to 2,434. Meanwhile lot sizes shrank about 4 percent from 1980 to 2005.

© Dearborn Real Estate Education, 2012

Basic Economic Principles of Value

• Highest and best use

• Substitution

• Supply and demand

• Conformity

• Anticipation

• Contribution

• Competition

• Change

Basic economic principles of value

� Highest and best use – the most profitable single use to which a property can be adapted; is subject to change

� Substitution – the maximum value of a property tends to be set by the cost of purchasing an equally desirable replacement; basis for the Sales Comparison Approach

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Substitution

�market value of real estate is influenced by the cost of acquiring a substitute or comparable property.

Basic economic principles of value

� Supply and demand (buyer’s market/seller’s market)– Supply increases, demand stays constant: prices

will fall

– Supply decreases, demand stays constant: prices will rise

– Demand increases, supply stays constant: prices will rise

– Demand decreases, supply stays constant: prices will fall

Supply and Demand

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Basic economic principles of value

� Conformity – maximum value is realized if the use of the land conforms to existing neighborhood standards

� Anticipation – value can increase or decrease if one anticipates some future benefit or detriment from the property

Conformity

� The economic principle which states that the maximum value of an improved property is realized when other properties in the immediate area have compatible and harmonious style

Anticipation

� The principle that the purchase price of property is affected by the expectation of its future appeal and value.

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Contribution

�The principle that any improvement to a property, whether to vacant land or a building, is worth only what it adds to the property’s market value, regardless of the improvement’s actual cost.

Competition

�The principle that a successful business attracts other such businesses, which may dilute profits.

Change

�The principle that no physical or economic condition ever remains constant.

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Basic economic principles of value

� Contribution – the value of any component of a property is what its addition contributes to the value of the whole or what its absence detracts from the value of the whole; beware of over improvement

� Competition – excess profits tend to attract competition

� Change – no physical or economic condition remains constant; life cycle

Basic economic principles of value

� Competition – excess profits tend to attract competition

� Change – no physical or economic condition remains constant; life cycle

© Dearborn Real Estate Education, 2012

The Appraisal Process

• Methodical collection

and analysis of data

– Specific data

– General data

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The Appraisal Process

� State the problem: what type of value is being sought?

� List the data needed and the sources

� Gather, record and verify the necessary data– General data – national, regional, city, and

neighborhood data; data about factors not located on the property

– Specific data – data on the subject land and improvements

– Both general data and specific data would include information regarding each of the three approaches to value

The Appraisal Process

� Determine the highest and best use of the site.

� Estimate the land value, usually by sales comparison analysis

� Estimate the value by each of the three approaches

� Reconcile the estimated values for the final value estimate

� Report the final value estimate

© Dearborn Real Estate Education, 2012

Approaches to Value

• The Sales Comparison Approach

• The Cost Approach

• The Income Capitalization Approach

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Sales Comparison Approach

–Comparing subject property to comparable properties that have sold recently

–Comps should be as similar to the subject as possible

–Adjustments are made to comps

–CMA is based on this approach

–Best approach for residential and land

© Dearborn Real Estate Education, 2012

Selecting Comparables

–Arm’s length transaction

–Comps should be as similar to the subject as possible

–Recently sold 3 or more comps

–Fewest adjustments possible

–Superior vs. inferior

–Correlation vs. simple averaging

The Sales Comparison Approach

� Comparing subject property to comparable properties that have sold recently

� Comps should be as similar to the subject as possible

– CMA is based on this approach

– Best approach for residential and vacant land

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The Sales Comparison Approach

� The factors for which adjustments to the comparable properties are made

� Date of sale – changes in economic conditions between the date of the sale of the comparable property and the date of the appraisal

� Location – compensate for location or neighborhood differences

The Sales Comparison Approach

� The factors for which adjustments to the comparable properties are made

� Physical features and amenities -- physical differences between the comparable properties and the subject

� Conditions of sale—motivational factors such as financing concessions, foreclosure or a sale between family members (not an arm’s length transaction)

The Sales Comparison Approach

� Selecting comparables

– The more similar the comp is, the more recently sold, and the fewer adjustments required, the more reliable the estimate of value

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The Sales Comparison Approach

� Selecting comparables

– Adjustments are made as follows

– If the comparable property is superior to the subject property or has a feature that the subject property lacks, the value of the comparable is decreased accordingly

– If the comparable property is inferior to the subject Property or lacks a feature that the subject property has, the value of the comparable is increased accordingly

The Sales Comparison Approach

� Selecting comparables

– Adjustments are made as follows

– After the appraiser has arrived at a value for each comparable (a minimum of three), he must determine a single value using a weighing process called correlation; not simple averaging

The Sales Comparison Approach

� Comparative market analysis (CMA)

– Real estate licensees must be familiar with appraisal techniques to perform a comparative market analysis (CMA) which is an informal version of the sales comparison approach

– Usually determines a range of value vs. a specific value like an appraisal

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SALES COMPARISON

Comparing the Subject Property to Comparables (recently sold properties) and making plus or minus adjustments for differences.

COMPARABLE

SUBJECT

$80,000

- 1,500

$78,500

Minus fireplace

Adjusted value

If the comparable had not had a fireplace, it would have sold for less because people are willing to pay extra for a fireplace.

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Comparative Market Analysis (CMA)

–Informal version conducted by real estate licensee

–Usually indicates a range vs. a specific value

–Refer to current and expired listings

–Should be kept current

–Client-level service

Sales Comparison ApproachThe subject property is a 3 bedroom, 2 ½ bath house with no garage. Market research indicates that a 2 car garage adds $7,500 value and a half-bath adds $1,800 value. A 3 bedroom, 2 bath home with a 2 car garage on the next block sold for $115,600 two weeks ago. Using the sales comparison approach, what is the indication of value?

A. $124,900

B. $106,300

C. $121,300

D. $109,900

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Sales Comparison ApproachThe subject property is a 3 bedroom, 2 ½ bath house with no garage. Market research indicates that a 2 car garage adds $7,500 value and a half-bath adds $1,800 value. A 3 bedroom, 2 bath home with a 2 car garage on the next block sold for $115,600 two weeks ago. Using the sales comparison approach, what is the indication of value?

$115,600 + $1,800 - $7,500 = $109,900 = D

© Dearborn Real Estate Education, 2012

Cost Approach

–Estimate the value of the land as if vacant using the sales comparison approach

–Estimate the current cost of reconstructing any improvement on the land

–Deduct any accrued depreciation

–Add the value of the land

–Best for special-purpose properties

Approaches to Value

� The Cost Approach

– Estimate the value of the land as if vacant using the sales comparison approach

– Estimate the current cost of reconstructing any improvement on the land

– Deduct any accrued depreciation from the estimated construction cost of new building (s) and site improvements

– Add the estimated land value to the depreciated cost of the building (s) and site improvements to arrive at the total property value

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Approaches to Value

� The Cost Approach

– Replacement vs. reproduction

� Reproduction cost – the current cost of a duplicate of the subject property, including both the benefits and the negative features of the property

� Replacement cost – the current cost of improvements with utility or function similar to the subject property

Approaches to Value

� The Cost Approach– Methods of estimating reproduction or

replacement cost� Quantity survey method—the cost of the raw

materials plus the cost of the construction labor plus indirect costs

� Unit-in-place method—replacement cost based on the installed costs of the structure's components

� Square-foot method—based on the average cost-per square foot or cost-per-cubic-foot of recently built similar structures; most widely used method

Approaches to Value

� The Cost Approach

– Depreciation

� Physical deterioration—normal wear and tear

– Curable – repairs that are economically feasible an physically possible

– Incurable—repairs that are not economically feasible

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Approaches to Value

� The Cost Approach

– Depreciation

� Functional obsolescence – outmoded items and poor design

– Curable – outdated physical or design features that could be replaced or redesigned economically

– Incurable – outdated physical or design features that could not be replaced or redesigned economically or physically

Approaches to Value

� The Cost Approach– Depreciation

� Economic (environmental or external) obsolescence – incurable, because it is caused by a problem external to the property and, therefore, beyond the property owner’s control

�Depreciation is usually calculated on a straight-line basis (age-life method), the assumption being that depreciation occurs at an even rate over the structure’s economic life

Approaches to Value

� The Cost Approach

– Special-purpose (unique) properties – cost approach most helpful in appraisal of such special-purpose buildings as schools, churches, and public buildings

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Approaches to Value

� Breakdown depreciation

– Physical deterioration

– Functional obsolescence

– Economic or external obsolescence

Depreciation

� The loss of value

Depreciation

� Functional obsolescence – too few baths, outdated kitchens, old plumbing

� Physical deterioration – rust, rot, peeling

� Economic obsolescence – incompatible with neighborhood

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Economic life

� The period of time over which an improvement to a property will contribute to the property’s value

© Dearborn Real Estate Education, 2012

Determining Reproduction/replacement Cost

• Square foot method

• Unit-in-place method

• Quantity-survey method

© Dearborn Real Estate Education, 2012

Depreciation

• Breakdown Method

– Physical deterioration

– Functional obsolescence

– Economic or external obsolescence

• Age-life Method

• Straight-line Method

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COST

Building replacement

cost

Accrued

depreciation

Site

value

Indicated

value- + =

Calculate Building Replacement Cost

Square feet

of building x $ per square foot = Replacement Cost

5,000 x $ 128 = $640,000

Calculate Depreciation

If Years of estimated

useful life = 40 years

100% ÷÷÷÷ 40 years

Annual depreciation

charge 2.5 %=

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Annual depreciation

charge

2.5 %

xNumber of

years

10

=

Total Accrued

Depreciation

25%

Total life

100%

Depreciation

25%

Remaining life

75%- =

Replacement cost

$640,000

Remaining

75%

Current

Building

Value

$480,000

x =

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© Dearborn Real Estate Education, 2012

Income Capitalization Approach

• Present worth of future rights to income

• Estimate gross income

• Deduct for vacancy

• Calculate net operating income (NOI)

• Rate of return = capitalization rate

• Gross rent multipliers

Approaches to Value

� The Income Capitalization Approach

– Present worth of future rights to future income

– Estimate gross income

– Deduct for vacancy

– Calculate net operating income

– Rate of return = capitalization rate

– Gross rent multipliers

Approaches to Value

� Steps in the income approach to value

a. Estimate the annual potential gross income – income from all sources, including rent, concessions and vending

b. Deduct for vacancies and collections losses (“bad debt”) to obtain the effective gross income.

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Approaches to Value

� Steps in the income approach to value

c. Deduct the annual operating expenses to obtain the net operating income; does not include

� Debt service (principal and interest payment)

� Depreciation (a non-cash payment)

� Capital expenditures / capital improvements

� The owner’s personal income tax liability

Approaches to Value

� Steps in the income approach to value

d. Estimate the price an investor would pay for the income produced by this particular type and class of property (cap rate)

� Compare the annual net operating incomes of recently-sold similar properties to

– The sales price of those properties

– The annual net operating income divided by the sales price results in the capitalization ("cap") rate

Approaches to Value

� Steps in the income approach to value

e. Apply the capitalization rate to the subject property's annual net operating income to obtain an estimated value

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INCOME CAPITALIZATION

Formula for CAP Rate:

Value x Income Capitalization Rate = NOI

NOI ÷ Income Capitalization Rate = Value

NOI ÷ Value = Income Capitalization Rate

NOI = net operating income

INCOME CAPITALIZATION

STEP 1:

Create Annual Operating Statement

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STEP 2:

Research market for acceptable capitalization (cap) rate

COMP 1

NOISales Price

COMP 3

NOISales Price

COMP 2

NOISales Price

== =CapRate

CapRate

CapRate

STEP 3:

Apply the Cap Rate to the Subject Property’s NOI

NOI

Cap RateVALUE=

Capitalization rate

� Example: assuming you net $10,000 and you paid $100,000 what is the CAP rate?

$10,000

$100,000= 10 %

NOI ÷ Value = Income Capitalization Rate

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Capitalization Rate

A property is valued at $100,000 and produces a net operating income of $12,000 per year. What is the overall CAP rate?

A. 12%

B. 13.6%

C. 11.5%

D. 10%

Capitalization Rate

A property is valued at $100,000 and produces a net operating income of $12,000 per year. What is the overall CAP rate?

NOI ÷ Value = CAP Rate

$12,000 ÷ $100,000 = 12 % = A

Capitalization Rate

A property is valued at $100,000 and produces a net operating income of $12,000 per year. The owner decides to sell, but the buyer insists on a 15% CAP rate. What is the sale price?

A. $85,500

B. $80,500

C. $80,000

D. $95,000

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Capitalization Rate

A property is valued at $100,000 and produces a net operating income of $12,000 per year. The owner decides to sell, but the buyer insists on a 15% CAP rate. What is the sale price?

NOI ÷ CAP Rate = Value

$12,000 ÷ 0.15 = $80,000 = C

Approaches to Value

� Gross rent multipliers and gross income multipliers are informal substitutes for income capitalization (see Figure 15.4)

a. Gross rent multiplier

a. Used for single-family residences and duplexes

b. Based on the gross monthly rent of recently-sold similar properties

c. The sales price divided by the gross monthly rent results in the gross rent multiplier

Approaches to Value

� Gross rent multipliers and gross income multipliers are informal substitutes for income capitalization

b. Gross income multiplier

– Used for non-residential income properties

– Based on the gross annual income (from all sources) of recently-sold similar properties

– The sales price divided by the gross annual income results in the gross income multiplier

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SCAN P 184

Gross rent multipliers

Sales Price

Rental Income= Gross Rent Multiplier

This is a substitute for using the income approach to valuation such as when you are appraising a duplex.

Gross Rent Multiplier

Formula for GRM:

Sales Price ÷ Monthly Gross Rental Income = Gross Rent Multiplier

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Gross Rent Multiplier

Property sales yielded the following:

What is the value a property in the area producing a monthly rent of $675?

Gross Rent Multiplier

What is the value a property in the area producing a monthly rent of $675?

Sales Price ÷ Monthly Gross Rental Income = Gross Rent Multiplier

Sales Price = Monthly Gross Rental Income x Gross Rent Multiplier

$675 x 125.34 = $84,375

© Dearborn Real Estate Education, 2012

Reconciliation

• Analyzing and weighing the different approaches to determine a final estimate of value

• Never use simple averaging

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Reconciliation

� Reconciliation – obtaining the final value estimate

1. The three approaches to value usually produce three different indications of value

2. All three should be used in estimating the final value

3. The three indications of value should not be averaged

4. Different situations will require a "weighing" of the indicated values

© Dearborn Real Estate Education, 2012

The Profession of Appraising

• Associations

• Designations

• Federally mandated guidelines (USPAP)

The profession of appraising

� The Appraisal Institute

– Residential Member (RM), Member

� The National Association of Independent

– IFA (member), IFAS (senior

� The American Society of Appraisers

– ASA (senior member)

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The profession of appraising

� National Association of Review Appraisers� American Society of Farm Manager and

Rural Appraisers� Appraising has become the most

specialized branch of real estate� To become state-certified, appraisers must

meet educational, experiential and examination requirements. Federally related appraisal must follow the guidelines as states in USPAP (Uniform Standards of Professional Appraisal Practice)