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Real Estate Appraisal

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What is an appraisal?

• An estimate or opinion of market value of a property or some interest in the property.

• The value that is estimated is for the average market participant.

• In contrast investment value is an estimate of value to a specific investor

• In estimating investment value we consider the specific situation of the investor.

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Why do we need market value?

• Transfer of ownership

• Financing of property

• Taxation

• Compensation for eminent domain

• Insurance purposes

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Factors affecting market value

• Physical forces: size, shape, location, topography• Economic forces: income, mortgage terms, general price

levels, property tax rates, supply and demand• Social forces: attitude towards house household formation,

population, household size, taste and preferences.• Governmental or institutional forces: zoning, subdivision

regulation, building codes, real estate taxation, etc

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What is market value

• VALUE in use -- utility to specific individual, subjective

• Value in exchange: supply and demand, objective

• Market value

• Market price: price negotiated between seller and buyer

• Cost:

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Principles of appraising

• Highest and best use

• anticipation

• substitution

• contribution or marginal productivity

• conformity

• change

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Organizing and performing appraisal

• defining the problem• defining market or trade area• physical and environmental data• demographic and social data• forces of supply and demand• income and expense analysis• highest and best use analysis• sales comparable• application of methods

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Methods of appraisal

• Income capitalization approach

• direct sales comparison approach or market approach

• cost approach

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Income capitalization approach

• V = NOI/R

• where V = market value

• NOI= net operating income

• R = capitalization rate

• What is capitalization rate ?

• it is not a discount rate

• cap rate is net of values appreciation or depreciation

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Deriving the capitalization rate

• Market extraction approach

• 1 2 34

• v 100,000 80,000 120,000 90,000

• NOI = 9,500 7,680 11,352 8,505

• NOI/R .095 .096 .0946 .0945

• Mean R = 9.5025

• Assume NOI for the property being valued is estimated to be 10,000

• V = 10,000/.095025 = $105,235

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Deriving capitalization rate

• Band of investment approach or the weighted average cost of capital

• R = (L/V)(MC) + (1-L/V)(EDR)

• MC = mortgage constant,

• EDR = equity dividend rate

• L/V = loan-to-value ratio

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Band of investment example

• L/V = 70%, interest rate = 10%

• amortization period = 25 years, monthly payment

• BTCF = $1,968, Equity = $31,570

• EDR = 1,968/31570 = 6.2337

• R = (.7)(.009087)(12) + (.3)(.062337) = .095031

• V = 10,000/.095031 = $105,228.

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Gross income multiplier (GIM)• Gross Income Multiplier = sales price/ Gross annual income

• Sales price = Gross income X GIM

– A B C D• Price $500,000 $800,000 $600,000 $400,000

• GI $100,000 $150,000 $100,000 $80,000

• GIM 5.00x 5.33x 6.00x 5.00x

• Subject gross income = $140,000

• Mean GIM = 5.3

• Estimated market value = 5.3x140,000 = $742,000

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Direct sales comparison

• Principle of substitution:

• Potential buyer will pay no more for a property than what has been paid for another equally desirable property

• Theory:

• Market value of (subject property) bears a close relationship to the prices of similar properties (comparable property) that have recently changed hands.

• Adjustments:

• Since no two properties are exactly alike we need to adjust the sales price of comparable property to arrive at the estimated market value for the subject property

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Steps in direct sales approach• First, find comparable properties that have sold recently

• Second, identify key features of the comparable and subject property

• Third, adjust the sales price of comparable properties to reflect the differences between comparable properties and the subject property.

• Fourth, estimate market value through a consolidation process that weighs the adjusted prices of comparable.

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Factors to adjust

• Property characteristics:

– size of parcel

– location

– square footage

– number of bedrooms

– type of construction

– quality of construction

– number of bathrooms

– age of building

– living area, etc

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Factors to adjust

• Nonproperty characteristics– date of sale– sales price– financing terms– condition of sale

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Rule for adjustment

• In adjusting the comparable price for differences the subject property is the 100% property.

• That is all adjustments are made from comparable to subject property

RULE:

• If the comparable has an element of value that is not present in the subject subtract the value of the element from the price of comparable.

• If the subject property has an element of value that is not present in the comparable property add the value of that element to sales price of comparable property.

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Cost Approach

• This approach states that the value of a property is roughly equal to:

– (1) the cost of reproducing the property

– (2) Minus a figure that approximate the amount of value used up in the course of property’s life.

– (3) Plus the value of the land.

• Two cost concepts:• Replacement cost

• Reproduction cost

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Accrued depreciation

• Physical depreciation

– incurable

– curable

• Functional depreciation

– curable

– incurable

• Economic or location depreciation

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Market value and Investment value

• If the investor’s rate of discount is higher that the market rate of discount, investment value will be lower than market value, holding cash flow constant

– A BAD BUY FOR THE INVESTOR

• If the investor’s discount rate is lower than what the market generally requires, investment value will be higher than market value all else equal

– GOOD BUY FOR THE INVESTOR

• If the discount rate for investor is equal to that of the market, market value will equal investment value

– NO ABNORMAL PROFIT