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Introduction to Real Estate Valuation

Definitions

o Valuation – a determination of the monetary values at some specified date of the property rights encompassed in an ownership

o Appraisal – stated result of valuing a property, making a cost estimate, forecasting earnings, or any combination of two or more of these stated results. It is also an act of valuing, estimating cost or forecasting earnings.

Definitions

o Cost estimation – an estimate of the amount of money that would be required at some specified date, to construct, produce, replace or reproduce some tangible and/or tangible thing, without regard to its ownership

o Earnings forecast – an estimate or forecast of the future net monetary returns, deliverable from something owned or considered as being owned

Definitions

o Therefore, appraisal is an estimate or opinion of value, where an estimate is NOT a:o Statement of valueo Determination of valueo Fixing of value

Definitions

o An appraisal is only one person’s opinion of value

o Different appraisers may arrive at different estimates

o The accuracy and usefulness of the value estimate depends on the appraiser’s skill, experience and judgment

Definition of Value

o Value – means the worth, usefulness or utility of an object to someone for some purpose

o Market value – defined as the

1. Highest price in terms of money

2. That real property is acquired

3. By a buyer who is willing to buy and a seller who is willing to sell

4. Both of whom have adequate knowledge of the actual and potential use/s of the property

5. Which has been offered for a reasonable time in the open and competitive market

International Valuation Standards (IVS)Definition of Value

o The estimated amount for which a property should exchange on the date of valuation between a willing buyer and a willing seller in an arm’s length transaction after proper marketing wherein the parties had each acted knowledgeably, prudently and without compulsion

Value in Use and Value in Exchange

o Value in Use – refers to the value of a thing or property to the holder which includes the amenities, benefits and income derived from it’s ownership, all of which are estimated in terms of money. This is subjective

o Value in Exchange – indicates the value of the property traded in the market. This is synonymous to objective value or market value

Value, Price & Cost

o Value and Price – value is the distinct attribute of a thing or commodity to attract and complement another thing or commodity in the market while price is the amount paid or offered for a thing or property. To the seller, the price is subjective value. It is value in exchange.

The objective value of a property may be higher or lower than its current price.

Value, Price & Cost

o Value and Cost – Cost is not price. Neither is it value. It represents the capital expense in the formation and construction of a finished product. It includes the original cost of land and construction materials as well as profit and professional services.

Normally, cost is less than price. The difference is profit.

Other Meanings of Value

o Land has plottage value when one or more parcels are consolidated so that its increment in value as a whole is much more than the total sum of the value of each parcel of land separately owned

o Rental value refers to the price fixed for the right to use a certain property for a specific period of time


o Cash value is the value of the property in an all-out sale. It is synonymous to market value.

o Investment value is the present worth of future benefit, or income of the property that the owner, or investor has acquired.

o Going concern value is the value of the business in operation, or property that will continue to be utilized. It includes tangible property such as real estate, equipment and machinery, fixtures and inventories plus intangible assets such as franchises, patents and goodwill.


o Book value is the original cost of an asset or property less accrued depreciation.

o Corporations under receivership may sell its assets at liquidation value or value. This value could be lower than its market value because the owners are forced to sell, or due to their ignorance of the real value of their assets.


o In estimating the depreciation in account of the corporate assets, the estimated salvage value is one of the factors to be considered. The other factors are (1) cost of the assets, and (2) their estimated useful life. Salvage value is the amount that maybe recovered minus cost of disposal when the assets will be retired or disposed of at a future time.


o Loan value is the maximum level of value, or appraised value, against which a property may be mortgaged to secure payment of the loan. A loan-to-value rate is usually fixed by the lending institution or bank.

o The insurance value is the cost of insurance coverage of the building or improvement to cover its loss due to earthquake, fire or other calamity. This is done by estimating the cost of replacing the entire building, or the portion thereof that has been damaged.


o Scrap value is the value of a depreciated building or the materials recovered from it.

o Condemnation value is the estimated value of a property that is the object of expropriation for public use. Just compensation is the fair and full equivalent, in money, for the loss sustained.

o Assessed value is the value of land and/or improvements for ad valorem tax purposes. The assessed value is multiplied by the tax rate to produce the amount of tax due to payment. It is synonymous to taxable value.

o .


o Zonal value is the fair market value of land in a specific zone or area established by the Bureau of Internal Revenue.

o .

Characteristics of Value

o Utility – ability of the property to satisfy human need

o Scarcity. Land is not scarce. It is the use for which it is intended or actually established that is becoming scarce. The scarcity, however, is not absolute.

o Effective demand. The desire coupled with the financial capacity of the buyer/s to acquire a piece of real property

o Transferability – refers to the quality of the property to be transferred or covered.

Factors that Influence Value

o Social forces relate to population growth, birth control measures and migration.

o Political forces are government-based. The degree of efficiency in the maintenance of peace and order and the effort of providing primary services such as electric light, water, fuel, and food. Ex. Zoning and land use ordinances

Factors that Influence Value

o Economic forces include the nature of basic industry and business activity in the neighborhood like trend of employment, salaries and wages of employees and workers and expansion of the housing program

o Physical forces refer to the location and age of the neighborhood: size, area, shape and topography of land; type of improvements and architectural trends; and street pattern, sidewalks and underground drainage

Bundle of Rights

Bundle of rights - rights which are encompassed by ownership of real estateo The right to possess and enjoy the use of the

propertyo The right to disposeo The right to exclude any person from the

enjoyment and disposal of the propertyo The right to recovero The right to convey by inheritance

Legal Rights and Interests

o Fee simple estateo Life estateo Leasehold interesto Leased fee interesto Other legal interests such as easement,

encroachment

Types of Appraisals

Informal Appraisals –made by almost everyone. They are usually based on a combination of knowledge, experience and intuition

Formal appraisals – usually made by people especially trained for this work and are used in:o Business and financeo Litigationo Taxationo Insurance

Economic Principles to Property Value

o Anticipation - the perception that value is created by the expectation of benefits to be derived in the future. Value is based on market participant’s perception of future benefits of ownership.

o Balance - relates both to the property as well as the environment in which the property is located. It is related to the property itself, this principle holds that value is achieved and maintained when all elements are in proper proportion.


o Change -the result of the cause and effect relationship among the forces that influence real property value. Change in the market for real estate due to social, economic, governmental, and environmental forces. Example: depreciation - loss in property value from any cause.

o Competition - holds that profits tend to spur competition. The more profitable a venture may appear, the more competition will be created. In other words, success breeds competition, and extremely high success breeds excess competition.


o Conformity - real property value is created and sustained when the characteristics of a property conform to the demands of its market. Zoning ordinances establish conformity in basic property characteristics.

o Contribution - holds that the value of a component is a function of its contribution to the whole rather than as a separate component. The cost of an item does not necessarily equal its contributory value.


o Externalities - outside forces that effect property values. Economies outside a property have positive effects on its value, while diseconomies have a negative effect on value externalities such as the neighbourhood have an effect on value.

o Increasing and decreasing returns - relates to the principle of balance as well as to the principle of contribution. This principle holds that as capital units are added, a certain point is reached where the added units do not contribute value commensurate with their costs.


o Opportunity cost - the cost of options forgone or opportunities not chosen. Investors will seek to select investments that provide the highest rate of return at the lowest level of risk. In other words, investors seek to maximize returns, yet are risk averse. It is related to the principle of substitution, and is relative to the income approach.


o Substitutiono when several similar goods or services are available,

the one with the lowest price attracts the greatest demand.

o a buyer will not pay more for one property than for another that is equally desirable.

o property values tend to be set by the cost of acquiring an equally desirable substitute property.

o recognizes that buyers and sellers or real property have other options, i.e., other properties are available for similar uses.

o fundamental to all three approaches to value, but is the back bone of the sales comparison approach.


o Supply and demand - the interaction of the supply and demand relationships for real estate in price determination. It relates to the factors of value - utility, scarcity, desire, and effective purchasing power.

o Surplus productivity - the net income that remains after the costs of various agents of production have been paid. It relates to the income approach. The agents of production – land, labour, capital and management

Valuation Process

o Definition of the problemo Collection and analysis of datao Analysis of highest and best useo Application and limitations of each approach to

value – sales comparison, cost, income capitalization

o Reconciliation and final value estimateo The Appraisal Report

Highest and Best Use Analysis

o Four tests – physically possible, legally permitted, economically feasible, maximally productive

o Vacant site or as if vacanto As improvedo Interim use

Approaches to Value

o Sales Comparison Approach (Market Data Approach) - a comparative approach to value that considers the sales of similar or substitute properties and related market data and establishes a value estimate by processes involving comparison. In general, a property being valued (a subject property) is compared to sales of similar properties that have been transacted in the open market. Listing and offerings may also be considered.

Approaches to Value

o Essential concepts in the Sales Comparison Approach – o Research and selection of comparableso Elements of comparisono Adjustment process

Approaches to Valueo Example – Matrix of comparables

Approaches to Valueo Cost approach - a comparative approach to the

value of property or another asset, that considers as a substitute for the purchase of a given property, the possibility of constructing another property that is an equivalent to the original or one that could furnish equal utility with no undue cost resulting fro delay. The Valuer’s estimate is based on the reproduction or replacement cost of the subject or asset, less total (accrued) depreciation.

Approaches to Valueo Essential concepts in the Cost Approach –

o Site descriptiono Improvement descriptiono Basic construction and designo Reproduction vs replacement costo Information source – Davis, Langdon & Seah

Construction Cost Handbook Philippines 2012

o Accrued depreciation

Approaches to Valueo Cost Approach procedure

1. Estimate the value of the land as if vacant and available for use

2. Estimate the total cost to build the existing structure, figured at today’s construction prices

3. Decide on an appropriate amount to allow for accrued depreciation, that is, the loss in value of the subject building as compared to a new structure

Approaches to Valueo Steps in the Cost Approach

4. Subtract the estimated depreciation from the cost of the hypothetical new structure, giving a depreciated cost estimate

5. Add the value of the land to the depreciated cost of the new structure. The result is the indicated property value by the cost approach

Approaches to Valueo Example – Cost Approach

Approaches to Valueo Income capitalization approach (Income

approach) - a comparative approach to value that considers income and expense data relating to the property being valued and estimates value through a capitalization process. Capitalization relates income (usually net income) and a defined value type by converting an income amount into a value estimate.

Approaches to Valueo Essential concepts in the Income capitalization

approach (Income approach)o Direct Capitalization Technique – V= I/ro Yield capitalization Technique – Discounted

Cash Flowo Estimation of income and expenseso Estimation of net incomeo Capitalization rates

Approaches to Valueo Steps in the Income Approach

1. Obtain annual rent schedules/revenue schedule for the subject property and compare with competition to arrive at a projection of reasonable rents/revenue for the subject

2. Estimate annual vacancy and collection losses

3. Subtract these from the gross income to arrive at the effective gross income

Approaches to Valueo Steps in the Income Approach

4. Estimate the annual expenses and subtract them from the effective gross income to arrive at the net income. Net income is sometimes called net operating income

5. Analyze comparable investments in order to arrive at a capitalization method and rate

6. Capitalize the projected net income into an estimate of value.

Approaches to Valueo Example - Income Approach

Reconciliation of Final Value Estimates

When the appraiser arrives at the final value estimate by considering all of the evidence supporting the different value indicators, as well as the relevance of the different appraisal techniques to the particular appraisal problem at hand

The Appraisal Report

Types of appraisal reports –

o Formal vs informal

o Short form vs narrative


Parts of a Narrative Appraisal Reporto Introduction - states the purpose (market

value, investment value, insurance value, etc.) and function (use of report, i.e., mortgage, estate, etc.) of the appraisal, identifies and describes the subject property, and presents the value conclusion

o Title pageo Letter of transmittalo Summary of Salient Facts and Conclusions

OR Executive Summaryo Assumptions and Limiting Conditions


Parts of a Narrative Appraisal Reporto Factual Data - contains facts affecting the

appraisalo Property identificationo Legal descriptiono Appraisal objective

o Purpose of the appraisal - answering the value question the client wants to answer i.e. to estimate market value, insurable value, or some other type of value


Parts of a Narrative Appraisal Reporto Function of the appraisal - client's

expected use the appraisal should be clearly stated, i.e. whether the appraisal is to be used for loan purposes, estate settlement, bankruptcy, or some other use.

o Definition of value o Scope - process of collecting, confirming,

and reporting data is describedo Property rights appraised


Parts of a Narrative Appraisal Reporto Effective Date of the Appraisalo Ownership History of the Propertyo Area – Regional and Neighbourhood

Analysiso Property Description

o Data Analysis and conclusionso Highest and Best Useo Appraisal or valuation processo Reconciliation and final value

estimateso Certification

o Addenda

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