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California Real Estate Chapter 11

Terms in this set (281)

"An appraiser may work for

-a financial institution,

-a private corporation with an active real estate department,

-a government agency, or

-an appraisal company.

Or an appraiser may be self-employed, hired to appraise property for a fee.

A self-employed appraiser is sometimes called a fee appraiser.

The person who employs the appraiser is the client.

The appraiser is the client's agent.

A principal/agent relationship exists and the laws of agency apply.

Because of the fiduciary relationship that exists between the appraiser and his client, an appraiser has a duty of confidentiality and should discuss the results of the appraisal process only with the client, unless given permission to discuss them with a third party.

Duties imposed by the agency relationship also require an appraiser to disclose in the appraisal report any interest he has in the property being appraised; in fact, in many transactions, federal law prohibits an appraiser from having any interest in the subject property.

And if the appraiser is uncertain about any aspect of the appraisal—whether to classify a particular item as real or personal property, for example—that information should also be included in the appraisal report.

An appraiser's fee is determined in advance, using a rate customary to the local market, based on the expected difficulty of the appraisal and the amount of time it's likely to take.

The fee can't be calculated as a percentage of the appraised value of the property, nor can it be based on the client's satisfaction with the appraiser's findings."

"To help ensure their independence and impartiality, appraisers in "federally related" transactions are not permitted to have any substantive communication with the mortgage loan originator (MLO) in a transaction.

Appraisals for loans that will be sold to the secondary market agencies must be arranged either through an independent appraisal management company, or through a separate department within the lender's organization, not by an MLO or anyone else in the loan production department.

In addition, real estate agents aren't allowed to select or compensate the appraiser in transactions involving loans that will be sold to Fannie Mae or Freddie Mac.

Under both federal and California law, it's illegal for someone with an interest in a transaction to attempt to improperly influence the appraisal through coercion, extortion, or bribery.

It is permissible to ask the appraiser to consider additional property information, explain the basis for her value estimate more fully, or correct errors in the appraisal report."
"The state of California licenses and certifies appraisers.

California doesn't require all appraisers to be licensed or certified, but it offers licensing and certification for those who need them to comply with federal law.

An appraiser must be licensed or certified to perform an appraisal in a federally related loan transaction if the loan amount is greater than $250,000.

Although the state doesn't require all appraisers to be licensed or certified, under federal law only appraisals prepared by state-licensed or certified appraisers in accordance with the Uniform Standards of Professional Appraisal Practice (USPAP) can be used in "federally related" loan transactions.

USPAP is a set of guidelines adopted by the Appraisal Foundation, a nonprofit organization.

(An appraiser who fails to abide by these standards in order to defraud a federally insured lender could be found guilty of a felony.)

The majority of real estate loans are federally related, since the category includes loans made by any bank or savings and loan association that's regulated or insured by the federal government.

** Transactions for $250,000 or less are exempt from this requirement, however.

Note that for the purposes of the California appraisal licensing law, the definition of an appraisal doesn't include opinions of value given by real estate licensees in the ordinary course of their real estate activities.

So a real estate agent's competitive market analysis is not considered an appraisal, and should not be referred to as an appraisal.

**Competitive Market Analysis does NOT equal Appraisal

Thus, a competitive market analysis prepared by a real estate agent for a listing presentation wouldn't be considered an appraisal."

"In California, the Office of Real Estate Appraisers examines appraisers and issues licenses.

There are four levels of appraisal licenses.

For all four levels, a 15-hour National USPAP course must be completed as part of the educational requirements explained below.

1. Certified General Real Estate Appraisers may appraise any type of real property.

This license requires 300 hours of appraisal-related education and 3,000 hours of appraisal experience, including 1,500 hours appraising nonresidential properties.

The appraisal experience must have been acquired over at least 30 months.

** A bachelor's degree is also required, although 30 semester credits in specified subject areas can be substituted for a degree.

An applicant for this type of license must pass the Uniform State Certified General Real Property Appraiser Examination."

2. "Certified Residential Real Estate Appraisers may appraise any one- to four-unit residential property, and any nonresidential property with a value up to $250,000.

This requires 200 hours of appraisal education and at least 2,500 hours of appraisal experience obtained over at least 30 months.

An associate's degree or 21 semester credits in specific subject areas is also required.

An applicant must pass the Uniform State Certified Residential Real Property Appraiser Examination."

3. "An appraiser with a Residential License may appraise any one- to four-unit residential property with a transaction value up to $1 million, and any nonresidential property with a value up to $250,000.

This license requires 150 hours of appraisal education and at least 2,000 hours of appraisal experience over at least 12 months (or 1,000 hours of experience for a holder of a valid California real estate broker license).

An applicant must pass the Uniform State Licensed Residential Real Property Appraiser Examination."

4. "An appraiser with a Trainee License must work under the technical supervision of a licensed appraiser and may assist on any appraisal that falls within the scope of the supervising appraiser's license.

This license requires 150 hours of instruction within the past five years and passage of the Trainee Level Appraiser Examination."

"An appraisal license is valid for 2 years.

To renew a license, the appraiser must have completed a seven-hour National USPAP Update course during the license term and must pay a renewal fee.

An additional 14 hours of continuing education are required each calendar year; documentation of continuing education must be submitted every four years."
(Value in exchange)

Market value is the most probable price the property should bring under all conditions needed for a fair sale.

The price someone should pay for the property under normal conditions.

The most probable price that a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price isn't affected by undue stimulus.

Note that the market value is the most probable price a property should bring.

An appraisal is a matter of estimation and likelihood, not certainty.

Market value is the price that should be paid if a property is purchased under normal conditions.

"Most widely accepted definition of market value, taken from the Uniform Standards of Professional Appraisal Practice:

The most probable price which a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus.

Notice that according to this definition, market value is the most probable price (not "the highest price") that the property should bring (not "will bring").

Appraisal is a matter of estimation and likelihood, not certainty."

Notice, too, that market value is the most probable price that should be paid if the property is purchased under normal conditions.

A sale can generally be considered to have taken place under normal conditions if:

-it was an arm's length transaction (a sale between unrelated parties);

-the property was offered on the open market for a reasonable length of time;

-the buyer and the seller both acted prudently & knowledgeably; and

-neither party was subject to undue stimulus or unusual pressure


The Federal Housing Administration offers this succinct explanation of market value:

The price which typical buyers would be warranted in paying for the property for long-term use or investment, if they were well informed and acted intelligently, voluntarily, and without necessity.

Since some transactions don't take place under normal conditions, the price actually paid for a property may be either more or less than its market value.
"Of the major forces that influence our attitudes and behavior, four interact to create, support, or erode property values:

-social ideals and standards,

-economic fluctuations,

-government regulations, and

-physical and environmental factors.

A change in attitudes regarding family size and the emergence of the two-car family are examples of social forces that affect the value of homes (in this case, homes with too many bedrooms or one-car garages).

Economic forces include employment levels, interest rates, and any other factors that affect the community's purchasing power.

Government regulations, such as zoning ordinances, serve to promote, stabilize, or discourage the demand for property.

Physical and environmental factors, such as climate, earthquakes, and flood control measures, can also have an impact on property values."

All four of these forces affect value independently of the owner's efforts.

For instance, an economic force such as inflation will cause a property's value to increase, even though the owner has done nothing at all to improve the property.

When the value of a property increases due to outside forces, the increase is referred to as an unearned increment.

Over the years, appraisers have developed a reliable body of principles, referred to as the principles of value, that take these forces into account and guide appraisers in making decisions in the valuation process.

Note that these principles are valid no matter which appraisal method is used to arrive at an estimate of value.
The principle of change states that a property's value changes constantly, in response to changing social, economic, governmental, and environmental conditions, and in response to changes in the property itself.

Every property has a four-phase life cycle: integration, equilibrium, disintegration, and rejuvenation.

The principle of change is concerned with how a property's value increases and decreases over time.

Property is always in a state of flux. This is why every appraisal is tied to a given date, called the effective date of the appraisal.

A property's value changes constantly, in response to shifting social, economic, governmental, and environmental forces. Its value also changes as the property itself improves or deteriorates over time

Real property is in a constant state of change. It goes through a four-phase life cycle of integration, equilibrium, disintegration, and rejuvenation.

"The principle of change holds that real estate values are constantly in flux, moving up and down in response to changes in the various social, economic, governmental, and environmental forces that affect value.

A property's value also changes as the property itself improves or deteriorates.

A property that was worth $500,000 last year might be worth $525,000 today; or it might be worth only $475,000.

Its value is likely to change in the coming year as well.

Because value is always subject to change, an estimate of value must be tied to a given date, called the effective date of the appraisal."

Related to the principle of change is the idea that property has a four-phase life cycle:

-integration,

-equilibrium,

-disintegration, and

-rejuvenation

Every property has both a physical life cycle and an economic life cycle.

The appraiser must take these life cycle stages into account when estimating a property's present worth.
According to the principle of anticipation, people buy property in anticipation of receiving benefits from it in the future.

An appraiser must consider not only the present state of the property, but how it may change in the future.

People buy property in anticipation of receiving benefits from it in the future.

For instance, a couple might buy a house anticipating that it will appreciate in value while providing them a place to raise their family.

It is those anticipated benefits that create value.

To apply the principle of anticipation, an appraiser must consider not only the present state of the property, but how it may change in the future.

Will the zoning laws that apply to the property change?

Is the region's economy heading for a downturn?

Will the surrounding property owners maintain or neglect their homes?

It's the future, not the past, that's important to appraisers.

Knowing that property values change, an appraiser asks:

What is happening to this property?

What is its future?

How do prospective buyers view its potential?

The appraiser must be aware of the social, economic, governmental, and environmental factors that will affect the future value of the property.

Value is created by the anticipated future benefits of owning a property.

It is future benefits, not past benefits, that arouse a desire to own.

Anticipation can help or hurt value, depending on what informed buyers and sellers expect to happen to the property in the future.

They usually expect property values to increase, but in certain situations they anticipate that values will decline, as when the community is experiencing a severe recession.
According to the principle of supply and demand, as the demand for a certain type of real estate in a certain location exceeds the supply, the market value of properties in that category tends to rise.

Likewise, as the supply exceeds the demand, the market value of that type of property tends to fall.

When the demand for a product exceeds the available supply, the value of the product will increase.

If the supply exceeds the demand, the value of the product will decrease.

As the demand for housing in a specific location increases, the market value of houses there will rise

In response to the increased demand, developers will build more houses.

Then as the supply increases, the market value of the houses will fall.

The law of supply and demand also applies to rental properties. The supply of available rental space is affected by fluctuations in market prices and rents.

An undersupply of rental units leads to high rents, which in turn prompts developers to expand the supply.

An oversupply of units results in high vacancy rates and lower rents.

The principle of supply and demand affects almost every commodity, including real estate.

Values tend to rise as demand increases and supply decreases, and to diminish when the reverse is true.

It's not so much the demand for or supply of real estate in general that affects values, but the demand for or supply of a particular type of property.

Ex. A generally depressed community may have one or two very attractive, sought-after neighborhoods.

The value of homes in those neighborhoods remains high, no matter what the general trend is for the rest of the community.
A property's value is maximized when the agents in production are in balance. The agents in production are labor, coordination, capital, and land.

When a property is serving its highest and best use, neither too much nor too little of its earnings are attributable to the land.

This principle maintains that the maximum value of real estate is achieved when the agents in production—labor, coordination, capital, and land—are in proper balance with each other.

To see whether the agents in production are in proper balance, the appraiser deducts a dollar figure that can be attributed to each agent from the property's gross earnings.

First, the appraiser deducts the wages (labor) that are paid as a part of the property's operating costs.

Next, the appraiser deducts the cost of the management (coordination).

The third item deducted is the expense of principal and interest (capital), which represents the funds invested in the building and equipment.

The surplus productivity—whatever earnings remain after the first three productive agents have been deducted—is credited to the land for its part in the production of the gross income.

The amount credited to the land will reflect the land's value under its present use.

If an imbalance exists and too much of the gross earnings are attributed to the land, the buildings are probably an underimprovement and the land is not serving its highest and best use.

If too little income is credited to the land, the buildings are probably an overimprovement and, again, the land is not serving its highest and best use.
Depth

Depth is the distance between a site's front boundary and its rear boundary.

A lot's depth is the distance between its front and rear boundaries.

Greater depth doesn't always translate into greater value.

Greater depth (more than the norm) can mean greater value, but it doesn't always.

Ex. Suppose Lot 1 and Lot 2 have the same amount of frontage along a lake, but Lot 2 is deeper; Lot 2 isn't necessarily more valuable than Lot 1.

The additional square footage of Lot 2 might simply be considered excess land.

Each situation must be analyzed individually.

Even when greater depth or less depth affects value, the increase or decrease in value usually isn't proportional to the increase or decrease in depth.

There are various rules of thumb concerning the relationship between depth and value.

One of the most common is the 4-3-2-1 rule, which states that the front quarter of a lot holds 40% of its overall value; the second quarter holds 30%; the next quarter holds 20%; and the back quarter holds only 10% of the value.

Because it's less accessible, the rear portion of a lot is less useful.

In some situations a depth table is used to evaluate how a lot's depth affects its value.

This is a table of mathematical factors that can be multiplied by the front foot value of a standard lot to estimate the value of a lot with a specified depth.

Depth tables aren't considered accurate enough for most appraisal purposes.

However, tax assessors sometimes use depth tables when valuing commercial property for tax purposes.

Under certain circumstances, combining two or more adjoining lots to achieve greater width, depth, or area will make the larger parcel more valuable than the sum of the values of its component parcels.

The increment of value that results when two or more lots are combined to produce greater value is called plottage.

The process of assembling lots to increase their total value is most frequently part of industrial or commercial land development.

It's true that when lot dimensions are fairly standardized, a lot with greater depth than the typical lot will generally be worth somewhat more.

And a lot with less depth than usual will be worth somewhat less.

However, the increase or decrease in value won't be proportional to the increase or decrease in depth.

Ex. Suppose the residential lots in a certain neighborhood are typically 50 feet by 100 feet and sell for $40,000.

One of the lots is 50 feet by 110 feet, or 10% deeper than the standard lot. But instead of selling for 10% more ($44,000), the price is only $41,200.

That's because the additional ten feet of depth do not give the lot 10% greater utility.

It is still a residential lot that will profitably support a house that conforms to the size and approximate value of the houses around it.

-Increases value per front ft.

-Decreases value per sq ft/acre

Ex. Extra Depth:

Standard lot (50x100=5,000sq ft)
Price: $40,000
Price per front ft.: $800
Price per sq ft: $8.00

Deeper lot (50x110=5,500sq ft)
Price: $41,000
Price per front ft.: $824
Price per Sq ft.: $7.49

Notice that when a lot is deeper than the typical lot, its value per front foot increases. But its value per square foot or acre decreases.

In our example, the standard lots sold for $40,000. That's $800 per front foot, or $8 per square foot.

The deeper lot sold for $41,200.

Its value per front foot is $824 instead of $800. Yet its value per square foot is only $7.49, instead of $8.

Ex. Less Depth

-Decreases value per front ft

-Increases value per sq ft/acre

Standard lot (50x100=5,000 sq ft
Price: $40,000
Price per front ft: $800
Price per sq ft: $8.00

Lot with less depth (50x90=4,500 sq ft)
Price: $38,400
Price per front ft: $768
Price per sq ft: $8.53

Conversely, when a lot has less depth than a typical lot, its value per front foot decreases.

But its value per square foot or acre increase
(Market data approach)

The sales comparison approach relies on the recent sales prices of comparable properties to estimate the market value of a property.

It is also called the market data approach because it uses information gathered about recent transactions in the local real estate market.

The sales comparison approach (also known as the market data approach) is the best method for appraising residential property, and the MOST RELIABLE method for appraising raw land.

It involves comparing the subject property to similar properties that have recently sold, which are referred to as comparable sales or comparables.

The appraiser gathers pertinent information about comparables and makes feature-by-feature comparisons with the subject property.

The appraiser then translates her findings into an estimate of the market value of the subject property.

Appraisers use this method whenever possible because the sales prices of comparables—which reflect the actions of informed buyers and sellers in the marketplace—are excellent indicators of market value.

For residential property, an appraiser needs at least 3 reliable comparable sales to have enough data for the sales comparison approach.

It's usually possible to find three good comparables, but when it isn't (for instance, if the market is inactive), the appraiser will turn to the alternative appraisal methods—the cost approach and the income approach.

Not only is the sales comparison approach very important in the appraisal of single-family homes, it's the best method for appraising vacant lots.

The sales comparison approach is based on information about recent transactions in the local real estate market

For this reason, the sales comparison approach is also called the market data approach.
A comparable sale should be recent, within the past 6 months if possible.

Recent sales give a more accurate indication of what's currently happening in the marketplace.

If the market has been inactive and there aren't 3 legitimate comparable sales from the past six months, then the appraiser can go back further.

(Comparable sales over one year old generally aren't acceptable, however.)

When the market is going through a major shift, such as a rapid downswing during a recession, comparable sales should be no more than 3 months old.

When using a comparable more than six months old (or more than three months old in a rapidly declining market), it's necessary to make adjustments for the time factor, allowing for inflationary or deflationary trends or any other forces that have affected prices in the area.

Ex. A comparable residential property sold ten months ago for $680,000. Local property values have risen by 5% over the past ten months. The comparable property, then, should be worth approximately 5% more than it was worth ten months ago.

$680,000 Value ten months ago
× 105% Inflation factor
$714,000 Approximate present value

The more time that passes, the less accurate these kinds of adjustments become.

As a general rule, appraisers don't use sales that took place longer than one year ago as comparables.

In fact, if a market has been inactive for many months, an appraiser may decide it isn't worthwhile to apply the sales comparison approach.

Rapidly changing economic conditions may also limit the usefulness of the sales comparison approach. In an especially volatile market, an appraiser will apply it very carefully, if at all.
To qualify as a comparable, a property should have physical characteristics (construction quality, design, amenities, etc.) that are similar to those of the subject property.

However, there usually will be significant physical differences between a subject property and its comparables.

When a comparable has a feature that the subject property lacks, or lacks a feature that the subject property has, the appraiser will adjust the comparable's price

The appraiser must make adjustments for these differences.

Ex. One of the comparables the appraiser is using is quite similar to the subject property overall, but there are several significant differences. The subject property has a two-car garage, while the comparable has only a one-car garage. Based on experience, the appraiser estimates that space for a second car adds approximately $25,000 to the value of a home in this area. The comparable actually sold for $720,500. The appraiser will add $25,000 to that price, to estimate what the comparable would have been worth with a two-car garage.
On the other hand, the comparable has a fireplace and the subject property does not. The appraiser estimates that a fireplace adds approximately $1,800 to the value of a home. She will subtract $1,800 from the comparable's price, to estimate what the comparable would have sold for without a fireplace.
After adjusting the comparable's price up or down for each difference in this way, the appraiser can identify what the comparable would have sold for if it had been identical to the subject property. When the appraiser repeats this process for each comparable, the value of the subject property becomes evident.

Most adjustments are necessary because of differences in physical characteristics.

If the subject property has a feature that the comparable lacks, the appraiser adds the value of that feature to the sales price of the comparable, to estimate how much the comparable would have sold for if it had that feature.

On the other hand, if a comparable has a feature that the subject property lacks, the appraiser subtracts the feature's value from the comparable's sales price, to estimate what the comparable would have been worth without that feature.

Ex. Suppose a comparable has a swimming pool, but the subject property does not.

In the appraiser's experience, a pool adds about $35,000 to a home's value. So she subtracts $35,000 from the comparable's sales price, to estimate how much it would have sold for without a pool.
The terms of sale can affect the price a buyer will pay for a property.

Attractive financing concessions (such as seller-paid discount points or seller financing with an especially low interest rate) can make a buyer willing to pay a higher price than she would otherwise be willing to pay.

An appraiser has to take into account the influence the terms of sale may have had on the price paid for a comparable property.

If the seller offered the property on very favorable terms, there's a good chance the sales price didn't represent the true market value of the comparable.

Under the Uniform Standards of Professional Appraisal Practice, an appraiser giving an estimate of market value must state whether it's the most probable price:

1. in terms of cash;

2. in terms of financial arrangements equivalent to cash; or

3. in other precisely defined terms

If the estimate is based on financing with special conditions or incentives, those terms must be clearly set forth, and the appraiser must estimate their effect on the property's value.

Market data supporting the value estimate (comparable sales) must be explained in the same way.

Since terms of sale can affect the price a buyer is willing to pay for a property, they are another primary element of comparison in choosing comparables.

If a comparable sale involved seller financing or other special terms, the appraiser must evaluate the impact of these terms on the transaction. If the impact on the sales price was too great, the comparable should not be used
Last but not least, a comparable sale can be relied on as an indication of what the subject property is worth only if it took place under normal conditions.

In other words, it was an arm's length transaction, both the buyer and the seller were informed of the property's attributes and deficiencies, both were acting free of unusual pressure, and the property was offered for sale on the open market for a reasonable length of time.

So the appraiser must investigate the circumstances of each comparable sale to determine whether the price paid was influenced by conditions that would render it unreliable as an indication of value.

Ex. If the property sold only days before a scheduled foreclosure sale, the sales price probably reflected the pressure that the seller was acting under.

Or if it wasn't an arm's length transaction—if the buyer and seller were relatives or friends—it's possible that the price was less than it would have been between two strangers.

Or if the home sold the same "day it was listed, it may have been underpriced.

In each of these cases, there's reason to suspect that the sales price didn't reflect the property's true value, so the appraiser would not use the transaction as a comparable sale.

Finally, the appraiser has to investigate the circumstances surrounding each comparable sale to make sure it took place under normal conditions.

A sale is considered to have taken place under normal conditions if:

-it was an arm's length transaction;

-the property was offered on the open market for a reasonable length of time;

-the buyer and the seller both acted prudently and knowledgeably; and

-there was no undue stimulus or unusual pressure on either party
A proper comparison between the subject property and each comparable is essential to an accurate estimate of value.

The more similar the properties, the easier the comparison.

A comparable property that's the same design and in the same condition as the subject property, on a very similar site in the same neighborhood, which sold under typical financing terms the previous month, will give an excellent indication of the market value of the subject property.

However, except perhaps in a new subdivision where the houses are nearly identical, the appraiser usually can't find such ideal comparables.

There are likely to be at least some significant differences between the comparables and the subject property.

So, as you've seen, the appraiser has to make adjustments, taking into account differences in time, location, physical characteristics, and terms of sale, in order to arrive at an adjusted selling price for each comparable.

It stands to reason that the more adjustments an appraiser has to make, the less reliable the resulting estimate of value will be.

These adjustments are an inevitable part of the sales comparison approach, but appraisers try to keep them to a minimum by selecting the best comparables available.

The appraiser bases his estimate of the subject property's value on the adjusted prices of the comparables, but the value estimate is never merely an average of those prices; careful analysis is required.

Also note that the original cost of the subject property (how much the current owners paid for it) is irrelevant to the appraisal process.
The second method of appraisal, the cost approach, is based on the premise that the value of a property is limited by the cost of replacing it.

Using the cost approach, the appraiser estimates the replacement cost of the building, deducts depreciation, and adds the value of the site.

The method of appraisal in which the appraiser estimates the replacement cost of the building, deducts depreciation, and adds the value of the site

(This follows from the principle of substitution: If the asking price for a home were more than it would cost to build a new one just like it, no one would buy it.)

The estimate of value arrived at through the cost approach usually represents the upper limits of the property's value.

The cost approach involves estimating how much it would cost to replace the subject property's existing buildings, then adding to that the estimated value of the site.

Because the cost approach involves estimating the value of land and buildings separately, then adding the estimates together, it's sometimes called the summation method.

There are three steps to the cost approach:

1. Estimate the cost of replacing the improvements.

2. Estimate and deduct any accrued depreciation.

3. Add the value of the lot to the depreciated value of the improvements

It's important to distinguish between replacement cost and reproduction cost.

Reproduction cost is the cost of constructing an exact duplicate—a replica—of the subject building, at current prices.

Replacement cost, on the other hand, is the current cost of constructing a building with a utility equivalent to the subject's—that is, a building that can be used in the same way as the subject.

Reproduction cost and replacement cost may be the same if the subject property is a new home.

But if the structure is older and was built with the detailed workmanship and expensive materials of earlier times, then the reproduction cost and the replacement cost will be quite different.

So the appraiser must base her estimate of value on the replacement cost.

The reproduction cost would be prohibitive, and it wouldn't represent the current market value of the improvements.

Replacement cost of improvements
-Depreciation of improvements
+Value of land
=Value of subject property

Ex. An old school building must be appraised, because the school district plans to sell it.
The sales comparison approach can't be used because the building is a special-purpose property and no comparable properties have been sold.
And the building doesn't generate income, so the income approach won't work.
As a result, the appraiser bases his value estimate on the cost approach alone.
(Comparative cost method)
(Comparative unit method)

The appraiser multiplies the structure's square footage by the current construction cost per square foot. This is the method appraisers use most often to estimate replacement cost.

The simplest way to estimate replacement cost is the square foot method (also known as the comparative cost method or comparative unit method).

By analyzing the average cost per square foot of construction for recently built comparable homes, the appraiser can calculate the square-foot cost of replacing the subject home.

The number of square feet in a home is determined by measuring the outside dimensions of each floor of the structure.

To calculate the cost of replacing the subject property's improvements, the appraiser multiplies the estimated cost per square foot by the number of square feet in the subject.

Ex. The subject property is a two-story house with a wooden exterior, containing 2,600 square feet. Based on an analysis of the construction costs of three recently built homes of comparable size and quality, the appraiser estimates that it would cost $202.35 per square foot to replace the home.

$202.35 Cost per square foot
× 2,2600 Square feet
$526,110 Estimated cost of replacing improvements

Of course, a comparable structure (or "benchmark" building) is unlikely to be exactly the same as the subject property.

Variations in design, shape, and grade of construction will affect the square-foot cost, either moderately or substantially. When recently built comparable homes aren't available, then the appraiser relies on current cost manuals to estimate the basic construction costs.

To determine the construction cost per square foot, an appraiser can use the cost per square foot of comparable new structures, or he can refer to cost manuals that list current construction costs.

Ex.
2,500 Sq ft in subject property
x $185 Current construction cost per sq ft
=$462,500 Estimated cost to construct

Subject property: 2,500 sq ft
Construction cost: $185 per sq st

Subject property: 1,200 sq ft
Construction cost: $220 per sq st

The cost per square foot of building a small house is typically greater than the cost per square foot for a larger house.

That's because the rules of volume purchasing apply.

Remember that the square footage of a home is determined by measuring its outside dimensions, excluding the garage, basement, and porches.
The indirect methods of estimating depreciation are the capitalization method and the market data method.

The direct methods are the straight-line method and the engineering method.

The straight-line method is the most widely used, while the engineering method is viewed as the most reliable.

When the property being appraised is a used home, the presumption is that it is not as valuable as a comparable new home; it has depreciated in value.

So after estimating replacement cost—which indicates what the improvements would be worth if they were new—the appraiser's next step is to estimate depreciation. Depreciation is a loss in value due to any cause.

Don't confuse an appraiser's approach to depreciation with an accountant's.

While an accountant is concerned with book depreciation for tax purposes, appraisers are concerned with actual losses in the value of real property.

Always remember that it's only the property improvements that depreciate, not the land.

An appraiser regards land as indestructible; it doesn't lose value.


After estimating replacement cost, an appraiser applying the cost approach has to estimate depreciation.

Depreciation is a loss in value resulting from any cause.

Keep in mind that an appraiser's approach to depreciation is different from an accountant's.

While an accountant is concerned with book depreciation for tax purposes, an appraiser is concerned with actual losses in the value of property.

In appraisal, there are three categories of depreciation: physical deterioration, functional obsolescence, and external obsolescence.
Functional obsolescence is depreciation caused by functional inadequacies or outmoded design.

Functional obsolescence may be curable or incurable.

Any defect within property boundaires that is not physical deterioration

Depreciation caused by functional inadequacies or outmoded design.

A loss in value due to functional inadequacies such as defects in design, outdated fixtures, or an inadequate floor plan.

For functional obsolescence to be considered curable, the cost of replacing the outmoded or unappealing aspect of the property must not exceed any increase in value that results from the replacement.

The replacement of outdated kitchen appliances will almost always increase the value of the home by enough to justify the expense.

Thus, outmoded appliances are a curable form of functional obsolescence.

Examples include obsolete kitchen appliances, one-car garages, and too few bathrooms in relation to the number of bedrooms.

Like physical deterioration, functional obsolescence may be curable or incurable.

A loss in value due to functional inadequacies, often caused by age or by poor design

Loss of value to an improvement to real estate because of functional problem, often caused by changing tastes or poor design.

A loss in value due to conditions within the structure which make the building outdated when compared with a new building. (4 bedrooms and 1 bath, insulation, narrow stairway, etc.)

Examples include an inconvenient floor plan (a bedroom opens directly off the living room), an unappealing design (massive cornices on the outside of the building), outdated fixtures (an old stove and no dishwasher), or too few bathrooms in relation to the number of bedrooms.

Like physical deterioration, functional obsolescence may be curable or incurable.

Functional obsolescence results whenever a building lacks functional utility.

A building's functional utility is its ability to fulfill the desires of its occupants or users; it includes attractiveness as well as actual usefulness.
(Economic obsolescence)

It is depreciation caused by forces outside the property, such as neighborhood decline or proximity to a nuisance. External obsolescence is always incurable.

Less frequently it is called environmental or locational obsolescence.

This is a loss in value from causes outside the property itself.

Adverse zoning changes, undesirable surroundings, traffic congestion, a shortage of essential services nearby—such as transportation, schools, and shopping—are all examples of external obsolescence.

Depreciation caused by forces outside the property, such as neighborhood decline or proximity to nuisances.

Also called economic obsolescence.

Caused by conditions outside the property itself, such as zoning changes, neighborhood deterioration, traffic problems, poor access to important areas like downtown or employment centers, or exposure to nuisances, like noise from airport flight patterns.

Identifying external obsolescence is the primary purpose of an appraiser's neighborhood analysis.

External obsolescence is beyond a property owner's control, so it's virtually always incurable.

Proximity to nuisances will result in a loss in value due to external obsolescence. The homes here lost value because electric transmission lines were built so close to them.

Identifying any external obsolescence is the primary purpose of an appraiser's neighborhood analysis.

External obsolescence is beyond an owner's control, so it's virtually always incurable.

Since external obsolescence is the result of negative influences from outside the site, it's always incurable. Such factors as a decline in the neighborhood, poor location, or market conditions are beyond the owner's control.

There's an old saying that more properties are torn down than fall down. As neighborhoods change, structurally sound buildings are demolished and replaced with new ones.

Note that a property's value is usually affected far more by obsolescence (external and functional) than by physical deterioration.
(Age-life method)

The straight-line method of estimating depreciation is the easiest method to apply.

The appraiser estimates what the useful life (economic life) of the building would be if it were new.

She then divides the estimated useful life into the building's replacement cost to determine how much depreciation would occur each year, assuming the improvements lose value evenly over the years.

The amount of annual depreciation is then multiplied by the age of the building

It should be noted that when an appraiser considers the age of a property, he's concerned with its effective age, rather than its actual chronological age.

The effective age depends on how long the appraiser believes the structure will remain productive in its present use.

If, in the appraiser's opinion, a 75-year-old building has 33 productive years ahead of it, and similar buildings typically have a 40-year useful life, then the building's effective age would be seven years old, rather than 75 years old.

(Remember that a building's physical life is typically longer than its useful life.

That's why the axiom "More buildings are torn down than fall down" is true.)

The following example shows how the straight-line method of estimating depreciation works.

Ex. After estimating that a building's replacement cost is $800,000, the appraiser uses the straight-line method to estimate how much the building has depreciated. Based on her knowledge of similar structures, she concludes that the building's useful life is 40 years. By dividing the replacement cost by the useful life, the appraiser determines that the value of the building decreases by $20,000 each year because of depreciation ($800,000 ÷ 40 years = $20,000 per year).

Suppose the appraiser decides that the building has a remaining useful life of 33 years. Its effective age is therefore seven years. The appraiser multiplies $20,000 (the annual depreciation figure) by seven (the building's effective age) to arrive at the estimated amount of depreciation. $20,000 × 7 = $140,000. Therefore, the depreciated value of the building is $660,000 ($800,000 - $140,000 = $660,000).

Straight-line depreciation can also be expressed as a percentage of the building's useful life.

The appraiser can divide the useful life (40 years) into the building's replacement cost new (100% of its value) to determine the percentage of its original value it will lose each year (100% ÷ 40 = 2.5% per year).

The straight-line method is sometimes called the age-life method because the depreciation estimate is based on a building's effective age in relation to a typical economic life.
(Gross scheduled income)
(Economic rent)

A property's potential gross income (also called its economic rent) is the amount it would rent for if it were available for rental in the current market.

The first step is calculating the property's potential gross income

A property's potential gross income is the amount the property would rent for if it were available for rental in the current market.

Economic rent differs from contract rent, which is the amount the property is actually renting for now under existing leases.

When using the income approach, the appraiser first finds the property's gross income.

He does this by estimating the rent the property would command if it were presently available for lease on the open market.

What it would earn on the open market is called the economic rent, as distinguished from what it is actually earning now, which is called the contract rent or historical rent.

Contract rent can be used to gauge the property's earnings potential.

A pattern of rent increases or decreases is a strong indication of whether the contract rent is above or below the economic rent.

The property's economic rent is also called its potential gross income or gross scheduled income.

This is what it could earn if it were fully occupied and all rents owed were collected.

But it's unrealistic to expect a rental property to be fully occupied throughout its productive life; vacancies must be expected.

Also, there are going to be tenants who don't pay their rent.

So the appraiser must make a deduction from potential gross income to allow for occasional vacancies and unpaid rents.

Called a bad debt and vacancy factor, this deduction is expressed as a percentage of the potential gross income.

Ex. The appraiser might deduct 5% from potential gross income as a bad debt and vacancy factor.

Once the bad debt and vacancy factor is deducted, the appraiser is left with a more reliable income figure, called effective gross income.
The capitalization rate is the rate of return an investor wants on his or her investment in a property.

To arrive at a value estimate using the income approach, an appraiser divides the subject property's net income by an appropriate cap rate.

The process of converting net income into a meaningful value is called capitalization.

Capitalization is the way appraisers convert future net income into an estimate of the present value of the property.

The capitalization process is expressed as a mathematical formula.

The formula is Income divided by Rate equals Value.

The mathematical procedure is expressed in this formula:

Annual Net Income ÷ Capitalization Rate = Value

Ex. The property's net income is $45,700 and the capitalization rate is 11%.

According to the capitalization formula, the property's value is $415,455.

$45,700 ÷ 0.11 = $415,455

The capitalization rate is the rate of return an investor (a potential purchaser) would want to receive on the money she invests in the property (the purchase price).

When the investor chooses the rate of return, it's plugged into the formula shown above.

By dividing the net income by the desired rate of return, the investor can determine how much she can pay for the property and still realize that desired return.

Ex. The property's annual net income is $160,000 and the investor's desired return is 9.5%.

$160,000 ÷ 9.5% =$1,684,211

The investor can pay up to $1,684,211 for a property earning $160,000 in net income and realize her desired yield of 9.5%.

The primary factor influencing the choice of a capitalization rate is the degree of investment risk.

If the property is a risky investment, investors generally require a higher capitalization rate—a greater return on the investment.

A higher capitalization rate will translate into a lower value for the property.

An investor who requires a high return will not pay as much for the same net income as an investor who will accept a low return.

Ex. A property's net income is $76,000. To an investor who wants an 11.5% return, the property is worth about &660,870.

$76,000÷11.5%=$660,870

To an investor who would settle for a 9.75% return, the property is worth approximately %779,487.

$76,000÷9.75%=$779,487

So the value of a particular property will vary from one investor to the next, depending on the rate of return each investor requires. The greater the desired rate of return (capitalization rate), the lower the property's value for the investor.
In effect, the capitalization rate is the rate of return an investor (a potential purchaser) would like to receive from the money she invests in the property (the purchase price).

The capitalization rate should usually take into consideration the return OF the investment as well as the desired return ON the investment.

The return ON the investment (like interest earned on a loan) is the investor's profit on the money she invested.

In contrast, return OF the investment refers to the investor's ability to recapture the original sum invested.

As a general rule, the return of the investment is even more important than the return on the investment, since it represents a larger amount of money.

A capitalization rate must take into consideration both the investor's desired rate of return on the investment and the return of the investment.

Interest is a return on an investment.

This is the investor's profit on the amount of money he has invested in the purchase of the property.

The return of an investment is the investor's ability to recoup the purchase price of the property at the end of his term of ownership.

This return of the investment is also called recapture.

The portion of the purchase price attributable to the land doesn't have to be recaptured during the investment period, because land is indestructible and its value can be recovered when the property is sold.

The improvements, however, are assets that will wear out.

Because the purchase price of the improvements won't be recovered when the property is sold, most investors insist on including in their capitalization rate a provision for recapturing their original investment.

In other words, a recapture provision is included in anticipation of future depreciation accrual.

A capitalization rate that provides for both interest and recapture is called an overall rate.

Ex. Ted bought a small apartment building for $1,250,000. The land is worth $500,000 and the building is worth $750,000. The building has a remaining economic life of 30 years. Ted expects a 10% return on his investment. He also wants the value of the building ($750,000) to be repaid over the 30-year economic life. That works out to $25,000 a year, or 2% of the purchase price annually. This 2% return of his investment, added to his 10% return on the investment, results in an overall rate of 12%.

When an investor buys real estate, he eventually wants to be able to recapture the original purchase price of the property.

Because land does not wear out, the amount invested in the land will be recaptured when the property is sold.

But the improvements will wear out, and that means their share of the original purchase price won't automatically be recaptured when the property is sold.
The building residual technique is used to estimate the VALUE of the BUILDING on the subject property.

It's used when land values are stable and easily determined, or when appraising an older building where depreciation is difficult to measure.

To apply the building residual technique, an appraiser starts by valuing the land alone, generally using the sales comparison approach.

Next, the appraiser uses the capitalization formula to find how much of the property's net income must be attributed to the land, based on the land's value.

In this example, she's using a 9% cap rate for this step. That's because she's decided a typical investor would consider 9% a suitable return on his investment in this property.

After determining the earnings that are attributable to the land, the appraiser subtracts the land's earnings from the property's net income.

What's left over (the residual) is the income credited to the building.

The first step in the building residual technique is to value the LAND separately from the building.

The appraiser then deducts from the property's annual net income the portion of the income that must be attributable to the land to justify its value.

What remains (what's left over) is the income to be credited to the building.

Finally, the appraiser applies the capitalization formula to the building's earnings to estimate the value of the building.

Because the building will depreciate over time, in this step the appraiser uses an overall rate, providing for recapture as well as interest.

In this example, the appraiser has added a 5% recapture rate to the 9% interest rate for a 14% overall rate.

Land's estimate value: $102,250
$102,250 x 9% = $9,203 (Land's Earnings)

$51,125 Property's net income
- 9,203 Land's earnings
= $41,922 Residual (credied to building)

$41,922 ÷ 14% = $299,443 (Building value)

The final step is to divide the net income attributable to the building by an appropriate overall capitalization rate to find the value of the building.

The building residual method is MOST reliable when land values are relatively stable and can be determined easily (because of an abundance of comparable sales and market data).

It's also used when appraising older buildings where depreciation is difficult to measure.
In the land residual technique, the BUILDING is appraised separately.

The land residual technique is used to estimate the VALUE of the subject property's LAND.

Appraisers apply this technique when the land is the site of a new building that represents the land's highest and best use.

They also use it when there aren't enough comparable sales to estimate the land value using the sales comparison approach.

Then the net income that must be attributable to the building is deducted to arrive at the net income to be credited to the land.

To apply the land residual technique, the appraiser first estimates the value of the building separately from the land.

Next, using an overall rate, she calculates the earnings that must be attributable to the building.

Then the appraiser subtracts the building's earnings from the property's net income.

The residual is the income credited to the land.

Finally, the appraiser applies the capitalization formula to arrive at the land's value.

In this step, because land does not depreciate, the capitalization rate is only an interest rate without a recapture provision.

It's not an overall rate.

Building's estimated value: $1,250,000
$1,250,000 x 12% = $150,000 (Building's earnings)

$176,470 Property's net income
- 150,000 Building's earnings
= $26,470 Residual (Credited to land)

$26,470 ÷ 10% = $264,700 (Land Value)

The land's earnings are then capitalized to determine the land's value.

(Note that the capitalization rate used in this step is only an interest rate, with no recapture provision, because land doesn't depreciate.)

The land residual technique is used when the land value can't be estimated by the sales comparison method because of an absence of comparable sales.

It's also used when the building the land supports is new and represents its HIGHEST and BEST use.
(Gross rent multiplier method)

An appraiser uses the gross income multiplier method to estimate the value of a single-family home used as a rental property.

The appraiser locates comparable rental properties that have recently sold, then analyzes the relationship between the sales price and the rental rate of each comparable.

If a residential appraiser uses the income approach at all, he will use a simplified version called the gross income multiplier method

As a rule, this method is applied only when appraising rental homes.

"It's sometimes called the gross rent multiplier method, since rents are typically the only form of income generated by rental homes.
In the gross income multiplier method, the appraiser looks at the relationship between a rental property's income and the price paid for the property

Ex.
Sales price: $275,000
Monthly rent: $1,815
Conclusion:The monthly rent is equal to 0.66% of the sales price; the sales price is approximately 150 times the monthly rent

Monthly rents may run about 1% of selling prices in one market, and more or less in another.

A market exists where specific rental properties compete with each other for tenants.

For competitive reasons, rents charged for similar properties tend to be much alike within the same market.

As a result, if one rental property has a monthly income that is 1% of its sales price, comparable properties will have similar income-to-price ratios.

A monthly multiplier is established by dividing the sales price by the monthly rental income.

An annual multiplier is calculated by dividing the sales price by the annual rental income.

Ex.
Sales Price: $275,000
÷
Monthly Rent: $1,815
=
Monthly Multiplier: 151.52
&
Sales Price: $275,000
÷
$21,780
=
Annual Multiplier: 12.63

After locating at least four comparable residential rental properties, the appraiser can determine their monthly or annual gross income multipliers (either is acceptable—it's a matter of the appraiser's preference) by dividing the rents into their respective selling prices.

Comp No. 1

Sales Price: $264,500
Monthly Rent: $1,800
Monthly Multiplier: 146.94

Comp No. 2

Sales Price: $276,525
Monthly Rent: $1,825
Monthly Multiplier: 151.52

Comp No. 3

Sales Price: $268,300
Monthly Rent: $1,850
Monthly Multiplier: 145.03

Comp No. 4

Sales Price: $280,750
Monthly Rent: $1,895
Monthly Multiplier: 148.15

"The appraiser uses the multipliers of the comparables to determine an appropriate multiplier for the subject property, taking into account the similarities and differences between the properties.

Then the appraiser multiplies the rent that the subject property is generating by the chosen multiplier for a rough estimate of its value as income-producing property.

The principal weakness of the gross income multiplier method is that it's based on gross income figures and doesn't take into account vacancies or operating expenses.

If two rental homes have the same rental income, the gross income multiplier method would indicate that they're worth the same amount; but if one is older and has higher maintenance costs, the net return to the owner would be less, and so would the value of the property.

If possible, the appraiser should use the subject property's economic rent as opposed to the contract rent (the rent the owner is actually receiving) in calculating the gross income multiplier.

Ex. The owner leased the home two years ago for $1,850 a month, and the lease contract has another year to go. Market rents have risen sharply over the past two years, so that the property could now command a much higher rent—probably about $2,200 a month. If the appraiser were to use the $1,850 contract rent in the gross income multiplier method instead of the $2,200 economic rent, it would distort the estimate of value.

Whenever possible, the appraiser should use the economic rent, not the contract rent (the current rental rate for the property), to calculate the gross income multiplier.

In any case, an appraised value based on the gross income multiplier method is considered a very rough estimate, because it doesn't take into account operating expenses, uncollected rents, or vacancies.

Note that the gross income multiplier method considers the property as a whole, rather than valuing the building separately from the land.

And this method is virtually never used to appraise vacant land.
Throughout the appraisal process, the appraiser is gathering facts on which he will base the ultimate conclusion, the final estimate of the property's value.

In many cases, the facts require nothing beyond simple verification; their meaning is self-evident.

In other cases, they require expert interpretation.

Appraisers refer to the assembly and interpretation of all the facts that influence a property's value as reconciliation.

Nowhere in the appraisal process do the appraiser's experience and judgment play a more critical role.

The final value estimate isn't simply the average of the results yielded by the 3 appraisal methods—

1. sales comparison,

2. cost, and

3. income

Rather, it's the figure that represents the appraiser's expert opinion of the subject property's value after all the data have been assembled and analyzed.

After determining the final estimate of value, the appraiser presents it to the client in an appraisal report.

The two most common types of reports are the narrative report and the form report.

Reconciliation refers to the act of assembling and interpreting the value indicators in order to arrive at a final value estimate.

Remember, the dollar figures that result from applying the three methods of appraisal are called value indicators.

The appraiser looks at each value indicator in light of the others, keeping in mind the data used. For instance, when a single-family dwelling is appraised, usually the sales comparison value indicator is given the most weight.

On the other hand, an apartment building might be judged more by its income-producing ability than by the sales comparison or replacement cost indicators. An appraiser would never average the indicators by adding them together and dividing by three. Judgment matters more than math in making the final value estimate.
(Age-life method)

To estimate depreciation using the straight-line method, the appraiser first judges how long the building's useful life (its economic life) would be if it were new.

Next, she divides the building's replacement cost by the useful life to get an annual depreciation figure.

Replacement cost
÷ Useful life
= Annual depreciation

Then the appraiser multiplies the annual depreciation digure by the building's effective age for an estimate of how much depreciation has accrued.

Annual depreciation
x Effective age
= Amount of depreciation

The effective age (as opposed to the actual chronological age) depends on how long the building will remain productive in its present use.

Ex. Suppose a building is actually 80 years old. An appraiser decideds it has 20 years of useful life left in it. If similar buildings typically have a 50-year useful life, then the subject's effective age is 30 years rather than 80 years.

The straight-line method of estimating depreciation is sometimes called the age-life method, since it considers a building's effective age in relation to a typical economic life.

Typical useful life of similar properties
- Remaining useful life of subject property
= Effective age of subject property

Ex. An appraiser estimates the subject building's replacement cost is $600,000. He decides that is would have a useful life of 50 years if it were new.

By dividing the useful life into the replacement cost, the appraiser concludes that the building will depreciate $12,000 per year.

$600,000
÷ 50 years
=$12,000 per year

The appraiser estimates that the building has a remaining useful life of 40 years, so its effective age is 10 years.

He mulitiplies the effective age by the annual depreciation to determine how much depreciation has accrued

$12,000 Annual depreciation
x 10 Effective age (years)
= $120,000 Amount of depreciation