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Real Estate Appraisal: Chapter 2 Understanding Value

Terms in this set (89)

The BEST definition of appraisal is:
a. An estimate of value
b. An unbiased opinion of value
c. An absolute
d. An uneducated guess
b. An unbiased opinion of value
Market value is best described as the
a. Highest supportable value
b. Most probable selling price
c. Arithmetic average of the adjusted sales comparables
d. None of the above
b. Most probable selling price
If a house was built before ______, it may contain asbestos.
a. 1950
b. 1960
c. 1970
d. 1980

http://www.youtube.com/watch?v=XdLzebBtA5o
d. 1980
The smallest house in a neighborhood will hold its value best. This illustrates the economic principle of:
a. Contribution
b. Diminishing Returns
c. Progression
d. Regression
c. Progression
The hottest new topic in real estate appraisal is currently
a. Sustainable green housing
b. Chinese drywall
c. Construction defects
d. Disclosure of the proximity and existence of a nuclear
facility, nuclear material or nuclear waste
a. Sustainable green housing
There are three approaches to value in appraisal. The approach most important for appraisal a single family owner-occupied home is the
a. Cost approach
b. Income approach
c. Sales Comparison approach
d. None of the above
c. Sales Comparison approach
An example of loss in value due to a functional utility issue is NOT:
a. A house with a garbled floor plan
b. A house with a one car garage in a neighborhood of
one car garages
c. A 4,000 square foot house in a neighborhood of
1,600 - 2,200 square foot homes
d. A house with a $100,000 kitchen remodel in a
neighborhood of $500,000 homes
b. A house with a one car garage in a neighborhood of
one car garages
Which of the following roofing materials is the longest lasting?
a. Composition shingle
b. Concrete tile
c. Clay tile
d. Smog-Eating tile

http://boralna.com/rooftiles/smog-eating-tile.asp
d. Smog-Eating tile
The first step in the appraisal process is to:
a. Collect all necessary date
b. Define the appraisal problem
c. Determine the resources necessary to solve problem
d. Drink a Starbucks green tea latte
b. Define the appraisal problem
The highest and best use represents:
a. The perfect improvement
b. The marginally productive use
c. The current use
d. None of the above
a. The perfect improvement

The perfect improvement satisfies the following four criteria: (1) legally permissible, (2) physically possible, (3) finanicially feasible and (4) maximally productive
Market
A place where goods are exchanged between buyers and sellers.
Marketability
The ease and speed with which a property can be sold at or near its market value based on its expected market appeal.
What issues may impact a property's marketability:
1. Adverse Transfer and/or Subdivision Public Report
Disclosure Issues
2. Functional Utility Issues
3. Conformity Issues
4. Unmarketable Title
Adverse Transfer and/or Subdivision Public Report
Disclosure Issues
Externalities, construction defects, stigma from detrimental conditions
Functional Utility Issues
Poor space configuration such as odd shaped rooms or tandem bedrooms
Conformity Issues
A dwelling may be without any architectural faults yet clash with the design or size of neighboring
Unmarketable Title
Structural encroachments, zoning restriction violations, etc.
Factors of Value
The 4 factors of value affect the relationship between supply and demand.

1. Utility
2. Scarcity
3. Desire
4. Effective Purchasing Power
Thing
Property, product, or commodity.

Doesn't have value unless all four factors are present.
Utility
-An item must serve a purpose that meets the needs of potential buyers.

-For something to have value, it must first have utility.

-It must satisfy some what or need that potential buyers have.

-Undersized lots have a more difficult passing ZONING LAWS & PRIVATE RESTRICTIONS, making a property less utilitarian.

-Real estate has considerable utility.

Example:
-Homes for shelter, factories for production, recreational use, agricultural and mineral products, & income.
Scarcity
The more scarce an item, the greater its value, so long as there is demand for it.

A thing can have utility, but is won't have value if there's a lot of it.

Example:
-There's a lot of oxygen demanded and there is more than enough to supply the need, making is less scarce.
Desire
To have value, there must be potential purchasers with a desire to own an item.

Value has concerned with its characteristics of potential buyers. For it to have value it must have buyers wanting to buy it.
Effective Purchasing Power
Potential purchasers must have the ability to pay for an item.

-Desire is not enough. It must be coupled with an effective purchasing power. You need to have potential buyers who have the ability to pay for it.

-Measured in terms of economic conditions such as inflation, unemployment & wage scales, and it has a tremendous impact on real estate values.
Effective Demand
Desirability + Purchasing Power
Market Value
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
Sales Price
What one particular buyer actually paid for a property in a specific transaction

Refers to the actual amount paid for an item by a particular buyer in an actual transaction.
Sales Price vs. Market Value
Sales Price is what the property sells for while Market Value is what the most probable sales price should be to a knowledgeable, well-informed and prudent buyer.

Therefore Sales Price and Market Value are often two very different amounts.
Cost
-Refers to production of an item

-Does not translate directly into value

-Used most often to refer to the production of an item, as opposed to price and value, which refer to an exchange.

-The SUM of money required to develope / improve on the land.

-Has 2 CATEGORIES: Direct & Indirect costs.
Types of costs
1. Direct
2. Indirect
3. Construction
4. Development
5. Replacement
6. Reproduction
Direct cost
The labor and materials involved in constructing an improvement.
Indirect cost
Other costs of building an improvement, such as architect's fees, etc.
Construction cost
The cost to build an inprovement, such as a house.

Appraisers distinguish the difference between Construction & Development costs.

Development cost may include the construction cost for each individual improvement that is part of the development.

Ex. Construction cost of each house in a subdivision.
Development cost
The cost to create a project.

Ex. Housing development
Replacement cost
The cost to create a substitute building of equivalent function and utility, using current methods, materials, and techniques.
Reproduction cost
The cost to create an exact replica of the building, using same design, materials, and construction methods as were used in the original.
Appraiser vs. other Real Estate Professionals

What is the one major difference in client-professional relationship between an appraiser and any other real estate professional (attorney, realtor, broker, etc.)?
In order to address the dynamics of this question we must first know and understand the definition of appraisal itself
Appraisal
An appraisal is best defined as an UNBIASED ESTIMATE or OPINION of VALUE along with the documentation to support that value conclusion.

-Appraisals are UNBIASED estimates or opinions of value

-Therefore unlike other real estate professionals, an appraiser must be a DISINTERESTED THIRD PARTY and may NOT be an ADVOCATE of his/her value or client.

-Appraisals must NOT MISLEAD the INTENDED USER.

-Appraisals must report a value conclusion based on proper research and accepted APPRAISAL METHODOLOGY
Types of value
**Vital to distinguish between the different types of values and to identify the particular type of value the appraiser is estimating.

1. Market value
2. Value in use
3. Investment value
4. Assessment value
5. Insurance value
6. Liquidation value
7. Going concern value
Market value
(Exchange value)
(Value in Exchange)

The value of property as determined by the open market.

The MOST PROBABLE selling price which a property should sell for in a competitive and open market after a reasonable exposure time, as of a specified date, in cash, or in terms equivalent to cash, under all conditions requisite to a fair sale, with the buyer and seller each acting prudently, knowledgeably, for self-interest, and assuming that neither is under duress.

It is:
-The amount of cash (or a cash equivalent),
-That a WELL-INFORMED and PRUDENT buyer is MOST LIKELY to pay for a property,
-In a typical transaction on the open market
-After adequate property exposure time

Implicit in this definition is the consummation of a sale as of a specified date and the passing of title from seller to buyer under conditions whereby:

1. The buyer and seller are typically motivated
2. Both parties are well informed or well advised, and acting in what they consider their own best interests
3. A reasonable time is allowed for exposure in the open market
4. Payment is made in terms of cash in US dollars or in terms of financial arrangements comparable thereto, and
5. The price represents the normal consideration for the property sold unaffected by special or creative financing or sales concessions granted by anyone associated with the sale.

Market Value refers to the amount of cash (or cash equivalent) that is most likely to be paid for a property on a given date in a transaction that takes place 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, as opposed to family member, friends or business associates)
-Neither the buyer nor the seller was subject to unusual pressure to act (undue stimulus)
-Both the buyer and the seller acted prudently and knowledgeably, and in his or her own best interests; and
-The property was exposed on the open market for a reasonable length of time.
Cash equivalent transaction (Market Value)
Amount of cash that is most likely to be paid for a property on a given date in a transaction that take place under NORMAL CONDITIONS.

CONDITIONS:
-it was an arm's length transaction (a sale between unrelated parties, as opposed to family members, friends, or business associates).
-neither the buyer nor the seller was subject to unusual pressure to act (undue stimulus)
-both the buyer and the seller acted prudently and knowledgeably, and in his or her own interests.
-the property was exposed on the open market for a reasonable length of time.

Financing considered typical for the marketplace

Few real estate transactions are all cash. When transaction financing is comparable to the financing typically available in the market, it is considered "cash equivalent"
Non-cash equivalent transaction (Market Value)
Financing varies from what is typically available on the market

If financing includes CONCESSIONS that are not typical in the market (such as a below-market interest rate in a seller-financed transactions or free flooring or kitchen upgrades or a free car, then the terms are "non-cash equivalent" and their effect on value must be taken into account
Value in use
Applicable when estimating the value of a property used for only one purpose.

-Often determined in relation to property's business operations
-Value affected by business climate
-Rarely used in residential appraisals
-Also called use value
Situations where use value appraisals are commonly used: (Value in use)
1. When valuing assets of a business
2. Where tax relief is granted for socially desirable uses, not highest and best use
3. Where no competitive market exists for a particular type of building
Investment value
The value of a property to a particular investor in the context of his or her investment goals.

-Entirely dependent on the client's needs.

Example: An appraiser may be asked to value a large parcel of vacant land based on developing it into an allowable amusement park use. In this case, the appraiser would be estimating the property's investment value.
Assessment value
(Ad Valorem) Used to determine property taxes.

-Annual property taxes that are based on the value of the property.

To determine assessed value, the appraiser must first estime market value (as defined by the tax law), then apply a certain percentage rate (called the assessment ratio) as specified under the assessment statue.

Assessed Value = Market Value x Assessment Ratio
Insurance value
Defined by the terms of a particular insurance policy.

The maximum reimbursement an insurer will pay if property damaged/destroyed.
Liquidation value
Used when lender is deciding whether to foreclose on delinquent loan or there is any distressed sale scenario.
Stigmatized Properties (Liquidation value)
Example: Sometimes a property will sell for 25% below market value or more and take three years to sell even in a market of appreciating values due to Detrimental Conditions (stigma).

Heaven's Gate - Rancho Santa Fe (1997)
Involved 36 UFO cult suicides

MacDonald's Massacre - San Ysidro (1984)
-21 people gunned down and 19 others injured
-As a result of this crime, the property was rendered WORTHLESS due to McDonald's concealment blunders and poor public relations.
-After razing the ravaged site, McDonald's built another restaurant nearby and donated the land to the city. The city established the Education Center on the site as part of Southwestern Community College.
Going Concern Value
The total value of ongoing business operation.

-Not used for residential appraisals.
Economic Drivers that Explain Value
-A knowledge of basic assumptions, postulates or premises that underlie appraisal methods is essential to an understanding of the purpose, methods and procedures of valuation

-The influences of Valuation Principles cannot be underestimated as they are important for a general understanding of the appraisal process

-Valuation Principles are rooted in economic theory
Valuation Principles
1. Principle of Substitution
2. Principle of Anticipation
3. Principle of Conformity
4. Principle of Progression
5. Principle of Regression
6. Principle of Consistent Use
7. Principle of Highest and Best Use
8. Principle of Competition
9. Principle of Change
10. Principle of Balance
11. Principle of Contribution (Contributory Value)
12. Principle of Increasing and Decreasing Returns
13. Principle of Economy of Scale
14. Principle of Supply and Demand
15. Principle of Surplus Productivity
Substitution
Principle of Substitution

-No prudent buyer will pay more for a property than it would cost to acquire an equivalent substitute property of equal utility.

Examples:
-A buyer selects the least expensive home in a neighborhood of homes of similar size
-In a market of declining values, the best sales comparable is not the most recent closed sale but rather the lower priced active listing of similar size and condition

The Principle of Substitution forms the foundation of the SALES COMPARISON & COST APPROACHES to value.

Appraisers compare:
-the prices of substitute existing properties in the sales comparison approach.
-the cost to build a new substitute property in the cost approach.
-the cost to acquire a substitute income investment in the income approach.

Appraisers must be aware of what consititues an "equivalent" substitute property in the particular market.
Anticipation
Principle of Anticipation

Related to the principle of change.

-Value of a property is determined by buyer's expectations of potential future benefits of ownership (rent, income, etc.)

-Value is affected by buyers' anticipation of the utility of owning property, and of the gain (or loss) to be realized on reselling the property.

Example:
-Depressed property values may occur as a results of expectations of a market slump portrayed by the

This principle forms the foundation of the INCOME APPROACH.
Production
The ability to create wealth.

Can be used to measure the value of land and its improvements.
4 Agents of Production
1. Captial (financial resources, money)
2. Land (natural resources)
3. Labor
4. Coordination (management or entrepreneurship)
Conformity
Principle of Conformity

-The value of a property is enhanced when surrounding properties and their uses conform to the size, architectural integrity or use of the subject property.

Example:
A dwelling may be without any architectural faults and yet clash so violently with the design of neighboring properties that marketability may be seriously diminished.
Progression
Principle of Progression

-Progression is the increase in value of a property that is attributable to its location among more desirable properties

Example:
A small home will tend to have greater gains in value if located in an area of larger sized homes
Regression
Principle of Regression

-Regression is the decline in value suffered by a property that is located in an area of less desirable properties.

Example:
A large custom quality home will tend to lose value if built in a neighborhood of smaller sized homes
Consistent Use
Principle of Consistent Use

Relates to the appraisal of improved property.

-The principle of consistent use requires both the land and the improvements to be valued for the same use, even if they are being valued separately.
Highest and Best Use
Principle of Highest and Best Use

Crucial to valuing real estate.

-The highest and best use of a property represents the perfect improvement.

-The perfect improvement meets all of the four (4) following criteria:
1. Legally permissible
2. Physically possible
3. Financially feasible
4. Maximally productive

-Limitations on highest and best use:
1. Zoning laws
2. Private restrictions
3. Building codes
4. Environmental laws
Competition
Principle of Competition

-Competition occurs when supply and demand are out of balance.

-Can also correct as excess of demand as well as supply.
Excess Competition
-An overreaction or overcorrection by the market, brought on by the lure of excess profit.

-Seeking to take advantage of this profit, sellers and builders bring so much new property to the market that supply outstrips demand , and values decline.
Change
Principle of Change

-Supply and demand are in constant flux, in response to changes in social/economic/other conditions.

Example:
An estimate value for an appraisal must always be as of a specific date called the "Effective Date."

-Important in regard to the sales comparison approach to value.
Comparable property
(Equivalent property)
(Comparable)

To estimate the value of the property being appraised, the appraiser must:

-take into account market conditions in effect when the comparable property was sold.
-make adjustments for any changes in the market between sale date of the comparable and appraisal date.

The more recent, the more reliable of current value.
Real Estate Cycle
1. Development (Integration)
2. Maturity (Equilibrium)
3. Progessive Decline (Disintegration)
* May repeat again.
+ Revitalization
Development
(Integration)

When values increase as raw land is improved.
Maturity
(Equilibrium)

Relative stability in value.
Disintegration Progessive Decline
Progessive decline in value.
Revitalization
This stage in the cycle can substitute for the initial development stage.
Gentrification
An example of revitalization.

Occurs when properties in a low-income neighborhood are purchased and renovated or rehabilitated by more affluent buyers.
Balance
Principle of Balance

-Value of property is greatest when all agents of production are in equilibrium (balance.)

*This principle can be applied to the four agents of production as well as supply and demand.

-An imbalance will result in an overimprovement or underimprovement and consequentially a loss in value.

*Individual property as well as neighborhood and districts can be imbalanced with being either overimproved or underimproved.

Prices and rents will be depressed until the market is able to absorb the oversupply.
Surplus Productivity
Principle of Surplus Productivity

-A way to measure the value of the land that has been improved.

-Assuming productivity (net income) is attributable to the agents of capital, labor, and coordination is equivalent to their cost.

-When the cost of capital, labor, and coordination is deducted from the total net incom for a property, the remaining income (surplus productivity) can be attributed to the land.
Point of Diminishing Returns
The point at which the agents of production come closest to being in balance.

At this point additional expenditures for capital, labor, or management fail to increase productivity enough to offset the cost.
Contribution
Principle of Contribution (Contributory Value)

-The value of a component, regardless of its cost, is equal to the amount of value it adds to the property as a whole as perceived by the market. (this principle is particularly useful to the Sales Comparison Approach.)

This principle is particularly useful to the sales comparison approach to value.

Example:
A pool costs $60,000 to build, but a buyer is only willing to pay $10K more for this feature.
Increasing and Decreasing Returns
Principle of Increasing and Decreasing Returns

Related to Principle of Contribution.

-Larger amounts of the Four Agents of Production will produce greater net income up to a certain point at which the maximal value will be developed.

Any excess expenditures will not produce a return commensurate with the original investments.

Example:
An added improvement stops producing any increase
Supply
Quantity of a particular item produced and sold in a market.
Demand
Number of buyers within a market who want to purchase an item.
Supply and Demand
Principle of Supply and Demand

The value of a commodity in a competitive market is determined by the relative levels of supply and demand.

The demand for a commodity is created by scarcity.

Prices decrease when supply exceeds demand of a commodity and increase when demand is greater than supply.

Examples:
-Condo conversions are typically worth 20% less than similar bedroom count and size units built as condos. Why? Condo conversions occur when apartments are changed to condominium ownership. Typical buyer demand is far less for condo conversions due to their limited apartment construction appeal with (1) insufficent parking ratios, (2) non-private common area laundry rooms and (3) high ratio of renters vs. owners. Many lenders will not lend unless a minimum of 50 percent of units in condominium communities are owner-occupied before. Realtors can be sued for failure to properly disclose the ratio of owner-occupied units in a condo project.

-Overbuilding saturated the downtown San Diego Condo market in 2006

-Value increases as more and more people compete for available housing
Economy of Scale
Principle of Economy of Scale

-The greater the volume (scale) of an item, the less each incremental volume should cost. All things being equal, a 2,800 square foot home should sell for less per square foot than a 2,000 square foot home.

Examples:
-Smaller buildings tend to sell/rent for a higher price per square foot compared to larger buildings

-Larger buildings tend to sell/rent for a lower price per square foot compared to smaller buildings
Opportunity Cost
There is a cost of not choosing an option, opportunity or an investment. Normally when we purchase something we give up money in exchange for a good or service we want. But the true cost, or opportunity cost, is usually more than this.

Economist Milton Friedman described this when he stated that "There's no such thing as a "free" lunch.

Example:
If I decide to buy a particular house and pay $400K for it, I am giving up not only something else that I could purchase with the $400K, but also something else that I could have done with the time spent in analyzing the subject's comparables and writing a sales contract for it.
Value
What a piece of property is theoretically worth under certain circumstances.

The relative worth of a thing, expressed in terms of some other thing.

USPAP Def.- MONETARY (dollars & cents) relationship between properties and those who buy, sell, or use. those properties.
Theory of Value
Should be viewed as a UNIFIED WHOLE.
Economic Theory
Value is not intrinsic.

The value of something is not inherent in he thing itself, but created buy conditions or circumstances (utility, scarcity, desire, & effective purchasing power).
Value vs. Price
Value is a CONCEPT & Price is FACT.
Forces Affecting Value
1. Social
2. Economic
3. Governmental
4. Environmental
Social Forces
The numbers, characteristics, lifestyles, standards, and preferences of the people in a particular market constitute the social forces that influence value in that market.

Values and the Supply and Demand in real estate are affected by changes in population, birth or death rates, or to migration into or out of an area, recreational activities, religion, education, and cultural amenities.
Economic Forces
Most strongly affect real estate values relate to the availability and cost of money for real estate lending, constuction, investment, and purchasing power of buyers in the real estate market.

Money markets are influenced by international investment climate, currency exchange rates, savings rates, inflation rates, national fical policy, and government borrowing.

Purchasing power affects local wage and unemployment rates, strength and diversity of local economic base, local construction costs, and local cost of living.

Larger scale economic forces are affected because particular industries rely on local man power, logistics, and demographics.
Governmental Forces
Affects of Governmental Forces:
-Direct intervention
-Influence on economy
-Zoning
-Land regulations

Provides:
-Police
-Fire protection
-Education
-Health services

Influences Laws governing:
-Landlord-Tenant relations (Eviction procedures)
-Defining Nature of Property Ownership (Statutes governing condominiums, cooperatives, timeshares)
-Building construction requirements (Occupational Safety Laws & Building Codes)
Environmental Forces
Aspects of physical environment, man-made or natural, that influence value.

Character of the land:
-Topography
-Soil characteristics (Stability & fertility)
-Mineral wealth
-Vegetation
-Bodies of water
-Climate (Temperature, wind, rain, & snowfall)
-Affects of local construction methods & costs,
-Necessary services
-Which area is desireable place to live
-Surrounding amenities
-Nuisances
-Hazards
-Views
-Neighborhood characteristics
-Access to employment
-Medical services
-Recreation
-Schools
-Churches
-Public transportation
-Proximity to incompatible uses, health, or safety hazards

For commercial or industrial properties:
-Proximity to markets for products
-Potential employee pools
-Access to suppliers or raw materials
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