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REAL ESTATE APPRAISAL AND INVESTMENTS
Terms in this set (131)
Valuation is the act or process of developing an opinion of value by anyone. A real estate appraisal is an appraiser's opinion of value resulting from the analysis of facts. An appraisal is not a determination of value, only an opinion.
The federal Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989 requires that a real estate appraisal used in connection with a federally related transaction be performed by a person licensed or certified by the state.
A federally related transaction is a real estate-related financial transaction involving a federal agency or a financial institution regulated or insured by a federal agency. Many states have further expanded the licensing and certification requirement at the state level to apply to any real estate appraisal, even if it is not for a federally related transaction.
To qualify for licensing or certification, a person must satisfy experience, education, and examination requirements set by the state under guidelines adopted by The Appraisal Foundation, a national organization composed of the major appraisal organizations.
A state licensed appraiser is a person licensed to make appraisals of:
noncomplex one- to four-family residential units having a value of less than $1,000,000.
complex one- to four-family residential units having a value of less than $250,000.
nonresidential property having a value of less than $250,000.
A state certified residential appraiser is a person certified to make appraisals of:
all types of residential property of one to four units without regard to transaction value or complexity.
nonresidential property having a value of less than $250,000.
A state certified general appraiser is a person certified to make appraisals of all types of real property, regardless of value.
A real estate agent will present his opinion of value in order to assist the owner in setting a listing price or the buyer in making an offer. This opinion of value is called a competitive (or comparative) market analysis (CMA). It relates the subject property to similar properties that have recently sold and properties that are currently available for sale.
A market analysis is a method of determining the price for which the subject home should sell based on what purchasers have paid for homes with similar features and in the same general neighborhood.
While a market analysis is not as comprehensive or technical as an appraisal and does not consider all relevant approaches to estimating value, it is very similar to one of the approaches (the sales comparison approach) and does call for the real estate agent to apply a number of valuation principles.
Value is worth. Value relates to the relationship between an item desired and a potential purchaser for the item, rather than to the item itself.
A $.15 pencil to the manufacturer may be worth $.05; to a wholesaler, it may be worth $.07; to a retailer, it may be worth $.10; to the purchaser, it may be worth $.15. However, if that person has pencils at home but needs one for only a few hours, it may be worth $.05. If that pencil is needed by a person who has paid $100 to take an exam and forgot a pencil and he will forfeit the $100 unless he can get a pencil, a pencil may be worth almost anything. Therefore, the value of that pencil would vary from person to person and from time to time.
Value can be subjective or objective. Subjective value (also called utility value, value in use, or investment value) is value related to the use for a specific user even if there is no identifiable open market demand for the item.
Schools, churches, libraries, single-use factories, industrial facilities, and company headquarters would be appraised for a specific use value. Their value would not be based on activity in the rental or sales market but on the contribution of the property to the utility or profitability of the owner.
When buyers are willing to pay more or invest more in a property than they know they would be able to realize on resale, the value to them reflects a subjective value. Objective value (also called value in exchange or market value) does not relate to just a specific user. Based on the willing buyer/willing seller concept, market value may be defined as the most probable price a property should bring in a competitive and open market under all conditions necessary for a fair sale, assuming that the buyer and seller are each acting prudently and knowledgably and that the price is not affected by undue stimulus (e.g., special financing or sales concessions).
Market value is determined by buyers and sellers, not by appraisers. Appraisers can only give opinions as to what that value might be.
Market value is not the same as market price or cost. Because the conditions for market value do not apply to every real estate transaction, the actual amount paid for a property will be its price (or market price). Price and value differ when parties:
are not equally motivated (e.g., the buyer has subjective reasons for wanting the property).
are pressured to buy or sell (e.g., there is a pending foreclosure).
are not well informed or are victims of misrepresentation or high-pressure sales tactics.
Cost is the total amount of money, labor, material and services spent to produce or develop the item. It does not necessarily reflect or control value.
The cost of constructing a house includes the cost to buy the land, put in streets and utilities, and construct the building. If the structure were built competently and reflected current tastes, and there was a normal market for that property, the value may very well be based on the builder's costs plus reasonable profit.
Differences in value are caused by the four characteristics of value:
Utility is the ability to satisfy a need or desire of a potential buyer. Land in an urban growth boundary has utility to a builder as the source of buildable lots, but land outside the urban growth boundary would lack such utility for a builder.
Scarcity is also needed. An item cannot have value unless there is also a degree of scarcity. As long as fresh air is plentiful, there is no demand to buy it, and it has no commercial value. Because of scarcity, value is influenced by supply-and- demand factors. Property with a view sells for more than property without a view because of scarcity. If every property in an area had a view of the mountains, there would be no additional value for the view.
Effective demand is demand for the item from people with a desire or need for it and the purchasing power to acquire it. The greater the desire or need for an item of those able to translate the desire/need into a purchase, the greater the potential value. A buyer may want a $2,000,000 house, but without the necessary funds, that desire would not influence the sale price of that house.
Transferability refers to the fact that, if benefits of an item are not transferable, the item has no value to a prospective purchaser. If property available for sale includes only a life estate, fewer rights are capable of being transferred and it will have a lower value than a fee estate.
There are three basic physical characteristics of real estate:
Immobility: The location of any given parcel of land cannot be changed. The major factor affecting real property value is its location. This results in relative scarcity of usable land. The choices and preferences for a given area (called "situs") causes similar parcels in different locations have different values.
Indestructibility: Land may lose value and may change its appearance, but it generally does not disappear, unless there is a natural disaster.
Non-homogeneity or heterogeneity: No matter how similar it may be to others, each parcel has its own location and features (e.g., size, shape, topography).
Real estate values are also affected by four general forces:
Physical and environmental characteristics, which can encourage or prevent development: Physical characteristics include any manmade or natural aspects of the location that make the location desirable or undesirable (e.g., schools, shopping, transportation). Environmental considerations include climate, hazards (e.g., earthquake, hurricane, flood), topography, natural barriers to growth (e.g., rivers, mountains), soil, view, water, etc.
Economic conditions, which cause property values to increase or decline: These include current employment and wage conditions, trends in interest rates and availability of mortgage money, building costs, etc.
Governmental or political regulations: These include direct tax levels, zoning, and growth and environmental limitations.
Social influences: These result in increased values for properties catering to the needs of an incoming population and decreased values for those properties catering to needs of the exiting population. Social influences on real estate values include population growth or decline and trends in population composition (e.g., influx or exodus of the elderly, families with children, and singles).
Any increase in value resulting from these forces, which are outside the influence and control of the property owner (e.g., from favorable rezoning, inflation or population growth), is considered an unearned increment.
Building construction in the United States is identified by either the International Building Code (IBC) or the Insurance Services Office (ISO). Both of these organizations classify construction types based on their resistance to fire. The most common types are:
Frame buildings: This is the type of construction used in most homes. They are buildings with exterior walls, floors and roofs of combustible construction. Wood frame is the most typical in residential construction.
Joisted Masonry buildings: These are buildings with exterior walls of masonry or fire-resistive construction. There are several types of joisted masonry buildings:
Hollow concrete blocks
Light Noncombustible buildings are buildings with exterior walls of light metal or other noncombustible material, and noncombustible floors and roofs. These are typically steel frame buildings.
Residential homes are usually constructed with concrete or concrete block foundations, wood framing, wood subfloors, drywall interior walls, wood or concrete based siding, and asphalt shingle or steel roofing. A contractor's construction schedule for a home might look like this:
Excavate for foundation
Pour foundation walls
Rough framing of home
Utility installation (electric, gas, water, sewer lines, etc.)
Drywall installation on interior walls
Finish carpentry including door and cabinet installatio
Window and door trim work
Tile floors and bath walls installation
Light fixtures installation
Finish heating, plumbing and electrical work
Install carpet and hardwood floors
The principle of anticipation holds that value is created by the expectation of future benefits to be derived from ownership and use of the property. While a buyer might take into account past sales and recent sales prices of similar or comparable properties, he would base his offer on what he thinks is the current value of the benefits he will derive in the future. This is the basic principle behind the appraisal of income property: The appraiser attempts to estimate the present value of income to be received in the future.
Whenever one makes comparisons, one is applying the principle of substitution. The principle of substitution holds that the value of property that is replaceable tends to be set by the cost of acquiring an equally desirable substitute property without any undue delay. This principle is the basis for all appraisal approaches: the sales comparison approach, the cost approach, and the income approach.
Sales comparison approach (market data approach): In this approach, homes and land are valued by comparing prices paid for similar properties.
Income approach: In this approach, properties which produce rental income (e.g., office buildings, apartments, retail properties) are valued based on their anticipated net income and rate of return. The appraiser will base the rate of return on rates received by investors who purchased similar properties.
Cost approach: The cost approach is most commonly used when sales data is lacking for the sales comparison approach and rental data is insufficient for the income approach (e.g., in appraising a church or a single-use property). In this approach, the appraiser compares the existing property to a similar building to be built. He estimates the value of the land, the cost to replace the improvements on the land, and the depreciation that makes the improvements as they exist less desirable than new improvements.
The principle of change holds that value estimates are valid only as of a specific point in time as neighborhoods and properties tend to go through a four-stage life cycle:
Integration (development or growth)
Equilibrium (stability or maturity)
Disintegration (deterioration, decline or old age)
Revitalization or rehabilitation
The principle of conformity holds that maximum value is realized when there is a reasonable degree of architectural homogeneity (or similarity) and land uses are compatible and conform to the standards for the area. Placement of ultramodern homes next to Victorian-style homes or extensive mixtures of residential and commercial uses would indicate a lack of conformity.
Underimprovements, overimprovements and misplaced improvements are those improvements that lack conformity with their surroundings. This leads to two related concepts.
Regression: This concept holds that the value of better property will suffer if it is placed in an area of lesser valued homes. The value of a home built at a cost of $250,000 would suffer if placed in an area of $160,000 homes.
Progression: This concept holds that the value of a lesser property will be enhanced if it is placed in an area of better homes. The value of a home built at a cost of $250,000 would be enhanced if placed in an area of $400,000 homes.
The principle of supply and demand holds that an increasing supply of units or a declining demand for them adversely affects the price they can obtain on the market. A decreasing supply or increasing demand would have the opposite effect. In a buyer's market, the supply of houses available exceeds the demand. In a seller's market, the demand for houses exceeds the supply and prices go up. Remember, demand must include buying power to satisfy the desire for a property.
The principle of increasing and diminishing returns holds that the value of property is governed by the contribution made by the four agents of production (i.e., land, labor, capital and coordination). The last agent to be satisfied is the land. Therefore, after the costs of labor, capital (money) and coordination (management) are paid, the remaining value is the value of the land. There are increasing returns as larger amounts of these agents produce greater net benefits. However, once the maximum value of the property has been reached, any further increase in these agents would not produce enough of a return to justify the additional investments.
After an owner with a $170,000 home spent $3,000 for improvements that added $10,000 in value, he spent another $5,000 for improvements that added $8,000 in value. He then spent another $6,000 for improvements that added $5,000 in value. Initially, he had increasing returns on his investments in his home, but as he added more improvements, the percentage of increased value diminished, until the last set of improvements did not increase the property value by even the amount spent.
The principle of competition holds that profits will encourage competition, and excess profits tend to create excessive competition, which can destroy profits.
The principle of contribution holds that the value of an improvement is measured by its contribution to the net return of the property (i.e., whether the money spent would add value in excess of the cost and at an acceptable rate of return). This would apply in determining whether to convert a basement to an apartment or whether to install a swimming pool in an apartment complex.
One aspect of contribution is the ratio of the land to the building area. An example is that a 10,000 square foot building site that has a 2,500 square foot home on it would have a land to building ratio of 4:1. This becomes important in determining if the land is being used in a comparable ratio to the properties surrounding the subject property, and whether the land is being put to its highest and best use.
The maximum value of land exists when the property is used for its highest and best use (i.e., the use that at the time of the appraisal is most likely to yield the greatest net return over a given period of time). This return could be measured in money or in the form of amenities. Amenities are aspects of a location or design that make the property more desirable (e.g., fireplaces, proximity to shopping and schools, building style, etc.).
Under the principle of highest and best use only those uses that are legal, possible, probable and economically feasible can be considered. Public and private restrictions dictate what uses are legal or permissible. When both apply, the more stringent restrictions prevail, whether they are public or private.
As the use of property is limited by zoning and private restrictions, the highest and best use of land zoned for a single-family dwelling cannot be a 20-unit apartment building; and the highest and best use of land zoned for 20 units is not a single-family home.
Depending on the circumstances, increased value may result from dividing large parcels into smaller ones or from creating greater utility by putting several parcels together. Putting several parcels of land under one owner is called assemblage. The added value resulting from assemblage is called plottage.
Two lots, each 100' wide, can only be used to place houses on them. As a result they are worth $40,000 each, or $80,000 total. When put under one owner, the result is a parcel 200' wide, which is large enough for a fourplex. Because of the greater possible utility, the two lots are worth a total of $140,000 together. This is $60,000 more than the total value when they were separately owned. This increase in value is plottage increment.
An appraisal is an opinion of value or the act or process of developing an opinion of the value of a property, or an interest in a property, as of a specified date by a person skilled in the analysis and valuation of real estate (an appraiser). The result of this process is usually a written appraisal report setting forth the estimate of value and any reservations or limiting conditions that apply to it.
In its Uniform Standards of Professional Appraisal Practice (USPAP), the Appraisal Foundation shows the real property appraisal process as an eight-step process
Define the appraisal problem
Conduct a preliminary analysis and develop a plan, and select and collect data
Develop a highest and best use opinion
Develop indicators of land or site value
Develop indicators of improved property value
Analyze prior sale, current agreements, options or listings of the subject property
Reconcile the value indicators to reach an opinion of value
Report opinion(s) of value
Depending on the appraisal assignment, general data and a market analysis may or may not be needed.
General data includes characteristics of the region, city and neighborhood, gathered primarily through research. Appraisal of the specific parcel entails a neighborhood analysis, since the location of the property is the primary factor affecting its value.
Specific data regarding the property being appraised relates to:
construction costs, sales prices, rental rates and operating expenses of properties comparable to the one being appraised.
legal and physical factors influencing the land value (e.g., zoning, property taxes, use restrictions, easements, and information about the site and improvements).
The Uniform Residential Appraisal Report (URAR) divides the description into the following categories: general description, exterior description, foundation, basement, insulation, room list, interior, heating, kitchen equipment, attic, amenities, car storage, and comments.
The general description is necessary to ensure that the proper structures are selected for comparison.
In analyzing the improvements, the appraiser must be aware of the depreciation of the improvements. Depreciation is defined as a loss in value from any cause. It results when improvements begin to lose acceptability to prospective purchasers or renters.
In some appraisals, the appraiser looks at depreciation from the standpoint of what has happened and in others from the standpoint of what is likely to happen. The loss in value from what has happened is accrued depreciation. Accrued depreciation is the difference between the value of the building at the time of the appraisal and the current replacement cost of the structure in new condition.
The land does not depreciate; only the improvements (buildings, sidewalks, cultivated orchards, etc.) do. From the moment they are added to the land, they begin to lose value in relation to their cost if new.
A house originally cost $100,000 to build. Today it is worth $450,000. If it burned to the ground, it would cost $600,000 to replace. This house has depreciated, since the $450,000 would be less than the cost of replacing that house with a new house today. The accrued depreciation for this structure, the difference between the replacement cost and the current value of the structure, would be $150,000.
In looking ahead to future depreciation, the appraiser considers accruals for depreciation. When an investor purchases income-producing property, his concern is with the depreciation he will have to correct out of income received from the property in the future. The investor wants to be sure that income received would be sufficient to recover the loss due to depreciation and leave a profit.
Depreciation results from physical deterioration and obsolescence.
Physical deterioration is the wear and tear or breaking down of the physical structure, which takes place over time. It is caused by natural forces and by use and may be evidenced by decay, dry and wet rot, insect damage, wear and tear, and vandalism. A major contributing factor is deferred maintenance. Deferred maintenance is usually identified as a lump sum expense needed for overdue repairs. It is best estimated by the appraiser observing the condition of the subject building.
Physical deterioration may be curable or incurable:
Deterioration is curable when items are repairable or replaceable and it makes economic sense to repair or replace them (e.g., a broken window or walls in need of paint).
Deterioration is incurable when the item is not repairable or replaceable or when it would not be economically feasible to repair or replace them at the time. For example, a roof that is five years old may be worth $1,000 less than it would be worth new, but since it would not be economically feasible to spend any money to replace the roof, the depreciation is incurable.
Obsolescence is the loss in the usefulness of structures that causes them to become less desirable or less useful. Obsolescence is usually more difficult to correct than deterioration. It is outdatedness caused by:
new inventions, construction methods, equipment, and systems (e.g., plumbing, heating, and electrical).
changes in the public's preferences (e.g., architecture, location, room sizes, ceiling height, etc.).
Obsolescence may be functional or external (economic).
Functional obsolescence is the loss of value due to factors of inadequacy or overadequacy within the property itself, often caused by changes in construction materials, methods, equipment and the desires of people.
Factors of overadequacy would include a heating system too large for the house, decorations costing more than buyers are willing to pay for them, or other items exceeding reasonable requirements.
Factors of inadequacy would include outdated plumbing features and components smaller than normally expected (e.g., a lack of closet space, a four-bedroom home with one bath, a poor room arrangement).
As with physical deterioration, functional obsolescence may be curable or incurable.
Curable functional obsolescence results from features that are no longer considered desirable by buyers but can be replaced or redesigned at a reasonable cost. It can be estimated by determining the cost to cure.
Incurable functional obsolescence would be items such as a poor room arrangement or a design feature that could not be corrected without an unreasonable amount of cost. For example, older multistory industrial buildings are less suitable than one-story buildings; this cannot be cured.
External obsolescence (also called economic obsolescence) is a loss in value resulting from conditions outside the property.
Among the many causes of external obsolescence are deterioration of the neighborhood caused by changes in use of neighboring properties, blight, changes in zoning and legislative restrictions, or fumes from a factory.
Since economic obsolescence is external to the property, it is generally incurable.
Depreciation affects an appraiser's judgment of the age and life of the improvements. Each property has an actual physical age and an effective age.
The actual age of improvements is the length of time they have been standing.
Effective age is the age of a similar and typical property of equal usefulness, condition and future life expectancy. It is the age the improvements appear to be, based on their condition. Since the condition of the improvements depends on how well the property is maintained and whether it has been remodeled or upgraded, the effective age may be less or greater than the actual age.
A 10-year-old building that is poorly maintained might have an effective age of 15 years, meaning that it is more comparable in utility and condition to a 15-year-old structure than to a 10-year-old structure.
Physical life is the period of time between the completion of building construction and the time when the building is no longer fit or safe to use. (The physical life of the building is terminated by deterioration.)
Economic life is the period of time between the completion of construction and the disappearance of the building's ability to produce services or income sufficient to offset the expenses. (The economic life is terminated by obsolescence.)
Because physical life represents the time a building can actually stand and economic life represents the time it would be profitable to let it stand, the economic life can never be greater than the physical life. It may be, and frequently is, less.
After gathering data about the neighborhood, site and improvements, the appraiser is ready to develop the value of the property using any or all of the three basic appraisal approaches that may apply to the property:
Real estate licensees marketing and selling single-family residences need a good understanding of the sales comparison approach (also called the market data approach). This is the valuation of properties based on the prices paid for similar, or comparable, properties. Since it is using comparison, it is based on the principle of substitution.
This is generally the best method of estimating the value of any type of property for which there is a sufficient number of sold comparable properties available (e.g., land, residences and other buildings with a high degree of similarity for which a ready market exists).
In performing this analysis, an appraiser will seek properties similar to the one being appraised and gather and verify relevant sales and/or rental data regarding these properties. Sales prices can be obtained from the appraiser's own records, financial news services, multiple listing sources, other appraisers, title insurance companies, and recorded deeds. Most deeds show the actual price paid for the property.
Differences between the comparable properties and the subject property need to be judged in terms of their probable effect on the price of each sold property and assigned either a dollar or a percentage value.
Where a difference in the comparable property detracts from its value, the value of that item is added to the sales price of the comparable property.
Where an element makes the comparable property more desirable, the value of that feature is deducted from the sales price of the comparable property.
By adding and subtracting for differences in the values of these features, the appraiser can obtain an adjusted sales price for each of the comparable properties. This provides a value range for the property being appraised. The appraiser, using his judgment, can then estimate the market value of the subject property within this range. He would not average his figures to arrive at the estimate but would give the greatest consideration to comparable sales that have occurred recently and have the greatest degree of comparability.
A second method of appraising real property is the cost approach (also called the summation approach, replacement cost approach, or reproduction cost approach). This approach can be used to appraise almost any type of improved property, but as it requires a greater degree of skill than the sales comparison approach, the cost approach is not the preferred method when the sales comparison approach is applicable. The cost approach, therefore, is most commonly used for specialty property such as public buildings, single-use factories, churches, etc. It is also used for evaluating property for fire insurance.
The most difficult aspect of this approach is estimating accurately the depreciation to the property, so the approach may be used where this difficulty is least likely to exist, such as for appraisals of new buildings. This approach is not conducive to appraising older buildings and cannot be used if the highest and best use of the land is different than its current use.
The basis of the cost approach is that the value of improved property can be estimated by adding the value of the land to the depreciated cost of the improvements on the land. The process involves the following steps to arrive at the current value of the property:
Estimate the value of the land.
Add the estimated cost of replacing or reproducing the improvements with new ones.
Estimate and deduct the depreciation to the improvements.
Like the sales comparison approach, the cost approach is based on the principle of substitution. It is valid because a person will pay no more for a building than the cost of constructing an equally desirable substitute, assuming no unusual delay.
The alternate name "summation approach" is derived from the adding and subtracting in this approach.
The first step in the cost approach is to estimate the value of the land as if it were vacant, generally by using the market data approach. In the cost approach, the land is appraised separately from the improvements.
The next step is to estimate and add the cost to replace or to reproduce the improvements on the property with new ones.
Replacement cost is the present cost of constructing a substitute structure equal to the existing structure in quality and utility but using current construction methods, materials, design and layout.
Reproduction cost is the present cost of constructing a substitute structure that is an exact replica of the existing structure, i.e., with the same materials, quality of workmanship, design and layout. Since reproduction cost might involve estimating the costs of utilizing materials and construction practices that are outmoded, it would be impractical or even impossible to estimate in many instances; reproduction cost would generally be used only for unique properties. Most often replacement cost, the cost of an equally desirable substitute, is used.
Whether based on reproduction or replacement, the cost desired is today's cost of replacing the existing improvements with new ones, not the actual cost of the existing structure itself. A home that cost $4,000 to build 30 years ago, might cost $200,000 to replace today with a new structure with similar utility and amenities. The $200,000 figure would be the one sought.
The comparative cost method (also known as square-foot method or cubic-foot method) is fast, inexpensive, and easy to understand, so it is the one most commonly used. It involves comparing the subject property with other similar buildings whose costs are known. Those costs, when divided by the number of square feet (for residential property) or cubic feet (in some commercial property) in the building, provide a unit cost per square foot or per cubic foot. This unit cost, when multiplied by the number of square or cubic feet in the subject property, produces the replacement cost.
The building being appraised has 1,500 square feet. The cost of similar buildings is $80 per square foot. The replacement cost would be 1,500 x $80 or $120,000. Adjustments would be made for the costs of various exterior and interior features that differ from the norm.
The unit-in-place method is a modification of the quantity survey. It involves combining all the costs into a unit cost for each portion of the building installed (or "in place"). Costs of floor structure, appliances, framing, stairway, heating, plumbing, roof, and foundation generally are based on this method.
The quantity survey method is the most detailed and complex of the methods and most frequently used by builders and professional cost estimators as the basis for a bid on a construction contract. It involves a complete itemization of all direct costs (e.g., hours of labor, cubic yards of concrete, etc.) and indirect costs (e.g., office overhead, insurance, interest, permits, contractor's profit, etc.).
If the building is the highest and best use for the land, and the land value and reproduction cost, or the replacement cost of new improvements, have been properly estimated, the total of the land value and the cost new will yield the upper limit of value of the property. (Land + Cost New = Upper Limit of Value). This upper limit is the property's maximum value, not the current market value.
Depending on the depreciation of the improvements, the market value may or may not be close to this upper limit of value. The current market value will be derived after the next steps in the approach: calculating accrued depreciation and then deducting it from the upper limit.
Calculating accrued depreciation entails measuring the loss of value that has already occurred over the past life of the improvement.
A number of methods may be used to do this, depending upon the sophistication required. The simplest, though least accurate, is the straight-line (age- life) method. This method is based on the presumption that the improvements depreciate at an equal rate each year until the end of their economic life, when the building would be torn down.
Since the building loses 100% of its cost over its economic life, the straight-line percentage of loss each year is calculated by dividing 100% of the replacement cost by the economic life.
Annual Depreciation = 100% of Cost ÷ Economic Life
With an economic life of 10 years, the annual loss would be 100% ÷ 10 or 10%.
With an economic life of 20 years, 100% ÷ 20 = 5% loss per year.
With an economic life of 50 years, 100% ÷ 50 = 2% loss per year.
The appraiser then:
multiplies the annual rate of depreciation by the effective age to determine the total percentage of value lost.
multiplies that percentage by the replacement cost of the improvements (not by the current value of the building) to arrive at the dollar amount of the loss.
Total Depreciation = (Annual Depreciation x Effective Age) x Cost
The final step in the process is to deduct the depreciation of the improvements to arrive at the current market value of the property.
+ Cost of improvements
Current property value
As a mathematical alternative, the appraiser could add the current value of the improvements to the value of the land. The current value of improvements is the percentage of their replacement cost after deducting depreciation. So, if total depreciation were 20%, the current value of the improvements would be 80% of the cost.
Current Value = (100% - Depreciation) x Cost
+ Current value of improvements
Current property value
The third appraisal approach is the income approach (or capitalization approach). This approach is used to appraise properties capable of producing rental income for the owner, i.e., apartments, office buildings, warehouses, etc. It bases the value of the property on the income the owner will receive and the rate of return the owner should find acceptable. The premise for this approach is that value is the present worth of future benefits: Value equals the price a person pays today for the right to receive net income from the property in the future.
The formula for this approach is I = R x V. It can be remembered as IRV. IRV stands for income, rate and value:
I (income) is the anticipated annual net income to be produced by the property.
R (rate) is the capitalization rate.
V (value) is the present worth of the property.
Since the net income is a percentage of the value, in estimating value, the income is divided by the rate: I = R x V; therefore I ÷ R = V
The net income is $200,000 and the capitalization rate is 10%:
Value = $200,000 ÷ 10% = $2,000,000.
The net income is $15,000 and the capitalization rate is 8%:
Value = $15,000 ÷ 8% = $187,500.
Net income is gross income less operating expenses. To estimate the net income, the appraiser must establish the property's gross income, or scheduled gross income. This is the total potential income from all sources, i.e., rental income, income from vending machines, parking, etc. It is not the current rent schedule but a figure of what the rents should be after an analysis of:
historical rent (rent paid by the tenants in past years).
contract rent (rent currently paid by the tenants).
economic or market rent (the amount of rental income that could be obtained if the property were vacant and ready to be rented out, or were used at its highest and best use).
Once the scheduled gross income has been estimated, it is adjusted to account for the fact that there are likely to be vacancies and unpaid rents during the course of the year.
Looking at past and present vacancy and collection loss rates for the property as well as the rates for comparable properties, the appraiser would determine a reasonable percentage of the scheduled gross rent anticipated to be lost. When vacancies and collection losses are deducted from scheduled gross income, the resulting figure is called effective gross income.
Effective gross income equals scheduled gross income less vacancies and collection losses.
The next step is to estimate operating expenses. Operating expenses include fixed expenses, variable expenses and reserves for replacement:
Fixed expenses are costs that are relatively permanent. They do not vary according to occupancy, e.g., real property taxes and property insurance.
Variable expenses are costs that vary according to occupancy, such as fuel, utilities, decorating, repairs, advertising, and management. Management is the most easily overlooked item as it is not always accounted for by owners. A reasonable cost should be estimated even if the current owner has a particularly cost-effective way of handling management.
Reserves for replacement are amounts set aside for replacing equipment or portions of the building that have a relatively short life expectancy. For example, if the ranges and refrigerators have an economic life of 10 years, the appraiser would estimate 1/10 of their replacement cost as an annual expense.
- Vacancies and Collection Losses
- Fixed Expenses
- Variable Expenses
- Reserves for Replacement
In addition to the quantity of income, the appraiser must consider the quality and durability of the income:
Quality relates to the stability of the tenants and the likelihood that they will continue to pay rent.
Durability relates to the period of time the income can be expected to continue; e.g., 5 years, 10 years, or 20 years.
Quality and durability of income are accounted for in the capitalization rate. The capitalization rate is a rate of return that converts net income to value. It relates the net income to the value, and it mathematically converts the net income figure to a value figure. If proper, it will attract investors with a number of investment options available to them to the property. The overall capitalization rate consists of a return on the investment and a return of the investment.
The overall capitalization rate includes an amount to provide the investor with a profit. It is called the return on the investment or the discount rate. It reflects a return to:
equal a safe rate offered by government bonds or banks on savings accounts.
compensate for risk (the greater the risk, the greater the amount to be added for risk).
compensate for lack of liquidity (how long it may take to convert the real estate to cash).
compensate for management of the investment (the time and effort involved in handling the investment itself).
Added to the return on the investment is a recapture rate. This is a rate of return of the investment in the improvement (or accrual for depreciation). If, due to depreciation of the building, there were a 2% annual loss of value to the property, the investor would need a 2% return for recapture of his investment in addition to the rate desired for the return on his investment.
Once a capitalization (cap) rate has been determined, the appraiser can capitalize the income, by dividing the net income by the capitalization rate, to get the value.
If net income is $40,000 and the capitalization rate is 10%, the value would be $40,000 ÷ 10%, or $400,000. (V = I÷R)
If net income is $40,000 and the capitalization rate is 20%, the value would be $40,000 ÷ 20%, or $200,000.
The higher rate produces a lower value, since a higher rate implies a greater risk.
For smaller income properties, such as single-family homes or duplexes, in areas where the property might be purchased either for use as a residence or use as an income producer, a gross rent multiplier is used instead of the income approach. While it uses the same method as the sales comparison approach, the gross rent multiplier is considered the income approach for residential properties.
A gross rent multiplier is a factor. If this factor is multiplied by the rental price of a property, the result is an estimated market value. The formula for using a gross rent multiplier is as simple as remembering its name.
Value = Gross Rent x the Multiplier
An appraiser can arrive at a multiplier by dividing sales prices of comparable properties that have changed hands recently by the rents being charged at the time of the sale. An appropriate multiplier for the subject property can be calculated by adjusting to account for differences between the subject property and comparable properties.
Sales Price ÷ Gross Rent = Multiplier
If rental properties in the area were selling for about 127 times their rents and the subject property was renting for $920 per month, its value would be 127 x $920, or $116,840.
The rental figures used are gross monthly rents. When appraising industrial or commercial properties or other properties that produce income other than from rents, an appraiser might use gross annual income. In these cases, the multiplier would be called a gross income multiplier, rather than a gross rent multiplier.
All three appraisal methods (sales comparison, cost, and income) have at least something to contribute in the valuation of a property. So all are considered and used when practical. Each serves as a check against the others and narrows the range within which a final estimate of value falls.
However, not all approaches are equally appropriate for a particular property. Therefore, the appraiser would never simply average the values obtained by the use of each of these approaches. Instead, he would interpret the data obtained and apply to each of his value estimates a weight proportionate to its merits in the particular instance. He would give the most weight to the income approach for income property, the sales comparison approach for marketable property, and the cost approach for property not commonly bought and sold in the market (such as churches and public buildings).
This weighing, called correlation or reconciliation, is the final step in estimating the market value.
Once correlation is completed, the last step is reporting the value to the client. The report most commonly used is the summary report, or form report. This consists of one or more sheets, providing data about the neighborhood and property. An example of this is the Uniform Residential Appraisal Report, used by most lending institutions.
A restricted report, or letter form report, is a signed, dated report providing only a description of the property, the type of value estimated, the purpose of the appraisal, and the value conclusion. A self-contained report, or narrative report, is the most complete type of appraisal report. It provides the value conclusion plus, the reasoning, computations, maps, photographs, charts and plats supporting the conclusion.
People may purchase real estate for a number of different purposes. Depending on the purpose for which the property is held, the Federal Tax Code will create different tax consequences, which may be significant to the owner.
personal use, such as a personal residence (home). A personal residence may be a single-family home, a condominium or cooperative unit, a houseboat, or mobile home, or even one unit of a duplex, triplex or four-plex. The residence may be a principal residence, a second residence, or other property used to provide housing for family members. A principal residence is the owner's main home, the place where the owner lives most of the time. A second residence includes a residence used part time by the owner (e.g., a beach or mountain property).
investment, with the expectation of profiting from an increase in value prior to resale, such as investing in unimproved land.
production of income. This is property used to produce rental income for the owner (apartments, office buildings, etc.).
use in the owner's principal trade or business. This may include a factory owned by the manufacturer, a company-owned office building, etc.
sale to customers. This is property acquired by a developer, builder or investor in order to be resold for a profit in the ordinary course of business. It is also known as dealer property.
Income taxes are considered progressive taxes because the tax rates increase as taxable income increases. Persons earning higher incomes pay a higher percentage of their income than do persons earning less.
Taxable income is the income on which tax is paid. Taxable income is gross income less certain tax deductions. Gross income includes all income, regardless of its source, unless the income is specifically excluded by the Internal Revenue Code (IRC).
The depreciation deduction serves as a tax shelter by reducing taxable income without incurring any actual expense in the year of the deduction. However, when the property is sold, the taxpayer must pay tax of 25% on the total accumulated depreciation.
Barb Dwyer paid $100,000 for the improvements on a rental property. Each year, for 10 years, she claimed a tax deduction of $3,600 for depreciation. During those years, she was in the 30% tax bracket. Over the 10 years, she saved $10,800 (30% x $36,000) in taxes. When she sold her property, she had to pay back $9,000 in taxes on the claimed depreciation (25% x $36,000). The 25% rate she had to pay was less than the 30% she would have paid had she not taken the deduction.
People who sell property pay income tax on the net total of their capital gains and this includes the sale of real property. Capital gains are taxed at a preferential rate in comparison to ordinary income. The amount an investor is taxed depends on both his tax bracket, and the amount of time the investment was held before being sold.
Short-term capital gains are taxed at the investor's ordinary income tax rate, and are investments held for a year or less before being sold.
Long-term capital gains are gains on dispositions of assets held for more than a year, and are taxed at a lower rate than short- term gains.
In real estate, capital gains are based not on what is paid for the home, but on its adjusted cost basis. To calculate this:
Take the purchase price of the home.
Cost of the purchase, including inspections, transfer fees, attorney fees, inspections, but not points paid on the mortgage loan.
Cost of sale, including attorney's fees, real estate commissions, and money spent to fix up the home immediately prior to sale.
Cost of improvements, including additions, swimming pools, decks, etc. Improvements do not include repairing or replacing something already there, such as putting on a new roof or buying new hot water heater.
The total is the adjusted cost basis of the home.
Subtract the adjusted cost basis from the amount for which the home is sold. This is the capital gain.
CAPITAL GAINS EXAMPLE
Original Purchase Price: $250,000
Improvements (New deck): $ 50,000
Subtotal (Adjusted cost basis): $300,000
Net Sales Price $500,000
Adjusted cost basis: $300,000
Capital Gain: $200,000
When real property is sold, or disposed of, there are further tax consequences. For most types of real property, the profit realized upon disposition is considered a capital gain. In some instances, a loss realized upon disposition is considered a capital loss. Capital gains are gains on the disposition of assets. They are subject to taxation. Capital losses on the disposition of assets may be tax deductible. Capital gains are taxed at the normal tax rate, if the asset had been held for one year or less, and at a rate of up to 15%, if the assets had been held for more than one year.
A loss on the sale of real property is tax deductible, except for property held as a personal residence. Losses on income and investment property are capital losses. These losses are fully deductible from capital gains. If they exceed the capital gains, up to $3,000 of net capital losses may be deducted from ordinary income each year. Losses on dealer property and property used in a trade or business are ordinary losses.
Adjusted Cost Basis
+ Assessments, Capital Improvements, Additions, etc.
- Depreciation Deductions, Uninsured Losses,
Payments For Sale of Rights In or Part of the Property
Adjusted Cost Basis
Determination of the amount realized from the sale of real property starts with the selling price. This is the total amount received for the property, including money, notes, mortgages and the value of any other property received. The amount realized is the selling price less selling expenses, such as commissions, advertising, legal fees, loan placement fees or discount points paid by the seller.
- Selling Expenses
- Adjusted Cost Basis
Capital Gain (or Loss)
Realized in the tax year in which property sold
Recognized in the tax year for which it is taxed
An individual may exclude, from his gross income up to $250,000 ($500,000 for a married couple filing jointly) of capital gains on the sale of real property if he used it as his primary residence for two of the five years before the date of sale. The two years of residency do not have to be continuous; the individual may meet the ownership and use tests during different two-year periods. However, both tests must be satisfied during the five-year period ending on the date of the sale. There are allowances and exceptions for military service, disability, partial residence and other reasons.
Taxes may also be deferred through use of a taxed-deferred exchange (tax-free exchange, nontaxable exchange, or Section 1031 exchange). It is sometimes referred to as a 1031 exchange because Section 1031 of the Internal Revenue Code (IRC) establishes the requirements relating to such an exchange.
The most common type of tax-deferred exchange is a like-kind exchange. A like-kind exchange (or like-for-like exchange) is an exchange of tangible like-kind properties, (e.g., real estate for real estate or personal property for personal property, but not real property for personal property). The exchange must involve only business, income or investment property. Neither property in the exchange may be used by the taxpayer for personal purposes, such as a home, or be dealer property, held for sale to customers. Within these guidelines virtually any type of properties could be exchanged. Therefore, a store building used in business could be exchanged for an apartment house used as an investment, since both are real property and neither is used for personal use or as dealer property.
The exchange of properties may be simultaneous or may be delayed. A delayed exchange actually involves a sale with the sale proceeds held by a facilitator. These funds are then used to make a purchase of property to replace the property sold. To qualify for the tax deferral in a delayed exchange, the taxpayer must identify potential replacement property within 45 days and actually take title to property identified within 180 days after the date he transfers title to the property given up in the exchange.
If the transaction qualifies as a tax-deferred exchange, the taxpayer will pay tax only on the lesser of his gain or boot received. Boot is money, unlike property or an assumption of a greater mortgage balance (mortgage relief) the taxpayer has received in the exchange. It arises from the difference between his equity in the property he gave up and his equity in the property received. If he pays boot, his entire gain would be deferred. If he receives boot, he would pay tax on the lesser of his gain or the boot received.
Ann and Bob exchange real property. Ann has property worth $140,000, with a $30,000 loan balance outstanding. Bob has real property worth $100,000 which is owned free and clear. Ann's equity (i.e., the difference between the property value and the liens encumbering the property) is $110,000; Bob's is $100,000. Therefore, Bob will give Ann $10,000 cash to balance their equities. Ann is receiving $40,000 of boot, consisting of $10,000 cash and $30,000 mortgage relief. In exchange, each party pays tax on their realized gain or boot received, whichever is less (so Ann must pay tax on $40,000 or her gain, whichever is less, and Bob can defer all of his gain and pay no tax, since he received no boot).
A homeowner is eligible for a major tax break on the sale of a home. If he has owned and lived in a home as his main home two of the past five years and has not excluded any gain on the sale of another home in the past two years, he may exempt $250,000 of gain. Therefore, if a person sells his home of two years and realizes a gain of $200,000, none of the gain is taxable. If he realizes a gain of $300,000, only $50,000 is taxable at the capital gains rate.
If there are co-owners, each is entitled to a separate exemption, if qualified. When a married couple files a joint return and each spouse has lived in the home as a main home two of the past five years and has not excluded any gain on the sale of another home in the past two years, the exemption is $500,000 of gain, even if only one spouse has owned the property for the required two years.
Value is the relationship between items and persons wanting those items. Differences in value are caused by four characteristics of value: the item's utility, scarcity, and transferability and demand. The value of real estate is influenced by its physical characteristics: its immobility, indestructibility and inhomogeneity or heterogeneity, and by four general forces: physical and environmental characteristics, economic conditions, governmental regulations and social influences.
Market value is 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 knowledgably, and assuming the price is not affected by undue stimulus," and is determined by buyers and sellers. Appraisers give an informed opinion when estimating the value of property. The most complete appraisal report is a narrative report. The appraiser uses different approaches, then analyzes and compares the results of each in a process called reconciliation or correlation.
The principle of highest and best use holds that the maximum value of land exists when the property is used for its highest and best use. This is the possible, feasible, and legally permissible use that, at the time of the appraisal, is most likely to yield the greatest net return over a given period of time.
Principle of Substitution
The principle of substitution holds that, if a property is replaceable, its value tends to be set by the cost of acquiring, by purchase or construction, an equally desirable substitute property without any undue delay. This principle is the basis for all of the approaches used to estimate value: the sales comparison (or market data) approach, the income (or capitalization) approach, and the cost approach.
The market data approach is the main valuation principle and holds that a prudent person would not pay more for a product than he would pay for a reasonable substitute.
The income approach holds that a person would not accept a lower rate of return than from a reasonable substitute.
The cost approach holds that a person would not pay more than it would cost to build a reasonable substitute.
Sales Comparison Approach
The sales comparison approach is a valuation of properties by comparing prices paid for similar properties. It is most likely to be used in appraising residential properties and land. In this approach, the appraiser collects and verifies sales data and compares the subject property to comparable properties in terms of location, time of sale, terms and conditions of sale, and physical characteristics (including amenities). Amenities are features that add to a property's desirability. Conditions of sale should not include foreclosures or other types of sales not in an open market. Where the properties differ, adjustments are made to the sales price of the comparable property (down if the subject property is not as good as the comparable, or up if it is better) to bring it to the price for which the subject property should sell.
The income (capitalization) approach is used to appraise properties that produce income by evaluating their net income and converting it to a value estimate. For income property, the value would be the present worth of future potential benefits, i.e., the anticipated net income to be obtained from the property. The estimated net income is calculated by subtracting an allowance for vacancies and bad debts from the scheduled gross income to arrive at an effective gross income, and then subtracting operating expenses (maintenance, repairs, management, etc.), fixed expenses (taxes and insurance), and reserves for replacement of items that wear out.
The greater the risk of the investment, the higher the capitalization rate the investor wants; the higher the rate, the lower the value of the property.
To calculate the value, the appraiser divides the estimated annual net income of the property by a capitalization rate. The capitalization rate is the rate of return the new owner can expect to receive, including a rate of return of the investment necessary to recapture depreciation costs. In calculating straight-line depreciation, an appraiser assumes that 100% of the property's cost will be lost by the end of its economic life (the period of time in which a building produces sufficient income to justify its continued use). Therefore, the annual recapture rate is determined by dividing 100% of the replacement cost by the economic life of the improvement.
For houses used as rental properties, a gross rent multiplier might be used. The value of a rental property is estimated by multiplying its estimated monthly rent by an appropriate multiplier. The multiplier is derived by dividing the sales prices of comparable houses that have sold by their monthly rents.
While the cost approach can be used for any property, it is most often used to appraise value in use for new buildings, where costs are easy to obtain, and for properties such as churches and public service buildings that cannot be compared to others that have sold or to those that produce income. The appraiser estimates the value of the land and the depreciated value of the improvements on the land separately and adds the two values to arrive at an estimate of the property's total value.
The most commonly used method to estimate the cost of residential property is the square foot method, using the average cost per square foot of living area to construct a building of the same type and quality. The total value of the land and the cost new of improvements, before deducting depreciation, is the upper limit of the value of the property.
Depreciation is a loss in value due to any cause. Causes include physical deterioration, functional obsolescence, and economic obsolescence. Physical deterioration is reflected in items in need of repair or replacement due to natural causes (like dry rot or termite damage), wear and tear, and deferred maintenance. An appraiser places the greatest emphasis on the observed condition of the building in calculating this depreciation. Rather than estimate depreciation based on the building's actual age, he estimates the building's effective age, i.e., its age based on its condition. A building has a lower effective age if well maintained, and a higher effective age if poorly maintained:
Depreciated value equals the cost to replace or reproduce the improvements less depreciation.
Replacement cost is the present cost of constructing a new substitute structure, equal to the existing structure in quality and utility, but using current construction methods, materials, design and layout.
Reproduction cost is the present cost of constructing a new substitute structure that is an exact replica of the existing structure.
Functional obsolescence results from loss of functionality due to basic construction techniques used, as well as inadequacy (e.g., a single-car garage, a small water heater), outdatedness, or overadequacy in a building. Economic obsolescence results from factors outside and surrounding the property, such as zoning, blight, high taxes, and pollution, and is, therefore, almost always incurable.
Real estate and other equity assets are hedges against inflation, as their value should increase as the value of the dollar decreases. Equity is the difference between the property value and the liens encumbering the property.
"Market value" is the highest price a property will bring if exposed for sale in the open market, allowing a reasonable time to find a purchaser who buys with knowledge of all the uses to which the property is adapted and for which it is capable of being used. It is often referred to as "the price at which a willing and informed seller would sell and a willing and informed buyer would buy, neither being under any pressure to act." Market value is estimated, not determined, by an appraiser.
In an appraisal, the appraiser would use market data to estimate exchange (market value). He would also estimate reproduction or replacement cost in a cost analysis. Neither the cost of construction nor the cost of acquisition would be relevant to the market data approach.
Physical deterioration is items in need of repair due to wear and tear, action of the elements, etc. It is curable if repairs are economically feasible, or incurable if repairs are not feasible. Functional obsolescence results from the property's physical or design features no longer considered desirable by buyers. It too may be curable or incurable. Economic obsolescence results from factors outside the property (e.g., zoning, neighborhood blight, airport noise, changes in tax laws, etc.) so it is incurable. Functional obsolescence is within the property boundaries; economic obsolescence is outside.
The gross income multiplier formula is Value (sales price) = Gross Income x Multiplier. The multiplier therefore = Value (sales price) ÷ Gross Income. For example, the gross income was $6,000 per year when the property sold for $75,000. The multiplier would be 75,000 ÷ 6,000 = 12.5. Note, the term "gross rent multiplier" is used when monthly rent is used. The term "gross income multiplier" is used when annual income is used.
"Plottage value" is the increased usability and value resulting from combining or consolidating adjacent lots into one larger lot.
The principle of regression states that the worth of better-quality property is adversely affected by the presence of lesser-quality property. The principle of progression is the opposite (the worth of lesser-quality property is increased by being located among better-quality property).
The "economic life" is the estimated period over which an improved property may be profitably utilized so that it will produce a yield over and above the economic rent attributable to the land. At the end of the economic life, the building is usually torn down or rehabilitated. The economic life can never be greater than the physical life, but is usually less, as physical life refers to how long the structure can stand, and economic life refers to how long it is profitable to keep it standing.
Land is immobile as the geographic location of any parcel of land cannot be changed. Land is durable and indestructible. Land is nonhomogeneous (no two parcels are ever exactly the same). "Nonhomogeneous" can also be referred to as "heterogeneous." ("Homogeneous" means "of the same or similar kind.")
Economic (or external) obsolescence results from factors outside the property (e.g., zoning, neighborhood blight, airport noise, changes in tax laws, etc.). Functional obsolescence results from the property's physical or design features no longer considered desirable by buyers. Economic obsolescence is outside property boundaries; functional obsolescence is within the boundaries. Physical deterioration is items in need of repair due to wear and tear, action of the elements, etc.
The "principle of conformity" states that maximum value is realized if the use of land conforms to existing neighborhood standards (e.g., design, construction, size and age of buildings as well as the social and economic status of residents). However, these factors should not be so uniform as to become monotonous.
Reconciliation (correlation) is the final step in the appraisal process, in which the appraiser reconciles the value estimates obtained from the market data, cost and income approaches to arrive at a final estimate of value for the subject property. He gives the most weight to the approach which is most relevant for the type of property being appraised and does not merely average the different values.
The cost approach is also used for new structures and for estimates of losses for insurance purposes, where the desired result is to estimate the cost to replace damaged items.
In the cost approach the value of the land is estimated (by the market data approach). Then the replacement or reproduction cost is estimated (by quantity survey, unit-in-place, or square foot methods); this gives the cost of replacing the existing structure with a new one. When the land and replacement cost are added together the result is the upper limit of value -- the value of the property if the structure were new. From this figure, subtract the estimate for accrued depreciation to arrive at the current value for the existing building and land.
The income property should obtain at its highest and best use is market rent or economic rent. The actual income received is the contract rent. If the contract rent exceeds the economic rent, the difference is excess rent.
The comparative cost (also known as square-foot or cubic-foot) method involves use of cost books showing the average cost per square foot for construction. This is the easiest means of estimating construction costs, so is more frequently used. Second in ease of use is the unit-in-place method. This involves adding the costs of the various building components together (roof, bathroom, wiring, foundation, etc.). The most difficult method is the quantity survey. This involves estimating the quantity of materials needed, the price of the material, the cost to install it, and overhead and profit. This method is used by contractors and experienced estimators, not appraisers.
The depreciation estimate is used to estimate the current value of improvements (current cost minus depreciation equals current value of improvements).
In the market data approach the appraiser defines the problem, collects sales data, verifies the data, and adjusts sales prices of comparable properties to reflect differences in time of sale, conditions of the sale, features of the property and location of the property.
Special-purpose and public service buildings (e.g., schools, churches, and post offices) and buildings of unique design and construction would be best appraised using the cost approach, since there would be very few comparable sales for market data analysis and there is usually no income produced by such properties. The cost approach is also used for new structures and for estimates of losses for insurance purposes.
The cost approach is based on the property's reproduction (or replacement) cost. Since most people will not pay more for a property than it would cost to buy a similar site and build a similar but new structure on it, the cost approach sets an upper limit of value for the property based on reproduction cost.
The cost approach is used for public service buildings. It does not set the lower limits of value; it sets the upper limits. In the cost approach the value of the land is estimated (by the market data approach). Then the replacement or reproduction cost is estimated (by quantity survey, unit-in-place, or square foot methods); this gives the cost of replacing the existing structure with a new one. When the land and replacement cost are added together the result is the upper limit of value -- the value of the property if the structure were new. From this figure, subtract the estimate for accrued depreciation to arrive at the current value for the existing building and land.
The cap rate is the rate of return desired by an investor. The greater the risk or depreciation, the higher the rate demanded by investors. Therefore, if two properties offer the same income potential, but one has a shorter economic life or greater risk (and therefore would have a higher cap rate), the one with the greater risk would be worth less.
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