Transcript Document

Real Estate Principles of Appraisal
Real Estate Brokers’ Program
Barbara Grodaes
Introduction
Main responsibility of agent is to protect the
interests of their clients.
 Agent must have the knowledge and ability
to form objective opinions and provide
unbiased estimates of real value.
 Agent is expected to be able to estimate the
market value and projected revenue of real
estate offered for sale with reasonable skill.
 Agent must have a basic understanding of
methods of evaluation and be able to form,
express and defend opinion of value.
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Fundamentals Theory/Principles
Appraisal definition is an estimate of value
based on current market happenings.
 3 Levels of appraisal knowledge.

Professional Appraiser
THIRD level of appraisal knowledge
Members of real estate & related fields
SECOND level of appraisal knowledge
GENERAL PUBLIC (bought/sold/owned/has owned Real Estate)
FIRST level of appraisal knowledge
Purpose and Function of Appraisal
An appraiser considers historical data in
order to forecast future probabilities (estimate
value) – does not set value.
 An appraiser studies the market and the
historical data and attempts to predict the
probable selling price of a property.
 Appraisers are often asked to estimate
market value (price property will sell under
average sale circumstances).
 Purpose is for specific type of value and
function is what use the appraisal is for.

Average Sale Circumstances
An informed buyer and seller (access to
reasonable market information, rather than
absolute knowledge).
 Rational or prudent behaviour by both buyer
and seller (acting in own self-interest).
 No undue pressure on either party (neither
under compulsion or abnormal pressures).
 A reasonable time is allowed to find a buyer
(property exposed in market for a set time).

Objective Versus Subjective
Objective concept of value means the cost
of creation is the measure of its value (no
personal attachment - is basis for cost
approach to value but not the dominant
concept in appraisal).
 Subjective concept of value means the
value is created and exists in the mind of the
individual (subjective value predominates in
the buyer’s mind – personal value).
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Elements of Value
Utility – must be useful and efficient.
 Scarcity – supply must be relatively scarce.
 Effective Demand – must be an ability to
purchase, not merely a desire to own.
 Transferability – must have the capability of
being transferred or exchanged for money.
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For real estate property to have value, it must
possess the features known these elements.
Forces That Influence Value
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Subjective value of property is influenced by
these forces which can create, maintain,
modify or destroy value. They are:
Forces – population growth, family sizes,
cultural backgrounds, education.
Political (Governmental) Forces – zoning or
land use controls, building codes, rent controls,
interest rate controls (federal/provincial/municipal)
Economic Forces – levels of interest rates,
employment trends, wage levels, availability of
mortgage money, supply and demand.
Physical Forces – climate, topography, soils,
flood plains, frost belts.
Social
Market Value, Price and Cost
Market value – expected price that should
result under specific market conditions.
 Price – historical: It is the amount for which a
property actually sold.
 Cost – the expenditure required to create a
property.
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At certain times, market value can be the
same as price or cost or both, but are not
interchangeable terms.
Study the basic Principles of Real Property Value.
Principles of Value
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Principle of Anticipation – expectation of future
benefits.
Principle of Change – value only valid at a
specified date.
Principle of Supply & Demand– price varies
(residential real estate, price can lag or inflate more extremely than other commodities)
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Principle of Substitution – when property is
replaceable (this principle underlies all the valuation approaches).
Principle of Balance – value is created and
sustained when there is proper equilibrium in the
amount and location of essential types of real
estate.
.
Principles of Value, continued …

Principle of Surplus Productivity – net
income that remains after the proper costs of
labour, co-coordinating expenses and capital
have been paid. The remaining net income is
attributed to the land and tends to fix land
value.
This principle is the basis for estimating
highest and best use of undeveloped
property.
Principles of Value, continued …
Principle of Increasing and Decreasing
Returns – increases in the factors of
production will produce increased returns, up
to a certain point only. After that, any
additional expenditure will not produce a
return commensurate with the additional
investments.
 Principle of Competition – profits create
competition and excessive profits breed
competition that tends to destroy those
profits.
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Principles of Value, continued …
Principle of Conformity – maximum value
is created and maintained where there is a
reasonable degree of uniformity or
homogeneity of use.
 Principle of Highest and Best Use – that
use, at the time of appraisal, that will most
likely produce the highest net return over a
given period of time.
This principle is the basic premise of value.

Nature of Property
Land – ground, soil and everything that is
attached to it, beneath it and above it.
 Property – physical thing and rights of
ownership of the thing.
 Real Estate – physical land and
improvements to and on the land (tangible).
 Real Property – physical real estate plus the
rights that go with ownership (tangibles/intangibles).
Owner has the right to use the property, to
sell it, to lease it, to enter it, to give it away, or
not to do any of these.

Four Powers of Government
Power of Taxation.
 Power of Eminent Domain (expropriation) –
right to take private property for public use
upon payment of compensation to the owner.
 Police Power – right to regulate property by
zoning bylaws, health, building and fire codes
and so on.
 Escheat –right to have titular ownership of a
property revert to it if the owner dies and
leaves no will or known heirs.

Restrictions on Ownership
Other restrictions on ownership rights include
Restrictive Covenants – limit use of property.
 Personal property – (movable items not part
of the real estate) take care in distinguishing
which items are personal property and which
are a part of the real estate.
 Market value of real property actually means
the ownership of that parcel of real estate
and the rights that go with ownership.

Appraisal Process
Define the Problem
Problem
Preliminary Survey
And Appraisal Plan
Data Collection
and Analysis
Highest and Best
Use
OK
Decide on one or
More approaches
Direct Comparison
Approach
Cost Approach
Reconciliation
Establish Value
Conclusion
Income Approach
Define the Problem
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After establishing client’s objectives, identify the
property both municipally and legally (survey plan
helpful).
Specify the property rights involved and identify the
rights of ownership.
Identify the purpose and function – purpose is type
of value and function is the use that will be made of
the value estimate.
Define type of value and state effective date.
Ascertain scope of appraisal in respect of the extent
of data collected.
Obtain commitment from the client to avoid later
problems & establish precise terms of reference.
Preliminary Survey & Appraisal Plan
First phase of field work – ‘windshield
inspection’ of neighbourhood and property.
 Determine type of data (general or specific).
Depending on purpose and function.
 Determine if additional help is required –
(engineer/lawyer/specialist of any kind).
 Determine the approach to be used – (cost,
income or direct comparison).
 Create an Appraisal Plan – will expedite the
efficient handling of the assignment.

Data Collection & Analysis

General Data includes the following forces:
(interest rates, lenders’ attitude,
average prices, ownership trends, stability, etc.)
Social (population, amenities, locations, etc.)
Political (local government, attitudes towards
taxes, assessments, planning and zoning).
Physical (location of city, location of neighbourhood, street layouts and subdivision system,
transportation, physical features, existence of
undesirable elements, etc.)
Economic
Study of Trends
Consider the forces which influence both
property values and their changes.
 Trend is defined as a series of related
changes brought about by a chain of cause
and effect. These are studied in order to
measure historical trend which then forms
basis for forecasting a future trend.
 A trend has 4 features necessary to analyze
possible future effect on property values:
1. Time
3. Cause
2. Direction
4. Effect
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Data Collection & Analysis, cont…
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Specific Data includes the following:
Details
about the property being appraised.
Details on comparable sales and local market
characteristics.
This information is used in determining highest
and best use and to make comparisons
necessary to estimate market value. The
character of the subject property provided helps
appraiser collect comparable data about land
sales, building sales and rents necessary to
complete.
Site Analysis
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A comprehensive site analysis is basic to
the valuation of any property. Five factors
which must be analyzed separately are:
1.
2.
3.
4.
5.
Physical Factors.
Locations Factors.
Legal/Governmental Factors.
Economic Factors.
Environmental Factors.
Physical Factors
Site Dimensions, Depth, Width, Shape, Area,
Soils and Topography, Services and Utilities,
Road and Street Patterns, Landscaping.
 The analysis of the above, the physical
factors, deals with forces affecting the
physical utility of the site.
 Accessibility, prominence, suitable/unsuitable
development as well as all physical factors
may have an influence on value.
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Locational Factors
Most significant single characteristic of any
site is its fixed location.
 Location is expressed in terms of the
relationship of the site to the surrounding and
nearby facilities and nuisances.
 Land Use Pattern, Access to Facilities,
Corner Influence, Hazards and Nuisances all
may have an influence on value.
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Legal-Governmental Factors
Legal factors deal with the permitted and
restrictive uses of the site.
 These include:
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Legal
Description
Title Data
Zoning
Taxes and Assessment
Easements
Title Restrictions.
Other Factors
Economic Factors – operating at the
neighbourhood or market area level,
including tax burden, utility costs and
servicing costs.
 Environmental Factors – problems or toxic
contamination can be found in many rural
and urban properties and can have a varying
impact on value. Appraisers are not experts
and will request copies of reports prepared
by experts.
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Building Inspection & Analysis
Inspection of Improvements – importance
cannot be overemphasized.
 Usually divided into two types:
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Site
Improvements such as: fencing,
landscaping, paved driveway, swimming pool,
parking area, outside lights, etc.
Building Improvements dealing with four
areas: general data, construction data,
equipment data, functional data.
Comparable Sales Data
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Detailed data is required on market sales of
comparable properties.
Itemization of key features serve as a basis for the
application of valuation techniques: estimating
value of the site, building construction cost, value of
property directly, all by comparison, and, deriving a
gross rent multiplier or a capitalization rate.
The required information includes: date, sales
price, location, land-use controls, physical
characteristics, functional utility and condition,
income and expense information, terms of financing
and conditions of sale.
Compare and Adjust
Make comparables transform to the subject –
remember the subject never moves.
 Compare each comparable independently.
 Key to Remember: (Singleton thing!)

Comparable is superior – SUBTRACT
If Comparable is inferior – ADD
If
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Two Rules of Thumb
1. Look for high number adjustment
2. Look for many adjustments
Margin error is higher for these.
Highest & Best Use

Cornerstone of any appraisal. Use which will
support the highest value and will produce
the greatest net return over a period of time.
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Definition – The reasonably probable and
legal use of vacant land or an improved
property, which is physically possible,
appropriately supported, financially feasible,
and that results in the highest value.
Criteria for Highest & Best Use

Four criteria need to be met to determine:
permissible – both current & potential.
Physically possible – concerning uses.
Financially feasible – anticipate earnings to
generate a fair and competitive return on its cost
of acquisition or development.
Maximally productive – of the range of
profitable uses of land, those uses which provide
the highest return or are maximally productive
will represent the highest and best use.
Legally
Highest & Best Use of Land as if Vacant
Assumes parcel of land is either vacant or
can be made vacant by demolition of existing
buildings.
 Key questions: What uses should be made of
the land? What type of buildings should be
constructed? When?
 When reasonable forecast of a change in
future use has been made, then the existing
use is known as an interim use.

Highest & Best Use of Property as Improved
Typically it is its existing use. Evaluation is
made in light of the existing improvements.
 Key questions: Do those improvements
represent the most profitable use of the land?
Should old building be maintain as is, or
should it be renovated to modern standards?
Is land more valuable for redevelopment to
alternative uses? Should the structure be
demolished?
 If appraiser believes existing use is not
highest and best use, then existing use must
be ignored in appraisal.
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Direct Comparison Approach
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This is based primarily on principle of substitution –
informed buyer will pay no more for a property than
cost of obtaining comparable, competitive property
with the same utility, on the open market.
Optimum results are obtained when good and
truly comparable properties are used – least
amount of adjustments needed.
Reduce selling price to a proper unit of comparison,
adjust to the sale price per unit, motivation, time,
location, physical, and all other adjustments, and
select an estimate within a value range.
Process tends to be judgmental, not scientific.
Units of Comparison
Price/Sq. Ft.
 Price/Unit
 Gross Income Multiplier = Price/Gross
Income
 Price Earning Multiplier= NOI/Price
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(NOI=net operating income)
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Monthly Rental Factor = Price/Monthly Rent
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Rule of Thumb – add up income for building
and multiply by Gross Income Multiplier.
Cost Approach
Also based on the principle of substitution.
 Simplistically divide the property into vacant land

value plus depreciated cost of improvements. The
reproduction cost new is adjusted for physical,
functional and locational depreciation. The sum of
vacant land value & depreciated improvements together provide an estimate of value.
 Also based on the objective concept of value
(cost to create as the main criterion).
4 Steps in Applying Cost Approach
1.
2.
3.
4.
Estimate the value of the site.
Estimate the cost of reproducing or
replacing the existing improvements as
though they were new on the effective date
of appraisal.
Estimate the accrued depreciation suffered
by the improvements from all causes.
Estimate value.
For properties where there is no market or
not an income stream, this method is most
valid to estimate market value.
Site (Land) Valuation – 4 Methods
Direct Comparison Method – easily
understood.
 Land Residual Method –(principle of surplus
productivity) used to find value estimate of a
site which is readily adaptable for use as the
location for an income-producing property.
 Land Development Method –for raw
acreage designated for subdivision or
development.
 Abstraction Method – seldom used as a
single tool, however, in the absence of good
comparables, can be valid and invaluable.

Cost Estimates

Choose an approach that would most
accurately reflect a true market value
estimate – reproduction cost or replacement
cost:
cost – cost of exact reproducing.
Replacement cost – cost of replacing same size
and utility using current technology, materials
and equipment.
Reproduction
Methods to Estimate Reproduction
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Quantity Survey Method – most accurate, detailed
and complex, usually done by professionals and
time-consuming.
Unit-In-Place Method – less detailed, reasonably
accurate, however still requires expertise and timeconsuming.
Comparative Method – most commonly used done
by direct comparison approach broken down into
cost/sq.M + variance – needs good comparables.
Cost Services – up-to-date information in forms
one can readily apply (quick and easy if manuals
kept up to date).
Depreciation
To complete cost approach to value, estimate
any losses in value due to the passage of
time or the resultant wearing away or
changes in utility of the building.
 Definition – loss in value due to any cause.
 Accrued Depreciation is the difference
between the reproduction cost or the
replacement cost of the improvement and the
market value of the improvement, both
measured as at the date of appraisal.

Physical Depreciation

Loss due to wear and tear, decay and
structural defects. There are 2 kinds:
– items that a buyer would anticipate
fixing immediately after buying (e.g.. short-lived
items such as floor coverings, furnace, hot water
tank, plumbing fixtures, painting, decorating,
broken windows/doors).
Incurable Physical Deterioration – items not
economically feasible to fix (e.g. long-lived items
such as floor joists, structure, or dry rot or
termite damage).
Repairs
Functional Depreciation

Loss in value to a building because of an
inability of the structure to perform its proper
function efficiently. This is divided into 2:
Functional Depreciation – cost of
replacing item is justified by the increase in
building utility and value (replace old furnace).
Incurable Functional Depreciation – cost of
replacing item is greater than the anticipated
increase in utility and thus, value – not a sound
undertaking (outmoded floor plan).
Curable
External Depreciation
Loss in value to a building arising from
sources outside of the property itself. Owner
has no direct control.
 Example of this type of depreciation would be
a house located next to a busy truck stop or
fast-food restaurant, depending on the
proximity to the subject.
 Has been referred to as external
obsolescence or locational obsolescence.

Measurement Age-Life Depreciation
Age-Life Method – refers to effective age
and life refers to economic life.
 Effective Age is the indicate age based on
use and care which may be < or > than the
chronological age.
 Economic Life is the period of time over
which a structure may reasonably be
expected to be competitive in the market in
the use for which it was intended (note: not
physical remaining standing).

Age-Life Method, continued…
Remaining Economic Life is the period
from the date of appraisal to the end of the
economic life. It is the difference between
economic life and effective age.
 Depreciation = Effective Age x Reproduction
Economic Life Cost
 This method applies only to physical
deterioration; it does not measure functional
or external forms of obsolescence.
 Also, it assumes components depreciate at
same rate, on a straight-line basis.

Engineering Breakdown Method
Another method of estimating or measuring
accrued depreciation.
 This is to depreciation what quantity survey is
to cost. Extremely detailed, piece-by-piece
breakdown of each and every part with a
separate depreciation measurement on each.
 Not often used by appraisers, because of its
complexity of the measurements and items
required.

Market or Sales Method
Another method of estimating or measuring
accrued depreciation.
 This compares the building being appraised
to others of a similar kind and quality, but
different age, that have recently been sold.
That portion of the price that represents the
building only is determined and then
compared to the estimate of the reproduction
cost of the building being appraised (accrued
depreciation).
 Weak in that land must be valued and good
comparable sales data must be available.

Observed Condition Method
Another method of estimating or measuring
accrued depreciation.
 Seldom used in its entirety but essential to
understand to be able to properly apply the
other methods. Application requires
observations of depreciation be categorized,
measured and deducted from the
reproduction cost.
 Method breaks down depreciation into
physical, functional and external
depreciation.

Physical (Repairs and Incurable)
Repairs measured by ‘cost to cure’.
 Estimating cost to cure requires
measurement of the reproduction cost of the
depreciated item that is included in the
reproduction cost of the whole structure.
 Be careful not to double depreciate section of
the report.
 Incurable measured by taking the ratio of
effective age to economic life and deducting
that ratio from the reproduction cost. This
applies to short- and long-lived items.
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Measurement Methods, continued...
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Curable functional depreciation – measure by
the cost to cure.
Incurable functional depreciation – measure by
taking the estimated or actual rental loss arising
from the deficiency and multiplying it by the gross
rent multiplier (GRM) if it is an income property.
(The GRM is the relationship between the annual
gross rent and the sale price).
External depreciation – measure by multiplying
rent loss resulting from this locational obsolescence
by the GRM of an income property. The result will
be the value loss to both land and building.
Estimate Market Value

Final step is calculation:
Reproduction Cost – Accrued
Depreciation = Value of Building
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Value of site and value of other outside
improvements (if any) are added to the value
of the building to arrive at the value of the
property.
Income Approach
Based on the theory that the value of a
property is the present worth of the future
income which this property is capable of
producing.
 Technique involves an estimation of the
gross income capability.
 Gross income is reduced by vacancy
allowance and operating expenses to a
stabilized net income estimate.
 Net income is capitalized at an appropriate
rate into an indication of market value.
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Application of Income Approach
1.
2.
3.
4.
5.
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Estimate the potential annual gross income
(AGI) less likely vacancies and bad debts.
Estimate the total annual operating
expenses.
Calculate the net operating income.
Select the appropriate capitalization rate.
Capitalize the net income into value.
Effective Gross Income = Gross Income – Allowance
for Vacancy – Collection Losses
Capitalization
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1.
2.
A capitalization rate is NOT a statement of a
rate return. It is merely a ratio, expressed
as a percentage used to convert current net
operating income into an expression of
market value or probably selling price.
Overall capitalization is made of 2 rates:
The rate of return on the invested capital.
The rate of return of the capital (recapture
rate).
Overall capitalization: V=I/R
Capitalize Net Income into Value

Using Direct Capitalization method
Note: 1. mortgage payments NOT operating expenses
2. Low risk = low cap rate = high value
Use Allan’s garage formula (Allan’s Insulated
I
roof is over his Recreational Vehicle) RV
(income over capitalization rate and value)
 Gross Rent Multiplier (GRM) is the ratio of
the sale price to the annual gross income at
the date of the sale.

Final Reconciliation & Value Estimate
Reconciliation is process which the appraiser
reaches a single value estimate based on an
evaluation and selection from among two or
more alternative conclusions.
 Review the reliability of the data and weigh
the relevance to the property.
 Use the best and most reliable to get your
final estimate of value.
 Note: not simply averaging the estimates.

Appraisal Report
Written presentation of the general and
specific data considered and analyzed, the
method used and the technique employed
together with a reconciliation that leads to
final estimate of value.
 Three basic types of reports:
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Form
Report.
Letter of Opinion.
Full Narrative Report.