Chapter 17. Georgia Real Estate An Introduction to the Profession Eighth Edition Chapter 17 Real Estate Appraisal

Chapter 17

Georgia Real Estate An Introduction to the Profession

Eighth Edition

Chapter 17

Real Estate Appraisal

Key Terms• appraisal• capitalize• comparables• cost approach• depreciation• fictional

depreciation• gross rent

multiplier (GRM)

• highest and best use

• income approach• market approach• market value• operating expenses• principles of value• projected gross

© 2015 OnCourse Learning

Overview

Market value is the most probable price that a property should bring in a competitive and open market under all conditions requisite to a fair sale.

Market value is the most probable selling price in an arm's-length transaction.


Overview

An arm's-length transaction is when a buyer and seller are • typically motivated• both parties are well-informed• both are acting in their own best

interest


Overview

• a reasonable time is allow for exposure in the open market

• payment is made in terms of cash or comparable to cash

• the price represents the normal consideration for the property sold


Purpose and Use of AppraisalsTo appraise real estate means to estimate its value.

A formal appraisal is an independently and impartially prepared estimate expressing an opinion of defined value of an adequately described property as of a specific date supported by the presentation and analysis of relevant market information.


The Real Property Valuation Process

The valuation process is the step-by-step procedure that appraisers use to conduct their work.


The Real Property Valuation ProcessThe valuation process involves the following steps: • define the appraisal problem• conduct a preliminary analysis• collect the data• estimate the highest and best use of

land as if vacant, and the property as improved


The Real Property Valuation Process

• estimate land value• estimate the improved property

value through the appropriate value approaches

• reconcile the results to arrive at defined value estimate

• report the conclusion of value


Characteristics of Value

Characteristics of value are:

DemandUtilityScarcityTransferability.



Demand is desire coupled with ability.

Utility refers to the usefulness or function of the product or service.



Scarcity means there must be a short supply relative to demand for there to be great value.

Transferability is value to anyone other than the person possessing it. Transferability refers to marketable title. If the title has a defect, it will lower the value of the property.


Principles of Value

The principle of anticipation states that present value is influenced by the anticipation of future benefit. Investors buy property in anticipation of future income.


Principles of Value

The principle of substitution states that the present value of a property is influenced by what a person would have to pay for a reasonably desirable substitute.


Principles of Value

The principle of competition states that demand creates profits, profits create competition, and competition stabilizes prices.


Principles of Value

The principle of change reminds us that real property uses are always in a state of change.


Principles of Value

The principle of conformity holds that maximum value was realize when there is a reasonable degree of homogeneity in the neighborhood.


Principles of Value

The highest and best use of a property is the use that will give the property it's greatest current value.


Principles of Value

The principle of supply and demand refers to the ability of people to pay for land coupled with the relative scarcity of land.


Principles of Value

On the demand side, you should consider population growth, personal income, and personal references.

On the supply side, you must look at the available supply of land and its relative scarcity.


Principles of Value

When the supply of land is limited and demand is great, the result is rising land prices.

Where land is abundant and there are relatively few buyers, the result is falling land prices.


Principles of Value

The principle of increasing returns states that a dollar spent adds a dollar to cost but more than a dollar to value.

The principle of decreasing returns states that a dollar spent adds a dollar to cost but less than a dollar to value.


Principles of Value

The principle of contribution states that the worth of an improvement is measured by what it adds in overall value regardless of the cost.


Multiple Meanings of the Word Value

Assessed value is value given to a property by the county tax assessor.

Estate tax value is the value that federal and state taxation authorities establish for a deceased person's property.


Multiple Meanings of the Word Value

Insurance value is concerned with the cost of replacing damaged property.

Loan value is the value set on a property for the purpose of making a loan.


Plottage Value

When two or more adjoining parcels are combined into one large parcel, it is called assemblage.


Plottage Value

If the assemblage causes an increase in value over the cost, the process is referred to as plottage.

The increased value of the large parcel over and above the some of the smaller parcels is called plottage value.


Rental Value

Rental value is the value of a property expressed in terms of the right to its use for a specific period of time.


Replacement Value

Replacement value is value as measured by the current cost of building a structure of equivalent utility.


Value

Before preparing an appraisal, make certain you know its purpose, and then state it the beginning of your report.


Buyer’s and Seller’s Markets

When supply and demand are unbalanced because of excess supply, a buyer's market exists.

When demand exceeds supply, it is a seller's market.


Value Approaches

There are three approaches to making a value estimate.

The first is to locate similar properties that have sold recently. This is the market approach, also called the market data approach or market comparison approach.


Value Approaches

The second approach is to add together the cost of the individual components that make up the property being appraised. This is the cost approach.


Value Approaches

Depreciation is estimated and subtracted from the cost to obtain the current depreciated cost of the building.

The land value is then estimated and added to the depreciated building cost to arrive at the estimate of value.


Value Approaches

The third approach is to consider only the amount of net income that the property can reasonably be expected to produce for the owner, plus or minus any anticipated price increase or decrease.

This is the income approach.


Market Comparison Approach

In a market comparison approach, the residence to be appraised is called the subject property.


Comparables

After becoming familiar with the physical features and amenities of the subject property, the next step is to locate houses with similar physical features and amenities that have sold recently.

These are known as comparables or “comps”.


Comparables

The more similar they are to the subject property, the fewer and smaller the adjustments that must be made.

It is best to use comparable sales no more than six months old.


Number of Comparables

Three to five comparables usually provide enough basis for reliable comparison.

Choose the sales that require the fewest adjustments.


Number of Comparables

Listings and offers to buy should not be used in place of actual sales. They do not represent a meeting of minds between a buyer and a seller.


Adjustment Process

We make adjustments to the sales price of each comparable to make it equivalent to the subject property today.

ALWAYS adjust the comparable, NEVER the subject.


Adjustment Process

Remember the abbreviations CIA and CBS


Comp InferiorAdd

CompBetterSubtract

Terms and Conditions of Sale

As a rule, the more accommodating the terms of the sale to the buyer, the higher the sales price, and vice versa.


Terms and Conditions of SaleWe are looking for the highest cash price the subject property may reasonably be expected to bring, given adequate exposure to the marketplace and a knowledgeable buyer and seller not under undue pressure.


Correlation Process

Some comparables are more like the subject property than others.

The correlation process gives the appraiser the opportunity to assign more weight to the more similar comparables and less to the others.


Vacant Land Valuation

Subdivided lots zoned for commercial, industrial, or apartment buildings are usually appraised and sold on a square foot basis.

Another method is to value on a front foot basis.


Competitive Market Analysis

The competitive market analysis is also commonly known as a CMA.



This method is based on the principle that value can be estimated not only by looking at similar homes that have sold recently but also by taking into account homes presently on the market plus homes that were listed for sale but did not sell.



The CMA is a listing tool that a sales agent prepares in order to show a seller what the home is likely to sell for.

The CMA helps the agent decide whether or not to except the listing.


Homes for Sale

The CMA will show similar homes currently offered for sale.

These are homes the seller's property will compete against in the marketplace.


Buyer Appeal

Factors that make a property more appealing to a buyer include good location, extra features, small down payment, low interest, meticulous maintenance, and a price below market.


Buyer Appeal

A property is more salable if the sellers are motivated to sell, want to sell soon, will help with financing, and will list at or below market.


Buyer Appeal

In addition to single-family houses the CMA can also be used on condominiums, cooperative apartments, townhouses, and vacant lots, provided sufficient comparables are available.


Gross Rent Multipliers

When a property produces income, a popular market comparison method is the gross rent multiplier or GRM.

The GRM relates the gross rent a property can produce to its purchase price.



GRM is computed by dividing the sales price of the property by its gross annual rent.

If you do work a GRM for a house, it is customary to use the monthly, not yearly, rent.



The GRM method is simple to apply. GRM takes into account only the gross rental property produces.

Gross rent does not allow for variations in vacancies, uncollectible rents, property taxes, maintenance, management, insurance, utilities, or reserves for replacements.



The GRM also overlooks the expected economic lifespan of a property.


Sales Price

Gross Rent= GRM

$700,000

$100,000= 7 GRM

Calculating a GRM


Building Sales Price GrossAnnualRents

Gross RentMultiplier

No.1 $245,000 $34,900 = 7.02

No.2 $160,000 $22,988 = 6.96

No.3 $204,000 $29,352 = 6.95

No.4

As a Group:

$196,000

$805,000

$27,762

$115,002

= 7.06

= 7.00

Cost ApproachThe market approach is of limited usefulness in valuing a fire station, school building, courthouse, or highway bridge.

These properties are rarely placed on the market, and comparables are rarely found.

The cost approach would be the most appropriate valuation tool for those situations.© 2015 OnCourse Learning

Cost Approach


Step 1: Estimate land as vacant $ 30,000

Step 2: Estimate new construction cost of similar building $120,000

Step 3: Less estimated depreciation -12,000

Step 4: Indicated value of building $108,000

Step 5: Appraised property value $138,000 by the cost approach

Estimating New Construction Costs

Reproduction cost is the cost at today's prices of constructing an exact replica of the subject improvements using the same or very similar materials.


Estimating New Construction CostsReplacement cost is the cost, at today's prices and using today's methods of construction, for an improvement having the same or equivalent usefulness as the subject property.

Replacement cost is the more practical choice.


Square-Foot MethodThe most widely used approach for estimated construction cost is the square-foot method.

It is based on finding a newly constructed building that is similar to the subject building in size, design, materials and construction.

The cost of this building is converted to cost per square foot.


Square-Foot Method


Quantity Survey Method

The most accurate but also the most time-consuming and difficult method to estimate construction cost is the quantity survey method.

This estimates the cost of the building brick by brick, board by board.


Unit in Place

The unit in place method takes into consideration the cost of the unit of construction inclusive of labor and materials and then estimates how many units would be needed.


Physical DepreciationPhysical deterioration results from wear and tear through use.

Actions of nature in the form of sun, rain, heat, cold, and wind. Physical deterioration can also result from neglect.


Functional Obsolescence

Functional obsolescence results from outmoded equipment, faulty or outdated design, inadequate structural facilities and over-adequate structural facilities.


Curable Depreciation

Curable depreciation is when the benefit to cure equals or exceeds the cost to cure.


Incurable Depreciation

Incurable depreciation occurs when the cost to cure exceeds the economic benefit.


Economic ObsolescenceEconomic obsolescence is also known as external obsolescence. It is the loss of value due to external forces or events.

Economic obsolescence is always considered to be incurable.


Economic Obsolescence

The chronological age of the building is important to value. What is more important is the remaining economic life of the building and whether it is functionally adequate for use in the future.


Computing Depreciation

The most common method of computing depreciation is the straight-line method.

Actual age is the age of the property measured in years. Effective age is the age the building appears to be.

It may appear older or newer.



Physical life is the number of years a building will be physically sound. Economic life is how long the building can continue to be productive.

Economic life is always shorter than physical life.



To compute straight-line depreciation, the cost of the building is divided by the economic life.

The resulting depreciation per year is multiplied by the effective age.




Building Cost

Economic Life= Depreciation per Year

Depreciation per Year X Effective Age = Accrued Depreciation

Depreciation Example


2,000 sq. ft bldg. x $68 per sq. ft. = $136,000 Cost New

X 10 Year Effective Age

$136,000 Cost New60-Year Economic Life

= $22,66.67 Depreciation per yr

$2,266.6667 Depreciation per year

$22,666.67 rounded to $22,700.00

Final Steps in the Cost Approach

• Current Construction Costs• Minus Depreciation• Plus Land

Equals total value of property


Income Approach

The income approach considers the monetary returns a property can be expected to produce and converts that into a value the property should sell for if placed on the market today.

To capitalize means to convert future income to current value.


Income Approach


Income

Rate= Value

$18,0000.09

= $200,000

Income and Expense Forecasting

The best starting point is to look at the actual record of income and expenses for the subject property over the past 3 to 5 years.


Income and Expense Forecasting

This is the projected gross, or scheduled gross, and represents expected rentals from the subject property on a fully occupied basis.

Vacancy and collection losses are subtracted from this.


Operating Expenses

The next step is to itemize anticipated operating expenses.

We must consider both the properties past operating expenses and what we expect those expenses to be in the future.


Operating Expenses

Improvements are not classified as expenses because they increase the usefulness of the property, which increases the rent the property will generate and therefore the properties value.


Operating Statement


Scheduled Gross Annual Income $84,000Vacancy Allowance and Collection Losses 4,200Effective Gross Income $79,800

Operating ExpensesProperty Taxes $ 9,600Hazard and liability insurance 1,240Property management 5,040Janitorial services 1,500Gardener 1,200Utilities 3,940Trash pickup 600Repairs and maintenance 5,000Other 1,330Reserves for replacement Furniture & furnishings 1,200 Stoves & refrigerators 600 Furnace &/or air conditioning 700 Plumbing & electrical 800 Roof 750 Exterior painting 900

Total Operating Expenses 34,400

Net Operating Income $45,400Operating Expense Ratio: $34,400 / $79,800 = 43.1%

Operating Expense Ratio


Operating Expenses

Effective Gross Income

= Operating Expense Ratio

Reserves

Reserves for replacement are established for items that do not require an expenditure of cash each year.

Reserves are established for other items that must be replaced or repaired more than once during the life of the building, but not yearly.


Net Operating Income

The operating expense total is then subtracted from the effective gross income.

The balance that remains is the net operating income (NOI).


Operating Expense Ratio

The operating expense ratio can be calculated by dividing the total operating expenses by the effective gross income.


Capitalizing Income

The final step in the income approach is to capitalize the net operating income.

What price should an investor offer to pay for a property that produces a given that income per year?


Capitalizing Income

The solution is income divided by rate equals value.


Income

Overall Rate= Value

Depreciation

Fictional depreciation is what the US treasury allows property owners to deduct as an expense when calculating income taxes.


Depreciation

The Internal Revenue Service allows a purchaser of an apartment building to completely depreciate the structure over a period of 27 1/2 years regardless of the age and condition of the structure.


Choice of Approaches

When appraising a property that is bought for investment purposes, the income approach is the primary method of valuation.

The cost approach can be used to determine whether it would be cheaper to buy land and build rather than to buy an existing building.


Reconciliation


Market Approach $180,000 x 75% = $135,000

Cost Approach $200,000 x 20% = $ 40,000Income Approach $160,000 x 5% = $ 8,000

Final Indicated Value $183,000

Appraiser’s Best Estimate

The appraised value is the appraiser's best estimate of the subject property's worth.

An appraisal is made as of a specific date.

It is not a certificate of value, good forever until use.


Appraiser’s Best Estimate

An appraisal does not guarantee that the property will sell for the appraised market value.

The buyer and the seller determine the actual selling price.


Formats of Appraisal Reports

There are three traditional formats to written reports.


The Letter ReportThe least formal report is the letter report.

It contains the conditions of the assignment, a summary of the nature and scope of the appraiser's investigation, and an opinion of value.


The Form Report

The form report is an appraisal made on a preprinted form.

This is the most common type of report used for real estate loan appraisals.


The Narrative Report

The narrative appraisal is the longest and most formal of the appraisal reports.


Documents

Chapter 17. Georgia Real Estate An Introduction to the Profession Eighth Edition Chapter 17 Real Estate Appraisal