SHORT INTRODUCTION TO CALIFORNIA REAL ESTATE PRINCIPLES,
© 1994 by Home Study, Inc. dba American Schools
Educational Objectives: Learn about Architectural and Economic Aspects, Methods and Valuation Principles, Methods of Site Valuation, Sales Comparison, Cost Approach, Income Capitalization Approach, R. E. TERMS GLOSSARY, INDEX.
The determination of fair market value is central to every real estate transaction. The real estate broker and associate should be familiar with value and how It Is estimated. The word value is subject to many interpretations and may mean different things to the same person at different times. To estimate the value of a specific parcel of real estate, it is necessary first to determine what type and for whom the value is to be measured.
Value may be qualified by a variety of specific adjectives which specify the type value being sought. The banker usually is looking for loan value. To the assessor, the value measure being sought is assessed value; the insurance agent seeks insured value. An accountant looks for book value. Potential buyers need to know value-in-use, value-in-exchange and investment values. To the seller, the value measures being sought are exchange value or market value.
Economic concepts of value
Value may be considered the present worth of future benefits. In the economic sense, value is the power of a good or service to command other goods or services in exchange. Value, however, is constantly changing, and must be defined by type and in light of current economic conditions.
Value-in-use is the ability of an economic good to produce income or amenities (non-monetary benefits) for the owner. Utility value is subjective in nature and may differ for individuals since everyone may not perceive the usefulness of an object in the same way. Utility value forms the basis for the market and income approaches in appraising.
Exchange value is determined in the marketplace, under purely competitive market conditions, and is the most probable price at which a willing buyer would buy and a willing seller would sell, neither being under undue pressure, and both being fully informed about the various uses of the property. This value can be objectively estimated through observing both past and present actions of buyers and sellers in the marketplace. The market data direct sales comparison approach to appraising is derived from this concept.
Cost of production is the value, expressed as the cost in monetary terms, of the agents in production (land, labor, capital and entrepreneurship) required to produce an economic good. Economic theory holds that larger amounts of the agents in production produce greater net income up to certain point (the law of increasing returns). At this point, the maximum value is developed (the point of decreasing returns). Any additional expenditures do not produce a return commensurate with the additional investment (the law of diminishing returns). The cost of production can be objectively measured and forms the basis for the cost approach in appraising.
Supply and demand value is the price established in a competitive market. If supply exceeds demand, prices will fall and demand will be stimulated. Conversely, if demand for a product exceeds the available supply, prices will rise. Real estate markets are slow to adjust to changes in supply and demand because it takes a relatively long time to increase the supply through new construction, and, once built, these buildings remain on the market even when demand declines.
Value vs. price vs. cost value is a market concept and, therefore, reflects market conditions at a given time. In appraisal, it is the most probable selling price. Theoretically, value and price should be identical. However, a market price (actual selling price) may reflect financing terms or unusual conditions and not solely represent market value. Cost is the outlay of capital required. In most circumstances, cost will set an upper limit to value. Both price and cost are historical in nature while value is forward looking None of these concepts equate to the others, but in combination and by comparison a probable price can be estimated.
Anything which has value possesses certain identifiable characteristics. These characteristics apply equally well to a loaf of bread, a gallon of gasoline, or to a parcel of real estate. Without any one of them, no value exists.
To have value, real estate must be able to satisfy human needs or desires. The utility value varies from person to person since no two people have exactly the same needs. Utility is not inherent in the real estate itself, but appears when people realize and implement its uses.
For anything to have value, it must be scarce. Real estate in urban areas is relatively more limited than land in rural areas. Therefore, the price per unit is higher and value is greater.
The demand for real estate influences value. Demand is frequently measured in terms of the economic base of an area created by those industries which provide goods or services for export or consumption outside the area. These industries cause money to flow into an area which in turn creates a demand for real estate as well as other goods and services. Demand must be supported by purchasers able to buy or it is not effective demand.
While real estate is not portable as are most goods, the rights in real property are transferred from one to another. The ability of these rights in real property to command money or other goods in exchange is an important characteristic of value.
Kinds of value
Value may be divided into categories by type or purpose of the appraisal. In reality, all types of value have the marketplace as a reference point. In most cases, value, other than market value, has merely been adjusted to reflect the purpose of the value estimate.
The most common reason for an appraisal is to estimate market value. Market value is the same as value in exchange, being 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, knowledgeably and assuming the price is not affected by undue stimulus.
Assessed value is established for the purpose of distributing the cost of local government in some equitable fashion. It is usually expressed as a percentage of market value at a given time.
Value that would be covered under insurance is the cost related to reproducing the structure only, since land value is not included.
Condemnation value is estimated in condemnation proceedings and is by legal definition the same as market value. In a partial taking, value may include damages to the remaining property.
The value of a lessee's interest in real property is the leasehold value. The rights valued would include use, duration of possession and enjoyment, but not disposition.
Retrospective value is the value of the property as of a previous date.
Going concern value which includes the value of goodwill, salvage value, and cash value are other common values that may be used.
Principles of value
The following basic principles of value apply to every appraisal analysis. They apply whenever scarce resources must be allocated among competing, alternative uses. In a market economy, such as ours, price is the rationing mechanism for allocating the scarce resource, real property.
Highest and best use is the overriding principle for value. Only when property is developed at its highest and best use will value be at a maximum. Highest and best use is that which is possible under current regulations, reasonable use of the site and current or probable use in the near future. A site can have only one highest and best use at a given time. Improved property is assumed to be at its highest and best use until it can be shown that the site value without the improvement exceeds the combined value of the site and current improvement. Highest and best use can change over time. A lot with an old single family home in an area that has become commercial is probably no longer highest and best use as it may once have been.
The principle of substitution implies that a purchaser would pay no more for a parcel of realestate than the cost of acquiring a substitute. This substitute can be either a similar property or an investment which would provide a similar return. The return is usually measured in monetary terms. For example, an investor would be indifferent between investing in the stock market or real estate if both would provide the same dollar return and carried the same risk. One investment would substitute for the other. The return may also be measured in the form of amenities. A home buyer may perceive that a three bedroom house on one street is a substitute for a similar house on another street. However, if the first house was perceived to he more conveniently located, they would not be substitutes.
To estimate value, the appraiser must be able to identify current market conditions; that is, market conditions that prevail at a given moment. However, recognition must be given to the principle of change.
The physical, legal, social and economic forces comprising the environment within which real estate is located are constantly changing. Change may be occurring so Slowly that to the inexperienced observer it is indiscernible, but the appraiser is trained to recognize not only the obvious but also the subtle indications which lead to change.
The appraiser views real property and its environment as though it is in a state of constant transition. He takes note of the past history of the property, its present state, and modifies the past trends and presents statistics with analysis and judgment to forecast the property's value. For example, the appraiser observes and identifies the phase of development of the subject neighborhood life cycle, whether it is in the development state, stable stage, declining and deteriorating state, or a rehabilitation state. The appraiser then considers what these states mean to the value of the subject property.
The amount of value one component adds to total value is its contribution. The additional income generated by the component must exceed its cost or it will detract from, rather than contribute to, value. The appraiser uses the principle of contribution to estimate accrued depreciation under the cost approach to value.
The value of income producing property is affected by the anticipated future income flows expected over time. This can be in the form of an annual yield on money invested or it may be in the form of income tax savings or capital gains when the property is sold. More than likely, the return will be measured by all three of the above or some combination of them. Returns may be magnified when investors use leverage (borrow) to finance property. '
Balance of uses is the combination of land uses in an area. Not all land in a city can be single family residential. There must also be apartments, businesses, schools, parks, and public uses.
The principle of balance is also referred to as the principle of conformity or the principle of homogeneity. This principle holds that maximum value is realized when a reasonable degree of similarity of property types and land usage is attained in an area or neighborhood as well as similar economic backgrounds for the inhabitants. Neighborhoods which have a similarity in terms of income levels and age composition of inhabitants tend to have higher real estate values than neighborhoods which have wide disparities in the make-up of inhabitant characteristics for these variables. Conformity does not necessarily imply monotony, however.
Areas which have land-uses that interact favorably and are compatible with one another have higher values than neighborhoods with incompatible land uses. For example, residential neighborhoods with appropriate recreational areas, adequate shopping, and proper street layouts providing accessibility and convenience to places of employment have higher values than residential neighborhoods encroached upon by industrial complexes which cause air pollution and noise, and create heavy traffic endangering the safety of children playing in the area.
Appropriate balance also refers to the proper combination of factors of production being assembled on a specific site. When an over improvement or superadequacy is made to a site, the effect is to decrease the value of the subject site to the approximate level of surrounding properties. This is known as the concept of regression. For example, if a high quality $100,000 improvement is made in an area comprised predominantly of $50,000 houses, the effect on value would be to decrease the value of the $100,000 unit.
In like manner, where an under improvement or deficiency exists on a site, the effect is to increase the value in a conforming neighborhood. Known as the concept of progression, it suggests low value property is positively affected by the proximity of more valuable properties while the concept of regression suggests expensive properties are affected adversely by the proximity of less expensive properties.
External economies or diseconomies over which a property owner has no control can have a positive or negative effect upon value. Real estate is especially subject to the effects of externalities ranging from population shifts to local government policies and administration, property taxes and social attitudes. Appraisers must be familiar with external conditions and events and be able to assess their impact on individual property values.
All real estate is immobile and fixed in its location and is a prisoner of its surroundings and the forces which affect and influence its environment. Therefore, the appraiser must observe changes which occur in their externalities and analyze their potential for creating, modifying, and destroying value. A change in zoning regulations, in the age composition of the inhabitants of a neighborhood, in income levels or in mortgage interest rates, all have the potential of affecting the value of real estate positively or adversely.
Normal competition will preserve value. If there is little competition, excess profits will be made. Eventually others will be drawn into the market, wiping away the excess profit, sometimes causing ruinous competition.
Supply and demand
The principle of supply and demand is that price varies directly but not necessarily proportionately, with demand, and inversely, but not necessarily proportionately with supply.
The greater the supply of an item, the lower will be its value. The supply of homes in an area is affected by construction costs, supply of skilled labor, capital costs, land availability, and natural resources. A buyer's market exists when a buyer is in a more commanding position as to price and terms because real property offered for sale is in plentiful supply in relation to demand.
The demand side of the market can be influenced by the population's age, taste, income, numbers, composition, in-migration/emigration, and the availability and cost of housing and credit. A seller's market exists when a seller is in a more commanding position as to price and terms because demand exceeds supply.
The economic life of a property is the number of years over which the improvements are expected to or do render services exceeding the costs of operation. Theoretically, when property has been totally depreciated, it has no remaining value. Its economic life has been fulfilled. However, the economic life of a property is its useful life and not necessarily book value or the physical life of the improvements.
Depreciation, therefore, cannot be measured using the actual age of property. If property has been kept in good repair, the effective age may be less than chronological age. On the other hand, neglect and poor maintenance may contribute to a reduction in the estimated remaining life of the property. Therefore, the effective age may or may not be the same as chronological age. Effective age is how old the property appears to be in the eyes of the appraiser.
An appraiser's estimate of value should reflect the opinion of an average person reacting in the current market. The appraiser must be familiar with economic theory and prevailing economic conditions, as well as building construction, surveying, and finance. Reaching a final value estimate is the product of the appraiser's research, skill, and judgment.
In estimating property value, the appraiser would use one or more of the market, cost, or income approaches. Theoretically, all three should lead to the same value estimate. However, in practice they seldom produce the same estimate. Increasing emphasis is being placed on the market approach as the best indicator of value on residential property, but not necessarily on commercial or income producing property.
The rationale for the market data approach in appraising real property comes from the concept of value in exchange and substituting. The process used by the appraiser involves comparing the subject property, the property being appraised, with similar properties (comparables) that have sold recently. The market data approach is also referred to as the direct sales comparison approach. Basic to the use of the market data approach is a relatively active real estate market. This approach is most often used in appraising residential property as generally little difficulty is incurred in finding recent comparable sales. The market data approach becomes more difficult to apply in appraising commercial and special purpose properties. The market for commercial property may not be active enough to provide the appraiser with recent comparable sales or the property may be so specialized, like hospitals and churches, that no comparable sales are available.
The first step in using the market data approach is to identify the relevant market area. The appraiser moves from the general area, usually state and city to the more specific area, usually the neighborhood. The neighborhood is a complex socio-economic structure as well as a physical area and the value of property is affected by the size, condition and social environment of the neighborhood. The accessibility of the neighborhood to shopping, jobs and schools, legal restrictions, availability of public services, and natural terrain are all considered by the appraiser. Supply and demand factors at work in the area would be investigated to identify their impact on property value.
The second step is to collect information on the subject property and on comparable properties. The type of property data gathered by the appraiser includes date of sale, type of financing and pertinent physical factors as well as any unique characteristic that might affect value. The physical factors are size and location of the lot, size of the building, number and type of rooms, type of construction, and general condition and age of the improvements. A hundred percent location is the site best adapted to carrying on a given type of business.
The appraiser then analyzes recent sales of property similar to the subject property, compares them to the subject property, and makes adjustments for any differences found. me information on comparable sales can be taken from public records, real estate agents, or current owners. Many large cities have businesses which maintain data plants containing information on real estate sales. All data obtained by the appraiser should be carefully verified before it is used.
The adjustments in appraising are always made to the comparables to make them more similar to the subject property. Never adjust the subject property. The appraiser begins to make adjustments either in dollar amounts or percentage value to the comparable sales. If the comparables are poorer in some characteristic than the subject property, value is added. If they are better than the subject property, value is subtracted.
1. The first adjustment made is for date of sale. Value is affected by the passing of time. The farther removed the sale of a comparable is from the date of the appraisal, the more difficult it is to adjust for time.
2. The single factor that usually has the greatest bearing on the value of real estate is location. Properties, even though quite similar, may have different values, either because they are in different neighborhoods or because they are in a different part of the same neighborhood.
3. It may be necessary for the appraiser to adjust for physical characteristics such as square feet of living area, the presence or lack of central heat and air, condition of the improvements, etc.
4. Since buyers are frequently willing to pay a higher price for a property in exchange for more favorable financing terms (an equity sale where the buyer can assume a low interest rate), the appraiser must investigate the type of financing to be used. Also, in order to be legitimate comparables, sales must be arms length transactions, not subject to the control or dominance of one of the parties. The sale between related persons or a forced sale would not be a valid comparable.
5. After the appraiser makes the adjustments, the adjusted sales price of the comparables provide a value range for the subject property, From this value range the appraiser would establish an indicated market value for the subject property. Usually the comparable requiring fewer adjustments is the most reliable indication of market value.
Direct Sales Comparison Example: The subject property is a nine year old brick veneer single family residence located in a middle class neighborhood of similar homes. The house contains 1993 square feet of living area and has a two car attached garage but no patio. It is in slightly less than average condition. The market in this area has been fairly stable over the last year. The appraiser was able to locate three similar homes that have recently sold and are in the same general area. All three are very similar to the subject except for some minor adjustments.
Comparable No. 1 is located one block away from the subject property. It is in average condition, is 218 square feet smaller than the subject and has an open patio. It sold six months prior to the effective date of the appraisal for $60,000.
Comparable No. 2 is located two blocks away from the subject. It is 171 square feet smaller than the subject, in about the same condition and it has a nice covered patio. It sold seven months ago for $58,000.
Comparable No. 3 is located three blocks away. It is 118 square feet smaller than the subject, is in about the same condition and has an open patio. It sold nine months ago for $54,000.
The adjustments and the indicated value arrived at by the sales comparison approach for this appraisal can be seen in the sample appraisal form on the following page.
B. The Cost Approach
The cost approach is derived from the principle of substitution and contribution. A distinction must be made between reproduction cost and replacement cost. Reproduction cost is the cost to construct an exact duplicate of the building including any functional obsolescence which may be present. Replacement cost is the cost of constructing a substitute building with equal utility but without functional obsolescence or necessarily the same materials and construction techniques. The appraiser selects the replacement cost of a building as a guide in the cost approach.
Four steps are involved in the cost approach.,
1. Determine the value of the land as if vacant and theoretically put it to its highest and best use. The direct sales comparison or market data approach is used to value the land.
2. Estimate the replacement cost new of the improvements as of the date of appraisal. Three alternative methods of estimating the replacement cost are: the quantity survey methods, the trade breakdown method, and the square foot or cubic foot method.
A. In the quantity survey method, the different quantities of materials needed to replace the structure are calculated and multiplied by the price of each to estimate material cost. To this is added the number of hours of labor times the hourly wage, plus a necessary sum for overhead and profit.
B. The trade breakdown method estimates replacement cost by breaking the building down into major functional parts or units. The cost of these units are developed from current market data and then multiplied by the appropriate measure. For example, if rough-in-framing costs $1 per linear foot installed (materials and labor), and 2000 linear feet of lumber were needed, the unit costs of each component are summed and added for indirect costs.
C. The square foot/cubic foot methods is the easiest to use and the most common. To use the square foot or cubic foot method the cost of a new building. similar to the subject property, is average over the size of the building. The resulting factor can then be applied to the subject property and replacement estimated. If, for example, general office buildings are estimated to cost $45 per cost square foot to construct and the subject property contains 5000 square feet of area, the replacement cost indicated would be $225,000. When figuring square footage of a house for appraisal purposes, outside measurements are used.
3. Estimate accrued depreciation from all sources and deduct it from replacement cost new. Depreciation is the loss in value from any and all causes while obsolescence is loss in value due to reduced desirability or usefulness. Accrued depreciation includes both and is the difference between replacement cost and market value, having nothing to do with the depreciation expense used on income statements for tax purposes. Usually accrued depreciation is broken down into physical deterioration, functional obsolescence and economic obsolescence.
A. Physical depreciation or physical deterioration is the loss in value resulting from normal wear and tear or from the action of the elements. Appraisers estimate this depreciation and classify it as curable depreciation or as incurable depreciation. If the cost to cure is less than or equal to value added, it is classed as curable physical depreciation. If the cost to cure is greater than value added, it is classed as incurable. Painting the trim or repairing window screens would probably be classed as curable, while structural decay too costly to repair, is incurable. Deferred maintenance is deterioration or loss of value resulting from postponed maintenance or neglect.
B. Functional obsolescence, the loss in value due to a change in technology, materials, or tastes, is also divided into curable and incurable forms. Small rooms, high ceilings, inadequate or outmoded plumbing, heating or air conditioning equipment would be classified as functionally obsolete if their presence cause a decline in demand or utility.
C. External or economic obsolescence is a loss in value due to an influence external to the subject property. These influences can be a change in neighborhood, encroachment of nuisances, or other negative externalities which affect the subject property and which can be measured.
4. Add the estimated land value to the depreciated replacement cost to reach a value estimate. The value estimate resulting from the summation of these steps should reflect market value. However, in some cases market value may exceed replacement cost.
The cost approach depends heavily on the appraiser's ability to measure depreciation and the market response to it. The cost approach is most easily used in appraising new or nearly new buildings which have suffered very little depreciation. Depreciation cannot be measured using the actual age of the property. If property has been kept in good repair, the effective age may be less than chronological age.
Cost Approach Example: Estimated market value of a 10 year old office building. The subject property is a 10 year old two story office building located on a 2.5 acre lot in an older section of town. The building is in fairly good condition both inside and out and except for the enclosing of an open stairway in order to meet current fire codes. (See calculation example following.)
Cost Approach--Calculation Example
Per Square Foot (new construction) $45.00
Central Air Conditioning 5.00
Sprinkler System 2.00
Total Per Square Foot Cost $52.00
Replace Cost of Building
6000 Square Feet x $52.00$312,000
Repaint Exterior $1,200.00
Replace Hall Tile 3,000.00
Total Curable $4,200.00
Structural Decay of Foundation
Estimated at 10% of cost
of $60,000) $6,000.00
Functional Obsolescence Curable:
Replace Poor Lighting $4,700.00
Enclose Stairway 8,000.00
Total Curable $12,700.00
Loss in Value Due to Poor
Floor Plan, estimated to be
5% of Replacement Cost $15,600.00
Value loss due to encroachment
of dilapidated buildings and traffic congestion, (estimated
Rent Loss Per Month Due to Location, $208;
Annual Rent Loss $208 x 12 = $2496;
Capitalized at 10%)$24,960
Total Depreciation from All Sources-63,460
Estimated Depreciated Building Value$248,540
Land Value, 2.5 Acres @ $8,000 per acre20,000
(Value Based on Market Comparison)
Estimated Market Value$268,540
C. The Income Approach
The economic concept of utility value and the principle of substitution provide the framework for the income approach to appraising. In this approach, emphasis is placed on the future stream of income that the property is expected to produce. It is an estimate of the value today of the ability to command money, either in the form of income or capital gains, or both, in the future.
The maximum gross possible income from all sources (rental income, parking, vending machines) that the property is expected to produce at 100% occupancy is first estimated. Current contract rent may not represent the maximum rent that could be produced if the property was operated under ideal management conditions,
An allowance for vacancy and collection losses is estimated and subtracted from gross possible income to arrive at effective gross income. Vacancy and collection losses are usually expressed as a percentage of rental income.
All annual operating expenses, those expenses necessary to keep the producing income, are subtracted from effective gross income to obtain the net operating income. Not included in operating expenses are any deductions for loan payments, depreciation, state and federal income taxes, or expenses of a personal nature. In addition, the operating statement must be treated to reflect annual expense even if actual payment is made on some basis other than on annual basis. Typical operating expenses are salaries, management fees, utilities, supplies, reserved for wasting parts, hazard insurance, ad valorem taxes, and accounting and legal fees.
Once net operating income has been determined, it is processed into a present value of land and buildings. The method for computing value based on anticipated net operating income is called capitalization. In applying the income approach, the appraiser usually bases the final value estimate on both the return over time and resale value at some future point in time.
The capitalization rate is the rate of return (yield) that an investor expects to earn on invested money. It is composed of the discount rate, which allows for return on investment or Interest, and the recapture rate, which allows for return of investment during the period of ownership.
Gross Rent Multipliers
A relationship between sales price and gross rent can be observed in the market place. Gross rent multipliers (GRM) provide a fairly reliable and easily calculated method of property valuation. The relationship is as follows:
Sales Price of Comparable/ Gross Rent of Comparable =
GRM x Gross Rent of Subject Property = Estimated Value
In order to use this method of valuation, the required information from a sufficient number of rental properties that have sold recently must be available. The gross rent at 100% occupancy is used and if the other properties are truly comparable to the subject property, it can be assumed that operating expenses and vacancy rates will also be similar. Adjustments are not usually made in using GRM.
EXAMPLE: Assume the subject property is a single family residence located in a neighborhood of similar homes, many of which are rentals rather than being owner occupied. The properties have sold within the last year. Their sales prices, monthly gross rents, and GRM are:
Sales Price Monthly Gross Rent GRM
65,500 570 114.91
64,000 560 114.29
62,000 540 114.81
61,500 535 114.95
66,500 580 114.66
The subject property is currently being rented for $660 which multiplied by a gross rent multiplier of 114 indicates a market value of $63,840, rounded to $63,800. The GRM of 114 is probably the best estimate to use since it is most prevalent, the average GRM is 114.72 which produces a value of $63,899.
Correlation of approaches
The final process concerning the value estimates provided by the three approaches is called correlation. In the correlation process, the appraiser weighs the relative importance of the results previously obtained and reaches a single, final, supportable estimate of market value. Correlation involves the application of judgment and analysis. The final reconciliation does not involve averaging the three indications of value. It is highly unlikely that the three approaches to value will provide the appraiser with a single value estimate. The final value estimate is the opinion of the appraiser based on careful analysis and professional skill.
Types of appraisal reports
An appraisal report is basically a report to the client which is designed to convey the information gathered by the appraiser and the final value estimate. Regardless of form, all appraisals require the same analytical process. Three forms or types of reports are commonly used: the letter report, form report, and narrative report.
A letter report is a written opinion of value. It does not include the amount of detail found in either the form report or the narrative report. The property description, purpose of appraisal, date of appraisal, estimate of value, and the signature of the appraiser are included.
Many mortgage lenders and insurers require the use of a form in appraisal reporting. The form used most frequently is the Uniform Residential Appraiser Report. The required information is supplied by checking boxes or filling in blanks. Form reports provide the client with a standardized method of obtaining information on property.
A narrative report is the most formal and extensive type of appraisal report. It provides the client with not only the salient facts related to the appraisal, but also the analytical procedure used by the appraiser. The supporting data on state, city, neighborhood, and comparables, together with all the information pertaining to the subject property (pictures, floor-plan, plot) are included in the narrative report. The approaches to the appraisal are explained as well as the reasoning process used by the appraiser in reaching the final value estimate.
The appraisal process
Every appraisal is a research problem and as such requires the appraiser to follow a definite process. The steps the appraiser goes through in reaching a final value estimate are as follows:
The first objective of the appraiser is to identify the property to be appraised, the rights or interests that are included, and the purpose of the appraisal The effective date of the appraisal is established at this point.
A well defined problem will lead the appraiser to the appropriate information needed. At this point the appraiser plans the research process to be followed and outlines the appraisal report.
Once the type of data necessary to the problem has been identified, the appraiser begin to gather it Some information of a general nature applicable to the market area is probably contained in the appraiser's files and will be easy to gather. Information on specific market conditions that affect the property, data on comparables, and information concerning the property itself requires more effort on the part of the appraiser. In addition, all information which will be used in reaching the final estimate must be carefully verified and the sources noted.
The data analysis will lead to a determination of highest and best use. The highest and best use should coincide with the definition of the problem. If it is different, the appraiser must re-value the problem and the client's objective since obtaining the appraisal. The analysis will include adjusting comparables used in the market approach and reconciling their sales prices to an indicated market value of the subject property. In the cost approach, data analysis will lead to a depreciated reproduction or replacement cost new of the improvements to which site value will be added to reach a value estimate. The income approach may not be appropriate on owner occupied residential properties. However, if the property is income producing, the analysis will provide a value based on capitalizing net income.
Most appraisal problems require the appraiser to reach a single, final market value estimate. In reaching this conclusion, the appraiser reviews all of the information as well as the estimates provided by each approach. Each approach is viewed critically for appropriateness to the appraisal problem. More often than not, one approach will prove to be more appropriate than the others and is relied on more heavily by the appraiser. The final value reached by the appraiser is an estimate of value as of the date of the appraisal only, and as such, is usually rounded to the nearest hundred or even thousand dollars.
In some cases the appraiser may find it appropriate to indicate a range of values rather than a single estimate. Again this depends on the nature of the problem and the objective of the client in obtaining the appraisal.
The final step in the appraisal process is to write the report to the client. It should be complete enough to convey to the reader the procedures used by the appraiser in reaching the final estimate. The information is presented in such a manner that the reader will come to the same conclusion of value as has the appraiser.
Every appraisal report, regardless of form will contain:
1 A description of property, including the legal description, a physical description, and a description of the rights involved.
2. The objective of the appraisal as stated by the client.
3. Effective date of the appraisal.
4. The supporting data and the analysis of the appraiser.
5. The final value estimate.
6. Statement of limiting conditions and the liability of the appraiser.
7. The certification of the appraiser attesting to the accuracy and reliability of the information contained in the report.
8. The signature of the appraiser, professional designation and qualifications
Depreciation for tax purposes
Real estate remains one of the businesses permitted to write off more money than that which is at risk in an investment. For income tax purposes, depreciation is an important area so far as investors in real estate are concerned. The following four techniques for calculation of depreciation are for tax purposes and result in book value. They are not generally useful in estimating current fair market value.
Straight-line depreciation is the reduction of value of a property in equal amounts during each year of its projected life.
The declining balance method is an accelerated depreciation format that can be applied to new rental residential property. Using the double declining balance method, the first year's depreciation is twice that of a normal year's depreciation under the straight-line approach. In the second year, it is calculated on the remaining undepreciated balance. It never gets to full depreciation but will reach scrap value.
The 150% declining balance works the same as the double declining balance except that it figures one and one half of the straight-line technique rather than double.
The sum of the year's digits method is useful for accelerated depreciation. It permits total depreciation of value over the life of the property. It works on the principle that the sum of the year digits for 10, for example, is 55. The first year the depreciation will be charged at 10/55, and the second year at 9/55.The tenth and last year will be 1/55.
Appraiser ethics requirements
Appraisal ethics is a different subject of study from real estate ethics standards and the two should not be confused. The following is an excerpt from the Uniform Standards of Professional Appraisal Practice prepared by The Appraisal Foundation.
Because of the fiduciary responsibilities inherent in professional appraisal practice, the appraiser must observe the highest standards of professional ethics. This ethics Provision is divided into four sections: conduct, management, confidentiality , and record keeping.
Comment: This provision emphasizes the personal obligations and responsibilities of the individual appraiser. However, it should also be emphasized that groups and organizations engaged in appraisal practice share the same ethical obligations.
An appraiser must perform ethically and competently in accordance with these standards and not engage in conduct that is unlawful, unethical, or improper. An appraiser who could reasonably be perceived to act as a disinterested third party in rendering an unbiased appraisal, review, or consulting service must perform assignments with impartiality, objectivity, and independence and without accommodation of personal interests.
Comment: An appraiser is required to avoid any action that could be considered misleading or fraudulent. In particular, it is unethical for an appraiser to use or communicate a misleading or fraudulent report or to knowingly permit an employee or other person to communicate a misleading or fraudulent report.
The development of an appraisal, review, or consulting service based on a hypothetical condition is unethical unless: l) the use of the hypothesis is clearly disclosed; 2) the assumption of the hypothetical condition is clearly required for legal purposes, for purposes of reasonable analysis, or for purposes of comparison and would not be misleading; and 3) the report clearly describes the rationale for this assumption, the nature of the hypothetical condition, and its effect on the result of the appraisal, review, or consulting service.
An individual appraiser employed by a group or organization which conducts itself in a manner that does not conform to these standards should take steps that are appropriate under the circumstances to ensure compliance with the standards.
The acceptance of compensation that is contingent upon the reporting of a predetermined value or a direction in value that favors the cause of the client, the amount of the value estimate, the attainment of a stipulated result, or the occurrence of a subsequent event is unethical.
The payment of undisclosed fees, commissions or things of value in connection with the procurement of appraisal, review, or consulting assignments is unethical.
Comment: Disclosure of fees, commissions, or things of value connected to the procurement of an assignment should appear in the certification of a written report and in any transmittal letter in which conclusions are stated. In groups or organizations engaged in appraisal practice, intra-company payments to employees for business development are not considered to be unethical. Competency, rather than financial incentives, should be the primary basis for awarding an assignment.
Advertising for or soliciting appraisal assignments in a manner which is false, misleading or exaggerated is unethical.
Comment: In groups or organizations engaged in appraisal practice, decisions concerning finder or referral fees, contingent compensation, and advertising may not be the responsibility of an individual appraiser, but for a particular assignment, it is the responsibility of the individual appraiser to ascertain that there has been no breach of ethics, that the appraisal is prepared in accordance with these standards, and that the report can be properly certified as required by Standards Rules 2-3, 3-2, 5-3, 8-3 or 10-3.
The restriction on contingent compensation in the first paragraph of this section does not apply to consulting assignments where the appraiser is not acting in a disinterested manner and would not reasonably be perceived as performing a service that requires impartiality. This permitted contingent compensation must be properly disclosed in the report.
Comment: Assignments where the appraiser is not acting in a disinterested manner are further discussed in the General Comment to Standard 4. The preparer of the written report of such an assignment must certify that the compensation is contingent and must explain the basis for the contingency in the report (See Standards Rule 5-3) and in any transmittal letter in which conclusions are stated.
An appraiser must protect the confidential nature of the appraiser-client relationship.
Comment: An appraiser must not disclose confidential factual data obtained from a client or the results of an assignment prepared for a client to anyone other than:
1) the client and persons specifically authorized by the client;
2) such third parties as may be authorized by due process of law; and
3) a duly authorized professional peer review committee.
As a corollary, it is unethical for a member of a duly authorized professional peer review committee to disclose confidential information or factual data presented to the committee.
An appraiser must prepare written records of appraisal, review, and consulting assignments including oral testimony and reports-- and retain such records for a period of at least five (5) years after preparation or at least two (2) years after final disposition of any judicial proceeding in which testimony was given, whichever period expires last.
Comment: Written records of assignments include true copies of written reports, written summaries of oral testimony and reports (or a transcript of testimony), all data and statements required by these standards, and other information as may be required to support the findings and conclusions of the appraiser. The term written records also includes information stored on electronic, magnetic, or other media. Such records must be made available by the appraiser when required by due process of law or by a duly authorized professional peer review committee.
Prior to accepting an assignment or entering into an agreement to perform any assignment, an appraiser must properly identify the problem to be addressed and have the knowledge and experience to complete the assignment competently; or alternatively:
1. disclose the lack of knowledge and\or experience to the client before accepting the assignment; and
2. take all steps necessary or appropriate to complete the assignment competently; and
3. describe the lack of knowledge and\or experience and the steps taken to complete the assignment competently in the report.
Comment: The background and experience of appraisers varies widely and a lack of knowledge or experience can lead to inaccurate or inappropriate appraisal practice. The competency provision requires an appraiser to have both the knowledge and the experience required to perform a specific appraisal service competently. If an appraiser is offered the opportunity to perform an appraisal service but lacks the necessary knowledge or experience to complete it competently, the appraiser must disclose his or her lack of knowledge or experience to the client before accepting the assignment and then take the necessary or appropriate steps to complete the appraisal service competently. This may be accomplished in various ways including, but not limit ed to, personal study by the appraiser; association with an appraiser reasonably believed to have the necessary knowledge or experience; or retention of others who possess the required knowledge or experience.
Although this provision requires an appraiser to identify the problem and disclose any deficiency in competence prior to accepting an assignment, facts or conditions uncovered during the course of an assignment could cause an appraiser to discover that he or she lacks the required knowledge or experience to complete the assignment competently. At the point of such discovery, the appraiser is obligated to notify the clients and comply with items 2 and 3 of the provision.
The concept of competency also extends to appraisers who are requested or required to travel to geographic areas wherein they have no recent appraisal experience. An appraiser preparing an appraisal in an unfamiliar location must spend sufficient time to understand the nuances of the local market and the supply and demand factors relating to the specific property type and the location involved. Such understanding will not be imparted solely from a consideration of specific data such as demographics, costs, sales and rentals. The necessary understanding of local market conditions provides the bridge between a sale and a comparable sale or a rental and a comparable rental if an appraiser is not in a position to spend the necessary amount or time in a market area to obtain this understanding, affiliation with a qualified local appraiser may be the appropriate response to ensure the development of a competent appraisal.
With regard to mass appraisal as defined herein, an appraiser must immediately take all necessary steps to ensure the mass appraisal is developed under the supervision of an appraiser who has the qualifications referred to in Standard 6.
This provision permits limited exceptions to sections of the Uniform Standards that are classified as specific guidelines rather than binding requirements. The burden of proof is on the appraiser to decide before accepting a limited assignment that the result will not confuse or mislead. The burden of disclosure is also on the appraiser to report any limitations.
An appraiser may enter into an agreement to perform an assignment that calls for something less than, or different from, the work that would otherwise be required by the specific guidelines provided that prior to entering into such an agreement:
1. the appraiser has determined that the assignment to be performed is not so limited in scope that the resulting appraisal, review, or consulting service would tend to mislead or confuse the client, the users of the report, or the public; and
2. the appraiser has advised the client that the assignment calls for something less than, or different from, the work required by the specific guidelines and that the report will state the limited or differing scope of the appraisal, review, or consulting service.
Exceptions to the following requirements are not permitted. Standards Rules 1-1, 1-5, 2-1, 2-2, 2-3, 2-5, 3-1, 3-2, 4-1, 5-1, 5-3, 6-1, 6-5, 6-6, 7-1, 8-1, 8-3, 9-1, 9-3, 9-5, 10-1, 10-3 and 10-5.This restriction on departure is reiterated throughout the document with the reminder comment Departure from this binding requirement is not permitted.
Comment: Before making a decision to enter into an agreement for appraisal services calling for a departure from a specific appraisal guideline, an appraiser must use extreme care to determine whether the scope of the appraisal service so be performed is so limited that the resulting analysis, opinion, or conclusion would tend to mislead or confuse the client, the users of the report, or the public. For the purpose of this provision, users of the report might include parties such as lenders, employees of government agencies, limited partners of a client, and a client's attorney and accountant. In this context the purpose of the appraisal and the anticipated or possible use of the report are critical.
If an appraiser enters into an agreement to perform an appraisal service that calls for something less than, or different from, the work that would otherwise be required by the specific appraisal guidelines, Standards Rules 2-2(k), 5-2(i), 8-2(h), and 10-2(h) require that this fact be clearly and accurately set forth in the report.
The requirements of the departure provision may be satisfied by the technique of incorporating by reference.
For example, if an appraiser's complete file was introduced into evidence at a public hearing or public trial and the appraiser subsequently prepared a one-page report that 1) identified the property, 2) stated the value, and 3) stated that the value conclusion could not be properly understood without reference to his or her complete file and directed the reader to the complete file, the requirements of the departure provision would be satisfied if the appraiser's complete file contained, in coherent form, all the data and statements that are required by the Uniform Standards.
Another example would be an update report that expressly incorporated by reference all the background data, market conditions, assumptions, and limiting conditions that were contained in the original report prepared for the same client.
REQUIREMENT FOR APPRAISER LICENSING
Title XI of the Financial Institutions Reform, Recovery and Enforcement Act (FIRREA) of 1989, a federal law, requires all states to regulate individuals who appraise real property in federally related transactions. In response to that Act, the California Legislature created the Office of Real Estate Appraisers (OREA) and gave its Director the authority, within federal and state guidelines, to establish standards for real estate appraisals, set qualifications for real estate appraisers, and discipline real estate appraisers. In California, licensing and certification for appraisers involved in federally related transactions became mandatory on November 1, 1992.This law still allows real estate licensees to prepare a market data comparison on property for sale as a courtesy for clients without being licensed or certified appraisers.
Federally Related Transaction -- A Federally Related Transaction is any real estate transaction which requires the services of an appraiser and which is overseen by one of the following federal agencies:
Federal Reserve Board (FRB)
Federal Deposit Insurance Corporation (FDIC)
Office of the Comptroller of the Currency (OCC)
Office of Thrift Supervision (OTS)
National Credit Union Association (NCUA)
Resolution Trust Corporation (RTC)
Transactions overseen by other federal agencies may also require the services of a licensed or certified appraiser depending on individual agency policy.
Transaction Value -- Transaction Value is the amount of the loan, sale, lease, etc. It is not the appraised value.
For example, a property appraised at $150,000 but requiring a loan of $110,000 would have a transaction value of $110,000.
The transaction value determines the required level of the license or certificate needed by the appraiser who performs the appraisal, subject to additional lender requirements.
Levels of Licensing and certification
There are three levels or classifications of Real Estate Appraiser licensing and certification. They are listed below, along with a description of the scope of practice for each level.
Licensed (Full or Provisional)
Scope of Practice: Appraisal of 1 to 4 unit residential property up to a transaction value of $1,000,000 if non-complex or $250,000 if complex in nature.
This includes the appraisal of vacant land where the highest and best use is for 1 to 4 unit residential purposes. The provisional and the full license convey the same authority.
Complexity -- The complexity of a transaction is a judgment of the lending institution. A transaction may be determined to be complex if the property to be appraised is atypical, or if the form of ownership or market conditions are atypical. Some examples of complexity factors include:
Atypical ownership rights, such as life estates, residences constructed on leased land, or the involvement of subterranean or air rights. Also, unusual deed restrictions, easements, encroachments and other similar factors.
Changes in neighborhood characteristics suggesting that the highest and best use has changed.
Actual or suspected environmental hazards.
Certified Residential; Scope of Practice
Appraisal of one to four unit residential property without regard to transaction value or complexity.
This includes the appraisal of vacant or unimproved land where the highest and best use is for 1-4 family purposes.
Note that appraisal of small apartment buildings of five or more units is not authorized at this level.
Certified General; Scope of Practice
Appraisal of all real estate without regard to transaction value or complexity.
(The following is reprinted by permission from the CalBRE Reference Book, p.451-454, 708)
Appraisers, as well as real estate licensees, are expected to be familiar with the different building styles encountered in their practice.
Cape Cod and Cape Ann styles are: generally quite small in size- -minimum with good taste; symmetrical-windows balanced on both sides of front door; either one or one and one-half stories with little head room upstairs, fairly steep gable or gambrel roof covered with wood shingles; and, exterior of wood siding.
New England Colonial.
A square or rectangular, box-like structure having: maximum of usable space; symmetrical-windows balanced on both sides of front door; either two or two and one-half stories gable roof covered with wood shingles; exterior of wood generally painted white; and, impressive front entrance usually with transom fan of glass above the door.
A moderate-sized home generally not more than 50 feet wide, with a symmetrical front having: an entrance at the center balanced by the windows; low-sweeping gambrel roof; exterior generally of stone, and, either one and one-half story with dormer windows, or two and one-half stories with dormer windows.
Georgian and Southern Colonial.
These styles have elaborate front entrances with plain or fluted columns; are generally of brick or wood; have prominent gabled roofs--often hipped; are very symmetrical; require large plots of land; large scale--not suitable for a minimum-sized house; and, either two, two and one-half or three stories.
This style has gothic refined lines with moulded stone around windows and doors; generally of brick, stucco, or stone; steep pitched roof, covered with slate or shingle; usually leaded metal casement windows; and, requires a large building site.
This style has protruding timber faces with stucco between the faces; lower story of heavy masonry; steep pitched roof; generally two stories; and, requires a large lot area.
A generally symmetrical style with front entrance in center; exterior of brick or stone, shutters on each side of windows; low hipped roof; two stories in height; and octagonal window on second floor over front door.
Usually a large house on a sizable plot; masonry exterior walls with very high roofs; large high windows with long shutters; and one and one-half or two and one-half stories.
Generally has turrets at entry, walls of brick or stone; unsymmetrical; and, steep pitched shingle roof.
Enclosed patios, red mission tiled roof; wrought iron decorations; and, stucco walls (usually white).
Small California Spanish.
Stucco exterior; flat composition roof with mission tile trim in the front; suitable for small lots; no patio; and, one story only.
Two stories; stucco (generally white); red mission tiled roof; second story balconies; and, decorative iron railings.
Modern and Contemporary.
Generally one story; usually flat or low pitched roof; often on concrete slab; large amount of glass; and, indoor-outdoor living.
California Bungalow or Ranch House.
One story; stucco with wood trim; often on concrete slab; shingle or shake roof; low and rambling; generally attached garage; and, indoor-outdoor living.
Any real estate salesperson or broker should be familiar with the basics of the product to be sold--the single-family home. Understandably there are details too technical in nature for the average broker or salesperson to be concerned with, but the key points of home construction should be studied.
In order to test the real estate license applicant on knowledge of construction, questions on housing terms for the different wooden members in the framework of a house are included in the real estate examinations. The prospective licensee should become familiar with the following words:
(End of the CalBRE Reference Book excerpt)