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SHORT
INTRODUCTION TO CALIFORNIA REAL ESTATE PRINCIPLES,
© 1994 by Home Study, Inc. dba American Schools
Click on link to go to:
Table of Contents; Chapter I: Real Property; Chapter II: Legal Ownership; Chapter III: Agency & Ethics; Chapter IV: Contracts; Chapter V: Real Estate Mathematics; Chapter VI: Financing; Chapter VII: Mortgage Insurance; Chapter VIII: Appraisal; Chapter IX: Transfers of Real Estate; Chapter X: Property Management; Chapter XI: Land Control; Chapter XII: Taxation; Chapter XIII: Fair Housing Laws; Chapter XIV: Macroeconomics; Chapter XV: Legal Professional Requirements; Chapter XVI: Notarial Law; Chapter XVII: Selling Real Estate; Chapter XVIII: Trust Funds Handling; Glossary; Index.
Chapter
VIII: Appraisal
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.
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.
Utility
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.
Scarcity
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.
Demand
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.
Transferability
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.
Market value
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
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.
Other values
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.
Substitution
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.
Change
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.
Contribution
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.
Anticipation
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
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.
Economic life
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
Basic Cost
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
Less Depreciation:
Physical Depreciation
Curable:
Repaint Exterior $1,200.00
Replace Hall Tile 3,000.00
Total Curable $4,200.00
Incurable
Structural Decay of Foundation
Estimated at 10% of cost
of $60,000) $6,000.00
Total Physical$10,200
Functional Obsolescence Curable:
Replace Poor Lighting $4,700.00
Enclose Stairway 8,000.00
Total Curable $12,700.00
Incurable
Loss in Value Due to Poor
Floor Plan, estimated to be
5% of Replacement Cost $15,600.00
Total Functional$28,300
Economics Obsolescence
Incurable:
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.
Letter
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.
Form
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.
Narrative
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.
Conduct
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.
Management
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.
Confidentiality
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.
Record Keeping
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.
Competency provision
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.
Departure provision
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.
Definitions
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.
Colonial.
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.
Dutch
Colonial.
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.
English
Elizabethan.
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.
English
Half-Timber.
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.
Regency.
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.
French
Provincial.
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.
French
Normandy.
Generally
has turrets at entry, walls of brick or stone; unsymmetrical; and, steep
pitched shingle roof.
True
Spanish.
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.
Monterey
Spanish.
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.
Home
Construction
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)
Reproduced by
permission from the CalBRE Reference Book
Reproduced by
permission from the CalBRE Reference Book
Architectural Styles
