Chapter 15 (Estimating Real Property Value) Flashcards
Federally related transaction
Any real estate–related financial transaction that a federal financial institution’s regulatory agency (FFIRA) has either contracted for, or regulates, and requires the services of an appraiser.
Transaction value
The loan amount in most appraisal assignments.
The specified value threshold of $250,000 is called the de minimis requirement.
Types of Value
- Assessed value is the value used as a basis for property taxation.
- Insurance value is an estimate of the amount of money required to replace a structure in the event of some catastrophic event such as fire.
- Investment value is the price an investor would pay, given the investor’s own financing requirements and income tax situation. This type of value is personal to a particular investor.
- Liquidation value is the value associated with a rapid sale. The amount of dollars a property should bring in a foreclosure sale is an example of liquidation value.
- Going-concern value is the value of an income-producing property or business characterized by a significant operating history.
- Salvage value is the estimated amount for which improvements can be sold at the end of a structure’s useful life.
Market Value
While the word value has many different meanings, market value is of special interest to the field of real estate.
The concept of market value is based on a theory that in any open market there will be a number of buyers and sellers. If hundreds of transactions are concluded over time, some parties will pay too much and some will pay too little. But the vast majority of value decisions by both buyers and sellers will tend to converge in a fairly small range.
That range represents a range of market value, whether the market is dealing in houses, oranges, cattle, or something else.
Many definitions of market value, or fair market value as it is sometimes called, can be found.
Fannie Mae and Freddie Mac require the following definition of market value for the appraisal of all real property securing a mortgage intended for sale to either of those major secondary market agencies:
The most probable price that a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus.
Inherent in this definition are the assumptions that:
market value applies to a specified date and may change with the passage of time;
the seller is able to convey a marketable title;
buyer and seller are typically motivated, and neither buyer nor seller is under any compulsion or pressure to conclude a sale;
both buyer and seller are well informed and acting in their individual best interests;
the property is exposed for sale on the open market for a reasonable time;
the terms of sale are in cash in U.S. dollars or in terms of financial arrangements comparable thereto; and
the price represents a normal consideration for the property, unaffected by creative financing or sales concessions such as seller contributions or buydowns.
Cost, Price, and Value
- Cost is the total expenditure required to bring a new improvement into existence plus the cost of the land. A contractor will install site improvements (water, sewer, and so forth); acquire the necessary permits; secure the services of architects, engineers, surveyors, and other professionals; construct the building; landscape the site; market the property; and so forth. The total of these expenditures is called cost. A contractor wants the cost to be less than the price a consumer will pay—and the consumer will pay more than the cost only if the consumer perceives the property’s value to exceed its cost.
- Price refers to the amount of money actually paid in a transaction. Price and value are not necessarily equal. For example, you might purchase a computer for $2,000. Its price was $2,000. However, it may actually command less (or more) than $2,000 in exchange if you were to attempt to sell the computer. In real estate, price is synonymous with contract price.
- The value of a good or service is determined by its ability to command other goods or services in exchange. Exchange value is the monetary value of a good or service to many buyers and sellers at a particular time. Today, we regard exchange value as market value, which is the consensus of the interactions of many buyers and sellers in the marketplace.
Overimprovement
An owner invests more money in a structure than the owner may reasonably expect to recapture.
Characteristics of Value
To have value, goods or services must possess the following four traits:
- To remember the characteristics of value, remember DUST:
1. Demand
2. Utility - In real estate, utility means the ability to provide useful services and benefits to an owner or tenant. (To fill a need)
3. Scarcity - When apartments are scarce, landlords can increase rents, and the excess demand will fill any resulting vacancies.
4. Transferability - The legal ability to convey title and possession of goods creates transferability. This is an unusually important factor in real estate.
Value cannot exist in cases where rights in land and the use of property cannot be transferred.
Highest and Best Use
The most profitable legal way that a property can be used.
The use must be:
legally permissible (zoning); physically possible (soil type, the site's shape, size, and slope); and financially feasible (income generated considering cost of improvements).
2 Types: Use of Vacant Land and Use of Improved Property
There are three approaches to estimating real property value:
Sales comparison approach (comparable sales method)
Cost-depreciation approach (cost method)
Income approach (income method)
Reconciliation
A process of weighted averaging used in the sales comparison approach to bring the adjusted values of several comparable properties into a single estimate of value.
In a reconciliation, any detected errors are corrected and, based on the type of property, a degree of priority (importance) is assigned to each approach used.
For example:
If the property being appraised is a vacant lot in an established neighborhood, the sales comparison approach is considered the most relevant approach to value.
If the property is an income-producing property, the income capitalization approach usually is given the most importance.
The cost-depreciation approach usually is most significant for newly constructed homes and for cross-checking the other two approaches.
It is also considered the most relevant approach when appraising special-purpose properties such as hospitals, schools, or government buildings.
Principle of Substitution
A prudent buyer or investor will pay no more for a property than the cost of acquiring an equally desirable substitute property.
The principle of substitution is the basis for all three approaches to market value.
Sales Comparison Approach
A method for estimating value by comparing similar properties with the subject property based on the theory that a knowledgeable purchaser will pay no more for a property than the cost of acquiring an equally acceptable substitute property.
The sales comparison approach (also called the comparable sales approach or market approach) is based on the premise that the value of a property can be estimated accurately by reviewing recent sales of properties (comparables or comps) similar to the property being appraised (subject property) and comparing those properties with the subject property.
Because time can affect property values, the sales used for comparison purposes must meet two qualifications:
- They must have occurred recently in the same market area where the subject property is located.
- The comparable properties selected must be similar to the subject property.
To remember how adjustments are made, remember CBS versus CIA:
*Comp
Better
Subtract
vs.
*Comp
Inferior
Add
Adjustment Grid
The process of comparison in the sales comparison approach is organized into an adjustment grid.
The adjustment grid is used to ensure that no adjustment factor important to a value conclusion is overlooked.
Adjustment Process
The appraiser prepares the adjustment grid by first entering the street address and sale price for each selected comparable.
Adjustments for transactional differences such as conditions of sale, financing terms, and changes in market conditions since the date of sale are made first, followed by adjustments for property characteristics. Those adjustments include the following:
- Financing terms.
Appraisers must confirm the financing associated with each sale because the sale price could reflect special financing terms, such as seller financing or seller-paid points.
Assume the financing associated with each of the sales was conventional financing and that it was typical financing for the market area.
- Conditions of sale.
Appraisers must research the conditions of sale to determine if the buyer or seller was under abnormal pressure to buy or sell or if there was a special relationship between the parties to the transaction, such as between family members or business associates. In the example below, the appraiser verified the conditions of sale for each of the sales and found them to be normal.
- Market conditions.
A property that sold last month or last year may sell for more, or for less, today, even though the property itself has not physically changed.
The criterion for making an adjustment for market conditions is whether the price paid for a comparable property, if that property were sold on today’s market, would differ from the price paid during some other period of time. Referring to the chart below, we see that the appraiser adjusted Comparable (Comp) 1 plus $2,830. Assume that Comp 1 sold six months ago and the appraiser has estimated a market conditions adjustment of 4% annually (or 2% for six months). The appraiser is adjusting the sale price of the comparable to estimate what the comp would have sold for under today’s market conditions. Similarly, Comp 2 sold three months ago so the appraiser has entered a plus $1,360 adjustment (or 1%). Comp 3 sold very recently, so a market conditions adjustment was not needed.
- Square footage.
Assume Comp 1 is 160 square feet larger than the subject property.
Because Comp 1 is superior to the subject property with respect to square footage, a downward adjustment is needed. The appraiser has estimated $60 per square foot as an appropriate unit of comparison and has entered an adjustment of minus $9,600 (or 160 square feet × $60). Because Comp 2 is 20 square feet smaller than the subject, the appropriate upward adjustment is needed.
- Landscaping.
Because Comp 3 has nicer landscaping, compared with the subject property, a downward adjustment is made to Comp 3.
Example
What is the estimated market value of a subject lot that is 110’ × 120’ (13,200 sq. ft.)?
Adjustment Analysis
Comparable Sales:
Sale 1: A lot 100’ × 120’ located across the street from the subject lot sold recently for $36,800.
Sale 2: A lot 110’ × 120’ in the same neighborhood as the subject lot sold recently for $37,000.
Sale 3: A lot 100’ × 100’ in a different but similar-quality neighborhood sold recently for $36,000.
Sale 4: A lot 130’ × 150’ located in a different but similar neighborhood but near a railroad sold recently for $39,800.
Solution:
Sale 1: $36,800 ÷ 12,000 sq. ft. = $3.067 per sq. ft.
Sale 2: $37,000 ÷ 13,200 sq. ft. = $2.803 per sq. ft.
Sale 3: $36,000 ÷ 10,000 sq. ft. = $3.600 per sq. ft.
Sale 4: $39,800 ÷ 19,500 sq. ft. = $2.041 per sq. ft.
Reconciliation:
Sale 1: $3.067 × .35 = $1.073
Sale 2: $2.803 × .30 = $.841
Sale 3: $3.600 × .20 = $.720
Sale 4: $2.041 × .15 = $.306
100% = $2.940 = $2.94 per sq. ft.
Total square footage of subject lot: 13,200
Reconciled value per sq. ft.: × $2.94
Estimated market value of subject lot = $38,808 (round to $38,800)
Note that in the reconciliation process, sale 3 was given less weight in the final analysis because it was in a different neighborhood, and sale 4 was given the least weight because of its proximity to a railroad track and its location in a different neighborhood. If all the comparables had been considered good representations of the subject property, the appraiser would have given all four comparables equal weight and simply averaged them to arrive at a value per square foot.
