Chapter 16: Real Estate Appraisal Flashcards
1
Q
Appraisal
A
An appraisal is an act or process of developing an opinion of value.
An appraisal is numerically expressed as a specific amount (e.g., $100,000), a range of values (e.g., $95,000 to $100,000), or as a relationship to a previous value opinion or benchmark (e.g., “Value is greater than the previous appraised value.” Or “The property is worth at least as much as the amount indicated to facilitate the loan.”).
2
Q
Appraiser
A
An appraiser is one who is expected to perform valuation services competently and in a manner that is independent, impartial, and objective. An appraiser conducts an analysis and renders an opinion as to the value of real property specified in his or her employment contract. Real property includes the physical land and improvements together with legal rights to own or use the property.
An appraiser is expected to produce opinions and conclusions based on evidence by sufficient research, analysis of information, and data that supports the rational and logic of those opinions and conclusions.
Appraisers are typically paid a fee that is based on the amount of time and the anticipated degree of difficulty not on the basis of the value of the property. Whether performing an appraisal, appraisal review, or appraisal consulting assignment, all appraisers must adhere to the Uniform Standards of Professional Appraisal Practice (USPAP).
3
Q
Cost
A
Cost is the actual or estimated amount required to create, produce, or obtain a property. It includes labor, materials, financing expense, land, management and overhead, and the contractor’s profit necessary to bring the finished product to the market. Cost may be more than, or less than, the market value of the property.
4
Q
Price
A
Price is the amount that is actually paid in a real estate transaction. It is not necessarily the asking amount or amount offered, and may not represent the actual market value of the property. It may be more than, or less than, the market value. Nonetheless, it is the amount that the buyer is willing to pay and the amount the seller is willing to accept.
5
Q
Value
A
Value is an opinion of the worth of a property at a given time in accordance with a specific definition of value. It is the monetary relationship between properties and those who buy, sell, or use those properties. There are many types of value, each of which has a different definition. In appraisal practice, value must always be qualified (e.g. market value, liquidation value, or investment value).
6
Q
The purpose of an appraisal and its function are
A
distinct
7
Q
Purpose of appraisal
A
The purpose of an appraisal is to estimate some type of defined value. There are many different types of value, each of which has a definition of its own. Purpose relates to the work the appraiser was retained to perform, that is, to estimate some type of value. Most appraisals are performed to estimate market value.
8
Q
Intended Use of appraisal
A
The use or uses of an appraiser’s reported appraisal, opinions and conclusions, or other valuation services by the appraisal client is referred to as its intended use (previously referred to as function in USPAP). For example, the client may use the appraisal to decide whether to sell or not, to buy or not, and at what price. A lender may use the appraisal to decide whether a loan should be made or not by using that property as security.
9
Q
What four elements interact to create or affect the value of real estate?
A
- Demand
- Utility
- Scarcity
- Transferability
10
Q
Demand (value)
A
real estate, like any other product or service, has no value unless someone has a need or desire for it. From an economic viewpoint, demand has two components: the desire for the item or service, and the financial ability to pay for it.
11
Q
Utility (value)
A
Real estate must serve a purpose or be useful in order to have value.
12
Q
Scarcity (value)
A
Real estate that is in short supply relative to the demand for it has value.
13
Q
Transferability (value)
A
the ability to convey a marketable title is paramount to the value of real estate. Although a property with a defective title can be conveyed, it is risky and a purchaser may substantially discount the price if they feel they would incur time and expense in curing the defect.
14
Q
Types of Value
A
Assessed Value Insurable Value Investment Value Liquidation Value Market Value Salvage Value Plottage Value Value-in-use
15
Q
Assessed Value
A
is the value assigned by the property appraiser for ad valorem tax purposes. Generally speaking, properties with a higher assessment should sell for more than properties with lower assessments.
16
Q
Insurable Value
A
or insurance value, is the value used by insurance companies as the basis for insurance coverage. Insurable value is often considered to be the replacement or reproduction cost plus allowances for debris removal or demolition and non-insurable items. Insurable value is less than the property’s appraised market value, because it excludes the value of land on which the building stands.
17
Q
Investment Value
A
is the value of a particular property to a particular investor. Potential purchasers of income-producing properties commonly request investment value appraisals. Investment value is the highest price an investor will pay for a property and the lowest price the seller will accept. Investment value is the value to a specific individual, while market value is the value in a typical transaction to a typical buyer.
18
Q
Liquidation Value
A
is the amount that remains after all assets of a business have been sold in a hurried, but not forced, sale and all liabilities have been paid. It is the value of a failing business that is not expected to continue. It can also be used to estimate the minimum value of a profitable business.
19
Q
Market Value
A
is the value to a typical buyer and a typical seller. This is the most common type of value that is estimated by appraisers. The market value of a property is the most probable price at which specified property rights should sell. However, several assumptions are inherent in this definition:
o The property has been exposed to the market for a reasonable time.
o Both buyer and seller are well informed and acting in their own self-interest.
o Neither party is acting under undue duress.
o The seller has the ability to convey a marketable title
o Payment is in cash in U.S. dollars, or terms equivalent to cash.
20
Q
Salvage Value
A
is the amount that can be received from the sale of the parts from a demolished structure.
21
Q
Plottage Value
A
is the increase in value resulting from an assemblage, or combining, of two or more adjacent parcels of land under one owner. Typically, the value of the whole parcel will be greater than the sum of the individual smaller parcels.
22
Q
Value-in-use
A
of real property is the net present value (income) which is generated by the property in a certain use for a certain owner. The value-in-use of a property may be higher or lower than market value.
23
Q
Principles of Values
A
Appraisal principles are the rules that govern the formation of value and help to explain how and why values change in the market. Appraisers use them to assist in arriving at their value conclusion.
- Anticipation
- Change
- Competition
- Conformity
- Contribution
- Highest & Best Use
- Progression
- Regression
- Substitution
24
Q
Anticipation
A
states that the value of a property today is the sum of its future benefits. When a potential buyer considers the purchase of a property, the benefits it will provide during that owner’s period of ownership forms the basis for the decision to buy, and at what price. Value today is measured in terms of future benefits. This principle is particularly visible in the purchase of income-producing real estate where present dollars are paid in exchange for the right to receive future dollars.
25
Change
states that circumstances can cause changes to occur in the market, which in turn may affect the value of real estate. An appraisal is made as of a specific date in order to take into account the market forces that influence value at that point in time.
26
Competition
recognizes that sellers compete with other sellers, and buyers compete with other buyers. This principle focuses on the effect of changes in supply and demand.
27
Conformity
states that the value of a property is sustained when it is in conformity with other properties in the same area. Conformity refers to size, architectural style, and other features.
28
Contribution
states that the value of a component of the property is the amount it adds to the total value of the property; in other words, the amount by which the value of the property would decrease by its absence. This principle illustrates the difference between the cost of a component and the value added by the component. Example: a swimming pool may cost $20,000 to install, but it may add only $15,000 to the value of the property.
29
Highest & Best Use
states that the best use for the property, known as its highest, best, and most profitable use, is that which will most likely produce the greatest net return to the land over a given period-of-time. This net return is realized in terms of money or other amenities.
30
Progression
applies when a lower-priced property is built or an existing property is inadequate (under-improved) in an area that consists of property that is more expensive. The lower-priced property will progress (increase) in value toward the level of the more expensive properties in the area. This principle tends to create price conformity within an area.
31
Regression
applies when a higher-priced property is constructed or an existing property is over-improved in an area that consists of lower-priced properties. The higher-priced property will regress (decrease) in value toward the level of the less expensive properties in the area. This principle, like the principle of progression, tends to create price conformity within an area.
32
Substitution
recognizes that no one would pay more for a property than the amount necessary to acquire an acceptable substitute. This principle is the basis for all mathematical methods that are used by appraisers to estimate value. Example: a property owner states that their house is worth $95,000. Buyers in the market can obtain a substitute property with the same features and utility for $90,000. The seller’s house, therefore, has a value of approximately $90,000, not $95,000.
33
The Appraisal Process
Appraisers follow a defined appraisal process when developing and reporting their opinions and conclusions in an appraisal assignment. The appraisal process is accomplished by following specific steps, the number of which depends on the nature of the appraisal assignment and the data available to complete it. In all cases, however, the valuation process provides the model to be followed in performing market research and data analysis, in applying appraisal techniques and in integrating the results of these analytic activities into an opinion of value.
Maps, cost information, previous appraisals, and other useful data that an appraiser accumulates and updates were historically referred to as the appraisal data plant. Today, this information is usually stored electronically.
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Step 1: Define the Problem
Define the problem. Before proceeding, the appraiser must have a clear understanding of the problem that needs to be solved in order to determine the appropriate scope of work to apply to the assignment. The following information is required to define the appraisal problem:
• Identify the client and other intended users
• Identify the client’s intended use (function)
• Identify the type and definition of value (purpose)
• Effective date of the opinion
• Identify the relevant characteristics of the property
• Identify any assignment conditions and assumptions, laws and regulations, or other conditions that affect the scope of work.
35
Step 2: Determine the Scope of Work
A preliminary analysis of the assignment is made to determine the type and extent of research and analyses required. The data is then collected and assembled for use. Communication with the client is necessary to obtain much of the information necessary of most elements of problem identification.
Data falls into two types:
• General Data- concerns the region, neighborhood, economy, and so on.
• Specific Data- is information about the subject property and potential comparable properties to be used in the analysis.
36
Step 3: Perform Data Collection & Analysis
This step includes a market analysis and a highest and best use analysis.
Market analysis- includes supply, demand, and marketability studies.
Highest and best use analysis- the property is analyzed to determine the highest and best use of the site as if vacant and the property as improved. The highest and best use as vacant is used to establish the value of the site based on how the site should be used rather than how it is being used. The property is analyzed again, thereby considering any improvements that are presently on the site. This assists in determining whether the present use is the best use, or if an alternative should be considered to maximize the value of the land and improvements of the property (property value). Alternatives include renovation or possible removal.
37
Step 4: Apply the Three Approaches to Value
Appraisers can utilize three mathematical methods to estimate the value of a subject property. All three are employed to the extent that they are applicable, unless the assignment does not require one or more of them to be used.
The three methods are:
• Sales comparison approach
• Cost-depreciation approach
• Income approach
All three approaches are used by the appraiser if the assignment, the available data, and the requirements of the client do not limit their application. Each yields slightly different results, and the differences must be reconciled into a final value conclusion.
38
Step 5: Estimate the Final Opinion of Value
After the three approaches have been applied and each has resulted in a value estimate, the three estimates are compared.
The appraiser’s confidence in the data and the appropriateness of the approaches to the assignment are weighed. Greater weight is given to the approach that the appraiser feels best reflects the value of the subject, and then a final value is estimated.
Weighing the evidence and arriving at a final value conclusion is based on the appraiser’s knowledge, experience, and training. It is not accomplished by averaging the values or using a mathematical process.
39
Step 6: Prepare the Final Report of Defined Value Opinions
The objective of the appraisal is to answer the client’s original question with regards to the value of the rights specified in the subject property. Once the final value estimate has been estimated the appraiser prepares a report that is to be delivered to the client. Although there are legal and technical aspects to the way in which appraisals are performed and appraisal reports are prepared, they can be categorized as a form, narrative, or an oral report.
40
Form Reports
are used in millions of appraisals each year. Most primary lenders and the secondary market require them. The use of a form standardizes the way in which information is reported and facilitates the underwriting process. This is the reporting preference for most residential appraisals.
41
Narrative Reports
are very comprehensive. They provide the client with the reasoning and conclusions of the appraiser in a detailed report that can contain as many as 50 to 300 or more pages. The length and content can vary depending on the nature of the assignment and the requirements of the client.
42
Oral Reports
are generally given only in connection with court testimony. Appraisers, who provide court testimony, must follow the same procedures used to prepare written reports and must maintain files that support their conclusions and testimony.
43
Sales Comparison Approach
The sales comparison approach, also referred to as the comparable sales approach, is used to estimate the value indicated by the recent sales of comparable properties in the market.
44
Principle of Substitution
This approach is a direct application of the principle of substitution. The principle of substitution states that if similar or comparable properties are available for sale, the one with the lowest price will attract the greatest demand. The price at which a property will most likely sell is closely related to the price at which similar properties in the same market have previously sold.
45
Requires an Active Market
The sales comparison approach requires an active market. If no sales have occurred, this method is not applicable. Conversely, this method is appropriate for any type of property where sales have occurred.
46
Used by Real Estate Licensees
This approach is usually the most applicable method for appraising residential properties and vacant land. It is the basis for the value estimates that are used by real estate brokers and sales associates in listing and selling real estate. A sales associate should focus much of their attention on this approach, as it will be used virtually every day in the practice of their profession.
47
Sales Comparison Approach Step 1: Locate Comparable Properties
A comparable property is a property that is competitive with the subject property (the property being appraised) and similar to it in terms of design, size, location, age, and condition.
To be comparable, the property should be a recent sale, preferably within the last six months. The sale must have been an arm’s – length transaction in which the seller and the buyer were unrelated and each was attempting to get the best price possible.
A minimum of three to five comparable properties is required, but eight to ten are preferable.
48
Sales Comparison Approach Step 2: Adjust Comparable Sales Prices
The comparable properties are not exactly the same as the subject property. Adjustments to the sales price of the comparable properties are made to allow for differences between the comparable and the subject property.
Adjustments are always made to the comparable property, but never to the subject property. The subject property sets the standard for comparison. The price of comparable properties must be adjusted to reflect the characteristics of the subject property. The price at which a comparable property was sold is a known fact. The value of the subject property is unknown and cannot be adjusted.
If the comparable property is superior to the subject property, the comparable sales price is adjusted downward by the value of the superior features. If the comparable property is inferior to the subject property, the comparable sales price is adjusted upward by the value of the inferior features.
49
Adjustments are made for differences in?
1. Financing terms
2. Conditions of sale
3. Market conditions
4. Location
5. Physical characteristics
Adjustments can be made in either dollar amounts or percentages. Adjustments for market conditions and location are often derived based on percentages. Whenever percentages are used, these adjustments must be made in the order above.
50
Financing Terms
the manner in which a property is financed can influence the price a buyer is willing to pay. If favorable terms are offered, the price may have been increased; if prohibitive interest rates are required, the price may have been decreased.
51
Conditions of Sale
this adjustment allows for the motives of the buyer and/or seller. The definition of market value assumes that no undue duress is involved in a sale. The appraiser makes adjustments to the sale price based on financing terms and conditions of the sale and develops a new value base for the property. Adjustments for market conditions are not applied to the correct value base.
52
Market Conditions
the market may have changed since the date of the sale of the comparable property. If so, the sales price of the comparable may have to be adjusted to account for the change. Inflation and deflation are the most common reasons for this adjustment. Adjustments for market conditions are made to the previous value base above, which becomes the new value base for adjustments for location and physical characteristics.
53
Location
if the comparable property is in a different neighborhood than the subject property, or is influenced by different external forces, such as traffic, an adjustment for differences may be required.
54
Physical Characteristics
adjustments are made for differences in the age, condition, number of baths and bedrooms, garage stalls, lot size, square footage of living space, and so on. The final adjustments for location and physical characteristics are now applied to the value base derived in market conditions to arrive at a final adjusted price.
55
Paired Sales Analysis
An appraiser can estimate the value of the various physical differences by locating properties in the area, one that has a particular feature and one that does not. Any difference in their sales price can be ascribed to that feature. This is called paired sales analysis.
56
Sometimes paired sales cannot be located
Sometimes paired sales cannot be located; therefore, different means must be employed to make adjustments. One method is to estimate the cost of a new item and deduct an amount from it, which represents any loss in value due to age and condition. Cost and value are not the same, so care must be used when employing this method.
57
Sales Comparison Approach Step 3: Reconcile the Adjusted Sales Price
Experience and judgment are used to weigh the adjusted sales price of each comparable property to infer an estimate of value for the subject property.
The adjusted sales prices of the comparable properties cannot be simply added and then averaged. A weighted average technique is used to determine the estimate of value.
Adjustments are always made to the comparable property NEVER TO THE SUBJECT PROPERTY.
58
Valuation: Cost-Depreciation Approach
The cost-depreciation approach, or cost approach, is used to estimate the current cost of reproducing or replacing a building, minus an estimate for depreciation, plus the value of the land. This approach is also based on the principle of substitution. No one would pay more for an existing property than the cost to purchase land and have comparable improvements constructed on that land, assuming no unusual time delay. The value of the subject property can be estimated by using either replacement cost or reproduction cost.
59
Replacement Cost
is the estimated cost at current prices to construct a comparable building with equal utility to the subject building by using modern materials, design, and features. A replacement building is not necessarily constructed with the same materials as the subject property. Some construction methods and materials may no longer be available; therefore, substitution may be necessary.
60
Reproduction Cost
is the estimated cost to construct at current prices an exact duplicate or replica of the building that is being appraised by using the same materials, design, and layout as the subject property. Reproduction cost is preferred in appraisals of historic properties.
61
What is the cost-depreciation approach best used to estimate?
• Newer properties,
• Special-purpose properties,
• Property proposed for renovation,
• Insurance purposes, and
• Properties infrequently exchanged or sold in the real estate market.
The cost-depreciation approach may be the only approach available to estimate the value of special-purpose properties, such as schools and churches.
62
Cost depreciation Step 1: Estimate the Site Value as if Vacant
The estimated value of the site must be determined as if it were vacant since land does not depreciate. The comparable sales approach is used to estimate the land value.
This estimated site value as if it were vacant will be added later to the depreciated cost of reproducing or replacing the building.
63
Cost depreciation Step 2: Estimate the Cost to Replace or Reproduce the Main Improvement 3 methods
1. Quantity Survey Method
2. Unit-In-Place Method
3. Unit-Of-Comparison Method
64
Quantity Survey Method
a detailed inventory and precise cost for each item required to construct the main improvement is compiled in the quantity survey method. This is similar to a bid estimate used by contractors to arrive at the estimated cost to construct a building. All components such as labor, materials, financing, and the contractor’s profit and overhead are added together. Although this method is the most accurate, it is time consuming and affords greater detail than is ordinarily required in most appraisals.
65
Unit-In-Place Method
the cost of each component of the property is estimated by using nationally published cost manuals. The cost of a square foot of finished wall, per cubit foot of concrete for foundations, and so on, can be obtained and added together. This method is a shortcut for the quantity survey method. Since the cost of a component, rather than each piece required for construction, is estimated, the method is simpler and faster; therefore, less time-consuming.
66
Unit-Of-Comparison Method
is a cost per square foot or per cubic foot of an entire building. This figure is multiplied by the number of square feet or cubic feet in a subject building to estimate the cost of the subject. A recently constructed building of a known cost per square foot or per cubic foot, which is called a benchmark building, can be used as a unit-of-comparison.
67
Cost Depreciation Step 3: Estimate the Amount of Accrued Depreciation in the Main Improvement 3 categories
1. Physical Deterioration
2. Functional Obsolescence
3. External Obsolescence
68
Accrued Depreciation
is the total loss in value the improvement may have incurred over its lifetime, measured against the cost of new.
69
Physical Deterioration
is any loss in value due to normal wear and tear from use, negligence, or aging of the building. Examples include broken windows, deteriorated roof shingles, faded or peeling paint, worn carpeting, and so on.
Physical deterioration can be either curable or incurable. Whether something is curable or incurable is based on economic feasibility. If repairing an item adds much or more value than the cost of the repair, it is curable. Otherwise it is incurable.
70
Functional Obsolescence
can be caused by either a deficiency or an over-improvement (or superadequacy). A structural deficiency or excess affects consumer preferences, which in turn affects value.
Functional obsolescence due to a deficiency is a loss in value due to the failure of a property to meet current consumer preferences due to changes in building design or standards. For example, a home with structural deficiencies, such as inadequate lighting, outdated fixtures, lack of central heat or air-conditioning, one bathroom in a four-bedroom home, or an inefficient floor plan all affect demand, and, consequently result in decreased value. Functional obsolescence may also be categorized as curable or incurable.
71
Over-Improvement
An over-improvement is an investment made to a property that does not make the best use of the property or is excessive in comparison with the improvement of similar properties. An over-improved property may suffer functional obsolescence since it will not sell in the market for the amount invested.
72
External Obsolescence
is a loss in value caused by factors beyond the boundaries of the subject property.
External obsolescence is considered to be incurable on the part of the owner since the problem is beyond on the property’s boundaries. A property located a landfill, wastewater treatment plant, or blighted area may suffer a value loss, but the problem is beyond the control of the property owner.
73
Economic Age-Life Method
There are several methods used by appraisers to estimate the amount of the accrued depreciation. The simplest is called the economic age-life method. The appraiser estimates the total economic life of a building, which is the number of years it will contribute value above the value of the land; this is 100% of its useful life. The appraiser then estimates the percentage of the total life lost or used up by depreciation. This is called its effective age. Effective age is the age a property appears to be, due to extensive updates, or excessive wear and tear (condition). Actual age is the true age of the property. When presented with both ages in a problem, use effective age for any calculations.
74
Economic Age-Life formula
Effective age ÷ Total Economic life = Total depreciation rate for the entire time period
Total depreciation % x Reproduction cost $ = total accrued depreciation amount for the entire time period
75
Valuation: Income Approach
The income approach is used to estimate the value that a property’s net earning power will support. This approach is used to estimate the value of income-producing property and for the valuation of a business.
The income approach is based on the assumption that the value of a property is related to the amount of income that it cane produce in the future. It is based on the appraisal principles of substitution and anticipation. The principle of anticipation states that the present value of a property is based on the benefits it can produce and its future income.
The two techniques that can be applied for the income approach are direct capitalization and gross multiplier.
76
Direct Capitalization Technique
Direct capitalization (or capitalization rate) is a mathematical process in which future income is converted into a present value.
77
There are seven steps in the direct capitalization approach
1. Forecast the potential gross income (PGI)
2. Estimate the vacancy and collection losses (V&C)
3. Calculate the effective gross income (EGI)
4. Estimate the operating expenses (OE)
5. Calculate the net operating expenses (NOI)
6. Select an overall capitalization rate
7. Estimate the subject property value
This technique is not used to value one- to four- family rental properties.
78
Income Approach Step 1: Forecast the Potential Gross Income (PGI)
Which is the total annual income for the coming year. The two types of gross income that must be considered are contract rent and market rent.
79
Contract Rent
is the rent amount that is specified in a lease. It is used if the existing tenants have excellent credit and long-term leases.
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Market Rent
or economic rent, is the rent amount that is estimated for vacant or owner-occupied space, and space occupied by tenants with short-term leases or those who have questionable credit. Market rent is based on rents charged in the market for properties that are comparable to the subject property.
81
Income Approach Step 2: Estimate the vacancy and collection losses (V & C)
Must be estimated.
This represents income that the owner will not receive. The amount of vacancy and collection losses is estimated from the history of the subject property and competitive properties in the same market. It is normally expressed as a percentage of the PGI.
82
Income Approach Step 3: Calculate the effective gross income (EGI)
Calculate the EGI by subtracting the V&C from the PGI. After subtracting, the remaining income is called the effective gross income (EGI)
If there is any other (OI) from miscellaneous sources, such as carport rentals, vending machines, and so on, add this amount after the V&C are subtracted.
```
The EGI is the actual amount the owner can expect to receive from operation of the property for one year into the future.
PGI Potential Gross Income
- V&C Vacancy & Loss
+ OI Other income =
EGI Effective gross income
```
83
Income Approach Step 4: Estimate the operating expenses (OE)
Estimate operating expenses (OE): OE = FE + VE + R
Operating expenses do not include mortgage payments, tax depreciation, capital improvements, personal expenses unrelated to the operation of the property, and income taxes. These are ownership charges, not property operating expenses.
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Fixed Expenses (FE)
do not change with occupancy levels. Examples of fixed expenses are property taxes and hazard insurance.
85
Variable Expenses (VE)
Variable expenses change with occupancy levels. Examples include maintenance, utilities, trash removal, janitorial expenses, and management fee (which usually based on a percentage of the EGI).
86
Reserves for Replacements (R)
are funds that are set aside annually to replace short-lived items. These are components that wear out and must be replaced before the end of the economic life of the building. Examples: stove, refrigerator, carpet, and roof cover.
87
Income Approach Step 5: Calculate the net operating income (NOI)
Subtract all three types of operating expenses from the EGI to calculate the net operating income (NOI).
88
The first five steps in income approach include
```
PGI
-V&C
+OI
=
EGI
-OE
=
NOI
Memory Device:
Please PGI
Visit V&C
Every EGI
Other OE
Night NOI
```
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Income Approach Step 6: Select an overall capitalization rate
The overall capitalization rate is a rate that is adequate to provide the investor with a return on the investment, and a return of the investment over the ownership period. This rate is derived from comparable properties in the same market
90
Income Approach Step 7: Estimate the subject property value
Estimate the value of the subject property by dividing the NOI by the overall capitalization rate.
Value = Net Operating Income ÷ Capitalization Rate
91
Using the IRV Formula to Derive Capitalization Rates
The IRV formula provides a simple way to derive capitalization rates from comparable sales by using the estimated value of a subject property and the estimated net operating income required from an investment property. In this formula:
I = Net Operating Income
R = Capitalization Rate
V = Estimated Value
92
The IRV formula can be expressed in three forms. If any two of the three components of the IRV formula are known, the value of the third or unknown component can easily be determined.
I = R x V
V = I ÷ R
R = I ÷ V
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Gross Multiplier Technique
A gross multiplier technique uses gross rent or income instead of net operating income to estimate the value of one- to four- family rental properties. A Gross Rent Multiplier (GRM) is applied for monthly rental properties. A Gross Income Multiplier (GIM) is applied for properties with annual gross rental income. Most markets use a monthly GRM, but some areas prefer to use an annual GIM.
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Gross Rent Multiplier (GRM)
GRM is used for monthly rental properties and is derived from comparable properties which are rented at the time of sale by using the following formula:
Comparable sales price ÷
Gross monthly rent = Gross rent multiplier (GRM)
The subject property gross monthly rent is multiplied by the GRM to estimate the value of the subject:
Subject property gross monthly rent x GRM = subject property value
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The Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA)
In response to the savings and loan crisis, Congress adopted Title XI of the Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989 (Title XI). Title XI was adopted to address the problem of unregulated persons performing incompetent and/or fraudulent appraisals for federally regulated financial institutions.
Title XI’s purpose is to “provide that Federal financial and public policy interests in real estate transactions will be protected by requiring that real estate appraisals utilized in connection with federally-related transactions are performed in writing, in accordance with uniform standards, by individuals whose competency has been demonstrated and whose professional conduct will be subject to effective supervision.”
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Title XI created a unique, complementary relationship between
the States, the private sector, and the Federal government. Title XI recognized that the States were in the best administrative position to certify and license real estate appraisers and to supervise their appraisal-related activities.
Title XI authorized the private sector, consisting of the Appraisal Foundation and its two independent boards, the Appraiser Qualifications Board (AQB) and the Appraisal Standards Board (ASB), to establish uniform minimum appraiser qualifications standards and uniform standards of professional appraisal practice.
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Why did Title XI create the Appraisal Subcommittee
Title XI created the Appraisal Subcommittee to oversee the activities of the States and the Appraisal Foundation.
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Title XI authorized
the Federal financial institutions regulatory agencies (the Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency and National Credit Union Administration) and the U.S. Department of Housing and Urban Development (HUD) to adopt regulations regarding real estate appraisals made in connection with federally-related transaction, including, when appraisals are required, who must perform the appraisals, and the manner in which appraisals must be performed.
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A federally-related transaction
is any real estate related financial transaction that a Federal Financial Institution Regulatory Agency (FFIRA) has either contracted for or regulates, and requires the services of an appraiser. Appraisal reports involving a federally-related transaction must be prepared by a state certified appraiser.
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The Appraisal Subcommittee (ASC)
The ASC of the Federal Financial Institutions Examination Council (FFIEC) was created in 1989, pursuant to Title XI of the FIRREA.
The purpose of ASC is to provide federal oversight of State appraiser regulatory programs and a monitoring framework for the Appraisal Foundation and the Federal Financial Institutions Regulatory Agencies in their roles to protect federal financial and public policy interests in real estate appraisals utilized in federally-related transactions.
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The Appraisal Foundation (TAF)
TAF was established to promote professionalism and to ensure public trust in the valuation profession. This is accomplished through the promulgation of standards, appraiser qualifications, and guidance regarding valuation methods and techniques. TAF is a non-profit organization that is given specific authority by Congress regarding real property appraiser qualifications and appraisal standards.
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What are TAF four independent boards?
1. Appraisal Practices Board (APB)
2. Appraisal Standards Board (ASB)
3. Appraiser Qualifications Board (AQB)
4. Board of Trustees (BOT)
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Appraisal Practices Board (APB)
offers voluntary guidance to appraisers, regulators, and users of appraisal services on recognized valuation methods and techniques for all valuation disciplines.
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Appraisal Standards Board (ASB)
develops, interprets, and amends the USPAP, the generally accepted standards of the appraisal profession.
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Appraiser Qualifications Board (AQB)
establishes the minimum education, experience, and examination requirements for real property appraisers to obtain a state license or certification. In addition, the AQB performs a number of additional duties related to real property and personal property appraiser qualifications.
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Board of Trustees (BOT)
appoints members to the APB, AQB, and ASB, secures funding for TAF operations, and monitors performance and oversight of the TAF’s boards and advisory councils.
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The Florida Real Estate Appraisal Board (FREAB)
The 1991 Florida legislature passed legislation that divided F.S. 475 into Parts I and II. Part I regulates real estate brokers, sales associates, and real estate schools; Part II regulates real estate appraisers who perform appraisals in federally-related transactions.
The purpose of Part II is to regulate real estate appraisers in the interest of the public welfare.
Part II of F.S. 475 created the Florida Real Estate Appraisal Board (FREAB) to administer and enforce that section of the law.
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Members of the FREAB
The FREAB consists of nine members, who are appointed by the Governor and confirmed by the Senate. Each member is appointed for a four-year term; however, no member may serve for more than two consecutive terms.
The members must consist of the following:
- Four members who are real estate appraisers who have been engaged in the general practice of appraising real property in Florida for at least five years immediately preceding the appointment.
- Two members who represent the appraisal management industry
- One member who represents organizations that use appraisals for the purpose of eminent domain proceedings, financial transactions, or mortgage insurance
- Two members who are representatives of the general public and are not connected in any way with the practice of real estate appraisal.
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FREAB Registration
Appraisers are required to register the office location(s) from which they operate.
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FREAB License Renewal
Appraisers must complete at least 30 hours of approved continuing educational courses, and renew their license every two years.
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FREAB Disciplinary Actions
Appraisers are subject to disciplinary actions to reprimand, fine, suspend or revoke their license, or be placed on probation.
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Appraisal License Levels
1. Registered Trainee Appraisers
2. Certified Residential Appraisers
3. Certified General Appraisers
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Registered Trainee Appraisers
are individuals who are registered with the DBPR and are qualified to perform appraisal services only under the direct supervision of a certified appraiser. There are educational requirements but there is no state exam requirement. Registered Trainee Appraisers provide valuation services in an independent, impartial, and objective manner. Bias or advocacy, such as personal interest in the property, on the part of an appraiser is prohibited.
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Educational requirements for registered trainee appraisers
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the minimum are 100 hours as follows:
• 30 hours of basic appraisal principles
• 30 hours of basic appraisal procedures
• 15 hours of National USPAP
• 25 hours of appraisal subject matter electives, which shall include six hours of rules and laws three hours of roles and responsibilities for supervisors and trainees.
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Certified Residential Appraisers
are individuals who are certified by the DBPR and are qualified to issue appraisal reports for residential real property of one- to four- residential units, without regard to transaction value or complexity, or as authorized by federal regulation. Under the provisions of FIRREA, the AQB establishes the minimum education, experience, and examination requirements for real property appraisers to obtain a state certification.
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Certified Residential Appraisers requirements
minimum AQB qualifications:
• A bachelor’s degree or higher (in any field) from an accredited college or university
• A minimum of 200 classroom hours of approved appraisal education, including the 15-hour national USPAP course
• 2,500 hours of experience obtained during no fewer than 24 months
• A passing grade on an AQB approved examination and a Florida state law exam
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Certified General Appraisers
are individuals who are certified by the DBPR to issue appraisal reports for any type of real property classification as well as personal property appraisals and business valuations.
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Certified General Appraisers requirements
Minimum AQB qualifications are:
• A bachelor’s degree or higher (in any field) from an accredited college or university
• A minimum of 300 classroom hours of approved appraisal education including the 15-hour national Uniform Standards of Professional Appraisal Practice (USPAP) course
• 3,000 hours of experience obtained during no fewer than 30 months
• Passing grade on an AQB approved examination and a Florida state law exam.
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Valuation for Non-Federally Related Transactions
Real estate licensees who are licensed under Part I of F.S. 475 are permitted to perform valuations for a fee in non-federally related transactions. However, a real estate licensee must always remember that although they can perform limited valuation duties, they cannot use the term appraiser or appraisal unless certified or registered to do so.
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Comparative Market Analysis (CMA)
A CMA is developed by using the same basic steps as an appraiser uses with the sales comparison approach, but employs less stringent methods. This type of analysis is useful when dealing with sellers to assist them in establishing a listing price, and with buyers who are considering an offering price.
A CMA typically requires a licensee to obtain information about recent sales, properties currently offered for sale, and properties that have previously been listed but failed to sell in the subject neighborhood. Depending on a level of activity in the area, a period of 6-to-12 months should be examined. Comparing the prices of these three groups of properties allows a licensee, and those with whom the licensee deals, to see the range within which a subject property will most likely sell.
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What are the sources of data for a CMA
the MLS, the property appraiser’s office and the Clerk of Courts.
Properties selected should be as similar as possible. Major features such as square footage of living area, type of roof cover, number of bedrooms and baths, lot size, swimming pools, and so on, should be given greatest weight. Lesser-cost items do not have much effect on prices and do not need to be considered. Adjustments for physical differences should be extracted from the market by using the methods discussed in the sales comparison approach for appraising.
Software programs are available to create quick, computer-generated CMAs. These programs can provide a quick value snapshot based on public data such as public tax records, but are not a substitute for genuine CMA performed by a licensee, since the licensee has local knowledge and access to additional information to use as a basis of the sales comparison.
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Broker Price Opinion (BPO)
A BPO is an estimate of a property’s value, determined by a real estate broker or sales associate. Although BPOs can be requested for many reasons, they are often requested by lenders who either own real estate that they have foreclosed on (REO or Real Estate Owned), or who may be considering a short sale transaction.
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Who can prepare a BPO
Anyone who holds an active broker or sales associate license, or appraisal certification in the state of Florida may prepare a BPO. The preparer is entitled to receive compensation for the BPO.
A lender may hire a real estate professional to perform a BPO to help determine the selling price of the property since the licensee typically has knowledge of the local market. The licensee will be asked to take photos of the property and complete a BPO report form provided by the lender. The report includes a neighborhood analysis of comparable properties along with local and regional market information. Factors what will affect the price of the property in a BPO report are the values of similar surrounding properties, sales trends in the neighborhood, and the amount of repair needed to put the property up for sale.
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BPOs are less thorough
BPOs are less thorough than an appraisal, but require more analysis than a basic CMA.
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Automated Valuation Model (AVM)
AVMs are electronic services that can provide an estimate of a property’s valuation very quickly. These models typically use electronic databases to compare the subject property to other properties in the area.
Although AVMs may be faster and easier than appraisals or BPOs, they do not take into account property condition, neighborhood characteristics, and recent transactional data. As a result, AVMs are a tool that may be used, but are often followed up with a site visit or an actual appraisal.
