Chapter 3 - Property Valuation and Financial Analysis Flashcards
Value
VALUE is defined as the worth of something to someone at a given time. In real estate, you can then apply modifiers to the basic word, therefore creating fair market value (FMV), which is the most commonly sought value conclusion.
FMV refers to the price a reasonable, unpressured buyer and seller would agree to for property on the open market, both having reasonable knowledge of the relevant facts.
There are several other variations on the root principle of value such as
- INVESTMENT VALUE - the amount of money an investor would pay for a property. It refers to an asset’s specific value based on certain parameters. It is an individual’s measurement of the asset’s property value.
- INSURANCE VALUE - defined as the cost incurred for replacing or repairing a damaged property with everything similar with which it was originally made, without factoring in any deduction for depreciation. (what’s it going to cost to replace if burned down)
- VALUE IN USE - The value of a property assuming a specific use, which may or may not be the property’s highest and best use.
Elements of Value
Value is impacted by numerous factors, known as the Elements of Value.
The ELEMENTS OF VALUE are:
- DEMAND, the number of buyers for the property
- UTILITY, the property’s possible uses, for example being a rental
- SCARCITY, the availability of similar properties and
- TRANSFERABILITY, the seller’s ability to transfer good title to a buyer clear of all encumbrances itemized in a title insurance policy. This is the most important one!
These elements of value can be easily memorized using the acronym “DUST”..
Further, these elements work together to create the CONCEPT OF VALUE. When there is a reduced demand, price goes down. When a specific property has an increased utility, a usage greater than a similar property, it’s value increases. Properties which are scarce, such as beachfront or Golf Course Frontage, will find the value increase. Alternatively if a property cannot be transferred, as is the case with a clouded title, the value of the property decreases.
Influences on Value
There are FOUR MAJOR INFLUENCES ON VALUE which are constantly changing. These influences on value can be easily memorized using the acronym “PEGS”.
- PHYSICAL, the properties proximity to commercial amenities, access to Transportation, the availability of freeways, beaches, Lakes, Hills, Etc. Consider the impact of an earthquake or beach erosion.
- ECONOMIC, rents in the area, vacancies and the percentage of homeownership. Job creation or increases in income can affect local real estate prices.
- GOVERNMENT, property taxes, zoning and building codes. Government policy, whether local, state, or federal, can influence value. and Consider what changes in zoning, Highway construction, or federal fiscal and monetary policy can have on local real estate.
- SOCIAL, high crime rate or good schools, etc. Finally, there are social changes that impact property values. Consider what a high crime rate does to the value or an improvement in local school scores.
Principals of Appraisal Valuation
Several economic concepts are used in the appraisal of real estate. These principles are referred to as
THE PRINCIPALS OF APPRAISAL VALUATION and include:
- The PRINCIAL OF SUPPLY AND DEMAND: For appraisal purposes, the principle of supply and demand holds that once the supply of available homes decrease, the value of homes increased since more people are demanding the available homes. This principle correlates to the density of the population and its level of income.
- The PRINCIPAL OF CHANGE: The principle of change hold that property is constantly in a state of change. The change a property goes through is seen in its life cycle. The life cycle of a property has four stages, these are: development, stability, Decline and renewal.
- ** DEVELOPMENT of the property includes the subdivision of lots, improvements constructed and the start of a neighborhood community.
- ** During the STABILITY stage of a property, owners become comfortable with their homes and not much has changed or improved. Maintenance is generally excellent during this period.
- ** the DECLINE stage is marked by owners moving out and renting their properties. During the stage, properties begin to deteriorate, lower social or economic groups move into the community and larger homes are converted into multiple family use.
- ** In the RENEWAL phase buyer see an opportunity to increase their Equity by purchasing the run-down homes and bring them up to current market standards.
- The PRINCIPAL OF CONFORMITY: The principle of Conformity hold that when similarity of improvements is maintained in a neighborhood, the maximum value of a property can be realized on a sale. Zoning regulations and conditions, covenants and restrictions (CC&Rs) tend to protect homeowners by narrowing the uses and excluding nonconforming uses of the property. For example “no Rebels allowed.”
- The PRINCIPAL OF REGRESSION: The principle of regression hold that the value of the best property in the neighborhood will be adversely affected by the value of other properties in the neighborhood. For example this is the pulling down of home values.
- The PRINCIPAL OF PROGRESSION: The principle of progression is the opposite of the principle of regression, holding that a smaller and less or maintain property in a well-kept neighborhood will sell for more then if the home or in an area of comparable properties.
- The PRINCIPAL OF CONTRIBUTION: The principle of contribution holds that the value of one component (an improvement) is measured in terms of its contribution to the value of the whole property rather than its cost. For example a house with a pool compared to a house with no pool.
- The PRINCIPAL OF SUBSTITUTION: the principle of substitution holds that a buyer will not pay more for a property if it will cost less to buy a similar property of equal desirability.
Methods of estimating Value
Methods of Estimating Value
An appraisal is an individual’s opinion or estimate of a property’s value on a specific date, reduced to writing in a appraisal report.
The appraisal report contains data collected and analyzed by the appraiser which substantiates the appraisers opinion of the property’s value.
The value of an income-producing property, given as a dollar amount, is the present Worth to an owner of the future flow of net operating income (NOI) generated by the property.
The appraisal process consists of four steps
- Identifying and defining the appraisal effort to be undertaken by the appraiser
- Data collection, including both general data on the area surrounding the property, and specific data on the improvements and property lot. For example comps, data in comps systems.
- Applying and analyzing the data
- Determining the value of the property.
Three approaches to estimating value in real estate appraisal
There are THREE APPROACHES to ESTIMATING VALUE IN REAL ESTATE APPRAISAL:
- MARKET COMPARISON ( also known as sales comparison or comps), which is most appropriate for single-family residences and the basis of the comparative market analysis that is used by real estate people
- COST APPROACH, used for special use properties such as churches, schools and public buildings, for example if there is a facility for use to the public, if it burns down what is the cost to rebuild
- INCOME APPROACH, valid for properties that generate rental income.
While each of the approaches has a unique methodology, they all work on the PRINCIPAL OF SUBSTITUTION. There are several other principles which assist appraiser in developing the estimate of value.
Market Comparison or Sales Comparison Approach (Comps)
The MARKET COMPARISON approach is the most commonly used to establish the fair market value of real estate. Applying the market comparison approach, the appraiser looks at the current selling prices of similar properties to help establish the comparable value of the property appraised. Adjustments are made for any differences in the similar properties, such as their location, obsolescence, lot size and condition of the properties.
To produce a more reliable appraisal, it is better to gather data on his many comparable sales, frequently called “COMPS,” as are available. Then compare each against the property being appraised for their similarities.
Cost Approach
The COST APPROACH - Appraisers setting value using the cost approach calculate the current construction cost to replace the improvements or structure. From the replacement cost, appraiser subtract their estimate of the accrued depreciation of the existing improvements due to obsolescence and deterioration to get the current replacement value of the improvements. Added to this is the value of the land as though it was vacant.
Thus, the appraised market value under the cost approach is the result of totaling the value of the lot plus the cost to replace the improvements minus obsolescence and physical deterioration (depreciation).
Income Approach
The INCOME APPROACH has two methods to arrive at a value determination:
1. The GROSS RENT MULTIPLIER - uses the potential or gross rent multiplied by a gross rent multiplier (GRM) to determine the value and
2. The CAPITALIZATION METHOD - determines the properties value based on the properties future income and operating expenses. This method uses the net operating income (NOI) and divide that number by capitalization rate (CAP RATE) to determine the value.
Net Operating Income / Capitalization Rate = Value
Income-producing properties use the income approach to determine a value of the property. Therefore, examples of properties appraised using the income approach include:
- Apartments
- Offices
- Industrial buildings
- Commercial units
- Other income-producing property.
The first step to establish value using the CAPITALIZATION METHOD is to determine the properties EFFECTIVE GROSS INCOME. A property’s effective gross income is it gross income minus vacancies and collection losses.
The second step is to deduct OPERATING EXPENSES ( these are variable expenses) from the effective gross income to determine the properties NET OPERATING INCOME (NOI). Operating expenses that very, such as utilities and repairs, are called variable costs. Operating costs that remain constant, such as property taxes, Security Services and insurance, are called fixed costs.
The third step is to mathematically divide the property’s NOI by the appropriate CAP RRATE. The CAP RATE is comprised of a prudent investor’s expected annual rate of return on monies invested in this type of property (adjusted for inflation and risk premiums), and a RATE OF RECOVERY of their invested money’s allocated to the improvements, also called DEPRECIATION.
The methods to calculate a cap rate are:
* THE BAND OF INVESTMENT - An appraisal method for investment property that determines the amount one would pay for a piece of real estate such that it equals its operating income. One calculates the band of investment by multiplying the operating income by a capitalization rate.
- THE SUMMATION METHOD - the process of determining the value of the land (its size, shape, location, surrounding infrastructure and changes), and then adding the value of improvements on the land (age, style, architectural features, number of rooms, renovations, etc).
- MARKET COMPARISON - which is an Appraiser’s preferred approach. The formula for Cap Rate is equal to Net Operating Income (NOI) divided by the current market value of the asset.
Finally, the fair market value of the property is determined by dividing the NOI by the cap rate.
Beyond a simple math formula, a cap rate is best understood as a measure of risk. So in theory,
A higher cap rate means an investment is more risky.
A lower cap rate means an investment is less risky.
Appraisal Report
The APPRAISAL REPORT is the documentation of the appraisers findings. The types of appraisal reports include:
- SHORT FORM - a filled-in form using checks and explanations
- LETTER FORM - a brief written report
- NARRATIVE REPORT - an extensive written report
Financial Analysis
Financial Analysis - To analyze a rental property’s income and expense history under the income approach, the appraiser begins with an annual property operating data sheet (APOD). The APOD breaks down both in dollar amounts and as percentages the income and specific operating expenses of the subject property so as to determine its profitability. From these facts, and appraiser then applies formulas to arrive at a current property value.
appraisal
Appraisal - an individual’s opinion of a property’s value on a specific date, documented in an appraisal report.
broker price opinion
Broker price opinion (BPO) - an agent’s opinion of a property’s fair market value based on comparable sales.
capitalization approach
Capitalization approach - an appraisal method used by an appraiser to arrive at a property’s value based on the present worth of a property’s future net operating income.
capitalization rate (cap rate)
Capitalization rate (cap rate) - the annual rate of return on investment produced by the operations of an income property or sought by an investor on the investment of capital. The cap rate is calculated by dividing the net operating income by the price asked or offered for income property. NOI / VALUE = CAP RATE
NOI / CAP RATE = VALUE
comparable sales (comps)
Comparable sales - sales of properties recently sold which have similar characteristics as the subject property being evaluated and are used for analysis in the appraisal of the subject property.
cost approach
Cost approach - one of the three approaches to estimate value in real estate appraisal, used for special use properties such as churches, schools, and public buildings. this is used usually in facilities for use by the public, and for example if the facility burned down what is the cost to rebuild it.
Reproduction is a version of the Cost Approach to appraisal valuation. Generally, the Cost Approach produces the highest estimate of value of all the appraisal methods.
These are all part of the Cost Approach Appraisal Method:
- Reproduction
- Unit-In-Place is a sub element of construction.
- Index Method is for historic cost valuations.
- Quantity Survey is the most detailed method used by subcontractors when making bids on projects.
depreciation
Depreciation - loss of property value brought about by age, physical deterioration or functional or economic obsolescence. The term used to account for the annual tax free return of capital invested in improvements over the life of the improvements, such as a reduction in the properties cost basis.
