Chapter 9

Real Estate Appraisal

This chapter introduces a central issue in real estate decision making, “What is the property worth?”

Understanding the Appraisal Profession:FIRREAState Requirements:

Licensed appraisersCertified residential appraisersCertified general appraisers

What is Value:Market Value

Motivated PartiesInformed PartiesMarket ExposurePayment in CashNo Special

CircumstancesInvestment Value

Price vs. Market Value

Market Value vs. Cost of Production

Other Types of ValueAssessed ValueInsurable Value

Key Appraisal Principles:AnticipationChangeSubstitutionContribution

The Traditional Appraisal Process:Definition of the problem:

Type of value-purposeDescription of propertySpecific Property rightsEffective Date

Data Selection and Collection:General market analysisSpecific property analysis

Highest and Best Use Analysis:As though vacant A

Land with improvements B

A Highest and best use of land as if vacant is defined as that use, from among reasonably probable and legal alternative uses, found to be physically possible, appropriately supported, financially feasible and which results in the highest land value.

B The highest and best use of the site as improved is defined similarly except it is the use that results in the highest property value.

Highest and Best Use :Definition:

That use of a parcel of land that results in the greatest long-term economic return to the owner.Reasonably ProbableLegally PermissiblePhysically PossibleEconomically Feasible

HBUVacant Land:What is zoning?Utilities?Will site perk?Road access?Others?Which use could create the highest price for

the site (i.e. highest and best use)?

HBULand with improvements“Analysis much more difficult”Present use is Highest and Best Use unless improvement can be demolished and value of land is worth more than site and current improvement

Application of the three approaches to valuation:Sales comparison approachCost approachIncome approach

Reconciliation of value indicationsReport of defined value

Sales Comparison Approach:Comparable sales data:

SelectionHow many comparables

Adjustment of sales data:Elements of comparison:

Property rights conveyed Conditions of sale Financing terms Market conditions Locational Characteristics Physical Characteristics

Applying the sales comparison approach (Table 10.1)

Cost Approach:Estimating site valueEstimating production cost:

Reproduction costReplacement cost

Estimating accrued depreciation:Physical deteriorationFunctional obsolescenceEconomic obsolescence

Applying the cost approach (Table 10.2)

Cost Approach to Value

Subject Property: 155 Potter Dr. Land Valuation: Size 60' X 135' @$450 per front foot = $27,000 Plus site improvements: driveway, walks, landscaping, etc. = 8,000

Total $35,000 Building Valuation: Replacement Cost 1,500 sq.ft.@$65 per sq.ft. = $97,500

Less Depreciation:Physical depreciation Curable (items of deferred maintenance) exterior painting $4,000 Incurable (structural deterioration) 9,750Functional obsolescence 2,000External depreciation 0

Total -15,750Depreciated Value of Building $81,750 Indicated Value by Cost Approach $116,750

Income Approach:Gross Income MultiplierNet Income CapitalizationDiscounted Cash Flow (Table 10.3)

“CAP RATES”: Capitalization RatesThe capitalization rate is the ratio of first-year NOI

to property value. NOI / Property Value = Cap. Rate

The Cap. Rate is the rate at which future income is converted into present value. This technique is referred to as capitalizing income, and is used to value income generating real estate.Value = NOI / Cap. Rate

The Cap. Rate implicitly reflects the projected future NOI. If Future NOI estimates are expected to be lower, the price paid for the property will be lower, and the cap rate for that property will be higher, which reflects less investor optimism.

ESTIMATING NOI (Net Operating Income)

Potential Gross Income- Vacancy and Collection Losses+ Other Miscellaneous Income= Effective Gross Income- Operating Expenses= Net Operating Income

Income Capitalization Approach to ValuePotential Gross Annual Income $60,000Market Rent (100% Capacity)Income from Other Sources +600

(Vending Machines and Pay Phones) $60,600Less Vacancy and Collection Losses(estimated) @4% -2,424Effective Gross Income $58,176

Expenses:Real Estate Taxes $9,000Insurance 1,000Heat 2,800Maintenance 6,400Utilities, Electricity, Water, Gas 800Repairs 1,200Decorating 1,400Replacement of Equipment 800Legal and Accounting 600Management 3,000

Total $27,000 Annual Net Operating Income $31,176

Capitalization Rate = 10% (Overall Rate) Capitalization of Annual Net Income: $31.176/.10 Indicated Value by Income Approach = $311,760

GIM ANALYSISGIM Analysis is useful when market derived capitalization rates are hard to verify. Gross incomes are much easier to estimate than net operating incomes. Beware, however, operating expenses can vary greatly, particularly on older buildings

Steps1Verify recent sales of similar properties (property use and location)

2Determine gross income of these properties.

3Calculate “market” GIM by sales price/gross income

4Estimate subject property’s value by: gross income x GIM

Example:Sales Price/Gross Income = GIM

Comp 1 $500,000/62,500 = 8Comp 2 $650,000/76,741 = 8.5Comp 3 $700,000/80,000 = 8.75

GIM Range= 8-8.75 Avg GIM=8.42

Subject: Gross Income=$65,000 x 8.42 = $547,300 65,000 x 8 =$520,000- - - 65,000 x 8.75 =

$568,750 (Range of Value)