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Participants in the real estate market commonly think of value in three ways:

  1. The current cost of 

    reproducing or replacing 

     the building, minus an estimate for depreciation, plus the value of the land (and entrepreneurial incentive, if applicable).

2. The value indicated by recent sales of comparable properties in the market.

3. The value that the property’s net earning power will support.

 

The Appraisal Foundation (TAF)

visit

The primary standards body, its Appraisal Standards Board (AQB), promulgate, and updates best practices as codified in the Uniform Standards of Professional Appraisal Practice (USPAP). In contrast, its Appraisal Qualifications Board (AQB) promulgates minimum standards for appraiser certification and licensing.

Uniform Standards of Professional Appraisal Practice – USPAP

REVIEW: The quality control standards for real estate appraisers.

REVIEW

USPAP relates to the appraisal specialty of real estate

 

 
 
 
 

The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA)

An Act to reform, recapitalize, and consolidate the Federal deposit insurance system, to enhance the regulatory and enforcement powers of Federal financial institutions regulatory agencies, and for other purposes.

Demanded all the states to develop systems for licensing and certifying real estate appraisers.

FIRREA gives both Freddie Mac and Fannie Mae additional responsibility to support mortgages for low-and moderate-income families.

 

How Fannie Mae and Freddie Mac Work

Banks lend money to people who want to buy a house. These loans, called mortgages, can be significant, as much as $300,000 or more, and borrowers typically have 15 to 30 years to repay them. With so many people needing mortgages, and with such long periods of time passing before these large debts are repaid, banks could run out of money to loan.

This is where Fannie Mae and Freddie Mac come in.

Fannie and Freddie work with lenders, not borrowers.

They buy mortgages from banks, which allows the banks to turn a quick profit and gives them the capital necessary to lend again.

FANNIE MAE

  • Fannie buys mortgages from private commercial banks, like Chase and Bank of America

FREDDIE MAC

  • Freddie buys mortgages from smaller banks, a.k.a., thrifts
 

Mortgage Backed Securities

Mortgage debt that Fannie and Freddie buy is then sold to investors as mortgage-backed securities (MBS).

Fannie and Freddie guarantee the loans that are bundled into the mortgage-backed securities they sell to investors.

In other words, if a borrower defaults on the mortgage, Fannie or Freddie will pay the investor (the ultimate owner of the mortgage debt) instead of the borrower.

 
 

Depreciation

Three Different Types of Depreciation

  1. Physical Deterioration

  2. Functional obsolescence

  3. External obsolescence

Land value is estimated separately in the cost approach.

Land Does Not Depreciate

Depreciation (appraisal)

Loss of property value due to any physical, functional, or external condition.

The loss of value in an improvement over time. It does not apply to land!

The cost of the structure divided by its economic life equals the annual amount of depreciation.

Depreciation is of three different types (physical deterioration, functional obsolescence, and external obsolescence) and is measured through market research and specific procedures.

Depreciation is

Wasting Assets. Land does not depreciate. Only the improvements (buildings) depreciate.

Effective Age

Age of an improvement, taking into consideration all forms of depreciation. A building maybe ten years old, but poor maintenance may have an effect of 20 years.

Physical Deterioration

Physical Deterioration

Ordinary wear and tear, age, and breakage.

Deferred Maintenance

Postponement of curable repairs; leads to further deterioration.

Physical Deterioration– a leaky roof, a cracked foundation wall, worn-out window tracks. Fixable.

Normal wear and tear on a building is neither external nor functional (internal) obsolescence. It’s deterioration.

Observed Condition Method

The method used by an appraiser to determine depreciation by subtracting observed physical deterioration, functional obsolescence, and external obsolescence figures from the replacement cost. 

 
 
 
 

Obsolescence (2Types)

 
 

Physical/Functional Obsolescence

Curable Depreciation

Depreciation that is not cost-prohibitive to repair.

Functional Obsolescence– four bedrooms, two-story home with one bathroom. A home with three bedrooms on the second floor and one bathroom on the first floor. Loss in value due to something on the property.  Usually Fixable.

A poor floor plan can cause functional obsolescence.

A single car garage could cause functional obsolescence.

 
 
 

External/Economic Obsolescence 

Incurable Depreciation

Loss of property value that cannot be fixed due to high cost or external factors.

External Obsolescence– Loss in value due to an airport expanding its runway, and now planes fly over a neighborhood at a low altitude. 

A deteriorating neighborhood with buildings not being maintained.

External is something outside the property. 

It could be a public dump or railroad tracks.

External obsolescence could result from a gas storage tank located near the proper.

 
 
 
 

Approaches to Value

 

Sales Comparison Approach

Based on the principle of substitution. 

Most appropriate for residential property, and sets the upper limit of value as it is concerned with most recent sales. Formerly known as the market data approach.

The sales comparison approach is most useful when several similar properties have recently been sold or are currently for sale in the subject property’s market.

Using this approach, an appraiser develops a value indication by comparing the subject property with similar properties, called comparable sales.

The sale prices of the properties that are judged to be most comparable tend to indicate a range in which the value indication for the subject property will fall.

The appraiser estimates the degree of similarity or difference between the subject property and the comparable sales by considering various elements of comparison:

  • Real property rights conveyed
  • Financing terms
  • Conditions of sale
  • Expenditures made immediately after purchase
  • Market conditions
  • Location
  • Physical characteristics
  • Economic characteristics
  • Use/zoning
  • Non-realty components of value

Comparables

Similar properties in the vicinity of the subject (property being appraised) in the direct sales comparison approach to value.

An appraiser will compare the comps to the subject and make adjustments to the comparables accordingly.

Comparable – a name for sold homes used in an appraisal or a CMA. The comparable gets adjusted when comparing it to the subject property.

In a sales comparison approach to appraisal, you subtract or add the comparable, not the subject property.

Substitution – what an appraiser uses to determine value by comparing equally desirable substitutes nearby.

 

Diminishing Returns

The point in time when improvements can’t add value to a property anymore. The property is overbuilt or over-improved for the neighborhood.

Progression 

the least expensive or smallest home in the neighborhood made up of more extensive and more expensive homes.  

What is the result of a doctor building a very large house in a neighbor of very small houses?

Regression

The doctor suffered from regression when he built a massive home in a neighborhood of tiny homes.

 
 
 
 

Cost Approach

Cost Approach

The cost approach is based on the understanding that market participants relate value to cost.

The cost approach is based on the understanding that market participants relate value to cost.

The cost approach is a real estate valuation method that estimates the price a buyer should pay for a piece of property is equal the cost to build an equivalent building.

In the cost approach, the property’s value is equal to the cost of land, plus total costs of construction, less depreciation.

Value of Land PLUS Costs of Construction MINUS depreciation.

It yields the most accurate market value for when a property is new than through alternative methods.

If there is a new home built on a farm and the nearest neighbor is 35 miles away, an appraiser will use the Cost Approach.

The current cost to construct the improvements can be obtained from cost estimators, cost manuals, builders, and contractors.

cost – depreciation + land worth = value of the property.

This approach is particularly useful in valuing new or nearly new improvements and properties that are not frequently exchanged in the market. Cost approach techniques can also be employed to derive information needed in the sales comparison, and income capitalization approaches to value, such as an adjustment for the cost to cure deferred maintenance items.

An approach to determining value based on adding the cost of the land (as if vacant) (+) the current replacement cost of improvements (-) accrued depreciation.

Estimated value of the land

In the cost approach, the value of a property is derived by adding the estimated value of the land to the current cost of constructing a reproduction or replacement for the improvements and subtracting the depreciation amount in the structures from all causes.

Entrepreneurial profit and incentive may be included in the value indication.

The current cost to construct the improvements can be obtained from cost estimators, cost manuals, builders, and contractors. Depreciation is of three different types (physical deterioration, functional obsolescence, and external obsolescence) and is measured through market research and specific procedures.

Land value is estimated separately in the cost approach.

This approach is particularly useful in valuing new or nearly new improvements and properties that are not frequently exchanged in the market. Cost approach techniques can also be employed to derive information needed in the sales comparison, and income capitalization approaches to value, such as an adjustment for the cost to cure deferred maintenance items.

An approach to determining value based on adding the cost of the land (as if vacant) (+) the current replacement cost of improvements (-) accrued depreciation.

Replacement Cost

Replacement Cost

Cost to replace a structure to a similar utility using current materials and modern construction methods.

Estimating replacement cost methods include square-foot, unit-in-place, quantity-survey, or index.

Reproduction Cost

Reproduction Cost

Cost to reproduce a structure exactly, using identical original materials and methods.

Sets the highest level of value.

A house was built on a ranch or farm where there are no comparable properties, what method would a appraiser use to find value?

Reproduction Cost

Even though it is a house, there re no comparable nearby.  The appraiser will resort to the price to reproduce the house.

Quantity Survey Method

Quantity Survey Method

The most complex, technical, time-consuming, and accurate method of determining replacement/reproduction cost is considering materials and labor and regulatory fees, survey, taxes, profit, etc.

They are applied primarily to historic structures.

Square-Foot Method

The most common and easiest method of determining replacement cost based on cost-per-square-foot of a comparable, recently constructed building multiplied by the square footage of the subject property

Unit-in-Place Method

Unit-in-Place Method

A method of determining replacement cost based primarily on the value of materials per square foot or yard (or another unit of measurement) plus labor, profit, etc.

Less technical and involved than the quantity survey method.

Development Method

Development Method

The estimated value after development less the *cost of development equals the approximate value of the land.

Accrued Depreciation (Cost Approach)

The difference between a property’s estimated reproduction cost (cost approach to value) and the current market value.

It is the sum of depreciation from all causes.

When an appraiser uses the income approach to a building, is he concerned about the price of the building next door?

NO

The appraiser does not take into account of any loans on a property

Example:

When finding the “Highest and best use” of a property the appraiser is not concerned with the property’s loans. 

 
 
 
 
 

Income Approaches

Gross Rent Multiplier

Capitalization is an investor’s rate of return.

A capitalization rate incorporates return on land and building and recaptures of the building.

With the income approach, the “highest and best use property” is the one that delivers the highest net return.

Gross Income Multiplier

Capitalization Approach

Income-producing real estate is typically purchased as an investment, and earning power is the critical element affecting property value from an investor’s perspective.

  • Value is measured as the present value of the future benefits of property ownership.

Rate of Return – Cap Rate Capitalization Rate

The rate of return.

An estimate of the rate of return an investor will demand the investment of capital in a property.

The yield of an investment is expressed as a percentage that the investor expects to make over ownership.

GRM – Gross Rent Multiplier. Residential homes.

Yield

Annualized amount of return to an investor; expressed as a percentage of the original investment.

Operating Expenses

Fixed expenses, variable expenses, and replacement reserves of operating and maintaining a property.

Expenses do NOT include debt service (value is the same whether mortgaged or purchased with cash), capital improvements, or depreciation. Loans are considered incidental.

Net Operating Income (NOI)

Projected income from a property, NOT including depreciation or cost of financing.

Effective Gross Income

Estimated income from a property after vacancy and collection loss is subtracted from gross income.

Residual Method

An appraisal process is used in the income approach to estimate the value of the building by deducting the land’s value.

The appraiser has to remember to add in the value of the land.

 
 


 
 

Comparison Approach, Income Approach, and Replacement Costs are the three best ways to determine value.

 

Automated Valuation Method (AVM)

Zillow and Trulia

An AVM is a residential valuation report that can be obtained in a matter of seconds. It is a technology-driven report.

The product of an automated valuation technology comes from analysis of public record data and computer decision logic combined to provide a calculated estimate of a probable selling price of a residential property.

An AVM generally uses two types of evaluation, a hedonic model and a repeat sales index.

Each is weighted, analyzed, and then reported as a final estimate of value based on a requested date.

 
 
 

Competitive/Comparable Market Analysis

CMA – Comparative Market Analysis is based on the Sales Comparison Approach

A CMA is a tool for real estate professionals. It helps the seller to determine a listing range.

A broker or salesperson uses them in attempting to find a listing price range.

It’sIt’s a scaled-down version of the appraiser’s sales comparison approach. It is NOT an appraisal.

A CMA estimates a home’s value done by a real estate broker to establish a listing or offer price.

This service is usually offered free of charge and without obligation.

A CMA should only be used as a reference for deciding at what price you should list or buy a home.

A tool for real estate professionals. 

It is NOT an appraisal. 

It does NOT indicate the value`

How does an agent get to the final selling pice using a CMA when the subject property is in a neighbor of many foreclosures?

When an agent wants to do a CMA in a mostly foreclosed neighborhood, he/she will take the actual arm’s length (or more) sales comparisons from the bank instead of the foreclosed price.

CMA- Comparative Market Analysis– Benefits the Seller. 

It helps agents determine a price range for a property to list. It doesn’t determine value. Only an appraisal can determine value.

 
 
 

Broker Price Opinion (BPO)

Broker Price Option (BPO)

Lenders often use them in conjunction with loan portfolio valuation, loss mitigation, short sales, or collections.

 
 
 

Cash Concept

The amount an individual would be willing to pay for the property in cash. (direct sales comparison approach)

When an appraiser is doing an appraisal, he does not use ‘land depreciation.’

The economic life of a building has come to an end when the value of the land and the building equals the land’s value only. It’s a teardown.

The best reason for buying real estate is appreciation.