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Evaluation Process: Essential Steps and Basic Concepts
Real Estate Appraisal: Objective estimation of a property’s value at a specific date, based on analyzing factors like physical characteristics, market conditionsโ (supply and demand, interest rates, economic growth), legal aspects (land division laws, taxes, environmental restrictions), and the highest and best use.
Importance of Appraisal: Assists in real estate transactions (buying/selling), financing, insurance, taxation, litigation (divorce, inheritance), and investment decisions.
Appraisal Process Steps:
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Defining the Problem:
- Property Identification: Location, area, type (residential, commercial, industrial), property rights (full ownership, lease, etc.).
- Purpose of Appraisal: Reason for appraisal (purchase, sale, financing, insurance, taxes).
- Effective Date of Appraisal: Date of value estimation, reflecting market conditions then.
- Standard of Value: Type of value to estimate (market value, use value, investment value, liquidation value).
- Property Rights: Defining rights associated with the property (Fee Simple, Leasehold, Easement).
- Assumptions and Limiting Conditions: Defining assumptions and restrictions affecting result accuracy.
Example: Appraising a residential house on 1/1/2024 for financing, assuming the property is in good condition.
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Preliminary Analysis and Market Data:
- General Data: Economic, social, governmental, and environmental factors affecting property values in the area.
- Specific Data: Information about the property, such as physical characteristics, building condition, sales history, income (if rented).
- Market Analysis: Supply, demand, prices, rents, vacancy rates, market trends.
Data Types:
- Primary Data: Collected directly (site visit, owner interview, government records).
- Secondary Data: Obtained from other sources (real estate databases, market reports, government studies).
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Highest and Best Use Analysis:
- Identifying most profitable and legal use of the property. Should be physically possible, legally permissible, financially feasible, and yield maximum value.
- Analysis done for the property as vacant land, and considering existing improvements.
Example: Land can be used for a house or commercial building. Analyzing return from each to determine the highest and best use.
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Land Valuation:
- Determining land value separately from improvements.
- Methods:
- Sales Comparison Approach: Comparing to similar recently sold lands.
- Extraction Method: Subtracting improvement value from a similar property’s sale price.
- Development Method: estimatingโ land value based on development return.
Note: Land value depends on location, area, shape, topography, accessibility, regulations.
Example:
- Similar 500 sq meter land sold for $100,000.
- The evaluated land value (500 sq meter) = $100,000.
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Application of Valuation Approaches:
- Three main approaches:
- Sales Comparison Approach: Comparing to similar recently sold properties, adjusting for differences.
- Cost Approach: Estimating value by calculating replacement or reproduction cost, subtracting depreciation, and adding land value.
- Income Approach: Estimating value based on income generation. Methods include:
- Direct Capitalization: V = NOI / R (Value = net operating incomeโโ / Capitalization Rate)
- Discounted Cash Flow (DCF): Estimating present value of future cash flows.
Note: Method selection depends on property type and appraisal purpose. Often, multiple approaches are used.
Examples:
- Sales Comparison: Commonly for residential homes and land.
- Cost: For new or specialized properties with no comparable sales.
- Income: For commercial/investment properties generating income.
- Three main approaches:
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Reconciliation:
- Reviewing and analyzing results from different approaches.
- Determining reliability of each approach, weighting more suitable approaches.
- Reaching a final value estimate.
Example: $150,000 (Sales Comparison), $160,000 (Cost). Weighting Sales Comparison more if the market is active with many comparable sales.
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Report Preparation:
- Writing a detailed report of all steps, and results.
- The report includes property information, appraisal purpose, date, value standard, data, methods, analyses, assumptions, restrictions, and the final value.
- Must be clear, accurate, objective, and compliant with professional standards.
Report Types:
- Narrative Report: Detailed report on all aspects.
- Summary Report: Less detailed, focusing on key results.
- Certificate Report: Short report stating the estimated value.
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Review:
- Comprehensive review by an independent third party (another appraiser or real estate expert).
- Ensures accuracy, objectivity, professionalism, and compliance.
Types of Value:
- Market Value: Estimated price in an open, competitive market with informed, willing parties.
- Value in Use: Value for a specific use, may differ from market value.
- Investment Value: Value to a specific investor, based on investment goals.
- Liquidation Value: Value from rapid sale under duress.
- Insurable Value: Value for insurance, reflecting replacement cost.
- Going Concern Value: Value of a business, including property, equipment, and goodwill.
Factors Affecting Value:
- Social Factors: Demographics, education, lifestyle trends, crime.
- Economic Factors: Interest rates, inflation, income/employment levels, economic growth.
- Governmental Factors: Zoning, taxes, environmental regulations, building codes.
- Environmental Factors: Location, climate, topography, access to services, natural hazards.
Principles of Valuation:
- Supply and Demand: Property value is affected by market balance.
- Substitution: Buyers won’t pay more than the cost of an equivalent property.
- Highest and Best Use: Property should be valued based on most profitable legal use.
- Contribution: Value of an element depends on its contribution to total value.
- Balance: Balanced production elements (land, labor, capital, management) for maximum value.
- Anticipation: Property value depends on expected future benefits.
- Change: Market conditions change, affecting property value.
- Conformity: Similar properties in an area have similar value.
- Competition: Influences property values.
Summary:
The chapter presents the foundations of real estate appraisal, including basic steps, value types, influential factors, and valuation principles.
Chapter Summary
The chapter aims to provide a comprehensive understanding of real estate appraisal, from basic concepts to the main steps for accurate and reliable valuation.
Key points:
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Concept of Value:
- Value is an estimate of the monetโary worth of the property, based on utility, scarcity, transferability, and effective demand (desire + purchasing power).
- Price is the actual transaction value, while value is an estimated concept.
- costโโ is the expenses needed to build or create the property, while value (and price) refer to the exchange of the property.
- Replacement cost is the cost of creating a substitute with similar utility.
- Reproduction cost is the cost of creating an exact replica.
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Economic Theory of Value:
- The marketโ is the interaction between sellers and buyers regarding real estate exchange.
- Supply and demand determine the value of the property in a competitive market. Values increase when demand exceeds supply and decrease when supply exceeds demand.
- The principle of substitution dictates that the value of a property cannot exceed the price of a substitute property with similar utility.
- A rational investor will not invest in a property if its income is less than the opportunity cost.
- Competition increases when supply and demand are unbalanced, tending to restore balance.
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Production as a Measure of Value:
- Wealth is created through the four factors of production: capital, land, labor, and coordination.
- Optimal property value is achieved when the factors of production are in equilibrium.
- Surplus productivity is attributed to land and is what remains of the property’s net income after deducting the costs of capital, labor, and coordination.
- Marginal productivity dictates that the value of a component of a property is the amount of increase in the value of the property as a whole due to its existence.
- Increasing investment in one factor of production in the property will initially increase the rate of return, but will eventually reach a point where the return begins to decline (point of diminishing returns).
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Impact of Use on Property Value:
- The property should be appraised at its highest and best use, which is any reasonable and legal use that generates the greatest profit.
- Consistency dictates that land and improvements should be valued for the same use.
- The value of a property increases when the uses of surrounding properties are compatible with the use of the property being appraised.
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Types of Value:
- Market value is determined by the market in a free transaction.
- Use value is the value of the property for a specific purpose only, as opposed to its highest and best use.
- Investment value is the value of the property to a specific investor, as opposed to its market value.
- liquidation valueโ is what the property can achieve with limited market exposure, such as in a mortgage sale.
- Assessed value is the market value multiplied by the applicable assessment ratio.
- Insurable value is the value of the property for compensation purposes under an insurance policy.
- Going-concern value is the value of an ongoing business that includes real estate as an integral part of its operations.
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Factors Affecting Value:
- social factorsโ include demographics and social norms.
- Economic factors include the cost of capital and the purchasing power of buyers and investors.
- Governmental factors include laws and regulations that affect value, such as zoning, taxes, environmental laws, financial regulations, and building codes.
- Environmental factors include land characteristics, climate, infrastructure, and location.
Conclusions:
- Understanding value and its influencing factors is the foundation of the real estate appraisal process.
- The appraiser must clearly identify the type of value being appraised.
- All social, economic, governmental, and environmental factors affecting property value must be considered.
- Knowing the optimal use of the property is one of the most important elements of accurate valuation.
