Foundations of Real Estate Appraisal

Chapter: Foundations of Real Estate Appraisal

Introduction

Real estate appraisal is the process of developing an opinion of value for a specific property. It’s not merely a guess, but a carefully considered estimate based on objective data, market analysis, and established appraisal principles. This chapter lays the scientific groundwork for understanding the core concepts that underpin competent and credible real estate appraisals. We will explore the definition of value, the forces that influence value, and the fundamental principles that guide the appraisal process.

1. Defining Value

Value is the central concept in real estate appraisal. However, it’s crucial to recognize that value is not an intrinsic property of real estate. Instead, it represents the monetary relationship between properties and those who buy, sell, or use those properties. (USPAP Definition).

• Value as an Opinion: Value is an opinion of worth, not a fact. It’s an appraiser’s reasoned conclusion based on available data and analysis. This opinion is valid at a specific time and under a specific definition of value.
• Types of Value: Different situations require different value definitions. Common types include:
  • Market Value: The most probable price a property should bring in a competitive and open market, assuming willing buyers and sellers, reasonable exposure time, and informed parties. Market value is very clearly defined in the chapter.
  • Investment Value: The value to a specific investor with particular investment goals.
  • Insurable Value: The value an insurance company is willing to reimburse in case of loss.
  • Liquidation Value: The value expected in a sale within a relatively short period.
  • Assessed Value: The value placed on a property by a tax assessing official for taxation purposes (Ad Valorem Taxes).
  • Going Concern Value: Value of an ongoing business or project.

2. Forces Influencing Real Estate Value

Real estate value is not static. It is influenced by a variety of external forces that interact to shape market conditions and property desirability.

• Economic Forces: These relate to the overall economy, including:
  • Interest Rates: Higher rates increase borrowing costs, potentially decreasing demand and property values.
  • Employment Levels: Strong employment typically leads to increased demand for housing.
  • Inflation: Can impact construction costs and operating expenses.
  • Economic Base: Strong, diversified economy brings sustained demand.
• Social Forces: These reflect societal trends and preferences, such as:
  • Demographics: Population growth, age distribution, and household size influence housing needs.
  • Lifestyle Preferences: Trends toward urban living or suburban sprawl impact location desirability.
  • Social Attitudes: Perceptions about neighborhood safety, school quality, and community amenities affect property values.
• Political Forces: These are government regulations and policies, including:
  • Zoning Regulations: Land-use controls that dictate permissible building types and densities.
  • Building Codes: Standards for construction quality and safety.
  • Property Taxes: Can significantly impact affordability and investment returns.
  • Government Restrictions of Property Rights: Eminent Domain, Escheat, Police Power, Special Assessments.
• Environmental (Physical) Forces: These include factors related to the natural environment and the specific site:
  • Location: Proximity to amenities, transportation, and employment centers.
  • Site Characteristics: Size, topography, soil conditions, and views.
  • Environmental Hazards: Flood zones, contaminated soil, and proximity to industrial sites can negatively affect values.

3. Fundamental Principles of Real Estate Appraisal

Several core economic principles guide the appraisal process. These principles are not laws but rather observed tendencies that consistently influence real estate value.

• Principle of Supply and Demand: Value is determined by the interaction of supply and demand in the market. If supply exceeds demand, prices tend to fall. If demand exceeds supply, prices tend to rise.
• Principle of Substitution: A person will not pay more for a property than the cost of another property having equal function and desirability. This principle underlies the Sales Comparison Approach.
• Principle of Anticipation: Value is affected by perceived future benefits. Investors buy property for its anticipated future income or appreciation.
• Principle of Change: Values are not constant because supply and demand are in constant flux.
  • Real Estate Cycle: Real Property Life Cycle is directly related to the Principle of Change (Development State, Maturity, Decline, Disintegration)
• Principle of Competition: When extraordinary profits are made, competition will enter the marketplace and profits will be reduced. High profits attract new businesses, which can eventually saturate the market and drive down prices.
• Principle of Conformity: Values are enhanced when surrounding properties conform in use to subject property. Properties that are similar in style, size, and quality tend to command higher prices.
• Principle of Contribution: The value of an improvement is equal to the increase of value added to the property. Not what the cost of the improvements are.
• Principle of Increasing and Decreasing Returns: Adding more of a factor of production (e.g., capital improvements) will increase returns only up to a certain point. Beyond that point, the additional investment will yield diminishing or even negative returns.
• Principle of Surplus Productivity: The cost that exceeds the cost of labor, capital and management (coordination) is attributable to the land.

4. Property Rights and Interests

Understanding the various rights and interests associated with real estate is essential for accurate valuation.

• Real Property vs. Personal Property:
  • Real Property: Land and anything permanently attached to it (buildings, fixtures).
  • Personal Property: movable❓ items not permanently attached to the land (furniture, appliances).
  • Fixture: A former item of personal property which has become part of the realty.
  • Method of Attachment: How firmly attached is the item?
  • Intention: What was the intent of the installer?
  • Agreement of the Parties: What does the purchase agreement say?
• Estates in Land: Represent the degree, quantity, nature, and extent of an owner’s interest in real property.
  • Freehold Estates: Ownership interests of uncertain duration.
    • Fee Simple: The most complete form of ownership, with the full bundle of rights.
    • Life Estate: Ownership for the duration of someone’s life.
  • Leasehold Estates: Rights to use and occupy property for a stated term.
• Non-Possessory Interests (Encumbrances): Rights or claims that affect the title to property but do not include the right to possess it.
  • Easements: Right to use another’s property for a specific purpose.
    • Easement in Gross: An easement benefitting a person rather than a property.
  • Liens: Financial claims against property.
  • Private Restrictions: Covenants, conditions, and restrictions (CC&Rs) that limit the use of property.

5. The Appraisal Process

The appraisal process is a systematic approach to developing a credible opinion of value. The text mentions eight steps:

1. Defining the Appraisal Problem: Clearly identify the property, the intended use of the appraisal, the effective date of the appraisal, and the type of value to be estimated.
2. Preliminary Analysis: Identify the necessary data and its sources, and create a plan for the appraisal.
3. Collecting, Verifying, and Analyzing the Data: Gather relevant market data, property data, and comparable sales data.
4. Highest and Best Use Analysis: Determine the most profitable, legally permissible, and physically possible use of the property. That legal and probable use that results in maximizing the value of the land.
5. Valuing the Site: Estimate the value of the land as if vacant and available for its highest and best use. Reasons for separate valuation.
6. Applying the Three Approaches to Value: Develop value indications using the Cost Approach, Sales Comparison Approach, and Income Approach.
7. Reconciling the Value Indicators: Weigh the reliability of each approach and arrive at a final estimate of value.
8. Reporting the Value Estimate: Communicate the appraisal findings in a clear, concise, and well-supported report.

6. Ethics and Standards in Appraisal

The appraisal profession is governed by ethical standards and professional guidelines to ensure objectivity, impartiality, and competence.

• Uniform Standards of Professional Appraisal Practice (USPAP): The universally recognized ethical and performance standards for appraisers.
• The Appraisal Foundation: A non-profit organization authorized by Congress to develop appraisal standards and appraiser qualifications.
  • Appraisal Standards Board (ASB): Develops, interprets, and amends USPAP.
  • Appraiser Qualifications Board (AQB): Establishes minimum education, experience, and examination requirements for appraiser licensing and certification.
• State Appraisal Regulatory Boards: Responsible for licensing and regulating appraisers within their respective states.

7. Practical Applications and Experiments

• Market Analysis Project: Conduct a market analysis for a specific property type in a given area. Gather data on sales, listings, vacancy rates, and economic trends. Analyze the data to identify market strengths and weaknesses, and project future value trends.
• Highest and Best Use Case Study: Evaluate a property with multiple potential uses. Analyze the feasibility, legality, and profitability of each use to determine the highest and best use. Consider zoning regulations, market demand, and environmental constraints.
• Sales Comparison Approach Exercise: Select a subject property and identify comparable sales in the market. Adjust the sale prices of the comparables to account for differences in property characteristics, market conditions, and financing terms. Reconcile the adjusted sale prices to arrive at an indicated value for the subject property.

8. Mathematical Formulas and Equations

• Area of a Rectangle:
  • Area = Length x Width
• Simple Interest:
  • Interest = Principal x Rate x Time
• Gross Rent Multiplier (GRM):
  • GRM = Sale Price / Gross Rent
• Capitalization Rate (R):
  • R = Net Operating Income (NOI) / Value
• Value:
  • Value = Net Operating Income (NOI) / Capitalization Rate (R)

Conclusion

This chapter has provided a foundational understanding of the key concepts and principles that underpin real estate appraisal. By grasping these fundamentals, aspiring appraisers can build a solid base for mastering the more advanced techniques and complexities of the profession.