Real Estate Appraisal: Principles

Chapter 1: real estate appraisal❓❓: Principles

Introduction

Real estate appraisal is a critical component of income capitalization and overall real estate valuation. It involves the process of developing an opinion of value❓ for a specific property, considering various factors that influence its market worth. This chapter will delve into the fundamental principles underpinning the appraisal process, providing a scientific framework for understanding how value is estimated. We will explore key concepts, theories, and methodologies utilized by appraisers, emphasizing their relevance to income capitalization techniques.

1. Value and its Dimensions

• Definition of Value: Value, in appraisal terms, is typically defined as the most probable price❓ a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus. This definition highlights several key dimensions.

  • Market Value vs. Other Values: It’s crucial to distinguish market value from other types of value, such as investment❓ value (value to a specific investor), insurable value (cost of replacement), or liquidation value (value in a forced sale).

• Economic Characteristics of Value (DUST): For a property to possess value, it must typically exhibit the following characteristics, commonly remembered by the acronym DUST:

  • Demand: There must be a desire and ability to purchase the property.
  • Utility: The property must be able to satisfy a need or want.
  • Scarcity: The supply of the property must be relatively limited.
  • Transferability: Ownership rights must be readily transferable.

2. Principles of Value

The following principles serve as guiding concepts in the appraisal process.

• 2.1 Principle of Supply and Demand:

  • Theory: This fundamental economic principle states that the value of a property is influenced by the relationship between the available supply of similar properties and the demand for them.

  • Equation: A simplified representation can be expressed as:

    • Price ∝ Demand / Supply

      Where price is directly proportional to demand and inversely proportional to supply.

  • Practical Application: An increase in demand without a corresponding increase in supply will typically lead to higher property values. Conversely, an oversupply can depress values.

  • Experiment: Consider a hypothetical market with 100 available rental units and 90 potential renters. The equilibrium rental rate will be lower compared to a scenario where there are 100 units and 110 potential renters. Track market responses to varying levels of demand.

• 2.2 Principle of Highest and Best Use:

  • Definition: The most profitable, legally permissible, physically possible, and financially feasible use of a property. It is the use that maximizes the property’s value.

  • Four Tests:

    1. Legally Permissible: The use must conform to zoning regulations, building codes, and other legal restrictions.
    2. Physically Possible: The site must be suitable for the proposed use, considering factors like size, shape, topography, and soil conditions.
    3. Financially Feasible: The use must generate sufficient income to cover operating expenses, debt service, and provide a reasonable return on investment.
    4. Maximally Productive: Among the feasible uses, the one that generates the highest net return to the property.

  • Practical Application: A vacant lot near a busy intersection might have a highest and best use as a retail strip mall rather than a single-family residence, even if residential zoning exists. The appraiser must justify this conclusion.

• 2.3 Principle of Substitution:

  • Theory: A prudent buyer will pay no more for a property than the cost of acquiring an equally desirable substitute on the open market. This principle forms the basis for the sales comparison approach.

  • Practical Application: If three similar houses are for sale, and two are priced at $300,000 while the third is priced at $350,000, a buyer will likely choose one of the less expensive options, unless the third property has some significantly superior feature.

  • Mathematical Representation (simplified):

    • Property Value ≤ Cost of Substitute

• 2.4 Principle of Contribution:

  • Theory: The value of a component part of a property is measured by the amount it contributes to the overall value of the whole property, not necessarily its cost.

  • Practical Application: Adding a swimming pool to a property might cost $50,000, but it might only increase the property’s value by $30,000 if the neighborhood is not conducive to swimming pools. The pool’s contribution to value is therefore $30,000.

• 2.5 Principle of Anticipation:

  • Theory: Value is created by the expectation of future benefits to be derived from the property. This is particularly important in income capitalization, where future income streams are discounted to present value.

  • Practical Application: An investor buys an apartment building anticipating that rents will increase in the future. This anticipation of higher income is a key driver of the property’s current value.

  • Mathematical Representation (simplified):

    • Value = PV (Future Benefits)

      Where PV is the Present Value and Future Benefits refers to income, appreciation, or other advantages of ownership.

• 2.6 Principle of Change:

  • Theory: Real estate values are dynamic and subject to constant change. Economic, social, political, and environmental forces can all influence property values.

  • Practical Application: A new factory opening near a residential area might initially increase property values due to increased employment opportunities, but may decrease due to congestion, pollution or noise.

• 2.7 Principle of Conformity:

  • Theory: Property values are maximized when there is reasonable similarity among properties in the neighborhood. This includes factors like architectural style, size, and quality of construction.

  • Practical Application: A large, modern house built in a neighborhood of smaller, older homes might not achieve its full potential value because it is out of conformity with the surrounding properties.

• 2.8 Principle of Competition:

  • Theory: Competition among similar properties affects value. Excess profits tend to attract competition, which can then drive down prices and returns.

  • Practical Application: A successful shopping center might attract new shopping center developments in the area, leading to increased competition and potentially lower occupancy rates or rents for all centers.

3. Forces Influencing Real Estate Value

Understanding the external forces that impact real estate values is crucial for accurate appraisal.

• Economic Forces: These include interest rates, inflation, employment levels, income levels, and economic growth.
• Social Forces: These include population trends, demographic shifts, lifestyle changes, and cultural preferences.
• Political Forces: These include government regulations, zoning laws, building codes, property taxes, and environmental regulations.
• Environmental Forces: These include climate change, natural disasters, proximity to amenities and disamenities (e.g., parks vs. industrial sites), and environmental contamination.

4. The Appraisal Process

The appraisal process is a systematic approach to estimating value, typically involving the following steps:

1. Definition of the Problem: Identify the property being appraised, the purpose of the appraisal, the date of the appraisal, and the type of value to be estimated (e.g., market value, investment value).

2. Scope of Work Determination: Determine the extent of the research and analysis required to develop a credible appraisal. This includes identifying the data sources, appraisal approaches to be used, and the level of detail required.

3. Data Collection and Analysis: Gather and analyze relevant data, including property data (characteristics, condition, sales history), market data (sales of comparable properties, market trends), and economic data (interest rates, employment rates).

4. Application of the Approaches to Value: Apply one or more of the three main approaches to value:

   • Sales Comparison Approach (Market Approach): Comparing the subject property to similar properties that have recently sold.
   • Cost Approach: Estimating the cost to reproduce or replace the property, less depreciation.
   • Income Capitalization Approach: Converting the property’s future income stream into an estimate of present value.

5. Reconciliation of Value Indications and Final Opinion of Value: Analyze the results of each approach and reconcile them into a single, final opinion of value.

6. Report of Defined Value: Communicate the appraisal findings in a written report.

5. Applying Appraisal Principles to Income Capitalization

The principles discussed in this chapter directly influence the application of income capitalization techniques. For example:

• Anticipation: Income capitalization relies heavily on anticipating future income streams. Accurate income projections are crucial for a reliable valuation.
• Highest and Best Use: Determining the highest and best use of the property is essential for estimating the potential income it can generate.
• Substitution: Market data, as used in finding capitalization rates, is directly related to the principle of substitution.

Conclusion

Understanding the underlying principles of real estate appraisal is essential for mastering income capitalization techniques. By grasping the concepts of value, the forces that influence it, and the systematic appraisal process, you can develop a more informed and accurate understanding of real estate valuation. The next chapters will delve deeper into specific income capitalization methods, building upon the foundation established in this chapter.