Real Estate Appraisal Principles and Procedures

Chapter: Real Estate Appraisal Principles and Procedures

Introduction

This chapter lays the foundation for understanding real estate appraisal, a critical skill for mastering income valuation as outlined in this “Mastering Income Valuation: From Annuities to Yield Rates” course. We will explore the core principles and standardized procedures employed in real estate appraisal, focusing on how these principles directly inform the income approach to valuation. Understanding these basics is crucial for effectively applying advanced techniques like discounted cash flow analysis, direct capitalization, and yield capitalization which will be taught in later modules.

1. The Nature and Function of Appraisal

1. 1 Defining Real Estate Appraisal:
   Real estate appraisal is defined as an impartial, unbiased, and objective estimate or opinion of the value of a specific interest in real estate as of a specific date, supported by relevant data. The function of an appraisal is to provide a credible and defensible opinion of value. This differs fundamentally from simply providing a ‘price’. The value estimate is derived from thorough research, market analysis, and application of accepted valuation principles.

2. 2 Purposes of Appraisals:
   Appraisals serve numerous purposes, each requiring a specific definition of value (e.g., market value, investment value, insurable value). Common purposes include:

   • Financing (mortgage lending)
   • Sales and Purchases
   • Tax Assessment (property taxes)
   • Estate Planning and Settlement
   • Eminent Domain
   • Investment Analysis: Crucial for applying the income approach, determining if a property’s income stream justifies its price based on investor-required rates of return. This directly relates to the annuity and yield rate concepts emphasized in this course.

3. 3 The Appraisal Process: A Systematic Approach
   The appraisal process is a structured methodology involving several distinct steps:

   1. Definition of the Problem: Identifying the property, the interest being valued, the purpose of the appraisal, and the effective date. This step directly impacts which approach to valuation will be most relevant (cost, sales comparison, or income). For income producing properties, this stage is crucial to identify the sources of revenue, the lease structures and the expense drivers.
   2. Preliminary Survey and Appraisal Plan: Gathering initial information about the property and the market, and formulating a plan for the appraisal process.
   3. Data Collection and Analysis: This is the most exhaustive part of the appraisal and includes:
      • General Data: Economic forces, social trends, governmental regulations, and environmental factors affecting the overall market area. For income properties, this involves analysing market rent and vacancy trends, as well as expense inflation and supply/demand balances.
      • Specific Data: Property characteristics (size, condition, amenities), site characteristics (location, zoning), and comparable sales data. Includes financial data (income statements, expense reports, rent rolls)
   4. Highest and Best Use Analysis: Determining the most probable and legal use of the property that is physically possible, appropriately supported, financially feasible, and results in the highest value.
   5. Application of the Valuation Approaches: Applying one or more of the three approaches to value (cost, sales comparison, and income).
   6. Reconciliation of Value Indications: Analyzing the results from the different approaches and arriving at a final value opinion.
   7. Report of Defined Value: Communicating the appraisal findings in a clear and concise report.

2. Fundamental Principles of Real Estate Value

Understanding the underlying principles of real estate value is essential for accurate appraisal.

2. 1 Principle of Supply and Demand:
   Value is influenced by the relative scarcity of a property and the desire (demand) for it. This is a fundamental economic principle:
   * Value ∝ Demand / Supply
   In the context of income properties, high demand for rental units and limited supply will drive up rents and, consequently, the property’s value, influencing capitalization rates and the applicability of annuity-based valuation models.

3. 2 Principle of Substitution:
   A prudent investor will pay no more for a property than the cost of acquiring an equally desirable substitute on the open market. This underpins the sales comparison approach and also informs the income approach by suggesting that investors will seek similar risk-adjusted returns from comparable investment opportunities.

4. 3 Principle of Anticipation:
   Value is based on the expectation of future benefits to be derived from the property. For income-producing properties, this is especially critical. Investors are buying the right to receive future income streams. This is the basis for Discounted Cash Flow (DCF) analysis, a central topic in this course. The present value of future cash flows, discounted at an appropriate rate reflecting the risk, determines the property’s value.

   *  *PV = CF1 / (1 + r)^1 + CF2 / (1 + r)^2 + ... + CFn / (1 + r)^n*
   *  Where:
       * PV = Present Value
       * CFn = Cash Flow in Year n
       * r = Discount Rate (Yield Rate)
       * n = Number of Years
   

5. 4 Principle of Change:
   Real estate values are constantly fluctuating due to changing economic conditions, market trends, and social factors. Appraisers must be aware of these changes and their potential impact on value.
   * Market cycle analysis is important, looking at expansion, recession, contraction and recovery.

6. 5 Principle of Conformity:
   Value is maximized when properties are similar and compatible with the surrounding area. Non-conforming properties may experience a decrease in value.

7. 6 Principle of Contribution:
   The value of any component of a property is measured by its contribution to the overall value, not by its individual cost. This principle is directly applicable to analyzing the impact of specific improvements or features on the income stream of a property.

8. 7 Principle of Highest and Best Use:
   The most profitable use of the property must be considered when determining its value.

3. The Three Approaches to Value

Appraisers typically employ three approaches to estimate value:

9. 1 Sales Comparison Approach:
   This approach compares the subject property to similar properties (comparables) that have recently sold. Adjustments are made to the sale prices of the comparables to account for differences in property characteristics.
   * Adjustments are made based on quantitative and qualitative analysis.
   * Critical to consider factors influencing income potential.
   * Adjusted Sale Price of Comparable = Sale Price ± Adjustments

10. 2 Cost Approach:
    This approach estimates the cost to reproduce or replace the subject property, deducts accrued depreciation, and adds the value of the land.
    * Useful for new or unique properties and properties where income data is scarce.
    * Less reliable for older properties with significant depreciation.
    * Value = Reproduction Cost – Accrued Depreciation + Land Value

11. 3 Income Capitalization Approach:
    This approach estimates value based on the income the property is expected to generate. This is the primary focus of this course.

    • Direct Capitalization: Involves dividing the property’s net operating income (NOI) by a capitalization rate (cap rate) to arrive at an estimate of value.
      • Value = NOI / Cap Rate
      • The cap rate represents the rate of return an investor expects to receive on their investment. It reflects the risk associated with the property and the market conditions. A high risk investment will require a high cap rate, and vice versa.
    • Yield Capitalization (Discounted Cash Flow Analysis): Projects the property’s future cash flows over a specified period (holding period), discounts these cash flows to their present value using a discount rate (yield rate), and adds the present value of the reversion (sale of the property at the end of the holding period).
      • This method aligns directly with the “annuities to yield rates” theme of the course.
      • Value = PV of Future Cash Flows + PV of Reversion

4. Data Collection and Analysis for Income-Producing Properties

Accurate data collection and analysis are critical for applying the income approach.

12. 1 Rent Rolls:
    Detailed records of current rents, lease terms, and tenant information. Analyze rent trends, vacancy rates, and lease expiration dates.

13. 2 Operating Expenses:
    Documented expenses such as property taxes, insurance, maintenance, utilities, and management fees. Analyze historical expense trends and compare them to market averages.

14. 3 Market Data:
    Information on comparable rental rates, capitalization rates, and discount rates. Gather data on sales of similar income-producing properties. Market rent and vacancy surveys are key for projecting future cash flows.

15. 4 Financial Statements:
    Review historical income statements and balance sheets to understand the property’s financial performance.

5. Highest and Best Use Analysis for Income Properties

Determining the highest and best use is crucial for accurate valuation, especially in the income approach.

16. 1 Four Tests of Highest and Best Use:
    • Legally Permissible: Conforms to zoning regulations, building codes, and environmental restrictions.
    • Physically Possible: Feasible given the property’s size, shape, topography, and soil conditions.
    • Financially Feasible: Generates sufficient income to cover operating expenses and provide a reasonable return on investment. This connects directly to the principles of income valuation taught in this course.
    • Maximally Productive: Produces the highest net income or value.
17. 2 Interim Use: The temporary use of a property until a higher and better use becomes feasible.
18. 3 Mixed-Use Properties: Properties that combine different uses, such as retail and residential. Analyze each component separately and then combine the results.

6. Reconciliation and Final Value Opinion

Reconciliation is the process of analyzing the results of the different valuation approaches and arriving at a final value opinion.
19. 1 Weighting the Approaches:
Different approaches may be given more weight depending on the property type and the availability of data. For income-producing properties, the income approach typically receives the most weight.
20. 2 Considerations:
Factors like the quality of the data, the reliability of the assumptions, and the market conditions should be considered. The goal is to arrive at a well-supported and credible value opinion.

7. Practical Application and Experiment Example: Deriving a Cap Rate

Experiment:

1. Objective: To derive a market-supported capitalization rate for apartment buildings in a specific area.
2. Procedure:
   • Gather Data: Collect sales data on at least five comparable apartment buildings that have sold recently in the subject area. Include sale price, NOI (Net Operating Income) at the time of sale, and relevant property characteristics (number of units, age, location, amenities).
   • Calculate Cap Rates: For each comparable, calculate the cap rate by dividing the NOI by the sale price: Cap Rate = NOI / Sale Price.
   • Analyze the Data: Analyze the calculated cap rates and identify any trends or patterns. Consider factors that may have influenced the cap rates, such as property condition, location, and lease terms.
   • Adjust for Differences: If necessary, adjust the cap rates of the comparables to account for differences between the comparables and the subject property. For example, if the subject property is newer and has higher-quality amenities than the comparables, a lower cap rate may be warranted.
   • Derive a Market Cap Rate: Based on the analysis of the comparable cap rates, derive a market-supported cap rate for apartment buildings in the subject area.
3. Expected Outcome: A range of cap rates from the comparable sales, and an average or median cap rate, representing the investor’s required rate of return for similar properties in that market.
4. Application: Use the derived cap rate to value a similar apartment building in the same market, applying the direct capitalization formula. Compare this value to other possible values derived from other approaches and reconcile results.

Conclusion

This chapter has provided a comprehensive overview of real estate appraisal principles and procedures, emphasizing the importance of these principles in applying the income approach to valuation. By understanding the underlying principles of value, the appraisal process, and the various valuation approaches, students will be well-equipped to master the advanced techniques taught later in this course, including discounted cash flow analysis and yield capitalization. The principles highlighted here will enhance your ability to critically analyze income streams, appropriately apply discount rates, and ultimately, make informed investment decisions based on accurate and reliable property valuations.