Principles of Real Estate Appraisal

Chapter Title: principle❓s of real estate appraisal❓❓

Introduction

This chapter, “Principles of Real Estate Appraisal,” forms the foundation upon which our understanding of depreciation, the core subject of this training course, “Mastering Depreciation: Unlocking Property Value,” is built. Accurate appraisal is crucial for identifying, measuring, and understanding depreciation – the loss in value from all causes. We will explore the scientific principles that underpin the appraisal process, emphasizing their relevance to understanding and quantifying physical deterioration, functional obsolescence, and External Obsolescence❓❓. The principles discussed here guide appraisers in developing credible opinions of value, which are essential for making informed investment decisions and effectively applying the age-life, sales comparison, and cost-to-cure methods.

I. Fundamental Economic Principles Influencing Value

These principles are the driving forces behind property value and directly impact the assessment of depreciation. Ignoring these principles leads to inaccurate appraisals and flawed depreciation estimates.

A. Supply and Demand

1. Definition: The relationship between the availability (supply) of properties and the desire (demand) for them.

2. Scientific Theory: Microeconomic theory posits that in a competitive market, price (value) is determined by the intersection of the supply and demand curves. Increased demand with constant supply drives prices up, while increased supply with constant demand drives prices down. Mathematically:

   • P = f(S, D)

     Where:

     • P = Price (Value)
     • S = Supply
     • D = Demand
     • f = Function representing the relationship

3. Application to Depreciation: Oversupply in a neighborhood due to economic downturn can lead to external obsolescence, negatively affecting property values and increasing depreciation. Conversely, high demand for properties with specific features can mitigate the impact of physical deterioration by increasing the overall value.

4. Example: Imagine a neighborhood where many new homes are built. The increased supply can lower the prices of existing homes, increasing depreciation, especially if the older homes have not been updated to compete with the new construction. This could lead to functional obsolescence due to outdated features or layouts.

B. Anticipation

1. Definition: Value is based on the expected future benefits of property ownership.

2. Scientific Theory: This principle aligns with the time value of money concept. Future income streams, utility, or resale value are discounted to their present value. The Discounted Cash Flow (DCF) analysis is a prime example.

3. Application to Depreciation: Expected future costs of repair or renovation due to physical deterioration directly influence the amount of depreciation. Properties anticipated to require significant future repairs will experience greater depreciation.

4. Example: An old roof that is nearing the end of its useful life will negatively impact the anticipated future cash flow of a rental property due to expected replacement costs. This anticipation of future costs translates into higher depreciation today.

C. Substitution

1. Definition: A rational buyer will pay no more for a property than the cost of acquiring an equally desirable substitute.

2. Scientific Theory: This principle is rooted in the concept of opportunity cost. Buyers will always choose the property offering the best utility and price combination.

3. Application to Depreciation: Comparable sales analysis relies heavily on this principle. If a similar property is available at a lower price due to less depreciation (better condition, newer improvements), the subject property’s value will be constrained.

4. Example: If two houses are nearly identical except one has a brand-new kitchen and the other has an outdated kitchen, the house with the updated kitchen is an equivalent substitute for the other, but at a higher price due to the upgrade. This limits how high the value of the outdated kitchen can be driven.

D. Conformity

1. Definition: Property values are maximized when they conform to surrounding properties.

2. Scientific Theory: This principle reflects the idea that homogeneity within a neighborhood creates stability and predictability, reducing risk and enhancing value.

3. Application to Depreciation: Non-conforming properties may experience higher depreciation due to functional or external obsolescence. A highly deteriorated property in a well-maintained neighborhood suffers more significant value loss than if it were located in a similar condition neighborhood.

4. Example: A poorly maintained, dilapidated house in a neighborhood of well-kept homes will suffer significant depreciation due to its non-conformity. It will be harder to sell and will command a lower price than similar homes in the neighborhood.

E. Competition❓❓

1. Definition: Competition among sellers can drive prices down, while competition among buyers can drive prices up.

2. Scientific Theory: Market equilibrium is achieved through competitive interactions. This principle reflects the dynamic nature of the real estate market.

3. Application to Depreciation: Intense competition from newer, more modern properties can accelerate depreciation of older, less desirable properties due to functional obsolescence.

4. Example: A newly constructed apartment complex with modern amenities will create competition for older apartment buildings. This competition can result in lower occupancy rates and rental income for the older buildings, leading to increased depreciation.

II. Principles Related to Property Characteristics and Depreciation

These principles directly influence the identification and measurement of the different types of depreciation.

A. Contribution

1. Definition: The value of a component is measured by its contribution to the overall value of the property, not its cost.

2. Scientific Theory: Marginal utility theory suggests that the value of an improvement is determined by the incremental utility it provides to the buyer.

3. Application to Depreciation: To accurately estimate depreciation, appraisers must consider how individual elements (e.g., roof, HVAC system, foundation) contribute to the overall value. For instance, a new roof, while costly, may not significantly increase value in a neighborhood where most properties have similarly aged roofs, thus reducing the impact of physical depreciation.

4. Experiment and formula: To apply this principle, the appraiser can do a paired sales analysis or multiple regression analysis to find the contribution of an element.

   • Contribution value of an element = property value with the element - Property value without the element.
     Example: If a new kitchen increases the total house value by $40,000, the Contribution value of the kitchen = total property value with the new kitchen - total property value without the new kitchen = $40,000.

B. Highest and Best Use

1. Definition: The most probable use of a property that is legally permissible, physically possible, financially feasible, and maximally productive.

2. Scientific Theory: This principle ensures that the property is valued based on its optimal utilization, considering all relevant constraints.

3. Application to Depreciation: Depreciation must be considered within the context of the property’s highest and best use. If a property is significantly underutilized, the calculated depreciation may not accurately reflect its true value potential if it were converted to its highest and best use.

4. Example: A large, dilapidated warehouse in a rapidly developing urban area might have minimal value in its current state due to significant physical depreciation and functional obsolescence. However, its highest and best use might be redevelopment into residential apartments, which would significantly increase its overall value. The depreciation analysis must consider this potential use.

C. Change

1. Definition: Real estate values are constantly changing due to various factors, including economic conditions, demographic shifts, and technological advancements.

2. Scientific Theory: Dynamic systems theory suggests that real estate markets are complex and constantly evolving systems.

3. Application to Depreciation: Depreciation is not a static measure. It is influenced by ongoing changes in the market and property characteristics. Appraisers must consider these changes when estimating depreciation to ensure accurate assessments.

4. Example: The introduction of new energy-efficient building materials can lead to functional obsolescence in older buildings that lack these features, increasing their depreciation.

III. Approaches to Value and Depreciation Estimation

The three traditional approaches to value provide frameworks for integrating depreciation analysis.

A. sales comparison approach❓❓

1. Principle: The value of a property is determined by comparing it to similar properties that have recently sold, making adjustments for differences.

2. Application to Depreciation: This approach directly incorporates depreciation by adjusting comparable sales for differences in physical condition, functional features, and external factors. Accurate estimation of depreciation in comparable sales is crucial for determining the subject property’s value.

3. Mathematical Representation: Adjusted Sale Price = Sale Price +/- Adjustments (Condition, Features, Location)

   • Adjustments for Depreciation: If the comparable property is newer and in better condition, a downward adjustment is made to its sale price to reflect the depreciation in the subject property.

4. Experiment example: To do a Sales comparison analysis for estimating depreciation, an appraiser must select at least three comparable sales that have sold within the last six months that are in the same neighborhood and have similar characteristics as the subject property. The appraiser must then make adjustments to the comparable sales prices based on differences between the properties.

B. Cost Approach

1. Principle: The value of a property is equal to the cost of constructing a new, equivalent structure, less accrued depreciation, plus the value of the land.

2. Application to Depreciation: This approach relies heavily on accurate depreciation estimation. The accrued depreciation represents the total loss in value from all causes (physical deterioration, functional obsolescence, external obsolescence) and is subtracted from the replacement or reproduction cost.

3. Mathematical Formula: Value = Cost of New Construction - Accrued Depreciation + Land Value

   • Accrued Depreciation: Calculated using methods such as age-life, cost-to-cure, or market extraction.

4. Experiment example: An appraiser can use the Cost Approach to determine a property’s depreciation. The appraiser must first determine the cost of new construction by doing a cost estimation. Second, the appraiser must determine the land value. After, the appraiser calculates the accrued depreciation with a method, such as the age-life, cost-to-cure, or market extraction.

C. Income Capitalization Approach

1. Principle: The value of a property is based on its expected future income stream.

2. Application to Depreciation: Depreciation is indirectly considered through its impact on income and expenses. Physical deterioration, functional obsolescence, and external obsolescence can all reduce a property’s rental income, increase operating expenses (e.g., maintenance costs), and shorten its economic life, thereby affecting its value.

3. Mathematical Formula: Value = Net Operating Income (NOI) / Capitalization Rate (Cap Rate)

   • Impact of Depreciation: High levels of depreciation may lead to lower NOI (due to increased vacancy or lower rents) and/or higher cap rates (due to increased risk), resulting in a lower property value.

4. Experiment example: An appraiser can use the Income Capitalization Approach to determine a property’s depreciation. The appraiser first obtains the Net Operating Income of the subject property. Then the appraiser looks at comparable sales and their cap rates.

IV. Conclusion

Understanding these core principles of real estate appraisal is crucial for accurately assessing depreciation and unlocking the true value of properties. By grounding our analysis in economic theory, property characteristics, and the established approaches to value, we can develop credible opinions of value and make informed investment decisions. The following chapters will delve deeper into the specific methods for identifying and measuring different types of depreciation, building upon the foundational knowledge presented here.