Appraisal Process: Approaches to Value

Chapter 7: Appraisal Process: Approaches to Value

Architectural Styles and Home Design: A Comprehensive Guide

Description: Unlock the secrets of home design and architectural styles! This course provides a comprehensive overview of different house types (one-story, two-story, split-level, etc.), architectural styles (Cape Cod, Colonial, etc.), and the crucial element of compatibility in design. Learn how to analyze site characteristics, understand market preferences❓, and maximize property value through informed design choices. Discover how architectural styles affect real estate value.

This chapter delves into the three fundamental approaches to value used in the appraisal process: the Cost Approach, the Sales Comparison Approach, and the Income Approach. Each approach will be examined with specific attention paid to its underlying principles, data requirements, mathematical formulations, and relevance to architectural styles and home design. The goal is to provide a scientific understanding of how these approaches, when properly applied, can be leveraged to maximize property value through informed design choices.

I. Introduction

Real estate appraisal seeks to estimate the market value of a property. Market value, as defined by the Uniform Standards of Professional Appraisal Practice (USPAP), is the most probable price which 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 chapter explores the three generally accepted appraisal approaches utilized to derive an objective opinion of market value.

II. The Cost Approach

The Cost Approach estimates value by considering the cost of constructing a new, similar improvement, accounting for depreciation❓, and adding the value of the land. It is based on the principle of substitution, which states that a rational buyer will pay no more for a property than the cost of acquiring an equivalent substitute. The Cost Approach is particularly relevant for new or unique properties, properties with limited comparable sales❓ data, and in valuing special-purpose properties. It also directly integrates the principles of architectural design and construction quality into the valuation.

A. Theoretical Framework

The Cost Approach is predicated on the following formula:

Property Value = Land Value + Cost of New Improvements - Accrued Depreciation

Where:

• Land Value: Estimated separately, reflecting its “highest and best use” as if vacant. This value is directly tied to the analysis discussed in Chapter 6 (Site Valuation).

• Cost of New Improvements: The estimated cost to construct a replica or replacement of the existing building at current prices.

• Accrued Depreciation: The total loss in value from all causes: physical deterioration, functional obsolescence, and external obsolescence.

B. Detailed Steps

1. Estimate Land Value: This is essential. Refer to Chapter 6.

2. Estimate Cost of New Improvements: Two primary methods are used:

   • Reproduction Cost: The cost to create an exact replica of the existing structure, using the same materials, design, and construction methods. Often impractical, especially for older buildings with obsolete materials.
   • Replacement Cost: The cost to build a property of equivalent utility, using modern materials, design, and construction standards. More commonly used, aligning with market substitution principles.

   Cost estimating can be performed using cost manuals (e.g., Marshall & Swift), quantity survey methods (detailed breakdown of labor and materials), or comparative unit method (cost per square foot based on similar buildings).

3. Estimate Accrued Depreciation: This is a critical and often challenging aspect. Depreciation is the loss in value from three sources:

   • Physical Deterioration: Loss in value due to wear and tear, deferred maintenance, and the effects of aging on the building’s structural components, exterior finishes, and interior systems. Can be curable (economic❓ally feasible to repair) or incurable.

     Example: Cracked foundation (incurable), peeling paint (curable).

     Formula: Depreciation = Effective Age / Total Economic Life. Effective Age is the age of the property based on its condition, which might be less than its actual age if well-maintained. Total Economic Life is the estimated period over which the property will contribute value.

   • Functional Obsolescence: Loss in value due to defects in design, layout, or utility that make the property less desirable or efficient compared to current market standards. Can be curable (e.g., adding a bathroom) or incurable (e.g., inefficient floor plan). Directly relates to the architectural compatibility described in the course description.

     Example: Outdated kitchen, inadequate closet space, poor traffic flow.

   • External Obsolescence: Loss in value due to factors external to the property, such as neighborhood decline, environmental contamination, or changes in zoning regulations. Typically incurable.

     Example: Increased traffic noise, proximity to a blighted area.

4. Calculate Property Value: Apply the Cost Approach formula using the estimated values from the previous steps.

C. Scientific Principles and Theories

• Principle of Substitution: The underpinning of the Cost Approach, ensuring that the estimated value aligns with what a buyer would rationally pay for an equivalent property.

• Depreciation Theory: Understanding the causes and types of depreciation and their impact on value requires a scientific approach, considering material science (degradation rates), engineering principles (structural integrity), and market psychology (buyer preferences).

D. Practical Applications and Experiments

• Experiment: Conduct a cost survey by obtaining quotes from contractors for different construction materials (e.g., roofing, siding). This will demonstrate the range of costs and the importance of accurate cost data.

• Architectural Style Impact: Compare the cost of replicating different architectural styles. For example, a complex Victorian design with intricate detailing will have a higher reproduction cost than a simple Ranch-style home. This reinforces the course description’s focus on understanding the impact of architectural styles on value.

• Formulas:

  • Effective Age / Total Economic Life = % Depreciation
  • Reproduction Cost New – Depreciation = Indicated Value

E. Relevance to Architectural Styles and Home Design

The Cost Approach highlights the significance of architectural design and construction quality on value. Superior designs with high-quality materials contribute to a higher replacement cost and lower depreciation, ultimately increasing property value. Conversely, outdated designs or poor construction methods result in higher depreciation and lower overall value.

III. The Sales Comparison Approach

The Sales Comparison Approach, also known as the Market Approach, is based on the principle of substitution. It estimates value by comparing the subject property to similar properties that have recently sold in the market. It is most effective when there are abundant, reliable sales data of comparable properties.

A. Theoretical Framework

The Sales Comparison Approach is premised on the idea that a rational buyer will pay no more for a property than what similar properties have sold for. This approach involves identifying comparable sales, adjusting their prices for difference❓s compared to the subject property, and reconciling the adjusted prices to arrive at an indication of value.

The fundamental formula is:

Subject Value = Comparable Sales Price +/- Adjustments

B. Detailed Steps

1. Identify Comparable Sales: Select properties that are similar to the subject in terms of location, physical characteristics (size, age, architectural style), condition, date of sale, and terms of sale. A key aspect is to find comparables within the same neighborhood/architectural style, thus directly connecting to this course’s description. Data sources include MLS, public records, and appraisal data services.

2. Verify Sales Data: Confirm the accuracy of the sales data by contacting the parties involved in the transaction (real estate agents, buyers, or sellers) or by reviewing public records. Ensure the sale was an “arm’s length” transaction, meaning it wasn’t influenced by special relationships or duress.

3. Identify Elements of Comparison: Determine the key differences between the subject property and each comparable sale. Elements of comparison include:

   • Property Rights Conveyed: Fee simple, leasehold, etc.

   • Financing Terms: Cash, conventional mortgage, seller financing. Adjustments are necessary to reflect the effect of non-market financing.

   • Conditions of Sale: Arm’s length transaction, motivated buyer and seller.

   • Expenditures Immediately After Sale Costs immediately post sale for necessary repairs or improvements that would have to be made before a buyer would be able to move into or use the property.

   • Market Conditions: Changes in market activity since the date of the comparable sale. This is also know as “time adjustments”.

   • Location: Neighborhood desirability, proximity to amenities, exposure to nuisances.

   • Physical Characteristics: Size, age, condition, design features, lot size, architectural style. For this course, architectural style is a key factor.

   • Economic Characteristics: Qualities such as income, operating expenses, lease provisions, management and tenant mix are used to analyze income-producing properties.

4. Make Adjustments to Comparable Sales Prices: Adjust the sales prices of the comparables to reflect the differences between them and the subject property. Adjustments are always made to the comparable sales price, not the subject.

   • Quantitative Adjustments: Based on market data, such as paired sales analysis (comparing sales of properties with and without a specific feature to isolate its value).

     Example: If a comparable property has an extra bathroom and the market indicates an extra bathroom is worth $5,000,subtract$5,000 from the comparable’s sales price.

   • Qualitative Analysis: Used when quantitative data is not available. Rank comparables as superior, inferior, or equal to the subject for specific characteristics.

     Example: Architectural style. If the subject has a more desirable architectural style, the comparable’s price will be adjusted upward.

5. Reconcile Adjusted Sales Prices: Analyze the adjusted sales prices of the comparables and reconcile them into a single value indication for the subject property. This involves weighing the reliability and relevance of each comparable, giving more weight to those that required fewer and smaller adjustments.

C. Scientific Principles and Theories

• Principle of Substitution: As with the Cost Approach, buyers are unlikely to pay more for the subject property than a similar, readily available substitute.

• Paired Sales Analysis: A statistical method used to isolate the contribution of individual property characteristics to overall value.

D. Practical Applications and Experiments

• Architectural Style Adjustment Experiment: Analyze sales of similar homes in a neighborhood, some with a recently renovated kitchen (modern style) and others with an original kitchen (outdated style). Calculate the average difference in sales price to derive a quantitative adjustment for kitchen style. This directly relates to the course description and could require the reproduction of designs for accurate comparison purposes.

• Time Adjustment Formula:

  • Sales Price at Time X * (1 + Appreciation Rate) = Adjusted Sales Price (Present Value)

E. Relevance to Architectural Styles and Home Design

The Sales Comparison Approach directly incorporates the principles outlined in this course. The selection of comparable properties requires careful consideration of architectural styles, design features, and the compatibility of the subject property with its neighborhood. Accurately assessing value hinges on understanding market preferences for different architectural designs and incorporating these insights into the adjustment process. For example, in a historical district, a Victorian-style home might command a premium, requiring upward adjustments to less aesthetically-compatible comparables.

IV. The Income Approach

The Income Approach estimates value by analyzing the income-generating potential of a property. It is most applicable to income-producing properties like apartments, retail buildings, and office buildings. While less common for single-family homes, the Income Approach can be used to analyze the investment potential of rental properties or to assess the market rent for a comparable property.

A. Theoretical Framework

The Income Approach is based on the principle of anticipation, which posits that a property’s value is derived from the present value of the future income it is expected to generate. There are various methods within the Income Approach, but the most commonly used in single-family homes is the Gross Rent Multiplier (GRM).

The basic formula is:

Property Value = Gross Rental Income x Gross Rent Multiplier

B. Detailed Steps

1. Estimate Gross Rental Income: Determine the market rent for the subject property by analyzing rents of comparable rental properties. This should reflect the income attainable on the open market.

2. Calculate Gross Rent Multiplier: GRM = Sales Price / Gross Rental Income. Determine the GRM by analyzing recent sales of comparable rental properties. Calculate the GRM for each comparable. The GRM formula may also look like this:

   GRM = Value (Sale Price) / Income (Gross Annual Rents)

   The range from the six sales of similar rentals in the market will be examined:
   Sale 1:
   $120,000Value$ 12,000 Rent / Year

   $120,000/$ 12,000 = 10 GRM

   The sales are now compared and a good judgment for the subject is made, with adjustments to the GRM being selected from the range. GRM range is typically between 6 and 12.

3. Apply GRM to Subject Property: Multiply the estimated gross rental income of the subject property by the GRM to arrive at a value indication.

C. Scientific Principles and Theories

• Principle of Anticipation: Value stems from future income.

• Time Value of Money: Future income is worth less than present income due to inflation, risk, and opportunity cost.

D. Practical Applications and Experiments

• Rental Rate Experiment: Survey several similar rental properties in the area. Adjustments for amenities or architectural style and design may affect rental rates. If so, adjust the rental rates for any differences with other rentals on the market.

• GRM Formula: As sales of similar rentals are accumulated, the appraiser can look for common multipliers.

E. Relevance to Architectural Styles and Home Design

The Income Approach is most relevant when assessing the investment potential of a rental property, where architectural design can influence both rental rates and occupancy rates. For example, an architecturally appealing property with modern amenities may command a higher rental rate and attract more desirable tenants, thus increasing the property’s value.

V. Reconciliation of Value Indications

After applying the three approaches to value, the appraiser must reconcile the value indications into a single, final value estimate. Reconciliation is not a simple averaging of the values. It requires the appraiser to analyze the strengths and weaknesses of each approach and assign weight to each indication based on its reliability and relevance to the specific appraisal problem.

Factors considered during reconciliation include:

• Data Availability: Were there abundant, reliable sales data for the Sales Comparison Approach?

• Market Conditions: Are costs and depreciation accurately reflected in the Cost Approach?

• Income Stream Reliability: Can future income be reliably predicted for the Income Approach?

• Property Type: The relevance of each approach varies with property type.

VI. Conclusion

Understanding the scientific underpinnings of the Cost Approach, Sales Comparison Approach, and Income Approach is paramount for effective real estate appraisal. By integrating these approaches with the principles of architectural styles and home design, appraisers can provide accurate and insightful value opinions that maximize property value through informed design choices. Ultimately, the goal is to determine the most probable price for a property within an open and competitive market.