Page 1 - Property Valuation and Appraisal Study Guide for the Real Estate License Exam
There’s a big difference between the price of a property and the value of a property. That’s why appraisers and appraisals of real estate are so necessary and important. In this section, we’ll cover the literally dozens of items that go into preparing a property valuation and learn how determining a property value is a mixture of art and science.
A real estate appraisal is used to establish the market value of a property. Appraisals are used for a variety of purposes, including sales, mortgage lending, property tax assessments, and insurance.
All states require real estate appraisers to be licensed in order to practice, just as real estate agents must be licensed. Licensing for appraisers falls into four general categories: Registered Trainee, Licensed Appraiser, Certified General Appraiser, and Certified Residential Appraiser.
Types of Licenses
Although there are four general types of licenses, individual states vary on how many they offer. In some states, appraisers only have a choice of two licenses, while in other states there are four types of real estate appraisal licenses available.
Certified Residential—A certified residential appraiser is licensed to appraise more expensive and more complex residential properties of up to four units.
Certified General—As this license suggests, a certified general appraiser is licensed to appraise all types of real property regardless of how expensive a property is or how complicated the property is.
Licensed—A licensed residential appraiser is limited to appraising less valuable and less complex properties. They normally work with low- or mid-range single family homes.
Registered Trainee—This type of appraiser is registered with the state to perform appraisal services only under the direction of a licensed or certified appraiser. Registered trainees are mentored before receiving their appraiser license or certification.
Federal law requires all state-licensed and certified appraisers to pass an exam administered by the state that the appraiser will do business in. Although the number of licenses varies between states, all state testing follows a uniform exam format.
Federal law also requires that all states have a State Appraiser Regulatory Agency responsible for certifying, licensing, and supervising their appraisal-related business activities. This law comes from Title XI of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989—also known as FIRREA.
The Purpose of an Appraisal
The purpose of an appraisal is to help someone make a decision in the purchase, sale, insuring, lending, or taxation of real estate. Appraisals are used to determine the estimated market value of real property.
Real Estate Value and Appraisals
The appraised value of a property is the property value at a given point in time. Because time changes, appraisal values can also change. In this section, we’ll look at several of the factors that can influence appraised real estate values.
Environmental and Physical
Physical factors that affect real estate values include the location, geography, and access to water and transportation. Environmental factors appraisers consider when establishing market value include air quality, wetlands and wildlife, and the condition of the soil.
Financial or economic value is the value that somebody gets from using real property. Different parties will see different economic values for their specific individual use. Those values can be the same, or higher, or even lower than the market value of the property.
Master planning by a municipality is a good example of the role that government can play in establishing real estate values. For example, a piece of land that lies alongside a proposed highway on/off ramp may have a higher value—due to future development potential—than a parcel of land with minimal access.
Social factors that can affect the value of real property include current and future population growth, local economic performance, and the rate of crime in the immediate market area.
Real estate appraisers run the risk of being sued by buyers, sellers, and lenders. Appraisers need to know the law and understand the potential liability of professional negligence, in the same way that real estate agents must.
Appraisal Value Types
The value of a property depends on who you ask. While market value is the most common, there are also many other kinds of value depending on the purpose of the appraisal and what will be done with the appraiser’s property valuation.
Three different methods are used to determine the market value of a property: sales comparison approach, cost of replacement approach, and income approach used for investment property generating rental revenue.
Other property valuations include the assessed value used for taxation, the liquidation value if a property needs to be sold immediately, and the insured value, which excludes the value of the land.
Loan or Mortgage—A lender will order an appraisal (paid for by the borrower) to ensure that the property value is at least equal to the sales price. Note that a property doesn’t have to appraise for the purchase price, only for the loan amount—but if this occurs, a buyer may need to put more money down.
Investment—Investment real estate is often appraised using the income approach. With this type of appraisal, the appraiser looks at the amount of cash being generated by the property, in addition to sales comparables.
Use and Exchange—Appraisals are also done on properties that are being exchanged for one another. The purpose of this type of appraisal is to ensure that the values of the properties being exchanged are equal to one another.
Assessed—Municipal tax assessors appraise a property for taxation purposes. Property tax assessors use different valuation formulas, and it is important to remember that the assessed value of a property is not the same thing as the market value.
Insurable—Insurance companies use appraisals to determine the replacement cost of a property. This type of appraisal does not consider the cost of the land, only the cost to repair or replace existing structures on the land. That’s because the land will not go away.
Going-Concern—This type of appraisal looks at the value of a business that is expected to continue operating versus going out of business. It factors in the value of the business real estate, the revenue the business generates, and any intangible assets, such as copyrights.
Comparative Market Analysis—Also known as a comparative residential market analysis, this is what real estate agents do when they pull comps for buyers or sellers. It is a less sophisticated version of what is done by a licensed professional appraiser.
Automatic Valuations—Also known as an AVM or automated valuation model, this type of appraisal is used to determine a property’s value at a future point in time. It is used to value residential property by combining historical sales from publicly available data with computer decision logic and mathematical modeling.
Evaluations—The FDIC, or Federal Deposit Insurance Corporation, sometimes allows lenders to use a property evaluation instead of an appraisal. Evaluations are used when: (1) Transaction value is $250,000 or less, (2) Business loan is $1 million or less and not dependent on real estate income or sale for loan repayment, (3) There are no changes to the property or market that affect the real property as collateral or no new money is being advanced (except for closing costs).
The Economics of Appraisal
Appraisals are a combination of art and science. Automatic valuations are a good example of using science to determine property value. But there are also many subjective factors or principles that are used in determining the market value of a property.
The principle of anticipation is what an appraiser utilizes when using the income approach to value a property. As the name suggests, the appraiser anticipates future income the property will generate to help determine the current market value of the real property.
The principle of balance—or proportionality—seeks to determine if there is balance in a specific area. For example, if a new apartment building is being constructed near neighboring apartment buildings, but the demand for apartment living is going down, the area would be considered to be out of balance by having too many apartments for too few renters.
Similar to the principle of balance, the principle of change looks at economic and social factors that affect property value, but on a more macro level. For example, if a community is undergoing gentrification or redevelopment, real estate could become more valuable in the future.
Competition is the tendency of highly profitable use to be duplicated. For example, if real estate investors see that rental prices are increasing, they may turn more units into rentals or build more rental property. Over a period of time, if the market changes, the area can also become unbalanced with too much supply and not enough demand.
The principle of conformity means that a property is more likely to increase in value if it is similar to surrounding properties. For example, a very old house in a neighborhood of brand new homes will likely be worth less per square foot even if the old house were the same size as the newer homes.
The principle of contribution means that the value of a particular part of a property is measured by how that part contributes to the overall property value. For example, a house with a brand new roof would increase the value of the house more than just the cost of the roof.
Increasing and Decreasing Returns
The principle of increasing and decreasing (or diminishing) returns means that something is profitable, or makes sense, only up to a certain point. For example, if a municipality increases its permitting costs and taxes on rental apartments to the point where the owner does not make enough profit, the rental apartments can be said to have reached the point of decreasing returns.
Opportunity cost is a benefit that someone potentially misses out on when they choose one property over another. Another way of thinking about opportunity cost is scarcity versus choice. If someone only has a certain amount of money to invest (scarcity), he or she tries to make the choice that offers the most opportunity (usually for profit) compared to other alternatives.
The principle of substitution is used to set the upper limit of value of a property. For example, everything else being equal, an apartment renter would not pay 10 percent more to rent property B when property A offers the exact same location, features, and amenities. The principle of substitution can also be thought of as people having choices.
Supply and Demand
The principle of supply and demand establishes both the price and quantity of real estate. For example, a seller’s market is when there is more demand for housing than there is supply. A buyer’s market is when there are too many homes on the market and not enough buyers.
Surplus productivity is what occurs when the owner’s expenses are deducted from the net income of a property. For example, if a property has a net income of $1,000 per month, but the owner spends $500 of her time and labor managing the property, the surplus productivity of $500 is the owner’s actual return on her investment.