Property Valuation and Appraisal Study Guide for the Real Estate License Exam

More About Appraisals

Markets and Analysis

Markets are affected by events and factors that occur on local, state, regional, national, and global levels. The housing crash of 2008 is an example of “bad things” that occurred on all levels at the same time, an event that had never happened before. That’s one example of why solid analysis plays a critical role in determining both current and future property values.

Real Estate Markets

Real estate markets—or property markets—are made up of owners and users of real estate. Real estate markets are affected by a wide variety of factors, including supply and demand, interest rates and finance, the economy and job market, and the availability of investment capital.

Available National Information

Thanks to the Internet, there is a lot of useful information on the national real estate market available for free or for a minimum fee. Popular online information services include Zillow®, RentCafe®, and Realtor.com®.

Local Sources of Data

The above sources can also be used to find local real estate market data. Data available from the county recorder’s office or tax assessor’s office is very useful and usually available online as well. Some of the best local sources for data include real estate agent company meetings, associations such as the local multiple listing associations, and networking events to learn what people in the field are actually seeing and doing.

Property Demand

There is a wide variety of sources that real estate agents use to determine property demand in their market. In addition to the local real estate board, other sources for property demand data include title companies, mortgage brokers and lenders, municipal planning commissions, chambers of commerce, and local business publications.

Role of Market Analysis

All of the above factors are used in real estate market analysis. The role of market analysis is to determine the true market value of a property—how much it can be sold for, how much it should be purchased for, how quickly a property can be sold or rented, and how much rent can be charged.

Feasibility Analysis

Feasibility analysis combines market analysis with a regulatory and technical viability analysis of a real estate acquisition. For example, although a real estate market analysis might show a rising demand for single-family housing, government regulations encouraging affordable rental housing might make developing more single-family homes less feasible and building apartments more feasible.

Valuation

Property valuation determines the economic value of real estate. There are several specific, defined steps in the valuation process. A step-by-step process is important because, in order to make solid financial decisions, buyers, sellers, and lenders must be able to accurately determine the worth or value of real property.

Establishing the Task and Goals

Establishing the task and goals, or defining the problem, is the first step in determining what must be done and why. If this part is unclear, then the resulting steps will likely yield bad or incorrect data that may lead to costly financial mistakes.

Planning

Once the task and goals are clearly understood, the next step is to establish a plan to accomplish the task at hand. This includes considering the highest and best use of the real property, determining the approach or approaches to be used, and determining the data needed to accomplish the task and solve the problem.

Obtaining Data

Data collection and analysis falls into three categories. It is important to remember that the data collected should always be verified. The three types of data collected are: (1) general economic, social, and neighborhood trends; (2) property-specific data such as square footage, lot size, and rooms; and (3) comparable property data such as transaction date, price, location, and features.

Analyzing Highest and Best Use

This concept assumes that the property will be put to its most profitable use. That use must be: (1) legal, (2) physically possible, and (3) financially feasible. For example, the highest and best use of a parcel of land along a highway intersection would be for a gas station and convenience store and not for a single-family dwelling.

Determining the Land Value

Six factors determine land value: (1) physical attributes such as location, (2) access to economic activities like jobs, (3) neighborhood amenities such as shopping and schools, (4) present and future land use, (5) demand and supply, and (6) location and transportation linkages and infrastructure.

Applying Valuation Approaches

Once the data is collected and research is complete, a property value is ready to be determined. The three most common valuation approaches are: (1) cost approach, (2) sales comparison or comparable approach, and (3) income capitalization approach used for residential investment and commercial real estate.

Reconciling

Reconciling is when two or more different value indicators are analyzed, weighted according to how reliable and relevant they are, then combined to determine a single value or sometimes a range of values.

Reporting

The appraisal report is a detailed, written analysis describing how the property value was determined. The report includes all backup data and relevant factors that led to the appraised value of the real property in the report.

Property Description

A description of the real property includes the site details, the improvements on the site, and the construction and design of those improvements. The property description must be thorough enough so that a reader who is not a licensed appraiser understands the property description.

Site

The site is the area of land on which something is constructed. Depending on the property, the site can be described as a plot, lot, area, or plat.

Improvements

Improvements are items that add long-term value to the site. A house built on a residential lot is an improvement, as is a free-standing garage or an in-ground swimming pool.

Construction and Design

Construction and design provide further details of the improvements on the site. Brick, block, and aluminum siding on framed wood are construction details. Ranch, colonial, and split-level are some of the terms used to describe the design of a property.

Best Use and Highest Analysis

The highest and best use analysis looks at the reasonably probable and legal use of vacant land or an improved property. The use must be physically possible, appropriately supported, financially feasible, and must result in the highest value for the real property.

“Of Land as if Vacant”

Developing vacant land is similar to having a blank slate. There are a lot of things you can potentially do with it. But because real estate investors want the best return on their money, the question becomes: What is the best use for the vacant land that will maximize the return on their investment? To answer this question, one needs to consider the physical, legal, and financial aspects that will work together to create the highest and best use, or maximum productivity.

Physical Possibility—Characteristics of the site such as size, contour or topography, shape, and access must be taken into consideration.

Legal Permission—Uses that are not allowed by government regulations, zoning, and land-use or master planning are excluded from the analysis—unless there is a reasonable expectation that they may be changed.

Financial Feasibility—Financial feasibility means the use must generate enough money to pay for the construction plus create enough profit for the developer or investor.

Maximum Productivity—This is the highest return to the developer or investor. Note that different investors measure return differently. Some look at the internal rate of return (IRR), others look at the net present value (NPV), while others consider the development profit.

“As Improved”

If a property is already improved—in other words it has one or more structures on it—three possibilities must be considered to find the highest and best use of the improved parcel: (1) demolish and redevelop, (2) continue the existing use, and (3) modify the existing use.

The Math and Statistics for Appraisal

Appraisers must have a thorough understanding of real estate finance, statistics, and the modeling of residential and commercial valuation and evaluation.

Two Types

Two types of mathematics and analysis are used for appraisals: finance math and the statistics used to enter data into the financial equations the appraiser will use to ultimately determine the highest and best use of real property.

Finance math— Finance math means that mathematical methods or applications are used to solve financial problems or answer financial questions. Other names for finance math include quantitative finance, financial engineering, mathematical finance, and computational finance.

Statistics—Statistics are the data that are used in financial math equations. There are correct and incorrect ways to use statistics. Appraisers, and real estate agents, must have a firm understanding of what a statistic actually means. Let’s use six property sales—$25,000, $70,000, $100,000, $100,000, $120,000, and $250,000—to explain the following four statistical terms.

Mean—Mean is another word for average. By adding up our six property sales and dividing by six, we see that the mean (or average) sales price is $115,000.

Median—The median is found by arranging the data from lowest to highest and finding the middle value. We have already done this for you—the median is $100,000.

Mode—The data point that appears most often is known as the mode. In our example, the mode is also $100,000. Note that the mode does not always equal the median.

Range—The range is found by arranging the data in order from highest to lowest, then subtracting the smallest value from the highest value. In our example, the range is: $250,000 - $25,000 = $225,000.

The Approaches

Appraisers take three approaches when determining the market value of a property: (1) Sales Comparison Approach, (2) Cost Comparison Approach, (3) Income Approach.

Sales Comparison

The sales comparison approach looks at recent property sales that are as similar as possible to the subject property being appraised. The four parts of the Sales Comparison Approach are: (1) comparables, (2) units and elements of comparables, (3) land and improvements, and (4) adjustments when needed.

Comparables and their selection—Appraisers try to use an “apples to apples” approach when selecting comparables. Recent comparable sales, location or nearness to the subject property, sales price per square foot, and subjective factors such as curb appeal, neighborhood, and amenities, closeness to schools, and traffic or noise levels are all considered.

Units and elements of comparison—An element of comparison is a property characteristic, such as property rights, conditions of the sale, and location, that causes the price to vary. Units of comparison include factors such as square feet, size of lot, number of bedrooms, and an ocean view.

Land and improved property—The majority of real estate that is appraised is made up of two parts: land and the improvements or structures on the land. Although homes in a subdivision may be of similar design on similar-sized lots, they would not appraise the same. A home backing to a busy highway would have a lower market value than one in front of a park, everything else being equal.

Adjustment— In the above example, the appraiser would make an adjustment between the two homes. An adjustment is a dollar amount that is added or subtracted from the subject property’s market value based on a characteristic of a comparable that is different from the subject property. A swimming pool, two-car garage, backyard deck, and a new roof are other examples of differing characteristics between a comparable and the subject property.

Cost

The cost approach determines market value based on the cost to build the property. It consists of the value of the land plus the cost of construction minus depreciation (since the subject property is not brand new).

Site value—Determining the value of the land—or the site—is the first step taken in a cost approach appraisal. If comparable vacant land cannot be found, the appraiser will estimate the land value. However, making an estimate will also make the appraisal less accurate.

Reproduction vs. replacement—Reproduction is the cost to construct the exact same structure. Replacement is the cost to build a structure that has the same usefulness. The cost approach usually uses the replacement cost of a property, not the reproduction cost.

Elements of depreciation—Depreciation is used to measure the remaining useful life of a property. Note that this is different from a depreciation deduction used for income tax purposes. The three factors used to assess depreciation are: (1) cost of the property, (2) estimated life of the property, and (3) scrap value of the asset.

Basic calculations—The basic calculations used in the cost approach utilize basic addition and subtraction. The market value of a property using the cost approach is determined by subtracting the land value and depreciation from the improvement costs: C - D + L = V.

Income

The income approach uses capitalized estimates of future cash flows to determine market value. Appraisers look for comparable income-generating properties and will make adjustments for different risk levels. For example, future cash flow from a fast-food chain is more reliable than the cash flow from a mom-and-pop diner.

Gross income multiplier—The gross income multiplier, or GIM, is a rough measure of an investment property’s value. The GIM is calculated by dividing the property’s sales price by its gross annual rental income.

Income vs. expenses—Gross income is the total rent that could be collected. Net income is the actual amount received after adjustments for vacancy and bad debt. Expenses should include not only routine operating expenses, but also money that will be spent for future capital repairs, deferred maintenance, or property improvements.