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

Partial Interests

Sometimes, there are parties that have a partial (or limited) interest in a property. Partial interests can affect the value of the real property and should be taken into consideration when determining the market value of real estate.

Leaseholds

Leasing fees or rents collected from tenants affect the market value of the property. A rent that is below market may make the property less valuable. An above-market rent would not necessarily make the property more valuable, because when the tenant vacates, the property owner may not be able to re-let at the same above-market rent.

Life Estates

If person A owns the property from person B under a life estate, then when person A dies, the property reverts back to person B. The market value of person A’s property is determined in large part by how old person A is. The older person A is, the lower the useful life of person A’s property is, because it will soon revert back to person B.

Easements

An easement is the right to cross someone else’s property for a specific purpose, such as accessing the nearest highway. An easement could reduce the market value of a property if it minimizes the potential development of the property the easement is on.

Timeshares

A timeshare is a form of fractional ownership where several joint owners have the right to use the same property for a fixed period of time per year. Timeshares can be bought, sold, and traded. The price that a timeshare owner is willing to pay for its share can affect the market value of the entire property and the value of the other timeshares.

Cooperatives

A cooperative, or co-op, is stock ownership in the corporation that owns the building, with each stockholder receiving a proprietary lease on a specific unit in the building. Co-op shares can be bought, sold, and traded. The price that a share is exchanged for can affect the value of the entire building and the other co-op shares.

Common Areas

Common areas such as swimming pools and parking areas are often found in condominium ownership. Each owner has an undivided separate interest as a tenant is a common owner of the common areas.

Standards and Ethics

Real estate is one of the main sources of wealth in the world. People who own, buy, sell, manage, invest, and lend money all depend on the unbiased opinions of value and analysis that appraisers provide. The industry adheres to a code of standards of professional practice and ethics. These are the moral principles that govern an individual’s behavior and conduct.

What is covered?

The standards and ethics rules for appraisers address the ethical and performance obligations through five provisions: Definitions, Ethics Rule, Competency Rule, Scope of Work Rule, and Jurisdictional Exception Rule.

What are ethics?

The Ethics Rule is divided into four sections: conduct, management, confidentiality, and record-keeping.

Assessment and Taxes

A property tax assessment is a determination of the market value of real property for taxation purposes. States vary in how they determine assessment value and how real property is taxed.

Tax Assessment

A tax assessment is the state’s determination of the market value of a property for taxation purposes. Assessments are normally conducted at the same time of the year or, in some jurisdictions, only when the property changes hands. Tax assessments are often based on sales comparables, the income a property generates, and the improvements made to real property.

Exemption

A property tax exemption reduces the assessed value of the property someone is responsible for paying taxes on. Some common property tax exemptions include a homeowner’s exemption, property owned by religious organizations, and government-owned real estate.

Tax Payment

Property tax assessments are made once a year or, in some cases, every other year. Property taxes are billed as a single amount, but payment is usually made in two equal installments. Residential mortgages usually include a monthly property tax payment that is accrued by the lender, then the lender makes the property tax payment on behalf of the borrower when the property tax is due.

Tax Calculation

After a property has been valued for tax purposes and any exemptions have been made, the property tax is then calculated by the taxing authority. Many taxing authorities use a mill rate—which is $0.001—to determine the tax. If a property is assessed at $100,000 and the taxing authority’s mill rate is 10, the property tax due would be: $100,000 x .001 x 10 = $1,000. Remember that different taxing authorities calculate property taxes differently.

Income Taxes

Just as with death and (property) taxes, paying income tax also can’t be avoided. But it can be minimized. Income tax laws differ between residential property that is a personal residence and income-producing property. In both cases, owners will find that there are significant tax advantages to owning real estate.

Personal Residence

A personal residence—also known as a principal residence—is the primary place where someone lives. It can be any type of residence, as long as the person lives there most of the time and on a permanent basis.

Home acquisition deductions—The IRS considers home acquisition debt to be any mortgage after October 13, 1987, that was used to buy, build, or significantly improve a main or secondary home, and whose mortgage is secured by that home. Home acquisition deductions include prepaid mortgage interest, points, prepaid mortgage insurance premiums, and prepaid property taxes.

Homeownership deductions—One of the reasons that owning real estate is an excellent way to build wealth is due to the number of homeownership tax deductions available. Items such as mortgage interest, real estate taxes, mortgage insurance premiums, and energy credits are all tax-deductible.

Home sale—As long as a home was used as a principal residence and was lived in for 2 of the 5 years before the sale, up to $250,000 of the profit from selling a home is tax-free, and up to $500,000 if a couple is married and files a joint tax return. This tax-free profit is available each time a home is bought and sold following the preceding guidelines.

Income Property

For tax purposes, the IRS treats income-producing property such as residential rental real estate and commercial property differently from owner-occupied property. However, there are still significant tax advantages to owning income property.

Operations—Income property owners pay income tax on the net income they receive from their investment. Remember that net income is the bottom line number. It is the amount left after cash expenses such as mortgage and insurance payments, property taxes, utilities, management fees, and landscaping have been paid, and after non-cash depreciation expenses have been deducted.

Resale—Unlike people who own their own home, people who sell investment property are liable for paying capital gains tax if the property is sold for a profit. However, there is a way to legally defer paying the capital gains tax, which we’ll discuss next.

Exchange—A tax-deferred exchange—also known as a 1031 Exchange or a Starker Exchange—is an IRS rule that allows investors to defer paying capital gains tax if another like-kind investment property is purchased. There are very specific rules to follow and investors should always use the services of a tax-deferred exchange facilitator.

Other Tax Concerns

Other potential tax concerns for property owners include paying transfer taxes (charged in some municipalities) when a property is sold and paying employee payroll taxes and benefits. Homeowners who rent out their principal residence or secondary residence for part of the year may also be liable for paying rental tax. While real estate owners pay a variety of taxes, they also create a significant economic impact by owning real property.

Economic Impact

The operation of commercial (and sometimes residential real estate) contributes to an area’s GDP or gross domestic product. These contributions can be measured by salaries and wages paid, and the jobs generated and supported by the real estate operations.

Contractor vs. Employee

Independent contractors—also known as 1099 workers—are people who have their own business and who are not employees of the real estate owner. Independent contractors are responsible for paying their own social security and payroll taxes.

Investment in Real Estate

Investment real estate is non-owner occupied property that is used to generate regular rental income from tenants and to generate capital gains as property values increase.

The Basics

Real estate investing simply means putting money that you have today to work so that you will have more money in the future. Unlike other investments, real estate investments can generate significant cash flow and appreciate in value over time. The profit or return must be high enough to pay for the costs of ownership and to compensate the investor for the investment risk being taken.

Advantages

There are four ways the investors make money in real estate: (1) property appreciation, (2) cash flow, (3) specialty services such as putting together a group investment, and (4) additional income generated from services such as lobby vending machines or laundry facilities.

Disadvantages

One of the main disadvantages to investing in real estate is that real estate is not a liquid investment. In other words, an owner cannot simply go online and enter a seller order as he would to sell a stock. Other drawbacks include the amount of capital needed, the risk and potential liability of dealing with tenants, and the active or hands-on involvement required unless the investor hires a professional management company.

Analysis

The risk of owning investment real estate can be greatly reduced by conducting a thorough analysis of the property, similar to the way an appraiser would value property. The analysis should include a detailed look at current operations, forecasting future performance, and planning for the worst.

Pro Forma Statements

Pro forma statements can also be thought of as what if statements. Pro formas are used to project future performance and to measure changes in performance if certain conditions occur. For example, a typical pro forma statement for a rental property would measure the monthly net income based on varying occupancy levels and time lengths taken to lease the vacant units.

Important Concepts

Different real estate investors will measure property performance differently. A deal that “makes sense” to one investor could easily make no sense to another investor. Common financial analysis measurements are gross rent multiplier, rate of return, and the equity dividend rate.

Gross rent multiplier—Also known as the GRM, the gross rent multiplier is used to evaluate income-producing property. The GRM is calculated by dividing the property sale price by the total gross annual rents: $1,000,000 sales price / $100,000 gross rents = 10. The GRM of 10 is then used to compare the property with other similar properties in the market.

Rate of return—The rate of return is a percentage that shows the total monies received after the cost of an initial investment. Also known as ROI—or return on investment—it is calculated like this: (gain from investment – cost of investment) / cost of Investment = ROI. This percentage is then used to compare potential investments with one another.

Equity dividend rate—Also known as a cash-on-cash return, the equity dividend rate is expressed as a percentage that measures the annual return to the investor. It is calculated like this: annual pre-tax cash flow / total cash invested = cash-on-cash return or equity dividend rate.

Strategy

Different real estate investors have different investment strategies. However, regardless of individual strategies, investors consider four factors: (1) life cycle, (2) purchase, (3) operations, and (4) resale.

Life Cycle

Real estate life cycles vary in length and are tied to the overall economy. The four phases of the real estate life cycle are (1) recovery (after a recession), (2) expansion, (3) over-supply or over-building, and (4) recession.

Purchase

Before purchasing property, real estate investors need to understand what phase of the real estate life cycle they are in. By knowing this, the investor is then able to develop an appropriate purchase strategy. For example, an investor buying in a recessionary period might have a longer-term buy-and-hold strategy. An investor buying in an over-supply period might choose a fix-and-flip strategy to avoid holding potentially overpriced property before a recession begins.

Operation

The investor must be able to generate enough income from the property to pay for the mortgage and insurance, normal operating expenses, property, and income tax. After that, there must be enough profit left over to compensate the owner for the investment risk that he or she is taking.

Resale

Real estate investors also hope to make money from selling a property that has appreciated in value over time. Professional real estate investors will utilize tax-deferred exchanges to trade up in property value rather than immediately pay capital gains taxes.