Real Estate Appraiser Guidelines - Part 2 PRINCIPLES OF VALUATION A knowledge of basic assumptions, postulates or premises that underlie appraisal methods is essential to an understanding of the purpose, methods and procedures of valuation. The following principles of value influences are the more important for a general understanding of the appraisal process.
> Principle of conformity. Holds that maximum value is realized when land uses are compatible and a reasonable degree of architectural harmony is present. Zoning ordinances help set conformity standards.
> Principle of change. Real property is in a constant state of flux and change, affecting individual properties, neighborhoods and cities. The appraiser follows trends and influences and is sensitive to changes in conditions that affect the value of real estate. Economic, environmental, government, and social forces affect all markets, especially real estate.
> Principle of substitution. This principle is the basis of the appraisal process. Simply stated, value will tend to be set by the cost of acquiring an equally desirable substitute. The value of a property to its owner cannot ordinarily exceed the value in the market to persons generally, when it can be substituted without undue expense or serious delay. In a free market, the buyer can be expected to pay no more, and a seller can expect to receive no less, than the price of an equivalent substitute. A property owner states that owner’s house is worth $95,000. Buyers in the market can obtain a substitute property with the same features and utility for only $90,000. The seller’s house, therefore, has a value of approximately $90,000, not $95,000. > Principle of supply and demand. Holds that price varies directly, but not necessarily proportionately, with demand, and inversely, but not necessarily proportionately, with supply. Increasing supply or decreasing demand tends to reduce price in the market. The opposite is also true.
> Principle of highest and best use. The best use of a parcel of land, known as its highest, best and most profitable use, is that which will most likely produce the greatest net return to the land over a given period of time. This net return is realized in terms of money or other amenities.
The application of this principle is flexible. It reflects the appraiser’s opinion of the best use for the property as of the date of his appraisal. At one period of time, the highest and best use of a parcel of land in a downtown business district might be for the development of an office building; at another time, a parking lot may be the highest and best use. A single-family house on a commercial lot may not be the highest and best use for the site. A four-unit apartment on multiple zoned land suitable for 30 units is probably not the long-term highest and best use of the land.
It is also useful to understand that highest and best use may not be only economic or profit-making in character. Environmental, aesthetic, and historical considerations are increasingly important in governmental views of highest and best use.
The Appraisal Institute, at Page 244 of the 10th Edition of The Appraisal of Real Estate, offers this definition for highest and best use: “The reasonably probable and legal use of vacant land or an improved property, which is physically possible, appropriately supported, financially feasible, and that results in the highest value.” The first reference in the definition applies to vacant land while the second applies to improved properties. This indicates that there may be two highest and best uses, one with the site vacant and the other as improved. These must be reconciled into a final highest and best use determination for the property being appraised.
Determining highest and best use includes assessing potential buyers’ motives, the existing use of the property, potential benefits of ownership, the market’s behavior, community or environmental factors, and special conditions or situations which come to bear on appraisal conclusions of value. > Principle of progression. The worth of a lesser-valued object tends to be enhanced by association with many similar objects of greater value (inadequacy or under-improvement).
> Principle of regression. The worth of a greater-valued object is reduced by association with many lesser-valued objects of the same type (super adequacy or over-improvement).
> Principle of contribution. A component part of a property is valued in proportion to its contribution to the value of the whole property or by how much that part’s absence detracts from the value of the whole. Maximum values are achieved when the improvements on a site produce the highest (net) return, commensurate with the investment. > Principle of anticipation. Value is created by anticipated future benefits to be derived from the property. In the Fair Market Value Analysis, appraisers estimate the present worth of future benefits. This is the basis for the income approach to value. Simply stated, the income approach is the analysis of the present worth of projected future net income and anticipated future resale value. Historical data are relevant because they aid in the interpretation of future benefits.
> Principle of competition. Competition is created where substantial profits are being made. If there is a profitable demand for residential construction, competition among builders will become very apparent. This could lead to an increase in supply in relation to the demand, resulting in lower selling prices and unprofitable competition, leading to renewed decline in supply.
> Principle of balance. Value is created and sustained when contrasting, opposing, or interacting elements are in equilibrium, or balance. Proper mix of varying land uses creates value. Imbalance is created by an over-improvement or an under-improvement. Balance is created by developing the site to its highest and best use.
> Principle of four-stage life cycle. In due course, all material things go through the process of wearing or wasting away and eventually disintegrating. All property is characterized by four distinct stages: growth, stability, decline, and revitalization.
Single properties, districts, neighborhoods, etc., tend generally to follow this pattern of growth and decline. It is also evident this process is frequently reversed as neighborhoods and individual properties in older residential areas are renewed and restored.
Revitalization and modernization in inner-city older neighborhoods may result from organized government programs or as a result of changing preferences of individual buyers. Most neighborhoods remain in the mature or stable stage for many years, with decline being hardly noticeable as renewal becomes essentially an ongoing process.
BASIC VALUATION DEFINITIONS Value Designations
There are many different designations or definitions of value. They may be divided into the following two main classifications:
> Utility value, which is value directed toward a particular use. This frequently is termed subjective value and includes valuation of amenities which attach to a property or a determination of value for a specified purpose or for a specific person.
> Market value, which represents the amount in money (cash or the equivalent) for which a property can be sold or exchanged in prevailing market conditions at a given time or place as a result of market balancing. It may be based on a “willing buyer” and “willing seller” concept. This is frequently termed the objective value, since it is not subject to restrictions of a given project. Appraisers carefully define the value being sought. Types of values are Liquidation Value, Insurable Value, Investment Value and, of course, Assessed Value (for taxation).
The real estate market sometimes places great importance on real estate financing terms. Market Value might be estimated for specific financing arrangements: seller carry-back, balloon payments, renegotiable mortgages or other “creative” financing techniques. Market Value Defined
In appraisal practice, the term Market Value is defined by agencies that regulate federal financial institutions in the U.S. That definition is the one found in USPAP and is given as: “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.” Implicit in this definition is the consummation of a sale as of a specified date and the passing of title from seller to buyer under conditions whereby: > buyer and seller are motivated;
> buyer and seller are well informed or well advised and acting in what they consider their best interest;
> a reasonable time is allowed for exposure in the open market;
> payment is made in terms of cash in United States dollars or terms of financial arrangements comparable thereto; and
> the price represents the normal consideration for the property sold, unaffected by special or creative financing or sales concessions granted by anyone associated with the sale.
(Source: Uniform Standards of Professional Appraisal Practice, Appraisal Foundation, 2000 Edition, page 160.)
Legal Definition
The legal definition of Fair Market Value under State law is found in the Code of Civil Procedure, Section 1263.320, as follows: “The fair market value of the property is the highest price on the date of valuation that would be agreed to by a seller, being willing to sell but under no particular or urgent necessity for so doing, nor obliged to sell, and a buyer, being ready, willing, and able to buy but under no particular necessity for so doing, each dealing with the other with full knowledge of all the uses and purposes for which the property is reasonably adaptable and available.” VALUE vs. PRICE
When reference is made to the value of a property, generally fair market value is meant. Market price is what one might get from the sale of the property in terms of money. Sometimes value and price are the same, most particularly when there is no compulsion to buy or sell. Under other circumstances, there might be a wide difference between the market value of a property and the actual sale price. The appraiser must be careful to consider normal buyers and sellers attitudes for the type of property appraised. The appraiser is estimating actual market value not theoretical value.
The immobility of real estate makes it unique. Theoretically, there are no two parcels exactly alike and therefore no means of making a total comparison between properties. Circumstances of one buyer and one seller affect the sale price of a specific property, whereas the actions of many buyers and sellers of similar type properties determine the going rate for the sale or exchange of property on the open market.
Among the various types of value that have been designated from time to time are book value, tax value, market value, cash value, capital value, speculative value, par value, true value, exchange value, reproduction value, physical value, replacement value, insurance value, investment value, rental value, face value, depreciated value, leasehold value, sound value, sales value and cost value.
The real estate broker should be concerned mostly with the concept of Fair Market Value, or simply market value, for this is the basis upon which most property is generally bought and sold.
VALUE vs. COST
Value can be distinguished from “cost” as well as from “price,” for neither is necessarily synonymous with value. The principal differences may be explained as follows: > Value has to do with the combined factors of present and future anticipated enjoyment or profit. The value sought in the appraisal of property may be said to be the discounted present worth of all desirable things (benefits) which may accrue from a skillful use of it. A conclusion in regard to these things will clearly be a matter of opinion: an intelligent estimate based on a thorough analysis of all available influencing factors and on reasonable and more or less warranted assumptions.
> Cost represents a measure of past (or prospective) expenditures in money, labor, material or sacrifices of some nature in acquiring or producing the commodity. While cost may be, and frequently is, a factor upon which value is partially based, it need not be, as it does not control present and future value. An example of this fact is the value of an apartment property as compared with an oil well (assuming that the building and drilling costs were the same). The oil well may prove to be a big producer and of great value, or it may prove to be a dry hole and of no value. An apartment building might be costly to build but have little value because of its bad location and high vacancy factor.
> Price is what one pays for a commodity, regardless of pressure motives or intelligence of the seller or buyer. Usually it is considered to be the amount of money involved in a transaction. Whether we receive in value more or less than what we pay for will depend on the soundness of judgment in the analysis or appraisal of value. Under an efficient market structure, price will usually tend to equal value, varying only as buyers and sellers have unequal knowledge, negotiating skills, or economic strength. Some factors influencing market price (as distinguished from value) are favorable financing, distress sale, forced purchase, uninformed purchaser or seller, misrepresentation of facts by the seller and high pressure sales practices.
Appraisers carefully distinguish between market value, cost and price in refining their appraisal conclusions.
Purposes and Characteristics of Value
The purpose of a valuation or an appraisal is usually indicated in the value concept employed, for example: market value, assessed value, condemnation value, liquidation value, cash value, mortgage loan value, fire insurance value, etc. The purpose of an appraisal frequently dictates the valuation method employed and influences the resulting estimate of value.
> Intended use. The intended use of the report has become distinct from the purpose of the appraisal. This relates to how the process has been separated from the writing of the report (Standard 1 vs. Standard 2 in USPAP). The purpose of the appraisal may be, for instance, to help in settling an estate. The intended use of the report may be to communicate the value findings to heirs only, or may include attorneys and/or taxing authorities. The purpose helps to define how the appraisal process will be laid out. The intended use will help to determine which report type is most appropriate for communicating the results of the process.
> Four elements of value. There are only four elements of value, all of which are essential. These are utility, scarcity, demand (together with financial ability to purchase), and transferability. None alone will create value. > For example, a thing may be scarce but, if it has no utility, there is no demand for it. Other things, like air, may have utility and may be in great demand, but are so abundant as to have no commercial value. Utility is the capacity of a commodity to satisfy a need or desire. To have utility value, real estate should have the ability to provide shelter, income, amenities or whatever use is being sought. Functional utility is an important test for determining value. Likewise, the commodity must be transferable as to use or title to be marketable.
Generally speaking, a commodity will have commercial or marketable value in proportion to its utility and relative scarcity. Scarcity is the present or anticipated supply of a product in relation to the demand for it. Utility creates demand, but demand, to be effective, must be implemented by purchasing power. Otherwise, a person desiring a product cannot acquire it.
Fundamental to the concept of value is the “highest and best use” principle, discussed earlier in this chapter. Location is a most important factor in determining highest and best use. Any analysis to reach a decision as to the “highest and best use” must include consideration as to the future supply and demand for such use within the area and a possible oversupply or undersupply with attendant effect on market demand and value. FORCES INFLUENCING VALUE The value of real estate is created, maintained, modified and destroyed by the interplay of the following four great forces: > Environmental and physical characteristics. Examples of physical characteristics include: quality of conveniences; availability of schools, shopping, public transportation, churches; similarity of land used; and types of physical hazards. Environmental considerations include climate, soil and topography, barriers to future development (oceans, mountains, etc.), transportation systems, and access to other areas/regions.
> Social ideals and standards. Examples of social forces include: population growth and decline; age, marriage, birth, divorce and death rates; and attitudes toward education, recreation, and other instincts and yearnings of mankind.
> Economic influences. Examples of economic forces are: natural resources; industrial and commercial trends; employment trends; wage levels; availability of money and credit; interest rates; price levels; tax loads; regional and community present economic base; new development trends; and rental and price patterns.
> Political or government regulations. Examples of political forces include: building codes; zoning laws; public health measures; fire regulations; rent controls; environmental legislation controlling types of new development; fiscal policies; monetary policies; government guaranteed loans; government housing; and credit controls. Each and every one of these many physical, social, economic and political factors affect cost, price, and value to some degree. The four forces interweave and each one is in a constant state of change.
Factors Influencing Value
> Directional growth. In any estimate of value, attention should be given to “the city directional growth” as well as to “Urban Renewal Plans.” The city directional growth refers to the manner and direction in which the city tends to expand. Properties in the direction of growth or renewal in different sections of the city tend to increase in value, especially if the growth or renewal is steady and rapid.
> Location. Location is an exceptionally important value factor because location influences demand for the property. Location must not be described too generally, and is an effective value factor only when it is specifically related to highest and best use. Brokers often claim, “The three most important characteristics for any property are location, location and location.” > Utility. Utility includes the capacity to produce. This important factor involves judgment as to the best use to which a given property may be put. Building restrictions and zoning ordinances affect utility.
> Size. The width and depth of a parcel of land will often determine the possibilities and character of its use.
> Corner influence. Corner sites sometimes have higher unit value than a site fronting on one street only. Disadvantages include loss of privacy, higher cost as off-site improvements cost more and lot maintenance is more expensive, and setbacks may require a smaller size house. Commercial properties benefit from corner sites because of easy access and added exposure.
> Shape. Parcels of land of irregular shape generally cannot be developed as advantageously as rectangular lots.
> Thoroughfare conditions. The width of streets, traffic congestion, and condition of pavement have an effect on the value of frontage properties and to a lesser degree on other properties in the neighborhood.
> Exposure. The south and west sides of business streets are usually preferred by merchants because pedestrians seek the shady side of the street on warm afternoons and merchandise displayed in the windows is not damaged by the sun. This traditional view in older commercial districts is somewhat offset by new architectural concepts (e.g., shopping malls), parking and convenience.
> Character of business climate. Larger cities develop residential, shopping, financial, wholesale, and industrial districts.
> Plottage or assemblage. An added increment of value when several parcels of land are combined under one ownership to produce greater utility than when the parcels are under separate ownership. In highly urbanized multiple residential and commercial areas plottage, or assemblage, makes it possible to gain that higher utility. An example of this would be a density bonus for the combining of residential lots. This principle may also apply to light industrial areas.
> Topography and character of soil. The bearing qualities of the soil may affect construction costs. Extensive foundations are usually necessary in soft earth. The type and condition of the topsoil affect the growth of grass, plants, shrubs and trees. Value may also be influenced by land contour and grades, drainage and view points.
> Obsolescence. Caused by external or economic changes which decrease the functional utility of a property, or by physical deterioration of the property. Changes in types and methods of construction, style of architecture, or interior arrangements for specific purposes may render a particular building out of date. Changes in the uses of neighboring property may also contribute to the obsolescence of a building. Careful appraisal will include the potential for remodeling, refurbishing or other method to restore value.
> Building restrictions and zones. These sometimes operate to depress values and at other times to increase values. > For example, there may be a vacant lot on a residential street which will sell for only $150 a front foot for single family residential use but would sell for $600 per front foot as an apartment site. Or a vacant lot in a zoned area may sell for more per front foot as a business site because of the supply of business sites being restricted by zoning.
Additional Factors Important for Residential Property
When appraising residential property, it is customary to make a direct comparison between the property being appraised (subject property) and comparable properties in the area which have sold recently. This is the market data or “sales comparison approach” method based upon the economic principle of substitution (i.e., the value of a particular property will not generally exceed the cost to purchase a similar, or substitute property which is equally desirable and available). > Gross rent multiplier. An appraiser may also use a technique known as Gross Rent Multiplier (GRM) by comparing actual rentals and sales prices of properties comparable to the subject to get another indication of value by multiplying the monthly rent by an appropriate GRM. If a comparable property rents for $700 a month and sells for $84,000, which is 120 times the gross monthly rental ($84,000 ÷ $700 = 120), the indicated GRM applicable to the subject property is 120. GRM applies only to rental income. When part of a property’s income comes from nonrental sources, an appraiser will use a similar gross income multiplier (GIM). > Square foot method. In making a preliminary estimate of the value of residential property, it is usual to evaluate the lot and the present value of the building. An estimate of the cost of replacing a building is usually made by the square foot method. The square foot method requires measuring the building and dividing it into rectangles. Multiplying the length by the width of each rectangle will produce the square footage of that segment. The total square footage of the residence is obtained by adding together the square footage of all rectangular segments. The sum obtained thereby is multiplied by an appropriate construction cost per square foot, depending upon the type of construction involved. The result is known as the replacement cost of the residence. Depreciation is then taken from the replacement cost to give the present value of the improvements. The present value added to the land value represents an indication of the value of the subject property. In analyzing depreciation, special attention should be paid to the condition of the building, the exterior finish and roof, the interior fixtures, plans and workmanship, interior decoration, plumbing, heating, and electric fixtures, etc. Particular attention should be given to the inspection of the foundation and the underpinnings of the house in connection with possible termite infestation and soil problems such as subsidence or expansion.
> Multi-family dwellings. Trends and standards for residential dwellings vary in the markets, especially for multi-family structures. Appraisers must consider: the layout; adequacy of size; conveniences; safety features and comfort; adaptability for intended use; and cost and ease of maintenance.
Additional Factors Important for Commercial Property
Commercial property is real property acquired for investment. Commercial structures are of many types, sheltering such businesses as shopping centers, banks, service establishments, restaurants, parking lots, retail stores and office buildings. A downtown, regional, or community commercial district is usually clearly defined and located on major streets. Store rentals and business leases are generally based on square footage of rentable area. In many localities the tenant pays, in addition to rent, all property expenses/charges such as taxes, insurance, maintenance, and assessments. Such a lease is a “net” (or, in some communities, a “net, net, net”) lease. Front footage valuations are still applicable in many downtown areas or location. In appraising such property, care must be used to properly evaluate such things as floor plans, utility, relationship of site area to improvements, obsolescence, parking accommodations, ratios of net rentable areas to gross area. Efficiency, safety, structural and design features are also very important, as are energy standards and efficiencies.
Additional Factors Important for Industrial Property
Industrial lands are usually valued in terms of gross buildable area, either by square foot or by acre (e.g., 30 cents a square foot; $13,000 an acre). One of the reasons for valuing industrial land in terms of area is that the parcel is generally all usable. Indeed, optimum efficiency of site, buildings and equipment are vital to the successful operation of industrial properties. Industrial buildings are generally constructed of concrete or steel, including prefabrications, or tilt-ups. Industrial parks (groups of industrial buildings having similar uses) have grown in importance. These require plenty of parking space, storage facilities, excellent operating layouts, management services, and even room to expand. These properties are frequently designed and equipped to meet needs of specific occupants.
> Topography. The topography of undeveloped land is of importance, and consideration should be given to the cost of grading, if required.
> Subsoil. The character of the subsoil is frequently overlooked, and yet may be vital. Quicksand, rock, or other detriments may make a certain site unsuitable for a given industry. Drainage may also be an important factor.
> Plottage value. There is an added increment of value known as plottage which is gained from combining land parcels in an urban area into a reasonably sized industrial site.
> Tract layouts. In the study and valuation of unimproved but potentially valuable industrial lands, it is often necessary to have the assistance of a competent engineer who is familiar with plant and tract layouts.
Additional Factors Important for Agricultural or Farm Lands
Present trends show larger and fewer farms, fewer farm buildings per acre, and fewer family-style operations. The type of buildings an appraiser usually finds on agricultural lands include residences, machine sheds, poultry sheds, multifunctional barns, silos, and various animal shelters. According to some experts in the field, farm buildings contribute less than 20% of the total property value.
One important factor in estimating the value of agricultural land is the nature and longterm trend of costs and prices for the crop grown or intended to be grown. For example, if the property is to be used as a dairy farm the appraiser must consider: whether the soil is suitable for hay and grain; water supply for the cattle and crops; proximity to markets; climatic conditions; labor conditions, etc.
Farm land valuation is highly specialized and often requires the assistance of soil and crop experts and appraisal specialists to evaluate irrigation systems and other equipment and machinery. |
