Defining Property Interests and Value Standards

Chapter: Defining Property Interests and Value Standards

Introduction

Real estate appraisal is not merely about estimating the price of a physical structure; it’s about understanding and quantifying the intricate web of rights, interests, and market forces that collectively define its value. This chapter delves into the critical concepts of property interests and value standards, providing a scientific and practical framework for accurate and reliable appraisal practices. Understanding these concepts is fundamental to ensuring that appraisals are legally sound, economically relevant, and ethically defensible.

1. Identifying Real Property Interests

Real property encompasses both the physical land and its improvements, and the bundle of rights associated with its ownership and use. These rights are often referred to as the “bundle of sticks,” each representing a distinct aspect of ownership. Accurately identifying these rights is paramount in determining the value of the real property.

1. Ownership Rights:
   A valuation of real property includes both physical real estate and rights that one or more individuals, partnerships, or corporations may have or contemplate having in the ownership or use of land and improvements.

   • Fee Simple❓❓: This represents the most complete form of ownership, granting the holder the full bundle of rights, including the right to possess, use, enjoy, and dispose of the property without limitation, subject only to governmental restrictions. This is the most common property interest appraised.
     • Example: A homeowner who owns their house outright with no liens or encumbrances holds the fee simple interest.
   • Partial Freehold Interests: These represent limited ownership rights, where the full bundle of rights is divided among multiple parties.
     • Example: A one-half partnership interest in a property.

   • leasehold interest❓s: This represents the right to possess and use a property for a specific period, as granted by the lessor (landlord) to the lessee (tenant) under a lease agreement. The value of a leasehold interest is the present value of the difference between the market rent and the contract rent over the lease term.

     • Let:

       • V_L = Value of the Leasehold Interest
       • R_M = Market Rent
       • R_C = Contract Rent
       • r = Discount Rate
       • n = Lease Term (in years)

     • V_L = Σⁿ_t=1 (R_M - R_C) / (1 + r)^t

     • Experiment: You can compare the leasehold interest of two identical properties. Property A has a lease with market rent. Property B has a lease with a contract rent below market. Property B will have a leasehold interest with a positive value for the tenant and negative value for the owner.

       • Mineral or Other Subsurface Rights: This grants the holder the right to extract minerals, oil, gas, or other resources from beneath the surface of the property.
       • Water Rights: This grants the holder the right to use water from a specific source, such as a river, lake, or groundwater aquifer.
       • Air Rights: This grants the holder the right to use the airspace above a property, often used for constructing buildings or infrastructure.
       • Rights of Co-owner: Rights that may be held by a partner, spouse, or co-tenant.
       • Easement Rights: A non-possessory right to use another person’s property for a specific purpose.

     • Example: A utility company’s easement to run power lines across a property.

2. Appurtenant Rights and Interests:
   The appraiser must know what rights outside the property transfer with the property. Appurtenant rights and interests that transfer with real estate can significantly effect value. Appurtenant easement rights over land of others generally enhances value.

   • A property might include rights in a common ownership of amenities such as a community pool, golf club membership, water rights and even easements.
   • An appurtenant easement allowing beach or docking privileges would significantly enhance the value of water related residential property.
   • A negative easement prohibiting another from blocking a favorable view would also be a plus factor as to value, which should be considered by the appraiser.

3. Restrictions on Ownership:
   In addition to knowing what property rights the client wants to have appraised, the appraiser must also identify any rights and restrictions that apply to the subject property. The property may include irrigation rights, for example, or the right to use an easement across adjoining property. On the other hand, property rights may be restricted by such things as zoning ordinances, public and private easements, rights-of-way, and private deed restrictions. The rights and restrictions that apply to the property may enhance or detract from its value.

   • Zoning Ordinances: These regulations govern the permitted uses of land within specific areas. Zoning can significantly impact property value by dictating density, building height, setbacks, and allowable activities.
   • Public and Private Easements: These grant specific rights to others to use the property for particular purposes, such as utility lines or access roads.
   • Rights-of-Way: Similar to easements, these grant the right to pass through or across a property.
   • Private Deed Restrictions (Covenants, Conditions, and Restrictions - CC&Rs): These are private agreements that limit the use of property within a development, often used to maintain property values and aesthetic standards.
     • Example: Restrictions on building height, architectural style, or the type of landscaping allowed.
     • Case/Example: Property A and Property B are similar in all respects, except that Property A is crossed by a public right-of-way. Because the right-of-way limits the use of Property A, it may have a lower value than Property B.
   • Property Taxes: Property taxes are a form of restriction on property rights. The appraiser must identify the taxes that apply to the subject property and analyze their affect on value. Property that is subject to a higher rate of taxation than other comparable properties, for example, may be less valuable.

4. Sources of Information:
   In the case of legal descriptions, the appraiser can identify many of the rights and restrictions that apply to a property by consulting the deed.

   • Deeds: Legal documents that transfer ownership of property. They often contain detailed descriptions of the property rights and any restrictions.
   • Title Abstract or Title Insurance Policy: These provide a summary of the property’s ownership history and any encumbrances.
   • Zoning and Planning Offices: Local government agencies that maintain records of zoning regulations and land use plans.
   • Tax Authorities: Local government agencies that assess and collect property taxes.

2. Defining the Standard of Value

The standard of value is the fundamental premise upon which the valuation is based. It defines the specific type of value that the appraiser is tasked with estimating. The selection of the appropriate standard of value is critical for ensuring that the appraisal is relevant and useful to the intended user.

1. Types of Value:
   Next the appraiser must determine the Standard of Value. The STANDARD OF VALUE refers to the type of value the client expects the appraiser to provide.

   • Market Value: This is the most probable price that 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 definition is widely used in lending and investment contexts. Relationship, terms, and conditions must be identified by the appraiser.
   • FHLMC/FNMA (Fannie Mae/Freddie Mac), America’s largest secondary lenders, define MARKET VALUE as “the most probable price which a property should bring in a competitive and open market under all conditions requisite to fair sale, the buyer and seller, each acting prudently, knowledgeably, and assuming the price is NOT affected by undue stimulus.”

   • Investment Value: This is the value of a property to a specific investor, based on their individual investment criteria, risk tolerance, and expectations. Investment value can differ from market value due to the investor’s unique circumstances.

     • Formula:
       • V_I = Σⁿ_t=1 CF_t / (1 + r_i)^t
       • Where:
         • V_I = Investment Value
         • CF_t = Cash Flow in period t
         • r_i = Investor’s required rate of return
         • n = Investment horizon

   • Insurable Value: This is the cost of replacing a property with a new one of similar quality, used for determining insurance coverage. It typically excludes the value of the land.

   • Value in Use: This is the value of a property to a specific user for a specific purpose. It reflects the economic benefits derived from the property’s use in that context.
     • Example: A factory’s value in use to the company that owns and operates it may be higher than its market value if sold to another party.
   • Liquidation Value: This is the estimated price that a property would bring in a forced sale, typically under distress conditions. It is usually lower than market value.

2. Importance of Agreement:
   In order to collect the proper information and to prepare a report that will be useful to the client, the appraiser and the client must agree on the Standard of Value that is to be utilized.

3. Case Example:
   A lender hires an appraiser to determine the value of a property, because the lender wishes to know whether or not it should approve a borrower’s loan for the purchase of the property. In this case the Standard of Value would be market value. The intended use would be for an approved loan and the intended user(s) would be the lender and those to whom the lender might assign the loan (FHLMC, FNMA, VA, and FHA).

3. effective date❓ of the Appraisal (Valuation Date)

Value estimates are always made as of a specific date, which is called the EFFECTIVE DATE OF THE APPRAISAL. This is because value typically changes over time. Market conditions, as well as the physical condition of the property, are subject to constant change, and both of these factors affect value. The Reconciliation Section of the URAR makes it clear that, for the uniform report, the market value is based on the date of the appraiser’s inspection.

1. Value as of the Current Date:
   In most cases, the client will want to know the value as of the current date. Occasionally, the appraiser may be asked to estimate value as of a past or future date.

   • Case/Example: A residential property is appraised at $120,000 as of June 1. On June 2, the house is completely destroyed by a tornado, substantially reducing the value of the property. But the value estimate contained in the appraisal is still valid, because it was made as of a specific date, prior to the catastrophe. (The appraisal may also have included an assumption clause, stating that the value estimate was based on the assumption that the described improvements were in good repair.)

2. Appraisal of Past Values:
   Appraisals of past values are possible if adequate data (comparable sales, etc.) exist for the period of time in question. Such data are, in fact, often available, provided the valuation date is not too far in the past, so the process of estimating past value is normally not much different than the appraisal of current value. “Appraisals of past value” are most often required in connection with legal proceedings, such as divorce settlements or tax audits.

   • Case/Example: The 2005 property taxes for a particular property are based on the assessed value of the property as of January 1, 2005. The property owner is informed of the assessed value in August, 2005. In order to challenge the assessment, the owner may need to obtain an appraisal of the property as of January 1, 2005, the date of the assessment. An appraiser may make such a past value estimate, provided that adequate data are available for the time in question.

3. Appraisal of Future Value:
   Unlike appraisals of past value, appraisals of future value are always speculative (theoretical) because it is impossible to predict future market conditions. Data for the future does not exist and must be assumed. An appraisal of this type often requires the appraiser to rely on Extraordinary Assumptions and Hypothetical Conditions.

Conclusion

Understanding and correctly identifying property interests and value standards are cornerstones of sound appraisal practice. By mastering these concepts, appraisers can produce credible, defensible, and ethically sound valuations that meet the needs of their clients and contribute to the integrity of the real estate market.