Appraisal Fundamentals and Principles

Chapter: Appraisal Fundamentals and Principles

Introduction

This chapter delves into the fundamental concepts and principles that underpin real property appraisal. Understanding these principles is crucial for anyone involved in real estate, finance, or property management. We will explore the scientific basis of valuation, providing a framework for making informed decisions regarding real property interests.

1. Defining Appraisal and Its Core Components

An appraisal is an opinion of value. This opinion is developed using an orderly process based on relevant data. The value being sought must always be qualified (e.g., market value, liquidation value).

• Opinion: Appraisal is not simply reporting facts; it involves analysis, judgment, and interpretation of market data.
• Orderly Process: Appraisals follow a structured methodology to ensure consistency and reliability.
• Value: This is the central concept. Value is the present worth of future benefits arising from the ownership of real property.

2. The Forces Influencing Real Property Value

Value is influenced by a complex interplay of factors, often categorized as:

• Economic Forces: These include interest rates, inflation, employment levels, and economic growth.
  • Example: A rise in interest rates can decrease property values by increasing borrowing costs.
• Social Forces: These encompass demographic trends, lifestyle preferences, and population growth.
  • Example: Increased demand for urban living can drive up property values in city centers.
• Political Forces: These are governmental policies, regulations, and zoning laws.
  • Example: A change in zoning regulations can significantly impact the value of land.
• Environmental (Physical) Forces: These include climate, topography, soil conditions, and proximity to amenities.
  • Example: Properties with scenic views or waterfront access generally command higher values.

3. Fundamental Principles of Valuation

Several core principles guide the appraisal process:

• 3.1 Principle of Anticipation: Value is influenced by the perceived future benefits of ownership.
  • Explanation: Potential future income, appreciation, or other advantages affect what a buyer is willing to pay today.
  • Formula: Present Value (PV) = Future Value (FV) / (1 + r)^n, where ‘r’ is the discount rate and ‘n’ is the number of periods.
  • Example: A developer anticipating high rental income from a new apartment building will pay more for the land.
• 3.2 Principle of Substitution: A rational buyer will not pay more for a property than the cost of acquiring an equally desirable substitute.
  • Explanation: This principle is the foundation of the sales comparison approach.
  • Application: Appraisers analyze comparable sales to determine the price range a property should command.
• 3.3 Principle of Supply and Demand: Value is determined by the interaction of supply and demand in the marketplace.
  • Explanation: When demand exceeds supply, prices tend to rise; when supply exceeds demand, prices tend to fall.
  • Formula: This is a basic economic principle. In a simplified model, price (P) and quantity (Q) are determined at the equilibrium point where the supply curve (Qs) intersects the demand curve (Qd): Qs = Qd.
  • Example: In a rapidly growing city with limited housing supply, prices for existing homes increase.
• 3.4 Principle of Conformity: Properties tend to achieve maximum value when they are similar to other properties in the area.
  • Explanation: Conformity creates stability and predictability, which buyers find desirable.
  • Example: A house that is significantly larger or more luxurious than others in a neighborhood may not sell for its full potential value.
• 3.5 Principle of Contribution: The value of a component is measured by the amount it contributes to the overall value of the property.
  • Explanation: Improvements should be evaluated based on the increase in value they add to the property.
  • Example: Adding a swimming pool to a house will increase its value, but the increase may not equal the cost of the pool.
• 3.6 Principle of Increasing and Decreasing Returns: Adding increments of one agent of production increases income at an increasing rate until a certain level. After that level is reached, additional increments of that agent of production will yield smaller rate of returns.
  • Explanation: Relates to the concept of marginal utility, where the additional value of each additional unit decreases.
• 3.7 Principle of Balance: Real property value is maximized when there is a proper proportion between the agents of production (land, labor, capital and entrepreneurship).
  • Explanation: Achieving value stability and the best return on investment requires optimal combination of real property agents.
• 3.8 Principle of Change: Real estate values are constantly changing due to market forces and trends.
  • Explanation: Economic, social, political, and environmental factors are in constant flux, impacting property values.
  • Application: Appraisers must consider current market conditions and trends when developing an opinion of value.
• 3.9 Principle of Consistent Use: When valuing land and improvements, they must be valued based on the same use.
  • Explanation: Land can’t be valued based on a commercial use and then improvements are valued for a residential use.
• 3.10 Principle of Surplus Productivity: The surplus productivity that exceeds the cost of labor, capital, and coordination is attributable to the land.
  • Explanation: It is the land’s unique qualities that capture excess income.

4. Distinguishing Value, Cost, and Price

These terms are often used interchangeably, but they have distinct meanings:

• Cost: The expenditure required to create a property or improvement. (Historical)
• Price: The amount actually paid for a property in a transaction. (Fact)
• Value: An opinion of the present worth of future benefits. (Opinion)

5. Types of Value

Different types of value are relevant in different situations:

• Market Value: The most probable price 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. (USPAP Definition).
• Investment Value: The value of a property to a particular investor, based on their specific investment criteria.
• Insurable Value: The value of a property for insurance purposes, typically representing the cost of replacing the physical structure.
• Liquidation Value: The value that could be realized from a quick sale, often under distressed conditions.
• Value in Use: The value of a property to a specific user for a particular purpose.
• Assessed Value: The value assigned to a property for tax purposes.
• Going-Concern Value: The total value of a proven operating business enterprise.

6. The Appraisal Process

The appraisal process is an orderly series of steps:

1. Problem Definition: Identify the client, intended use, type of value, and property characteristics.
2. Scope of Work Determination: Decide the extent of research and analysis required.
3. Data Collection and Analysis: Gather relevant market, property, and comparable data.
4. Highest and Best Use Analysis: Determine the most profitable and legally permissible use of the property.
5. Land Valuation: Estimate the value of the site, independent of any improvements.
6. Application of Valuation Approaches: Employ the sales comparison, cost, and income approaches (as applicable).
7. Reconciliation of Value Indicators: Analyze the results of the different approaches and arrive at a final opinion of value.
8. Report Preparation: Communicate the appraisal findings in a clear and concise report.

7. Highest and Best Use

This is a critical concept in appraisal. Highest and best use is defined as the most probable use of a property that is:

1. Legally Permissible: Complies with zoning regulations and other legal restrictions.
2. Physically Possible: Suitable for the site’s characteristics and limitations.
3. Economically Feasible: Generates sufficient income or utility to justify development.
4. Maximally Productive: Results in the highest possible value.

8. Approaches to Value

Appraisers typically rely on three approaches to value:

• 8.1 Sales Comparison Approach: Compares the subject property to similar properties that have recently sold.
  • Process: Identify comparable sales, adjust for differences (e.g., location, size, condition), and derive an indicated value.
  • Formula: Indicated Value = Sale Price of Comparable +/- Adjustments
  • Example: If a comparable property sold for \$300,000 and is 100 square feet larger than the subject, an adjustment may be made to reflect the size difference.
• 8.2 Cost Approach: Estimates the cost to reproduce or replace the property, less depreciation, plus land value.
  • Process: Estimate the cost of new improvements, deduct for physical deterioration, functional obsolescence, and external obsolescence, and add land value.
  • Formula: Value = Cost of Reproduction/Replacement - Depreciation + Land Value
  • Example: The cost to build a new house is \$200,000. Accumulated depreciation is estimated at \$20,000, and the land is valued at \$50,000. The indicated value is \$230,000.
• 8.3 Income Approach: Estimates value based on the income the property is expected to generate.
  • Process: Estimate potential gross income, deduct for vacancy and expenses to arrive at net operating income (NOI), and capitalize the NOI into a value.
  • Formula: Value = Net Operating Income (NOI) / Capitalization Rate (Cap Rate)
  • Example: A rental property generates an NOI of \$20,000 per year. If the appropriate cap rate is 8%, the indicated value is \$250,000.

9. Reconciliation

Reconciliation is the process of analyzing the results of the different valuation approaches and arriving at a final opinion of value.

• Explanation: The appraiser considers the strengths and weaknesses of each approach and assigns a weighting to each based on its relevance and reliability.
• Application: Some approaches may be more reliable than others depending on the type of property and the availability of data.

10. Reporting

The final step is to communicate the appraisal findings in a report.

• Form Reports: Standardized reports used by lenders and other clients.
• Narrative Reports: Detailed reports that provide a comprehensive analysis of the property and market.
• Oral Reports: Verbal appraisals, typically followed by a written summary.

11. Professional Standards and Ethics

Appraisers must adhere to professional standards and ethics to maintain objectivity and integrity.

• Uniform Standards of Professional Appraisal Practice (USPAP): Establishes ethical and performance standards for appraisers.
• Appraisal Foundation: Oversees the development and promulgation of USPAP.
• Competency: Appraisers must have the knowledge and skills necessary to perform an assignment competently.
• Independence: Appraisers must be impartial and unbiased in their opinions.
• Scope of Work: Appraisers are responsible for specifying the scope of the work performed.
• Intended Use: Appraisers must understand the intended use of the appraisal by the client.

Practical Application and Related Experiments

• Sales Comparison Experiment:
  Find three similar properties in an area and compare them. Adjust sale prices by calculating the percentage difference and applying it to the comparable price.
• Cost approach research project:
  Choose a property and use online tools or professional services for an estimate replacement cost. Compare this cost with market value.
• Income approach analysis:
  Analyze investment property to determine annual operating expenses and net operating income. Discuss how differing cap rates change overall value.

Conclusion

This chapter has provided a comprehensive overview of appraisal fundamentals and principles. Understanding these concepts is essential for making informed decisions about real property. By adhering to professional standards and ethics, appraisers play a vital role in ensuring the integrity and transparency of the real estate market.