Foundations of Real Estate Appraisal and Financial Institutions

Chapter: Foundations of Real Estate Appraisal and financial institutions❓

Introduction

This chapter provides a comprehensive foundation for understanding real estate appraisal and its intricate relationship with financial institutions. We will delve into the fundamental principles, theories, and practices that underpin the appraisal process, emphasizing its crucial role in the financial ecosystem. We will also examine the regulatory framework governing appraisals, particularly in the context of financial institutions and lending.

1. The Nature of Value and Appraisal

1.1 Defining Value

• Value: The monetary relationship between properties and those who buy, sell, or use those properties (USPAP definition). Value is an opinion of worth, not a fact.
• Value is not intrinsic to a property but arises from the interaction between a property and market participants.
• Value is always tied to a specific date and definition.
• Price: The amount actually paid for a property in a transaction. It may or may not reflect value.
• Cost: The expenditure required to create or acquire a property. Cost does not necessarily equal value.

1.2 Characteristics of Value (DUST)

The four essential elements that contribute to value are:

1. demand❓: The desire and ability to purchase or lease property.
2. Utility: The ability of a property to satisfy a want or need.
3. Scarcity: The limited availability of a property relative to demand.
4. Transferability: The ability to convey ownership rights from one party to another.

1.3 Types of Value

Different value definitions serve specific purposes:

• market value❓❓: The most probable price a property should bring in a competitive and open market, assuming a willing buyer and seller acting prudently and knowledgeably, and sufficient time for exposure in the market.
• Investment Value: The value of a property to a particular investor based on their individual investment criteria.
• Insurable Value: The value of property for insurance purposes, typically representing the cost to replace or rebuild improvements.
• Liquidation Value: The value of a property when it must be sold quickly, often under duress.
• Going Concern Value: The value of an operating business, including both real and personal property, as well as intangible assets.

1.4 Definition of Appraisal

An Appraisal is (noun) the act or process of developing an opinion of value; an opinion of value. (Adjective) Of or pertaining to appraising and related functions such as appraisal practice or appraisal services. An appraisal must be numerically expressed as a specific amount, as a range of numbers, or as a relationship (e.g., not more than, not less than) to a previous value opinion or numerical benchmark (e.g., assessed value, collateral value). (USPAP definition).

2. Principles of Value

Several economic principles influence real estate value:

1. Principle of Anticipation: Value is based on the expected future benefits of ownership. Investors purchase properties based on anticipated future income or appreciation.

   • Example: A developer purchases land anticipating future demand for housing in the area.
     2. Principle of Change: Real estate markets are dynamic and constantly evolving. Value is affected by ongoing social, economic, governmental, and environmental changes.

   • Real Estate Cycle: Development -> Maturity -> Decline -> Revitalization
     3. Principle of Supply and Demand: Value is determined by the interaction of supply and demand in the marketplace.

   • Formula: Value = f(Supply, Demand)

   • When demand increases and supply remains constant, values rise. When supply increases and demand remains constant, values fall.
     4. Principle of Substitution: A buyer will pay no more for a property than the cost of acquiring an equally desirable substitute. This principle underlies all three approaches to value.
     5. Principle of Contribution: The value of a component of a property is measured by its contribution to the overall value, not its individual cost.

   • Formula: Value_improvement = Value_property - Value_{property without improvement}.

   • Example: Adding a swimming pool increases value only if the market desires a pool.
     6. Principle of Increasing and Decreasing Returns: Adding increments of one agent of production (land, labor, capital, coordination) will enhance income at a increasing rate until it reaches a point where income will diminish.

   • Example: Adding workers to a construction site will speed up the building process and increase profits at an increasing rate to a point, where there are to many workers and they begin getting in each other’s way and profits decline.
     7. Principle of Conformity: Value is maximized when properties are similar in style, age, and condition within a neighborhood. Non-conforming properties may experience diminished value.
     8. Principle of Consistent Use: When valuing a property, the land and improvements must be valued based on the same use. One cannot value the land with an improved property as vacant if the land has a higher and best use in an improved state.

3. The Appraisal Process

The appraisal process is a systematic approach to forming an opinion of value. It generally involves these steps:

1. Problem Definition:
   • Identify the client and intended users.
   • Determine the purpose of the appraisal (e.g., mortgage lending, estate settlement).
   • Define the type of value sought (e.g., market value, liquidation value).
   • Specify the property to be appraised (legal description, address).
   • State the effective date of the appraisal.
   • Identify relevant assumptions and limiting conditions.
   • Example: An appraiser is hired by a bank to determine the market value of a single-family home for mortgage lending purposes as of July 1, 2024.
2. Scope of Work Determination:
   • Identify the extent to which the property is to be inspected.
   • Identify the extent of data research and analysis.
   • Determine the report type (e.g. Summary, Narrative, restricted).
3. Data Collection and Analysis:
   • Gather general data: Regional, city, and neighborhood information affecting value.
   • Gather specific data: Information on the subject property and comparable sales.

4. Highest and Best Use Analysis: Determine the most probable and legal use of the property that is physical❓ly possible, appropriately supported, financially feasible, and results in the highest value.

   • Four Tests of Highest and Best Use:
     • Legally permissible.
     • Physically possible.
     • Financially feasible.
     • Maximally productive.
       5. Land Valuation: Determine the value of the site as if vacant and available for its highest and best use.

   • Methods of Land Valuation:

     • Sales comparison.
     • Allocation.
     • Extraction.
     • Land residual.
     • Development method.
     • Ground rent capitalization.
       6. Application of the Approaches to Value:

   • Sales Comparison Approach: Value is estimated by comparing the subject property to similar properties that have recently sold, making adjustments for differences.

     • Formula: Value_subject = Sales Price_comparable +/- Adjustments

   • Cost Approach: Value is estimated based on the cost to reproduce or replace the improvements, less depreciation, plus the land value.

     • Formula: Value = Cost of Reproduction/Replacement - Depreciation + Land Value

       • Income Capitalization Approach: Value is estimated based on the present value of the anticipated future income the property is expected to generate.

     • Formula: Value = Net Operating Income (NOI) / Capitalization Rate (Cap Rate)
       7. Reconciliation: Analyze and weigh the value indications resulting from the different approaches to arrive at a final opinion of value.
       8. Report: Communicate the appraisal results in a written report or oral presentation. The report must clearly state the appraisal problem, data and analysis, reasoning, and final opinion of value.

4. Approaches to Value

The three approaches to value provide different perspectives on how value is determined.

4.1 Sales Comparison Approach

• Based on the principle of substitution.
• Involves identifying comparable sales, making adjustments for differences in location, size, features, condition, and date of sale.
• Example: A comparable property with a similar square footage has a sales price of $300,000. The comparable has one less bedroom than the subject property. The appraiser determines that the additional bedroom increases the value by $10,000. The indicated value of the subject property is $310,000.
• Quantitative Adjustment: A dollar amount is added or subtracted from the comparable sales price to reflect the difference.
• Qualitative Adjustment: A relative comparison is used that assesses the superiority or inferiority of a comparable to the subject property.

4.2 Cost Approach

• Based on the principle of substitution.
• Most reliable for new or unique properties.
• Involves estimating the cost to reproduce or replace the improvements, deducting depreciation, and adding the land value.
• Depreciation: Loss in value due to physical deterioration, functional obsolescence, and external obsolescence.
  • Physical Deterioration: Wear and tear.
  • Functional Obsolescence: Design or feature inadequacies.
  • External Obsolescence: Factors outside the property’s boundaries.
• Formula: Value = Cost of Reproduction/Replacement - Depreciation + Land Value

4.3 Income Capitalization Approach

• Based on the present value of future income.
• Most applicable to income-producing properties (e.g., apartments, office buildings, retail).

• Involves estimating the property’s net operating income (NOI) and applying a capitalization rate (cap rate) to determine value.

  • NOI = Effective Gross Income - Operating Expenses
  • Cap Rate: The rate of return an investor requires on an investment property.
  • Formula: Value = Net Operating Income (NOI) / Capitalization Rate (Cap Rate)

5. Appraisal Reporting

The results of an appraisal are communicated in a report.

5.1 Types of Appraisal Reports

USPAP recognizes three main types of appraisal reports:

1. Self-Contained Appraisal Report: Contains a summary of all information that was deemed to be significant to the solution of the appraisal problem.

2. Summary Appraisal Report: A condensed version of the self contained report where the explanations are deleted.

3. Restricted Appraisal Report: Intended for limited use and reliance. This report type has no summary or explanation of the data or methods used.

5.2 Essential Elements of an Appraisal Report

• Identification of the client and intended users.
• Statement of the purpose of the appraisal.
• Identification of the property being appraised.
• Effective date of the appraisal.
• Description of the scope of work.
• Summary of the data and analysis used.
• Description of the appraisal methods used.
• Statement of the appraiser’s opinion of value.
• Signed certification by the appraiser.
• Assumptions and Limiting Conditions

6. Financial Institutions and Appraisal Regulations

6.1 The Role of Appraisals in Financial Institutions

• Financial institutions rely on appraisals to assess the value of real estate collateral for mortgage loans.
• Accurate appraisals are crucial for making sound lending decisions and managing risk.
• Appraisals also play a role in other financial transactions, such as estate planning, tax assessments, and foreclosures.

6.2 Federal Regulations

• The Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989 established minimum requirements for appraisals used in federally related transactions.
• FIRREA requires that appraisals be performed by state-licensed or certified appraisers who meet specific education, experience, and examination requirements.
• The Appraisal Subcommittee (ASC) of the Federal Financial Institutions Examination Council (FFIEC) oversees state appraiser regulatory programs.
• Title XI of FIRREA requires the establishment of appraisal standards and oversight of appraisers.

6.3 The Appraisal Foundation

• The Appraisal Foundation is a non-profit organization that develops and promotes appraisal standards and qualifications.
• The Appraisal Foundation consists of:
  • Appraisal Standards Board (ASB): Develops, interprets, and amends the Uniform Standards of Professional Appraisal Practice (USPAP).
  • Appraiser Qualifications Board (AQB): Establishes minimum education, experience, and examination requirements for state-licensed and certified appraisers.
  • Appraisal Practices Board (APB): Identifies and issues opinions on recognized valuation methods and techniques for the purpose of voluntary appraisal guidance.

6.4 The Uniform Standards of Professional Appraisal Practice (USPAP)

• USPAP is the generally recognized ethical and performance standards for appraisal practice in the United States.
• Appraisers must comply with USPAP when performing appraisals for federally related transactions.
• USPAP covers various aspects of appraisal practice, including ethics, competency, scope of work, data collection, analysis, and reporting.

7. Ethical Considerations

• Appraisers must maintain impartiality, objectivity, and independence in their work.
• Conflicts of interest must be disclosed.
• Confidentiality must be maintained.
• Appraisers must not engage in unethical or fraudulent practices, such as inflating values or accepting undisclosed fees.

Conclusion

A strong understanding of real estate appraisal principles and financial institution regulations is essential for success in the real estate and finance industries. Accurate appraisals protect lenders, investors, and consumers, and ensure the stability of the financial system. As the market continues to evolve, ongoing education and professional development are critical for appraisers to remain competent and ethical.