PROPERTY VALUATION

Valuing property accurately is very important to sellers, home purchasers, lenders, and
real estate investors. In this lesson, you'll learn about property valuation and some of its
key principles.

The Value of DUST

Real estate sellers, buyers, and lenders need be able to determine the worth of real
estate in order to make good financial decisions. Property valuation is the process
which determines the economic value of real estate.
Property valuation typically seeks to determine fair market value, the price at which a
knowledgeable seller willingly sells her property and a knowledgeable buyer will willingly
purchase it. In other words, it assumes both parties have all the relevant information
and neither are forced to buy or sell. Fair market value is not always equal to the sales
price. For example, a short sale of real estate may not bring fair market value because
the seller is distressed and must sell the property right away. Potential buyers know this
so they have a bargaining advantage and usually get the property for less than market
value.
Property valuation lies upon four foundational pillars. Demand, the first, is the
magnitude of interest and buying power in the market for purchasing property. Utility,
the second, is the ability of the real estate to satisfy the use or need of prospective
purchasers. Scarcity, the third, recognizes that there's a limited supply of real
estate. Transferability, the fourth, refers to the ease at which a parcel of real estate
can legally be transferred to a new owner. Many people use the acronym DUST to help
remember these four important concepts.

Property Principles
Let's explore principles that are commonly used to help determine property value.
The principle of conformity states that real estate whose use and style conforms with
property in the immediate area usually has a higher value than property that doesn't.
The principle of change recognizes that various forces act upon and change the real
estate market and property values. For example, pollution that spills into a residential
neighborhood is an environmental change that would lower property values.
The principle of substitution is simply the ability of one piece of real estate to be an
acceptable substitution of another. For example, if three-bedroom ranch homes in your
neighborhood are selling for $200,000, you're not going to get much more than
$200,000 for your own three-bedroom ranch home if you sell it. This is because buyers
can substitute your house for another one for that price. The principle of supply and
demand states that if supply of real estate exceeds demand, prices will go down, but if
demand exceeds supply, prices will go up.
The principle of highest and best use states that property will get the best price when
it is being used in a way that produces the highest economic value. For example, a
single-family home in an industrial area is not the highest and best use of the real estate
because an owner can get a better return by using the property for commercial use.
Remember, most people don't want to buy houses in the middle of an industrial park.
The principle of progression dictates that neighboring higher value real estate can
pull up the value of lesser value property in the same area. In other words, the worst
house on the block is worth more just because it's around the best houses in the
neighborhood.
The principle of regression is the inverse of the principle of progression. If a high-
valued property is surrounded by lower-valued property, the price of the higher value
property tends to be pulled down. The principle of contribution involves determining
how each component of the real estate contributes to its overall value. For example,
consider a residential lot with a house and pool. We can consider the land, the house,
and the pool as separate components that add to the overall value of the real estate.
The principle of anticipation involves assessment of the parcel's future potential. For
example, vacant land that's right next to a growing part of a vibrant city has more value
than land next to a desolate part of the same city. The principle of competition relates
to supply and demand; the more competition there is for a particular type of property,
such as residences or retail spaces, the higher the price will be.
Let's take a look at property appraisal and broad explanations of different approaches.
We'll discuss how these approaches work and what purposes they serve, and help
understand how they tie into the final reconciliation of value.

Property Appraisal Definition

Before Bob can complete his home purchase, the lender is going to insist on an
appraisal. Why? Lenders need to be sure the house is worth at least the mortgage
amount so if they have to sell it in foreclosure they won't take a loss. An appraiser is a
neutral third party paid by the lender, homeowner, or home buyer. An appraiser's job is
to determine an estimate of the property's fair market value.
Property appraisal is the process of creating an estimate of value for real estate. Fair
market value (FMV) is the price a property would sell for given a reasonable amount of
time and assumes the buyer and seller know about all the details of the property. For
the appraiser to get an accurate value, they must collect appropriate data and apply one
or more approaches. He or she will then explain the appraisal decision in a final
reconciliation of value.
FMV isn't always clear. Value differs with who the buyer is. A rental investor may value
a property differently than someone looking to buy a house to live in. Appraisers use
three different approaches to estimate value. Each approach tends to favor certain
kinds of deals. The three can be used in concert with each other to create a more
complete value estimate.

Data Collection
The appraiser must collect accurate data to make an informed estimate. The following
data is useful depending on the exact approach being used:

Recent sale prices of similar homes

New construction costs
Value of various improvements and their expected life spans for depreciation
Rental prices and predictable expenses of similar homes

Appraisers can pull prices and rental information from the Multiple Listing Service (MLS)
database or third party websites that share some of the MLS information. The MLS is
the central listing used by agents which shows current and recently sold properties. An
appraiser can learn how much new construction and remodeling costs by figuring out
the materials and labor charged by experienced builders in the local market. Major
replacements or additions to a house are depreciated over 27.5 years, or as directed in
IRS guidelines. And predictable expenses? Just think of the regular costs that apply to
any house: taxes, insurance, and utilities.

Property Appraisal Approaches

The cost approach expresses value as the cost of building an identical property on a
different piece of land nearby. It might be cheaper to build a new property instead of
buying an existing one. It is useful in valuing homes in new construction areas. In older
areas, new buildings may not be practical.
The comparative sales approach is most often used in retail purchasing. The
appraiser looks at what similar homes in the area have recently sold for. Any differences
between those homes and the one for sale are adjusted. Adjustments show how value
changes with the differences. An extra bedroom on the house for sale might add value
compared to the recently sold home. A smaller yard may mean a decrease in value
compared to one of the recent sales.
Depreciation General Definition
Buildings wear out, technology improves, and general consumer tastes change.
Neighborhoods and communities change. All of these are an unavoidable fact of real
estate. Real estate investors who understand depreciation have the knowledge to make
competent decisions in the face of these changes.
In the most general sense, depreciation refers to the diminished value of an asset as
time passes. The effects of time cause a building to gradually become obsolescent (or
out of date, aged). This can occur in different ways, including:

Physical
Functional
External
Economic

Let's take a deeper look at these forms of obsolescence and then learn a bit about
curable or incurable obsolescence.

Physical Obsolescence
Eventually, everything gets old and wears out. Paint fades, roofs start leaking, and
carpets become threadbare. A house that looks old and falling apart, on the inside or
outside, also hurts property values. Wear and tear is a constant consideration and
creates physical obsolescence or depreciation if left unrepaired.

Functional Obsolescence
If something about a house just seems too old fashioned and doesn't mesh with modern
tastes, it's a form of functional obsolescence. As technology improves, sometimes the
infrastructure of the house just isn't up to par anymore. More electronic items in a house
increases the power demands, necessitating more wiring and larger circuit breaker
boxes. A home with lower available amperage will require upgrades to accommodate
most families' computers, TV's, stereos, tools, and other electronics. More families
today demand at least two bathrooms in a home, and older homes may only have one.
These factors will further depreciate the value of a house.

External Obsolescence
External obsolescence are those depreciating factors that occur outside the property.
What if an interstate or high voltage power line runs right next to a house? Most people
don't want to live in that house if they can avoid it. Those factors will devalue a home
compared to a similar home that isn't subject to noise or eyesores. A neighboring house
with broken windows, a cracked driveway, and roof that is falling in diminishes the value
of surrounding homes.

Economic Obsolescence
A subset of external obsolescence is depreciation attributable to changing economic
conditions. If the neighborhood is full of vacant homes due to foreclosure, the property
value of the whole neighborhood will diminish. Zoning changes, regional loss of jobs, or
the new development of dense, low income housing may negatively impact property
values.

Area-Regional & Neighborhood Analysis in Property Appraisal

In this lesson, you will learn how to interpret the area-regional and neighborhood
analysis section in a property appraisal report. Many factors and considerations
determine if the current use of the property is the highest and best available.

Location

Miami metro area

The purpose of an area-regional and neighborhood analysis is to determine the highest

and best use available for a property. This is a critical aspect of any property appraisal;
you cannot accurately value a property until you make this determination. An area-
regional and neighborhood analysis provides both positive and negative information
about the property.
What is the Highest and Best Use?
Think about an old 1940s farmhouse on two acres on the corner of a major street,
surrounded by big box stores, fast food drive-through restaurants, and other shopping
centers. Comparable rural properties might sell for $100,000 or rent for $1,000 per
month. You might be able to re-build a similar structure for $200,000 or less. However,
these figures are basically meaningless. Why? Because the highest and best use of this
land is clearly not a farmhouse to own or rent out. The highest and best use might be a
drugstore or a bank that would sell for millions of dollars. You might be able to bulldoze
the farmhouse, lease the land to a drug retailer, and have them pay you $10,000 a
month for a ground lease.
Likewise, a neighborhood analysis might indicate problems that have a negative impact
on the area. Perhaps residential builders were overly exuberant and built homes much
further out than the market could ultimately bear. The area might have been rural with
few job prospects within reasonable commuting distance, or possibly completely
dependent on something like a natural gas field that has since been shuttered. The area
may not have adequate schools or may lack a grocery store and other shopping
options. Understanding these factors would be extremely important; it would just as
important, if not more so, than reviewing information about the structure itself such as
square footage and number of bedrooms.

Physical Considerations
One of the first physical considerations to look at includes the location and boundaries
of the area. Neighborhoods are typically bound by streets or geographic features such
as mountains or a canal. In Phoenix, Arizona, being north of a particular canal
determines if you are in Arcadia or Lower Arcadia, with a corresponding difference in
price of $300,000 or more. Access and transportation are another consideration; transit-
oriented developments located close to public transportation may sell for a large
premium. Land use and expected changes in the area's land use are important; if, for
instance, homes in the area are being torn down and replaced by trendy zero lot homes
and lofts. Hilly terrain might provide amazing views or it might make building on a site
too challenging to be profitable. Properties in a coastal area of California might benefit
from an ideal Mediterranean-like climate. An infill property in a developed area might
benefit from the utilities already being at the lot line.

Social Considerations
Even though social considerations may be more difficult to quantify, they can be just as
important as physical considerations. Think about things like having a house with a
Beverly Hills address or a retail store located on prestigious Fifth Avenue in New York
City. Is the property located in an area that tourists love to visit? Is it located in a school
district with great schools? Is there a conformity of development within the area where
everything is nice, or is there a hodgepodge of quality and different uses sandwiched
together? Is this an area where a lot of people live or want to live, and a place where
businesses want to be?

Market Data Analysis in Property Appraisal: Definition & Factors

Comparative Market Analysis (CMA) is a method for pricing a real estate property that is
for sale. Factors that are important in CMA include market area delineation, demand
analysis, supply analysis, absorption analysis, vacancy analysis, and market rental
analysis.

Market Analysis
Comparative Market Analysis (CMA) is a method used to help buyers, sellers, and
real estate agents or brokers to fairly price a property. Simply put, it is an analysis of the
cost of similar properties within the same area of a community, as well as other
characteristics such as features of the property and vacancy rates in the area.
Adjustments are made according to a property's individual differences from similar
properties nearby. Most often a real estate agent will assist a seller by examining other
properties in order to help a seller set an appropriate list price or help a buyer formulate
a suitable offer.

Supply and Demand Analysis

A supply and demand analysis requires several modifications to standard
microeconomic procedures. One of the most important factors is the unique
characteristics of a specific real estate market. The following unique characteristics are
of particular importance:
1. Durability - Real estate property is generally considered very durable. Homes and
other buildings can last for centuries and the land which they are on can be considered
'indestructible.' For this reason, real estate markets are often gauged by a 'stock/flow
market' standard. Real estate supply stock is determined by the stock of the previous
period, deterioration rate of currently existing stock, renovation rates of currently
existing stock, and amount of new development. About ninety-eight percent of supply is
already existing real estate, while only two percent is from new development.
2. Heterogeneity - It can be difficult to price real estate in terms of its exact location,
financing, and the building itself. For this reason, supply is defined in terms of service
units. This means that any physical unit of a real estate property is able to be
deconstructed according to the services it provides or may provide.
3. High Transaction Costs - Transaction costs can include real estate fees, moving
expenses, legal fees, deed registration, and land transfer taxes. Even the seller typically
ends up paying between one and six percent of the purchase price on real estate
transactions.
4. Time Delays - Market adjustment can be affected by time delays in the buying
process. For this reason, an imbalance can be found even in a short length of time.
5. Investment Goods and/or Consumption Goods - An investment good is expected
to gain a return. Consumption goods are expected to be utilized in some way. Many
buyers combine these functions, causing over-investment in real estate property.
6. Immobility - This refers to the fact that the goods in real estate are unable to be
moved, leaving buyers to have to sell the property, whether it be commercial or
residential (minus the consideration of mobile homes).
7. Demand for Housing - The demands of residential markets are generally
determined by demographic information but can also be affected by property price,
income, financing, consumer and/or investor preferences, and prices of substitutes and
complements.
8. Supply of Housing - Supply is determined by use of land, labor, and several inputs
like building materials and utilities. The quantity of new supply is determined by input
costs, existing house stock prices, and production technology. Estimated cost
percentages can be estimated by the costs of acquisition, site improvement, labor,
materials, financing, administrative procedures, and marketing.

Other Definitions and Factors

Market Area Delineation - This process defines the geographic extent of demand for a
given property. This is often used with commercial real estate. For example, the market
delineation for a space in a strip mall may state that this location will likely get
customers from a three county area. This is important for commercial real estate buyers
in that it will affect the number of potential customers and that will have an effect on the
profitability of their business.
Absorption Analysis - This method of analysis allows buyers, sellers, and real estate
agents or brokers to ensure that their specific buying and selling strategies are aligned
with the landscape of their particular market. Absorption rate is the average number of
months it should take to sell homes that are currently listed in the local market. Past
sales and current inventory are not sufficient factors in determining the landscape of
local real estate. This method allows sellers to align their list price with the necessary
time frame to sell their property. It allows buyers to make an appropriate and fair offer
on a property if the list price is too high. Real estate agents and brokers are able to
utilize this analysis to have a competitive edge with clients as they gain an upper hand
when negotiating contracts and offers. The knowledge of absorption rate is also one of
the most effective ways to demonstrate knowledge of the market, which will help to
better serve current clients and interest new ones.

Site Analysis Defined

A site analysis involves analyzing the value of the site in regards to its characteristics
and in relation to the real estate in the general area surrounding the site. In some case
of the subdivision lot based on its individual characteristics and in the context of the
neighborhood it's in.

Legal Characteristics of Site

1. Examine the legal characteristics of the residential lot when performing her site
analysis. She'll need to determine the correct legal description of the property,
usually from a recorded deed. The legal description will provide the legally
recognized location and boundaries of the property.
2. Examine the tax burden on the property to determine whether it's comparable to
surrounding properties of similar size and characteristics. Keep in mind that a
high tax burden may adversely affect the value of real estate -- especially if the
burden is out of sync with similar properties in the neighborhood.
3. Examine the nature and extent of public and private restrictions burdening the
property. Review the city's zoning ordinances in relation to the property, which is
a public restriction. Zoning ordinances dictate how you can use a piece of
property within a specific geographical area, known as a zone. For example,
because the property is going to be used as a single-family residence, Nicole will
want to make sure the property is zoned for residential housing instead of
commercial or industrial uses.
4. Determine whether the property is burdened by easements and restrictive
covenants. An easement is defined as a right to use land owned by someone
else for a specific purpose. For example, the probably to find utility easements on
the lot permitting the power and water companies to lay pipes and lines across
part of the property. On the other hand, a restrictive covenant is a legally binding
private agreement that places restrictions on how the land can be used. For
example, it's quite common for modern residential subdivisions to assert some
control over the architectural features of home exteriors, prohibit fences and
prohibit boats and RVs being parked on the property.
 5. To know whether someone other than the current property owner has a legal
interest in the property. For example, the owner may have leased the property to
someone else and also determine if someone other than the current owner holds
mineral or water rights that are part of the property.

Physical Characteristics of Site

To carefully review the property in terms of its physical characteristics as well as
compare the characteristics of the subject property to the characteristics of the
properties surrounding it and also take a look at the size and shape of the property, as
well as examine its topography. Is it hilly or flat? Is there water on it? The nature of the
soil may be examined, as well as the nature of any landscaping. Nicole will also note
whether public utilities are readily available on the site (e.g., whether the site has ready
access to the city's water and sewage system).

Cost Approach to Property Valuation: Definition & Process

Cost Approach Defined

The cost approach to property valuation compares the price of one piece of real estate
with how much it would take to build a similar property. It is one of the three primary
methods of property appraisal. Buyers work on the assumption that it doesn't make
sense to pay more for a property when comparable newly built real estate costs less
money. Cost approach can be calculated by the following formula:
Building Construction Cost - Depreciation of Existing Property + Cost of Land =
Market Value

Cost Approach Limitations

The cost approach system has many limitations in practice. The method assumes that
the buyer could find the land to build an identical property and that's not always the
case. Higher cost of land on another lot might drive the price up even if building costs
are reasonable. Construction costs are another vital factor. Would similar construction
methods be used to build a new home in the area to those of existing homes there - or
would the construction be functionally equivalent but with hidden expenses? One
example of a building cost would be the material used to build walls in a new home. Do
plaster walls have the same value as drywall in real world purchase prices?
Additionally, the local political or economic environment might not be friendly to new
construction. The area could already be fully developed. Local planning authorities
might be so restrictive that new construction is not worth the trouble. Unfortunately,
these factors aren't considered in the cost approach.
Another consideration is that older property can have major depreciation. It might be
difficult to accurately account for this. What if a certain construction material or method
is no longer used? Sometimes making adjustments for depreciation is a challenging
process. The appraiser has room for a lot of subjectivity.

Cost Approach Benefits

One benefit of the cost approach is that it can help identify market status. If the building
cost of a new house would be greater than the value of an existing house in an area, it's
a sign the older property could be undervalued. Likewise, if new home construction
costs are cheaper than an existing property's value, the cost approach may reveal that
the older property is overvalued.
The cost approach also works with other methods. If another method's accuracy is in
doubt, the cost approach may give a stronger value estimate. A second or third
valuation of a property offers other data points to estimate a fair market price.

The Sales Comparison Approach to Property Valuation

The Comparative Sales Approach Method Defined

Every homeowner has given some thought as to what their home is worth. But how do
they know with any certainty if they want to sell? The seller might have an overly
optimistic idea of value. On the other hand, the seller might think the house is worth far
less than it actually is. You might have heard of a real estate agent 'pulling comps' on a
house. A comparative sales approach method of property valuation can help estimate
a realistic fair market value.
The comparative sales approach looks at a selection of similar recently sold properties
near the subject property. The property being appraised is the subject property. Similar
homes are called comparables. These comparables are ideally as similar as possible
houses that have been sold very recently. Comparables have to be actual sales. People
can ask any price they want for a house, but actual sale prices are factual and provide a
true benchmark for comparison. If a long time has passed since the sale, the estimate
of value will not be as precise. The same is true if there are many major differences
between the properties.
Real estate agents , as mentioned above, use the comparable sales approach a
research method to help sellers determine a reasonable listing price. An agent could
also estimate comparables for a buyer to make sure they aren't overpaying for a house.
The Comparative Sales Approach Method in Practice

The Income Approach to Property Valuation

Income Approach Definition

Bill wants to buy a rental property. Since this won't be the house where he lives, his
main concern is making a profit. An investor's point of view on value is often different
than a retail buyer. Bill might be willing to overpay for his own house, but a rental should
be treated as a business decision. An income approach for appraisal is an ideal method
in this case.
The income approach to property valuation is suitable for income producing real
estate. It weighs the potential income of the property to the purchase price. Within the
approach, there are three common techniques. These include direct capitalization,
discounted cash flow, and gross income multiplier methods.

Direct Capitalization
Direct capitalization is calculated by dividing the net operating income by the desired
capitalization rate (cap rate). The capitalization rate formula is:
capitalization rate = net operating income / sale price
Net operating income for a rental house is:
rents - mortgage interest - depreciation - reserve funds for future expenses
If the net operating income a property is $4,000 per year and it will sell for $150,000, the
cap rate is 2.66%. If the same property brought in $6,500 per year, the cap rate would
be 4.33%.
To find the direct capitalization value, let's take that $6,500 net operating income and
divide it by a goal cap rate of 6%. The direct capitalization method tells us that the
investor should not pay more than $108,333.33. With the current level of income, that is
how much the house has to be bought for to meet the 6% cap rate goal.

Discounted Cash Flow

The discounted cash flow method is mathematically the same as the net present
value formula in other types of investing. It is the sum of the present values of rents over
a period of time. Present and future values can be quickly and easily calculated using
spreadsheet software or financial calculators. The investor would be interested in
purchasing an income producing property if the present value of the expected future
rents over a desired time period is greater than the purchase price.
Let's say in a given property the present value of all the future net income in a desired 5
year investment period is $75,000. Under those conditions, an investor would not want
to pay anything more than $75,000. That would mean the property could break even in
5 years. Every dollar below that amount increases the profit margin and drops the break
even time line..

Gross Income Multiplier

The gross income multiplier method is a ratio of the selling price over the gross
monthly rent:
Selling price / gross monthly income = gross income multiplier